CHAPTER :- 6

BANKING
 Commercial Bank
A commercial bank is that financial ins tu on which accepts deposits from
the people and gives loans for the purpose of consump on or investment.
Other func on of commercial banks are credit crea on, transfer of funds,
agency jobs and general services.

Important Note :-
 A financial ins tu on is not a banking ins tu on if it does not perform
the two primary func ons : (i) accep ng chequeable deposits, and (ii)
making advances or offering loans.
 LIC is a financial ins tu on but not a bank, as it offers loans but does not
accept chequeable deposits from the people.
 Post offices are not banks, even though they accept deposits from the
people. Because they not offer loans.
 Assump ons of Money/ Credit Crea on Process :-
(i) All the commercial banks in the economy is treated as single unit as is
termed as ‘Banks’.
(ii) There are no cash receipts and payments i.e. all the transac ons are
routed through banks only.

 Process of Money Crea on by the Commercial Banks

i) Banks receive cash deposits from the people. These are called
‘primary deposits’
ii) Bank lend money many mes more than their cash reserves.
iii) Money is lent by the commercial bank not in the form of cash, but in
the form of ‘credit entry’ in the accounts of the borrowers. These
credit entries are known as secondary deposits.
iv) The borrower can issue cheque against ‘credit’ (loans) in their
accounts. The cheque circulates in the economy as money.
v) Primary deposits + Secondary deposits = Demand deposits held by
the people in the commercial bank.

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 vi) Total demand deposits with the banks are many mes more than the
cash reserves of the commercial banks. This is because the
commercial banks know that all the depositors would not show up in
the banks to withdraw all their deposits by way of cash.
vii) If experience shows that withdrawals are generally around percent of
demand deposits, the banks need to keep only percent of deposits as
cash reserve.
viii) All demand deposits held by the people serve as money supply in the
economy, just like cash held by the people.
ix) Demand Deposit serving as money supply is called bank money. This
is money created by the banks. Because this is circula ng in the
system not in the form of cash, but in the form of cheques issued by
the banks to the holders of demand deposits.

Note :- When credit crea on process ends?

Ans. It comes to an end when total reserves becomes equal to ini al
deposits.

Demand Deposits = 1 ̸ CRR * Cash Reserves or

Primary Deposits

 Factor affec ng Money Crea on by the Commercial Banks

1. Cash Balances with Commercial Banks (Primary Deposits) :-
 These can be used as cushion money (emergency fund) for the
crea on of credit.
 Higher these cash balances, greater the money crea on (or credit
crea on) capacity of the commercial banks.
2. Cash Reserve Ra o (CRR) :-
 Higher the CRR , lower the Capacity to create money.
 Higher the Vault cash, lower would be the capacity to create money.

 Primary Deposits and Secondary Deposits

Primary Deposits cash deposits with the commercial banks by the people.
These are a part of Total Demand Deposits of the banks.

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 Secondary Deposits are those which arise on account of ,loans by the banks
to the people. These are a part of Total Demand Deposits of the banks.

Note :- Primary Deposits indicate savings of the depositors with the banks,
secondary deposits indicate borrowings of the depositors from the banks.
Secondary deposits are also called Deriva ves Deposits.

Total Demand Deposits of Commercial Banks = Primary Deposits +

CC
Secondary Deposits
CRR And Credit Mul plier

 In India, CRR is determined by RBI (Reserve Bank of India). Therefore, it is

also called LRR (Legal Reserve Ra o).
 The commercial bank is required to keep the cash reserve with the RBI.
 Once CRR is known, we can find out ‘credit mul plier’, or the number of
mes the commercial banks can create credit, per unit of their cash
reserves with RBI. Credit Mul plier indicates the maximum amount of
money that the commercial banks can create, given their cash reserves
with the RBI.

K = 1/ CRR

Here, k= Credit Mul plier, CRR= Cash reserve ra o.

 The Central Bank

The central bank is an apex bank that controls the en re banking system of
a country. It is sole agency of note-issuing and controls the supply of money
in the economy. It serves as a banker to the government and manages forex
reserves of the country.

 Func ons of the Central Bank

1. Bank of Issuing Notes :- Central Bank of country has the exclusive
right of issuing notes. This is called Currency Authority func on of the
central bank. The notes issued by the central bank are unlimited legal
tenders.

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 2. Banker, Agent, Advisor to the Government :- Central bank is a
banker, agent, and Financial Advisor to the government.
i) As a banker to the government, it manages accounts of the
government.
ii) As an agent to the government, it buys and sells securi es on
behalf of the government.
iii) As an advisor to the government, it frames policies to regulate
the money market.

