Banking

Unit-2
Chapter-2
 Introduction
➢ Banks are the financial institution which accepts deposits from the people
& provide loans for the purpose of investment & construction to the people.

Deposits Lends
Household Banks Firm

types

Commercial Central
Bank Bank
Features of BANKS
1.Acceptance of deposits.
Process banking
2. Creation of money by lending of funds.
Commercial Banks
Functions
1. Accepting Deposits
Deposits

❖ Current Account ❖ Saving Account ❖ Fixed Deposits

➢ Can be withdrawn ➢ Minimum balance ➢ Deposits for the fixed
anytime by cheque ➢ Account used by term
households & firms ➢ Account used by
➢ Account is used by households & firms
business man ➢ Interest is given
➢ Limited restrictions ➢ Minimum balance
➢ No minimum balance
➢ Higher interest on
➢ No interest received longer term deposits
➢ No restriction on
➢ Money is paid on
withdrawl. maturity
Commercial Banks
Functions
2. Advancing loans Credit

Short Term Loans Cash Credit Overdrafts

➢ Loan is given as ➢ Credit limit is ➢ Extended to current
personal loans sanctioned. account holders
➢ HH or firm sectors use ➢ Producers or traders only
this type of account use this account. ➢ Can withdraw more
➢ Whole amount is ➢ Withdrawn based on money than is in the
chargeable for interest level of availability of account
➢ Maturity period is stock ➢ Interest paid on
decided by the banks. ➢ Interest charged on amount withdrawn
withdrawn amount and not on the
➢ Inventory stock used extent of OD facility
as security ➢ Bank keeps security
Commercial Banks
Functions
1
3. Credit Creation = 𝐿𝑅𝑅 × 𝑝𝑟𝑖𝑚𝑎𝑟𝑦 𝑑𝑒𝑝𝑜𝑠𝑖𝑡
Mohan

Rs. 90

Rs. 90
Initial deposit Rs. 100
Bank
Rs. 72.9
Rs. 72.9 Rs. 81

Ram
Rs. 81 Sohan

Money multiplier process/ money creation by commercial banks

: Money lent by bank
Credit : Rs. 100 + 90 +81 + 72.9 + ……. > initial
: Deposit of bank deposit of Rs 100
 Working of money creation by commercial banks
Rounds of transactions Deposits Legal reserves (10%) Loans (90%)
First round 100 (primary/initial) 10 90

Second round 90 (derivative/secondary) 09 81

Third round 81(derivative/secondary) 8.1 72.9

Fourth round 72.9(derivative/secondary) 7.29 65.61

---- ---- ---- -----

Total 1000 100 900

Commercial Banks
Functions
1
3. Credit Creation = 𝐿𝑅𝑅 × 𝑝𝑟𝑖𝑚𝑎𝑟𝑦 𝑑𝑒𝑝𝑜𝑠𝑖𝑡

By the process of legal reserve ratio, creates credit many times more than the primary deposits.
1
Credit is created by the formula = × 𝑝𝑟𝑖𝑚𝑎𝑟𝑦 𝑑𝑒𝑝𝑜𝑠𝑖𝑡
𝐿𝑅𝑅

• If LRR =10%
• Then bank will deduct 10% of Rs 100 (primary deposit) & remaining Rs 90 can be loaned out to other
person
• Suppose Rs 90 is being given to Mohan & it will be deposited to Mohan’s account which he can
withdraw through cheque.
• Suppose he withdrew this amount for purchasing machinery for his production unit from Mr Sohan.
• Mr Sohan again deposits the amount in bank. (if we assume there is unified banking system in the
economy)
• Again bank will deduct 10% of Rs 90 i.e. Rs 9 & remaining Rs 81 can be loaned out to another
person- RAM.

• This process of loaning out of the deposits after deducting LRR goes on till it becomes Virtually Zero.
1
• So credit creation = × 𝑝𝑟𝑖𝑚𝑎𝑟𝑦 𝑑𝑒𝑝𝑜𝑠𝑖𝑡
𝐿𝑅𝑅
1
= 10% × 100 = Rs 1,000
 Central Bank – Meaning

❖ Apex bank of the country

❖ Responsible for the monetary and financial
system
❖ Control
❖ Supervision
❖ Regulation
❖ Organisation
❖ In India : Reserve Bank of India is the central
bank of the country.
Functions of central bank
1. Issuing notes/ currency authority function of the
central bank- Central bank of the country has the exclusive right of
issuing notes. These notes are an unlimited legal tendor (Legal tendor
money which can be paid in discharge of any debt. Legal action can be
taken against a person who refuses to accept it.)

