Commercial Bank And Credit Creation By Commercial Bank

1. Commercial bank is a financial institution which performs the functions

of accepting deposits from the public and making loans and investments,
with the motive of earning profit.
2. Process of money creation/deposit creation/credit creation by the
commercial banking system.
(a) Let us assume that the entire commercial banking system is one unit. Let
us call this one unit simply “banks’. Let us also assume that all receipts and
payments in the economy are routed through the banks. One who makes
payment does it by writing cheque. The one who receives payment deposits
the same in his deposit account.
(b) Suppose initially people deposit Rs.1000. The banks use this money for
giving loans. But the banks cannot use the whole of deposit for this purpose.
It is legally compulsory for the banks to keep a certain minimum fraction of
these deposits as cash. The fraction is called the Legal Reserve Ratio (LRR).
The LRR is fixed by the Central Bank. It has two components. A part of the
LRR is to be kept with the Central bank and this part ratio is called the Cash
Reserve Ratio. The other part is kept by the banks with themselves and is
called the Statutory Liquidity Ratio.
(c) Let us now explain the process, suppose the initial deposits in banks is
Rs.1000 and the LRR is 10 percent. Further, suppose that banks keep only
the minimum required, i.e., Rs.100 as cash reserve, banks are now free to
lend the remainder Rs.900. Suppose they lend Rs.900. What banks do to
open deposit accounts in the names of the borrowers who are free to
withdraw the amount whenever they like.
• Suppose they withdraw the whole of amount for making payments.
(d) Now, since all the transactions are routed through the banks, the money
spent by the borrowers comes back into the banks into the deposit accounts
of those who have received this payment. This increases demand deposit in
banks by ?900. It is 90 per cent of the initial deposit. These deposits of
Rs.900 have resulted on account
of loans given by the banks. In this sense the banks are responsible for
money creation. With this round, increased in total deposits are now
Rs.1900 (=1000 + 900).
(e) When banks receive new deposit of ?900, they keep 10 per cent of it as
cash reserves and use the remaining Rs. 810 for giving loans. The borrowers
use these loans for making payments. The money comes back into the
accounts of those who have received the payments. Bank deposits again
rise, but by a smaller amount of Rs.810. It is 90 per cent of the last deposit
creation. The total deposits now increase to Rs.2710 (=1000 + 900 + 810).
The process does not end here.
(f) The deposit creation continues in the above manner. The deposits go on
increasing round after round but Deposit Creation By Commercial Banks
each time only 90 per cent of the last round deposits. At the same time cash
reserves go on increasing, each time 90 per cent of the last cash reserve.
The deposit creation comes to end when the total cash reserves become
equal to the initial deposit. The total deposit creation comes to Rs.10000, ten
times the initial deposit as shown in the table.

It can also be explained with the help of the following formula:

3. Banks required to keep only a fraction of deposits as cash reserves Banks

are required to keep only a fraction of deposits as cash reserves because of
the following two reasons:
(a) First, the banking experience has revealed that not all depositors
approach the banks for withdrawal of money at the same time and also that
normally they withdraw a fraction of deposits.
(b) Secondly, there is a constant flow of new deposits into the banks.
Therefore to meet the daily demand for withdrawal of cash, it is sufficient for
banks to keep only a fraction of deposits as a cash reserve.
4. When the primary cash deposit in the banking system leads to multiple
expansion in the total deposits, it is known as money multiplier or credit
multiplier.