3. Banker`s Bank and Supervisory Role :-

i) The Central Bank accepts deposit from the commercial bank.
And offer them loans.
ii) The central bank provides ‘Clearing House’ facility to the
commercial bank. It is a cheque clearing facility provided at one
centre to all the banks.
iii) In its supervisory role, the central bank ensures that the
commercial bank shows compliance to its direc ves,
par cularly rela ng to CRR and SLR. The central bank changes
CRR, SLR as and when required. It ensures that the commercial
banks shows compliances to these changes so that the desired
targets are achieved.

4. Lenders of the last Resort :- It means is a commercial bank fails to get

financial accommoda on from anywhere, it approaches the central
bank as a last resort. Central bank advances loans to such a bank
against approved securi es . By offering loans to the commercial banks
in situa on of emergency, the central bank ensures (i) that the banking
system of the country does not suffer any set- back, and (ii) that money
market remains stable.

5. Custodian of Foreign Exchange :- Central bank is the custodian of

na on’s foreign exchange reserves. It also exercises ‘ managed floa ng’
to ensures stability of exchange rate in the interna onal money
market.

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 6. Clearing House Func on :- Central Bank performs the func ons of
clearing house.

7. Control of Credit :- The principal func on of the central bank is to

control the supply of credit in the economy. It implies increase or
decrease in the supply of money in the economy by regula ng the
‘crea on of credit’ by the commercial banks. During infla on, the
supply of money is reduced and during defla on, it is reduces.

 Difference between The Central Bank and Commercial Bank

Basis of The Central Bank Commercial Bank
Difference
1. Meaning The central bank is the apex A commercial is that financial
bank- the bank of all banks in the ins tu on which accepts deposits
country. All the commercial from the general public and offers
banks func on under the loans to people for the purpose of
control of the central bank. consump on and investment.
It accepts deposits from the
commercial bank and advances
loans to them. But. It does not
deal with the general public.
2. Role in The central bank regulates the A commercial bank contributes to
money supply of money. the supply of money by way of
supply credit crea on.
3. Role in The central bank is a custodian A commercial bank is not a
forex of forex reserves of the country. custodian of forex reserves of the
Reserves It conducts ‘managed floa ng’ country. However, it deals in the
to regulate exchange ate of the sale and purchase of foreign
domes c currency. exchange for the purpose of
profit.
4. Currency The central bank is a note- A commercial bank is not a note-
Authority issuing authority. It is a currency issuing authority.
authority of the country.

5. Goal The central bank focuses growth A commercial bank focuses on

and stability of the economy. profit maximisa on.

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 Control of Money Supply (Or Credit Supply) by the Central Bank
The central bank adopts various measures to control the supply of money in
the economy. Largely, these measures relates to credit supply by the
commercial banks. These are broadly classified as:
(A) Quan ta ve Instruments
(B) Qualita ve Instruments

(A) Quan ta ve Instruments of Credit Control

Quan ta ve instruments are those instruments of credit control which
focus on the overall supply in the economy.
1) Bank Rate :- Bank rate refers to the rate of interest at which the RBI
lends money to the commercial banks. The increase (or decrease) in
bank rate is o en followed by increase (or decrease) in the market rate
of interest. Accordingly, the cost of credit (also called the cost of
capital) changes in the market.

 Rise in Bank Rate Rise in market rate if interest Rise in cost of

capital Fall in demand for credit Fall in supply of money
Infla on is controlled.
 Fall in Bank Rate Fall in market rate of interest Fall in cost of
capital Rise in demand for credit Rise in the supply of money
Defla on is controlled.

2) Open Market Opera ons :- Open market opera ons refer to the sale
and purchase of securi es in the open market by the RBI on behalf of
the government. By selling the securi es (Like, Na onal Saving
Cer ficate-NSCs) in the open market, the RBI soaks liquidity (cash)
from the economy. And by buying the securi es, the RBI releases
liquidity.

 Sale of Securi es by the RBI Soaks liquidity and leads to a fall in

cash reserves of the commercial banks Fall in credit crea on
capacity if the commercial banks Fall in money supply Infla on
is controlled.
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  Purchase of Securi es by the RBI Release liquidity and leads to a
rise in cash reserves of the commercial banks Rise in credit
crea on capacity of the commercial banks Rise in money supply
Defla on is controlled.

3) Repo Rate :- The rate at which RBI offers shorts period loans to the
commercial banks by buying the government securi es in the open
market is called ‘Repo Rate’. In fact, it is a Repurchase Rate. A
repurchase agreement is signed by both the par es sta ng that the
securi es will be repurchased by the commercial banks on a given date
at a predetermined price. During infla on , the cost of capital is
increased by increasing the repo rate. On the other hand, during
defla on, the cost of capital is reduced by reducing the repo rate.
 Rise is Repo Rate Rise in cost of capital Fall in demand for
credit Fall in supply of money by the commercial banks
Infla on is controlled.
 Fall in Repo Rate Fall in cost of capital Rise in demand for
credit Rise in supply of money by the commercial banks
Defla on is controlled.

