VIKAS RANJAN | MACRO | CH6 | CLASS XII

CH-6 BANKING
Bank is an institution which receives our deposits and gives us loans.

Types of bank

1. Commercial Bank

2. Central bank

COMMERCIAL BANK

A commercial bank is a financial institution which accepts deposits from the public and gives loans for purposes of
consumption and investment.

Function of commercial bank

(I)Accepting Deposits

The primary function of every commercial bank is to accept deposits from the public. They accept deposits from
every class and from every source.

The banks accept three types of deposits:

(a) Demand deposits/Current deposits

(b) Saving deposits

(c) Fixed Deposits

Current Deposit Saving Deposit Fixed Deposit

Those deposits which can Those deposit on the Those deposits which can
be withdrawn by the withdrawal of which bank be withdrawn only after
depositor at any time by places certain restrictions. the expiry of certain fixed
means of cheque or period, say a few months or
otherwise. few

years.

There are no restrictions on There are limited There are restrictions on

bank rules. paid on maturity.

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No interest is given on Interest is given, lesser High rate of interest is

deposits. than on fixed deposits. given.

It is sent at regular It is sent at regular No statement is given.

intervals. intervals.

Businessmen use this Households and firms are Households and firms use
account. the user of this account. this account.

(II) Advancing Loans:

A certain part of the cash received by banks as deposit is kept in the reserve and the rest is given as loans. Types of
loans:

(a) Cash Credit/loans

(b) Demand Credit/loans

(c) Short term loans

(d) Overdraft Facilities

Cash Credit Demand Loans Short term loans

A credit limit is sanctioned up to This loan can be recalled on This loan is given as personal loans
which the user may borrow from demand by the bank at any time. or, is advanced as priority sector.
the bank on a given

security.

Producers, traders use these types Those, whose credit needs Household, firms and priority
of loan. fluctuate, use this category of sectors use this type of loan.

loan.

It is charged on amount Whole amount of loan is Whole amount of loan is

actually used. chargeable to interest. chargeable to interest.

No stated maturity. No stated maturity. Stated maturity as per bank

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rules.

Overdraft facilities: Banks provide overdraft facilities to their customers who maintain a current account with the
bank. When a customer gets an overdraft facility from a bank, this means that he allowed drawing cheques in
excess of the balance standing in his account to the extent of the amount of overdraft limit.

3. Money (or Credit or Currency) Creation by commercial banks

The capacity of commercial banks to create credit depends on two factors:

(i) Amount of initial/fresh/primary deposits

(ii) LRR(Legal Reserve Ratio)

It is the fraction of deposits of commercial banks which is legally compulsory for the commercial bank to keep in
the form of cash (CRR) and liquid assets (SLR) as reserves.

Money Creation = Initial deposit X 1/LRR OR Money Creation = Initial deposit X Money multiplier

(Money/ Deposit multiplier is a multiple by which total deposits increase due to initial deposit.) Example- Assumed
that initial/primary deposit in a bank is Rs.1000.

LRR = 20% i.e. 20/100 = 0.2

Total money creation= 1000 X 1/0.2 = 1000 X 5 = Rs.5000

Working of Money Creation by Commercial banks

Rounds of transaction Deposits Legal Reserves (20%) Loans

First round 1000 200 800

Second round 800 160 640

Third round 640 128 512

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Fourth round 512 102.4 409.6

.............. ---- ---- ----

............... ---- ---- ----

Total 5000 1000 4000

It shows that if LRR is 20% then with initial deposit of Rs. 1000, a commercial bank will be able to create Rs.5000
worth of deposits.

CENTRAL BANK

A Central bank is an apex institution of the monetary and banking structure of the country .It regulates the entire
banking system of the country. Central bank is a govt. Owned institution. It is a non-profit making institution. It
acts in the public interest.

NOT IN THE SYLLABUS( FOR THE SESSION 2020-21

Functions of a central bank:

1. Issue of currency/Bank of issue/Currency authority function

Bank of issue refers to a bank which has the legal right to issue currency. In India the Central Bank is the sole
authority for the issue of currency (except one rupee notes and coins) in the country.

Central Bank is an apex financial institution of the economy that provides financial and banking services for its
country’s govt. and commercial banking system as well as implementing the govt’s monetary policy and issuing
currency.

The currency issued by Central Bank is circulated in the economy as legal tender money (Money that has to be
accepted legally in settlements of debt is legal tender.)

The Central Bank issues all the currency (from Rs.2 and above) against reserve of gold and foreign securities which
bit has to keep as per statutory rules.

2. Banker to the Government:

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Central bank everywhere in the world acts as banker, agent and advisor to the government.

As a banker to the govt, it manages the banking accounts of govt. Departments. It performs the same banking
function for the govt. as commercial bank performs for its customers. It accepts deposits and makes payment for
the govt. It also gives short period loans to the govt.

As an agent to the government, it buys and sells securities, treasury bills on behalf of the govt. It also manages
public debt.

As an advisor, it advices the govt. on economic, banking and financial matters.