2. Banker to the govt. – Central bank is the banker, agent & financial
advisor to the govt.
As a banker to the government it manages accounts of the govt. Carry
out all banking business of the govt.
As an agent to the govt. it sells & purchases securities , collects taxes &
other payments on the behalf of govt.
As an advisor to the govt. it helps the govt. in framing policies to
regulate the money market.
Functions of central bank
3.Banker’s Bank & supervisor-
It is an apex bank of all the banks in the country. The central bank has almost
same relation with all the other banks in the country as a commercial bank has
relation with its people.
• It accepts deposits from commercial banks & offer them loans.
• The rate at which central bank gives loans to commercial banks called as
bank rates.
• It set up norms for all the commercial banks & supervises all such banks.
4.Lender of the last resort
On the occasions when commercial banks face shortage of fund because of higher amount
withdrawn by the depositors, commercial banks arranges this extra fund
• By taking loans from other commercial banks or
• Foreign banks
But if still loan requirement is not fulfilled then it takes loan from central banks.
In such situation central banks acts as a lender of the last resort.
And central bank ensures that the banking system & money market doesn’t suffer.
5. Custodian of foreign exchange & cash reserve
• Central bank is the custodian of nation’s foreign exchange reserves & exercises
managed floating to ensure stability of exchange rate in the international money market.
• The central banks not only maintains foreign exchange reserves but also holds a part of
the cash reserves of banks because commercial banks are supposed to deposit CRR
with the central bank (as a measure of credit control).
6. Clearing house function
• As central bank holds the cash reserves of all commercial banks, so it becomes
easier & convenient for it to act as their clearing house.
• Central bank can easily settle claims of various commercial banks against each
other by making debit & credit in their accounts as all commercial banks have their
account with central bank.
7. Control of credit
➢ Due to economic fluctuations (inflation & deflation) the central bank controls the
money supply & creation of credit. During inflation the supply of money is reduced &
during deflation supply is increased.
Control of credit & MONEY SUPPLY
Monetary Policy : Government policy regarding directing, regulating and
controlling money supply in the economy, is called monetary policy.

Measures of monetary policy

Quantitative Monetary Measure Qualitative Monetary Measure

1. Quantitative measures
These measures influence the total amount of money supply in circulation. During inflation the
supply of money is reduced & during deflation supply is increased

1. OPEN MARKET OPERATIONS

“It is the process of selling & purchasing govt. bonds/securities through bank to the people &
Commercial Banks by the govt.’’

Excess demand / INFLATION Deficient demand / DEFLATION

At the time of excess demand govt. For controlling deficient demand central
sells govt. bonds through bank to the bank should resort to buying of govt.
securities, by buying securities the central
people so that money availability with
bank injects the additional purchasing
commercial bank will be lessor & also
power into the system which results in
with the people & so they will expansion of credit as a result AD increases .
demand lessor.
 Purchases
Sells securities securities from
to the people& the people&
commercial commercial
banks banks

Flow of money Flow of money

from the from central
Excess Demand commercial DD & deflation bank to the
& Inflation banks & people situation is commercial
situation is to the central controlled banks
controlled banks.

Increases the
Credit capacity
Restricts lending lending
of the
capacity of the
Purchases of
capacity of
commercial securities
commercial commercial
banks also
banks. banks
reduced
 2. BANK RATE
– “It is the rate of interest which is charged by central bank from commercial banks when it gives loans to them’’.
Excess demand / INFLATION Deficient demand/ DEFLATION
At the time of excess demand Bank Rate is increased by the central At the time of deficient demand Bank Rate is decreased by the central
bank so that there will be lessor flow of loans from bank to the people bank so that there will be more flow of loans from bank to the people
so that there will be lessor demand by the people. so that there will be more demand by the people.

