UNIT- 2 BANKING

OBJECTIVE 22.04.2022

 STUDY AND UNDERSTAND HOW MONEY IS CREATED BY

COMMERCIAL BANKS.
 KNOW ABOUT RBI – THE APEX BANK
 ACQUIRE THE KNOWLEDGE THE VARIOUS FUNCTIONS OF
RESERVE BANK OF INDIA.
 MONEY CREATION BY COMMERCIAL BANK
COMMERCIAL BANK

SOURCE OF MONEY SUPPLY IN THE ECONOMY

UNLIKE CENTRAL BANK –

COMMERCIAL BANK DO NOT HAVE THE AUTHORITY OF ISSUING
CURRENCY

THEY SUPPLY MONEY THROUGH DEMAND DEPOSITS (saving and

current a/c)
CENTRAL BANK ( RBI ) AND ITS FUNCTION
PROCESS OF MONEY CREATION BY COMMERCIAL BANK
 CENTRAL BANK ( RBI ) AND ITS FUNCTION
Central bank is an apex bank that controls the entire banking system of the
country. It is the 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. Reserve bank of India is the central bank of India.
 OBJECTIVE 27.01.2022
 KNOW ABOUT RBI – THE APEX BANK
 ACQUIRE THE KNOWLEDGE ON VARIOUS FUNCTIONS OF
RESERVE BANK OF INDIA.
 ANALYSE AND UNDERSTAND THE VARIOUS INSTRUMENTS
USED BY THE CENTRAL BANK TO CONTROL MONEY SUPPLY
(OR CREDIT SUPPLY)
DIFFERENCE BETWEEN CENTRAL BANK AND COMMERCIAL BANK
CENTRAL BANK ( RBI ) AND ITS FUNCTION
CENTRAL BANK

(1) Bank of issue (7) Controller of Credit

(2)banker, agent and (3) Custodian (5) Lender of (6) Clearing House
Advisor to Government of Cash Reserves (4) Custodian Last Resort
of Foreign Balances
 (1) BANK OF ISSUE (NOTES)
 Central bank has the monopoly of note-issue in every country. The currency notes printed
and issued by the central bank are declared unlimited legal tender throughout the country.
This is called Currency Authority function of the Central bank.
 It avoids the possibility of over-issue by individual banks.
 The central banks, thus, regulate the currency of country and the total money-supply in the
economy. The central bank has to keep gold, silver or other securities against the notes
issued.
OBJECTS OF THE SYSTEM OF CURRENCY REGULATION

(i) People’s confidence in the currency is maintained

(ii) Its
supply is adjusted to demand in the economy
2. BANKER, AGENT AND ADVISER TO THE GOVERNMENT:
 Central bank, everywhere, performs the functions of banker, agent and adviser to the
government.
 As a banker to government, it manages accounts of the government.
 As an agent to the government, it buys and sells securities on behalf of the government.
 As an advisor to the government, it frames policies to regulate the money market.
 3. Custodian of Cash Reserves:
 All commercial banks in a country keep a part of their cash balances as deposits with the
central bank, may be on account of convention or legal compulsion. They draw (loan)
during busy seasons and pay back during slack seasons.
 Part of these balances is used for clearing purposes, means that the central bank provides
‘Clearing House’ (where the cheques and bills from member banks are exchanged) facility
to commercial bank
 In its supervisory role, the central bank ensures that the commercial banks show
compliance to its directives particularly relating to CRR and SLR, other member banks
look to it for guidance, help and direction in time of need to achieve the target .
4. CUSTODIAN OF FOREIGN BALANCES:
 Central bank is the custodian of nation’s foreign exchange reserves.
 After World War I, central banks have been keeping gold and foreign currencies as reserve
note-issue and also to meet adverse balance of payment, if any, with other countries.
 It also exercises ‘managed floating’ to ensure stability of exchange rate in the
international money market. Managed floating refers to the sale and purchase of foreign
exchange with a view to achieving stability of exchange rate for the domestic currency.
 5.LENDER OF LAST RESORT:
 It means that if a commercial bank fails to get financial accommodation from anywhere, it
approaches the Central bank as last resort.
 Central bank advances the loan to such a bank against approved securities.
 By offering loan to the commercial banks in situations of emergencies, the Central bank
ensures:

a) That the banking system of the country does not suffer any set back.
b) Money market remains stable.
5.LENDER OF LAST RESORT:
 6. CLEARING HOUSE:
 In India the Reserve Bank of India acts as the clearinghouse for scheduled banks, which
have statutory accounts with it. Through this function the Reserve Bank of India enables
the banks to settle their transactions among various banks easily and economically.
 This function of clearing house enables the other banks to settle their interbank claims
easily. Further it facilitates the settlement economically.
 The cheques of two banks are cleared through their accounts with central bank. ... This
reduces the requirement of cash reserves of the commercial banks.
 The Central bank performs the function of clearing house. The cheques of
two banks are cleared through their accounts with central bank. ... This reduces the
requirement of cash reserves of the commercial banks.
 7. CONTROLLER OF CREDIT:
 The principle function of 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 regulating the
‘creation of credit’ by the commercial bank control the inflation and deflation.