Central Bank And Their Functions

1. The central bank is the apex institution of a country’s monetary system.

The design and the control of the country’s monetary policy is its main
responsibility. India’s central bank is the Reserve Bank of India.
2. Functions of Central Bank.
(a) Currency Authority:
(i) The central bank has the sole monopoly to issue currency notes.
Commercial banks cannot issue currency notes. Currency notes issued by
the central bank are the legal tender money.
(ii) Legal tender money is one, which every individual is bound to accept by
law in exchange for goods and services and in the discharge of debts.
(iii) Central bank has an issue department, which is solely responsible for the
issue of notes.
(iv) However, the monopoly of central bank to issue the currency notes may
be partial in certain countries.
(v) For example, in India, one rupee notes and all types of coins are issued
by the government and all other notes are issued by the Reserve Bank of
India.
(b) Banker, Agent and Advisor to the Government: Central bank
everywhere in the world acts as banker, fiscal agent and adviser to their
respective government.
(i) As Banker: As a banker to the government, the central bank performs
same functions as performed by the commercial banks to their customers.
• It receives deposits from the government and collects cheques and drafts
deposited in the government account.
• It provides cash to the government as resumed for payment of salaries and
wages to their staff and other cash disbursements.
• It makes payments on behalf of the government.
• It also advances short term loans to the government.
• It supplies foreign exchange to the government for repaying external debt
or making other payments.
(ii) As Fiscal Agent: As a fiscal agent, it performs the following functions :
• It manages the public debt.
• It collects taxes and other payments on behalf of the government.
• It represents the government in the international financial institutions
(such as World Bank, International Monetary Fund, etc.) and conferences.
(iii) As Adviser
• The central bank also acts as the financial adviser to the government.
• It gives advice to the government on all financial and economic matters
such as deficit financing, devaluation of currency, trade policy, foreign
exchange policy, etc.
3. Banker’s Bank and Supervisor:
(a) Banker’s Bank: Central bank acts as the banker to the banks in three
ways: (i) custodian of the cash reserves of the commercial banks; (ii) as the
lender of the last resort; and (iii) as clearing agent.
(i) As a custodian of the cash reserves of the commercial banks, the central
bank maintains the cash reserves of the commercial banks. Every
commercial bank has to keep a certain percent of its cash reserves with the
central bank by law.
(ii) As Lender of the Last Resort.
• As banker to the banks, the central bank acts as the lender of the last
resort.
• In other words, in case the commercial banks fail to meet their financial
requirements from other sources, they can, as a last resort, approach to the
central bank for loans and advances.
• The central bank assists such banks through discounting of approved
securities and bills of exchange.
(ii) As Clearing Agent
• Since it is the custodian of the cash reserves of the commercial banks, the
central bank can act as the clearinghouse for these banks.
• Since all banks have their accounts with the central bank, the central bank
can easily settle the claims of various banks against each other simply by
book entries of transfers from and to their accounts.
• This method of settling accounts is called Clearing House Function of the
central bank.
(b) Supervisor
(i) The Central Bank supervises, regulate and control the commercial banks.
(ii) The regulation of banks may be related to their licensing, branch
expansion, liquidity of assets, management, amalgamation (merging of
banks) and liquidation (the winding of banks).
(iii) The control is exercised by periodic inspection of banks and the returns
filed by them.
4. Controller of Money Supply and Credit: Principal instruments of
Monetary Policy or credit control of the Central Bank of a country are broadly
classified as:
(a) Quantitative Instruments or General Tools; and
(b) Qualitative Instruments or Selective Tools.
(a) Quantitative Instruments or General Tools of Monetary Policy: These are
the instruments of monetary policy that affect overall supply of money/credit
in the economy. These instruments do not direct or restrict the flow of credit
to some specific sectors of the economy. They are as under:
(i) Bank Rate (Discount Rate)
• Bank rate is the rate of interest at which central bank lends to commercial
banks without any collateral (security for purpose of loan). The thing, which
has to be remembered, is that central bank lends to commercial banks and
not to general public.
• In a situation of excess demand leading to inflation,
-> Central bank raises bank rate that discourages commercial banks in
borrowing from central bank as it will increase the cost of borrowing of
commercial bank.
-> It forces the commercial banks to increase their lending rates, which
discourages borrowers from taking loans, which discourages investment.
-> Again high rate of interest induces households to increase their savings
by restricting expenditure on consumption.
-> Thus, expenditure on investment and consumption is reduced, which will
control the excess demand.
• In a situation of deficient demand leading to deflation,
-> Central bank decreases bank rate that encourages commercial banks in
borrowing from central bank as it will decrease the cost of borrowing of
commercial bank.
-> Decrease in bank rate makes commercial bank to decrease their lending
rates, which encourages borrowers from taking loans, which encourages
investment.
-> Again low rate of interest induces households to decrease their savings by
increasing expenditure on consumption.
-> Thus, expenditure on investment and consumption increase, which will
control the deficient demand.
(ii) Repo Rate
• Repo rate is the rate at which commercial bank borrow money from the
central
bank for short period by selling their financial securities to the central bank.
• These securities are pledged as a security for the loans.
• It is called Repurchase rate as this involves commercial bank selling
securities
to RBI to borrow the money with an agreement to repurchase them at a later
date and at a predetermined price.
• So, keeping securities and borrowing is repo rate.
• In a situation of excess demand leading to inflation,