3. Banker’s bank and supervisor:

As a banker’s bank, it performs the following:

• Custodian of cash reserves

• Clearing house function

• Lender of last resort

As a supervisor, the Central bank supervises, regulates and controls the commercial bank. It also includes periodic
inspection of banks.

4. Controller of Credit and Money Supply:

Monetary policy of Central bank refers to the policy of Central Bank related to the control of money supply and
availability of credit in the system.

The instruments of monetary policy (methods of credit control) are categorised into two groups:

(i) Quantitative methods

(ii) Qualitative methods

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1. Quantitative Methods:

Quantitative methods refer to those instruments of monetary policy which affect the volume of credit in the
economy.

These are:

(I) Repo Rate—Repo rate (short form of re-purchase option) refers to the market rate of interest at which central
bank lends money to commercial banks for short period.

Commercial bank banks get loans from central bank by selling securities to the latter. However, this is a conditional
loan. The condition is that banks will repurchase their securities after a fixed time period at pre-determined price.

When repo rate increased, it increases the rate of interest; credit becomes costlier, demand for credit reduces,
less money goes to the economy, purchasing power is curtailed, AD falls and excess demand is corrected.

When repo rate is reduced, it decreases the rate of interest, demand for credit increases, more money flows to the
economy, purchasing power increases, AD rises and deficient demand is corrected.

(II) Reverse Repo Rate— It is the rate of interest at which the RBI borrows from commercial banks for short
period. This is done by selling govt. bonds to banks. The banks utilise the reverse repo rate facility to deposit
their short term excess funds with the RBI and earn interest on it.

When reverse repo rate increased, it encourages the commercial bank to park their surplus funds with the central
bank. This has a negative effect on the lending capability of commercial banks. Demand for credit reduces, less
money goes to the economy, AD falls and excess demand is corrected.

When reverse repo rate is reduced, lending capability of the commercial bank increases, demand for credit rises,
AD rises and deficient demand is corrected.

(III) Bank Rate-- It refers to the rate of interest at which country’s central bank lends money to commercial
banks for a long period. Changes in bank rate affect the money supply in the economy.

During inflation (i.e. a state of rising of prices), to control the volume of credit, central bank raises its bank power is
curtailed, and AD (Aggregate Demand) falls and excess demand is corrected.

During deflation (i.e. a state of falling prices), central bank reduces the bank rate. It decreases the rate of interest,
makes the credit cheaper, demand for credit increases, more money flows to the economy, purchasing power
increases; AD rises deficient demand is corrected.

(IV) Open Market Operation (OMO)—It refers to purchase and sale of govt. securities in the open market
(public and commercial banks) by the central bank.

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Sale of securities— During excess demand/inflation, the central bank starts selling govt. securities in the market.
The Central Bank withdraws additional purchasing power. There will be contraction of credit, less money will flow
in the economy, and purchasing power in the economy reduces. AD falls and excess demand stands corrected.

Purchase of securities— During deficient demand or deflation, the central bank starts purchasing securities from
the open market. By purchasing the govt. securities, the central bank injects additional purchasing power in the
economy which expands credit. More money will flow in the economy, purchasing power in the economy
increases. AD rises and deficient demand is corrected.

(V) Legal Reserve Ratio/Varying Legal Reserve Requirements—LRR is that fraction of deposits of commercial
banks which is legally compulsory for them to maintain on two accounts:

(a)Cash Reserve Ratio (CRR) (b) Statutory Liquidity Ratio (SLR)

CRR refers to the minimum % of deposits (total demand and time deposits) of commercial banks which is kept
with RBI.

SLR is the % of deposits of commercial bank which every bank is required to maintain with itself.

An increase in CRR & SLR reduces the excess reserves of commercial banks and limits their lending power, and
control excess demand.

A decrease in CRR & SLR increases excess reserves of the banks and thus, increases their ability to give credit, and
control deficient demand.

2. Qualitative methods:

These measures affect allocation of credit between alternative uses.

Margin Requirement: It refers to the difference b/w the amount of loan granted and the value of security offered
for the loan. Ex. If margin requirement is 20% then the bank is allowed to give loan only up to 80% of the value of
security.

When margin requirement is increased, there will be contraction of credit, less money will flow in the system,
purchasing power in the economy reduces. Aggregate demand falls and excess demand controlled.

When margin requirement reduces, there will be expansion of credit, more money supply will flow in the
economy, purchasing power increases, AD rises and deficient demand is corrected.

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(I) Moral Suasion and Direct action: It is a combination of persuasion and pressure that the central bank applies to
other banks in order to get them fall in line with its policy. It is done through letters, speeches and hints to the
banks.

Central Bank may take direct action against member banks which do not comply with its policies of credit
expansion or contraction.

(II) Selective credit control/Credit Rationing: It aims at limiting the maximum amount of bank loans and
advances. This can be applied in both a positive as well as negative manner.

In a positive manner, the credit will be channelized to particular priority sectors. In a negative manner, the flow of
credit will be restricted to particular sectors.

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