COMMERCIAL BANK

Bank- It is an institution which receives funds from the

public and gives loans and advances to those who need them.

Banking has been defined as accepting, for the purpose

of lending or investment, deposits of money from the public
which are payable on demand or withdrawable by cheque, draft
and order or otherwise. Thus, banks act as a bridge between the
users of capital (investors) and those who save (savers).

Commercial Bank- It is an institution that accepts

deposits from the general public and extends loans with the
sole purpose to earn profit.
 Post Office Savings Bank is not a bank because it accepts
deposits but does not lend. Financial institutions (FIs) like LIC,
UTI, IDBI, etc. are not banks. Differences between banks and
financial institutions are:

1. Financial institutions lend but do not accept chequable

deposits.
2. Financial institutions do not perform agency functions
and general services. But banks perform agency and general
services.
3. Financial institutions do not create credit. But banks
have the capacity to add to the total money supply of an
economy by means of credit creation.
Money is anything usable for undertaking transactions,
i.e., receipts and payments. The stock of such money in an
economy is called Money supply.
 The basic measure of money supply has two
components: currency with public and demand deposits
in commercial banks.
The currency is created by the central bank (Reserve
Bank of India in India) and is called High Powered Money.
Demand deposits are created by the commercial banks and are
called bank money.

Commercial banks receive deposits from the public. The

depositors are free to withdraw, in part or in full, their deposit
amounts by writing cheques. The banks use the money in these
deposits to give loans. These functions of the commercial
banking system are the basis of deposit creation. How much
are the deposits created is determined by the amount of initial
deposits by the public and the Legal Reserve Ratio.
 The quantitative outcome is called money multiplier. Let us
explain the process of money creation and the measure of money
multiplier. Note that money creation is also called 'deposit creation'
or ‘credit Creation’.

The Process of Money Creation

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 of the ratio is called the Cash Reserve Ratio. The
other part is kept by the banks themselves and is called the Statutory
Liquidity Ratio.
 Let us now explain the process. Suppose the initial deposits
in banks are 100 and the LRR is 20 per cent. Further suppose that
banks keep only the minimum required 20 as cash reserve, no more
no less. Banks are now free to lend the remainder 80.
Deposit Creation by Commercial Banks
Deposits Loans Cash Reserves
(LRR = 0.2)
Initial 100 80 20
Round I 80 64 16
Round II 64 51.20 12.80
- - - -
- - - -
- - - -
Total 500 400 100
Money Multiplier
How many times the total deposits would be of the initial deposit
is determined by the LRR. The multiple is called the money or
deposit multiplier. It is given by the formula:
1
Money Multiplier = ---------
LRR
In the above illustration, LRR is 0.2 therefore,
1
Money multiplier = ----- = 5
0.2
The total money creation is thus:
Money creation = Initial Deposit X 5
= 100 X 5 = 500
MEANING OF CENTRAL BANK

Every country has an apex institution which is a leader

of the money market.
Its function is to supervise, regulate and control the
activities of the commercial banks as well as other financial
institutions. It plays a leading role in organising, running and
developing the monetary and financial system of a country.
Central Bank is the principal banking and monetary
institution of a country which has the monopoly to issue note.
The Statutes of the Bank for International Settlements
defines a central bank as "the bank in any country to which
has been entrusted the duty of regulating the volume of
currency and credit in that country.”
FUNCTIONS OF A CENTRAL BANK (RBI)

1. Currency Authority
The Central Bank is the sole authority for the issue of
currency in the country. All the currency issued by the central
bank is its monetary liability. This means that the Central
Bank is obliged to back the currency with assets of equal
value.

2. Banker to the Government

The central bank acts as a banker to the government-
both Central as well as State governments. It carries out all
the banking business of the government and the government
keeps its cash balances on current account with the central
bank.
3. Bankers' Bank and Supervisor
As the banker to banks, the Central Bank holds a part
of the cash reserves of banks, lends them short-term funds
and provides them with centralised clearing and remittance
facilities. The banks are required to deposit a stipulated ratio
of their net total liabilities (the CRR) with the Central Bank.

4. Controller of Money Supply and Credit (Credit

Control Policy of RBI)
The various credit policy or monetary instruments
used by the Central Bank of the country can be divided into
two parts:
(A) Quantitative Instrument -

(i) Bank Rate Policy - The bank rate is the rate at

which the central bank lends funds as a 'lender of last resort'
to banks, against approved securities or eligible bills of
exchange. The effect of a change in the bank rate is to change
the cost of securing funds from the central bank. An increase
in the bank rate increases the, costs of borrowing from the
central bank. This will reduce the ability of banks to create
credit.

(ii) Repo Rate – It refers to the rate of interest at

which the central bank gives short period loans to the
commercial banks.
Repo Rate -
This rate is also known as the repurchasing rate, and this rate is
used in a banking transaction like a repurchase agreement.
In a repurchase agreement, central bank sells securities to commercial
banks and agrees to repurchase these securities after a certain period of
time at a pre-defined price. Therefore, the interest rate used in these
securities for repurchase is known as a repo or repurchase rate.

(iii) Open Market Operations –

OMO is the buying and selling of
government securities by the Central Bank from/to the public or
banks. It does not matter whether the securities are bought or sold to
the public or banks because ultimately the amount will be deposited
in/or transferred from some banks. The sale of government securities to
banks will have the effect of reducing their reserves.
(iv) Legal Reserve Requirements - Banks are obliged to
maintain reserves with the Central Bank on two accounts, (a) the
Cash Reserve Ratio or CRR (b) SLR or Statutory Liquidity Ratio.

(a) CRR - Under CRR the banks are required to deposit with
the Central Bank a percentage of their net demand and time
liabilities. Varying the CRR is a tool of monetary and credit
control. An increase in the CRR has the effect of reducing the
banks excess reserves and thus curtail their ability to give credit.

(b) SLR – It refers to liquid assets of the commercial banks

which they are required to maintain (on daily basis) as a
minimum percentage of their total deposits. The liquid assets
include: cash, gold and unencumbered approved securities.
(B) Qualitative Instrument -
(i) Imposing margin requirement on secured loans - A
margin is the difference between the amount of the loan and
market value of the security offered by the borrower against the
loan. If the margin imposed by the central bank is 40%, then the
bank is allowed to give a loan only up to 60% of the value of the
security.

(ii) Moral Suasion - This is a combination of persuasion

and pressure that the central bank applies on the other banks in
order to get them to fall in line with its policy. This is exercised
through discussion, letters, speeches and hints to banks.
(iii) Selective Credit Controls (SCCs) - These can be applied
in both a positive as well as a negative manner. Application of
SCCs in a positive manner would mean using measures to
channel credit to particular sectors, usually the priority sectors.

5. Custodian of Foreign Exchange Reserves -

The central bank is the custodian of a country's stock
of gold and international currencies. The central bank maintains
the stability of exchange rate fixed by the government their
internal values, and help the government to pursue a coordinated
policy towards balance of payment situation in a country.
6. Lender of Last Resort -
The central bank is under the obligation to provide funds
to commercial banks as and when they need financial help. The
aim is that no sound and genuine business transaction should be
restricted or abandoned due to shortage of funds. Commercial
banks approach the central bank as a last resort in distress.

Some Important Questions from this Chapter -

1. What is a commercial bank?
2. Explain the lending function of commercial bank.
3. Explain ‘banker to the government’ function of central bank.
4. What is meant by cash reserve ratio?
5. State three functions of a commercial bank. Explain any one of them.
6. Explain the meaning of cash statutory liquidity ratio.