-> Central bank raises repo rate that discourages commercial banks in
borrowing from central bank as it will increase the cost of borrowing of
commercial bank.
-> It forces the commercial banks to increase their lending rates, which
discourages borrowers from taking loans, which discourages investment.
-> Again high rate of interest induces households to increase their savings
by restricting expenditure on consumption.
-> Thus, expenditure on investment and consumption is reduced, which will
control the excess demand.
• In a situation of deficient demand leading to deflation,
-> Central bank decreases Repo rate that encourages commercial banks in
borrowing from central bank as it will decrease the cost of borrowing of
commercial bank.
-> Decrease in Repo rate makes commercial bank to decrease their lending
rates, which encourages borrowers from taking loans, which encourages
investment.
-> Again low rate of interest induces households to decrease their savings by
increasing expenditure on consumption.
-> Thus, expenditure on investment and consumption increase, which will
control the deficient demand.
(iii) Reverse Repo Rate
• It is the rate at which the Central Bank (RBI) borrows money from
commercial bank.
• In a situation of excess demand leading to inflation, Reverse repo rate is
increased, it encourages the commercial bank to park their funds with the
central bank to earn higher return on idle cash. It decreases the lending
capability of commercial banks, which controls excess demand.
• In a situation of deficient demand leading to deflation, Reverse repo rate is
decreased, it discourages the commercial bank to park their funds with the
central bank. It increases the lending capability of commercial banks, which
controls deficient demand.
(iv) Open Market Operations (OMO)
• It consists of buying and selling of government securities and bonds in the
open market by Central Bank.
• In a situation of excess demand leading to inflation, central bank sells
government securities and bonds to commercial bank. With the sale of these
securities, the power of commercial bank of giving loans decreases, which
will control excess demand.
• In a situation of deficient demand leading to deflation, central bank
purchases
government securities and bonds from commercial bank. With the purchase
of these securities, the power of commercial bank of giving loans increases,
which will control deficient demand.
(v) Varying Reserve Requirements
• Banks are obliged to maintain reserves with the central bank, which is
known as legal reserve ratio. It has two components. One is the Cash
Reserve Ratio or CRR and the other is the SLR or Statutory Liquidity Ratio.
• Cash Reserve Ratio:
-> It refers to the minimum percentage of a bank’s total deposits, which it is
required to keep with the central bank. Commercial banks have to keep with
the central bank a certain percentage of their deposits in the form of cash
reserves as a matter of law.
-> For example, if the minimum reserve ratio is 10% and total deposits of a
certain bank is Rs. 100 crore, it will have to keep Rs. 10 crore with the
Central Bank.
-> In a situation of excess demand leading to inflation, Cash Reserve Ratio
(CRR) is raised to 20 per cent, the bank will have to keep Rs.20 crore with
the Central Bank, which will reduce the cash resources of commercial bank
and reducing credit availability in the economy, which will control excess
demand.
-> In a situation of deficient demand leading to deflation, cash reserve ratio
(CRR) falls to 5 per cent, the bank will have to keep Rs. 5 crore with the
central bank, which will increase the cash resources of commercial bank and
increasing credit availability in the economy, which will control deficient
demand.
(vi) The Statutory Liquidity Ratio (SLR)
• It refers to minimum percentage of net total demand and time liabilities,
which commercial banks are required to maintain with themselves.
• In a situation of excess demand leading to inflation, the central bank
increases statutory liquidity ratio (SLR), which will reduce the cash resources
of commercial bank and reducing credit availability in the economy.
• In a situation of deficient demand leading to deflation, the central bank
decreases statutory liquidity ratio (SLR), which will increase the cash
resources of commercial bank and increases credit availability in the
economy.
• It may consist of:
-> Excess reserves
-> Unencumbered (are not acting as security for loans from the Central
Bank) government and other approved securities (securities whose
repayment is guaranteed by the government); and
-> Current account balances with other banks.
(b) Qualitative Instruments or Selective Tools of Monetary
Policy: These
instruments are used to regulate the direction of credit. They are as under:
(i) Imposing margin requirement on secured loans
• Business and traders get credit from commercial bank against the security
of their goods. Bank never gives credit equal to the full value of the security.
It always pays less value than the security.
• So, the difference between the value of security and value of loan is called
marginal requirement.
• In a situation of excess demand leading to inflation, central bank raises
marginal requirements. This discourages borrowing because it makes people
gets less credit against their securities.
• In a situation of deficient demand leading to deflation, central bank
decreases marginal requirements. This encourages borrowing because it
makes people get more credit against their securities.
(ii) Moral Suasion
• Moral suasion implies persuasion, request, informal suggestion, advice and
appeal by the central banks to commercial banks to cooperate with general
monetary policy of the central bank.
• In a situation of excess demand leading to inflation, it appeals for credit
contraction.
• In a situation of deficient demand leading to deflation, it appeals for credit
expansion.
(iii) Selective Credit Controls (SCCs)
• In this method the central bank can give directions to the commercial
banks not to give credit for certain purposes or to give more credit for
particular purposes or to the priority sectors.
• In a situation of excess demand leading to inflation, the central bank
introduces rationing of credit in order to prevent excessive flow of credit,
particularly for speculative activities. It helps to wipe off the excess demand.
• In a situation of deficient demand leading to deflation, the central bank
withdraws rationing of credit and make efforts to encourage credit.