4) Reverse Repo Rate :- The rate at which Rbi accepts deposits from the
commercial banks (through government securi es) is called ‘Reverse
Repo Rate’. It is also called Reverse Repurchase Rate. In this case, a
reverse repurchase agreement is signed by both the par es sta ng that
the securi es will be repurchased on a given date at a predetermined
price. Reverse Repo Rate allows the commercial banks to generate
interest income.
When reverse repo rate is lowered, banks are discouraged to park their
surplus funds with the RBI. On the other hand, a rise in reverse repo
rate may induce the commercial banks to park more funds with the RBI
to generate interest income.

 Fall in Reverse Repo Rate Less fund are parked by the

commercial banks with the RBI to generate interest income
More funds are used as a CRR-funds with the RBI, for the crea on

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 of credit Supply of money increases Defla on is
controlled.
 Rise in Reverse Repo Rate More funds are parked by the
commercial banks with the RBI to generate interest income
Less funds are used a CRR-funds with the BRI, for the crea on of
credit Supply of money decreases Infla on is
controlled.

5) Cash Reserve Ra o (CRR) :- It refers to the minimum percentage of a

bank’s total deposits required to be kept with the RBI. It is fixed by the
RBI and is varied from me to me to regulate the supply of money in
the economy. When the supply of money is to be increased, CRR is
lowered, and when the supply of money is to be reduced, CRR is
raised.
 Rise in CRR Rise in cash reserves for a given amount of demand
deposits Fall in money supply of the commercial banks
Infla on is controlled.
 Fall in CRR Fall in cash reserves for a given amount of demand
deposits Rise in money supply of the commercial banks
Defla on is controlled.

6) Statutory Liquidity Ra o (SLR) :- Every Bank is required to maintain a

fixed percentage of its assets in the form of liquid assets, called SLR.
The liquid assets include : (i) cash, (ii) gold, and (iii) unencumbered
approved securi es. The rate of SLR is fixed by the RBI and varied from
me to me. To decrease the supply of money (as during infla on) ,
the central bank increase SLR. On the other hand, SLR is reduced to
increase the supply of money (as during defla on ) in the economy.

 Rise in SLR Rise in liquid assets to be held by the commercial

banks with themselves Fall in the availability of funds for CRR-
deposits with the RBI Fall in money supply of the commercial
banks Infla on is controlled.
 Fall in SLR Fall in liquid assets to be held by the commercial
banks with themselves Rise in the availability of the funds

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 for CRR-deposits with the RBI Rise in money supply of the
commercial banks Defla on is controlled.

(B) Qualita ve Instruments of Credit Control

Qualita ve instruments are those instruments of credit control which
focuses on selected sectors of the economy.

1) Margin Requirement :- The margin requirement refers to the

difference between the current value of the security offered for loan
(called collateral) and the value of loan granted. The margin
requirement is raised when the supply of money needs to be reduced.
The margin requirement is lowered when the supply of money is o be
increased.

 Rise in Margin Requirement Fall in demand for credit Fall

in supply of credit by the commercial banks Fall in money
supply Infla on is controlled.
 Fall in Margin Requirement Rise in demand for credit Rise
in supply of credit by the commercial banks Rise in money
supply Defla on is controlled.

2) Ra oning of Credit :- Ra oning of credit refers to fixa on of credit

quotas for different business ac vi es. Ra oning of credit is introduced
when the supply of credit is to be checked par cularly for specula ve
ac vi es in the economy. The RBI fixes credit quota for different
business ac vi es. The commercial banks cannot exceed the quota
limits while gran ng loans. This restricts the supply of money in the
economy. And infla on is controlled . On the other hand, ra oning of
credit (is already in prac ce ) is withdrawn to increase the supply of
money. This controls infla on.

 Introduc on of Credit Ra oning Decrease the supply of

credit by the commercial banks Decrease the supply of
money Infla on is controlled.

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  Withdrawal of Credit Ra oning Increase the supply of credit
by the commercial banks Increase the supply of money
Defla on is controlled.

3) Moral Suasion :- It is like rendering an advise to the commercial banks

by the RBI to follow its direc ves. The banks are advised to restrict
loans during infla on, and be liberal in lending during defla on.
Important Note :-
Moral suasion is a combina on of both ‘persuasion’ and ‘pressure’. The
RBI tries to persuade the commercial banks to follow its direc ves, but
if persuasion does not work, it uses the required pressure as an apex
bank of the country. If pressure also does not work, the RBI can use
direct ac on which includes derecogni on of the concerned bank.

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