Bank rates Bank rates

increases decreased

Borrowing Borrowing
Less More becomes cheaper
becomes
borrowing/credit borrowing/credit for commercial
expensive for
supply supply banks
commercial banks

Borrowing
Increases interest Borrowing
becomes Decreases interest
rates for its becomes cheaper
Expensive for rates for its people
people for people
people
3. CASH RESERVE RATIO
-“ It is the % of total assets of the commercial banks which is kept with help with the central banks as a
reserve to meet the emergencies’’.
Excess demand / INFLATION Deficient demand/ DEFLATION
At the time of excess demand CRR is increased by the central At the time of deficient demand CRR is decreased by the
bank for the commercial banks so that there will be lessor central bank for the commercial banks so that there will be
flow of money as loans from bank to the people & further more flow of money as loans from bank to the people &
there will be lessor demand by the people. further there will be more demand by the people.

CRR increases CRR decreases

Force commercial Decrease in CRR by

banks to keep more CRR commercial banks

Discourages banks to Encourages banks to

lend money lend money

Leads to less flow of Leads to more flow

money of money
4. STATUTORY LIQUIDITY RATIO
It is the % of total assets of the commercial banks which is kept in liquid from (in cash, in gold, in bonds) to fulfil
with drawl needs of the depositors.’’
Excess demand / INFLATION Deficient demand/ DEFLATION
At the time of excess demand SLR is increased by the central At the time of deficient demand SLR is decreased by the central
bank for the commercial banks so that the money left for loans bank for the commercial banks so that the money left for loans
out purpose, will be lessor in this way there will be lessor flow of out purpose, will be more in this way there will be more flow of
loans from the bank to the people. & so there will be lessor loans from bank to the people. & so there will be more demand
demand by the people by the people

SLR increases SLR decreases

Increase in the reserve decrease in the reserve

deposits by the deposits by the
commercial banks commercial banks

Discourages banks to Encourages banks to

lend money lend money

Leads to less flow of More money/credit

money creation
 5. REPO RATE/REPURCHASE RATE
Refers to rate at which commercial banks borrow money from central bank for a short period of time .

• Increase in repo rate

• Increase in market rate of interest • Decrease in repo rate
• Decrease in market rate of interest

% • Increase in cost of credit

• Reduction in cost of credit
• Decrease in demand for loan % • Increase in demand for loan

• Decrease in money supply

• Increase in money supply

INFLATION DEFLATION
 6. REVERSE - REPO RATE /REVERSE REPURCHASE RATE
Refers to rate at which central banks offers to banks when they deposit their surplus cash with central
bank for a short period of time.

• Increase in reverse repo rate. • Decrease in repo rate

• Commercial banks get more • Commercial banks get less income

% income from central banks. from central banks.
• So the banks deposit more with % • So the banks deposit less with
central banks. central banks.

• Reduction in money supply • Increase in money supply

INFLATION DEFLATION
[C] Monetary policy- qualitative :
1. Safety Margin Requirement- “ It is the difference of monetary
value of the assets offer for loan & the amount of loan granted by
the bank.

Collateral/mortgage/security = 1,00,000

Commercial
Household
bank

Loan 80,000

Bank keeps a Margin of Rs. 20,000

 Excess demand Deficient demand
At the time of excess demand safety margin is At the time of deficient demand safety margin
increased by the central bank so that people is decreased by the central bank so that
will be discouraged to take loan from bank, in people will be encouraged to take loan from
this way there will be lessor flow of money as bank, in this way there will be more flow of
loan from bank to the people & there will be money as loan from bank to the people &
the lessor demand by the people there will be the more demand by the people

2.Rationing of credit- “It is the policy in which selective credit

control measures are adopted by the bank such as directing the
loans for a particular purpose & fixing up credit by the commercial
banks.’’ Excess demand Deficient demand
At the time of excess demand rationing At the time of deficient demand it is
of credit is introduced & Channelizes cancelled if introduced earlier.
credit.
3.Direct Action/Moral Suasion - “Central Bank initially advices the
commercial banks to follow the norms which are setup to control demand
level of the economy.”
If commercial banks do not obey those norms, finally the legal action is
taken by central bank against the commercial banks, called direct action.