Words that Matter

1. Commercial Bank: Commercial bank is a financial institution which

performs the functions of accepting deposits from the public and making
loans and investments, with the motive of earning profit.
2. Legal Reserve Ratio: It is the minimum ratio of deposits legally required
to be kept by the commercial banks with themselves (Statutory Liquidity
Ratio) and with the central bank (Cash reserve Ratio).
3. Money Multiplier or Credit Multiplier: When the primary cash deposit
in the banking system leads to multiple expansion in the total deposits, it is
known as money multiplier or credit multiplier.
4. Central Bank: The central bank is the apex institution of a country’s
monetary system. The design and the control of the country’s monetary
policy is its main responsibility.
5. Quantitative Instruments or General Tools of Monetary
Policy: These are the instruments of monetary policy that affect overall
supply of money/credit in the economy.
6. Qualitative Instruments or Selective Tools of Monetary Policy: The
instruments which are used to regulate the direction of credit is known as
Qualitative Instruments.
7. Bank rate: It is the rate of interest at which central bank lends to
commercial banks without any collateral (security for purpose of loan).
8. Repo rate: It is the rate at which commercial bank borrow money from
the central bank for short period by selling their financial securities to the
central bank.
9. Reverse Repo rate: It is the rate at which the central bank (RBI) borrows
money from commercial bank.
10. Open Market Operation: It consists of buying and selling of
government securities and bonds in the open market by central bank.
11. Cash Reserve Ratio: It refers to the minimum percentage of a bank’s
total deposits, which it is required to keep with the central bank.
12. Statutory Liquidity Ratio: It refers to minimum percentage of net total
demand and time liabilities, which commercial banks are required to
maintain with themselves.
13. Marginal requirement: Business and traders get credit from
commercial bank against the security of their goods. Bank never gives credit
equal to the full value of the security. It always pays less value than the
security. So, the difference between the value of security and value of loan is
called marginal requirement.
14. Moral suasion: It implies persuasion, request, informal suggestion,
advice and appeal by the central banks to commercial banks to cooperate
with general monetary policy of the central bank.
15. Selective Credit Controls (SCCs): In this method the central bank can
give directions to the commercial banks not to give credit for certain
purposes or to give more credit for particular purposes or to the priority
sectors.