Performing all these functions, the central bank focuses on growth with
stability. ( Growth refers to a sustained rise in GDP. Stability refers to the
elimination of inflationary and deflationary situation in the economy.
DIFFERENCE BETWEEN CENTRAL BANK AND COMMERCIAL BANK
 OBJECTIVE 28.04.2022

 ACQUIRE THE KNOWLEDGE HOW CENTRAL BANK IS

DIFFERENT FROM COMMERCIAL BANK.
 UNDERSTAND WHAT ARE VARIOUS INSTRUMENTS USED IN
CONTROLLING MONEY SUPPLY.
 UNDERSTAND THE VARIOUS INSTRUMENTS USED BY THE
CENTRAL BANK TO CONTROL MONEY SUPPLY (OR CREDIT
SUPPLY).
QUESTIONS
INSTRUMENTS OF CREDIT CONTROL (RBI)
Quantitative Bank Rate
Instruments
Repo Rate
Reverse Repo Rate
INSTRUMENTS OF Cash Reserve Ratio
CREDIT CONTROL
Statutory Liquidity Ratio

Open Market Operations

Qualitative
Margin
Instruments
Requirements
Rationing of Credit

Moral Suasion
 QUANTITATIVE INSTRUMENTS

CONTROL MONEY SUPPLY IN THE ECONOMY

LOWERED TO TACKLE INFLATION RAISED TO

TACKLE DEFLATION
 OBJECTIVE 26.04.2022

 TO UNDERSTAND WHAT ARE VARIOUS INSTRUMENTS USED

IN CONTROLLING MONEY SUPPLY.
 TO UNDERSTAND THE VARIOUS INSTRUMENTS USED BY THE
CENTRAL BANK TO CONTROL MONEY SUPPLY (OR CREDIT
SUPPLY).
 TO KNOW THE DEFINTIONS OF VARIOUS INSTRUMENTS (Bank
rate, repo rate, reverse repo rate, cash reserve ratio, statutory liquidity
ratio, open market operations.)
 1. BANK RATE
 Meaning of bank rate: Bank rate (discount rate) refers to the interest rate at
which the domestic banks borrow money from a nation's Central Bank based
on the monetary policy of the country as a long-term loan (90 days to 1 year).
Bank rate policy involving the variation of discount rates to influence the
market rate of interest, which plays a crucial rate in the creation credit.
BANK RATE DEMAND FOR CREDIT SUPPLY OF MONEY CONTROL THE INFLATION

BANK RATE DEMAND FOR CREDIT SUPPLY OF MONEY CONTROL THE DEFLATION

 Current bank rate is 6.75%

 REPO RATE
Definition: Repo rate is the rate at which the central bank of a country (Reserve Bank of
India in case of India) lends money to commercial banks for a short period in the event of
any shortfall of funds.
 Repo rate is used by monetary authorities to control inflation. The current repo rate is
6.50%.
 In fact, it is a Repurchase rate. The RBI issues a loan cheque to the commercial banks by
buying them the government securities. But, it carries the agreement of repurchase of
securities by the commercial banks at the predetermined date and at a predetermined
price.
REPO RATE COST OF CAPITAL DEMAND FOR CREDIT / MONEY SUPPLY OF MONEY
CONTOL INFLATION

REPO RATE COST OF CAPITAL DEMAND FOR CREDIT / MONEY SUPPLY OF MONEY
CONTOL

DEFLATION
 3. REVERSE REPO RATE:

Definition: Reverse repo rate is the rate at which the central bank of a country (Reserve Bank
of India in case of India) borrows money from commercial banks for a short period within the
country or accepts deposits from commercial bank.
 It is a monetary policy instrument which can be used to control the money supply in the
country. The current reverse repo rate in India is 3.75%.
 It is also called Reverse Repurchase Rate. It is signed by the both the parties stating that the
securities will be repurchased on a given date at a predetermined price.
REVERSE REPO RATE FUNDS T0 RBI SUPPLY OF MONEY CONTROL

INFLATION

REVERSE REPO RATE FUNDS T0 RBI SUPPLY OF MONEY CONTROL

DEFLATION
 OBJECTIVE 13.04.2021

 TO UNDERSTAND THE VARIOUS INSTRUMENTS USED BY THE

CENTRAL BANK TO CONTROL MONEY SUPPLY (OR CREDIT
SUPPLY).
 TO KNOW THE DEFINTIONS OF VARIOUS INSTRUMENTS (Bank rate,
repo rate, reverse repo rate, cash reserve ratio, statutory liquidity ratio, open
market operations.) WITH THEIR CURRENT RATES.
 TO UNDERSTAND VARIOUS QUALITATIVE INSTRUMENTS (Margin
requirements, Moral suasion, Rationing of credit)
 4. CASH RESERVE RATIO:
Definition: Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits
of customers, which commercial banks have to hold as reserves either in cash or as deposits
with the central bank.
 CRR is set according to the guidelines of the central bank of a country.
 The current Cash Reserve Ratio (CRR) is 4.5%.
CRR CASH RESERVE FROM DD MONEY SUPPLY
CONTROL INFLATION
CRR CASH RESERVE FROM DD MONEY SUPPLY
CONTROL DEFLATION
 5.STATUTORY LIQUIDITY RATIO:
 Statutory Liquidity Ratio or SLR is the minimum percentage of deposits that a commercial
bank has to maintain in the form of liquid cash, gold or other securities.
 It is basically the reserve requirement that banks are expected to keep before offering
credit to customers. The SLR is fixed by the RBI and is a form of control over the credit
growth in India. The current SLR is 18.00 %.
 The SLR was prescribed by Section 24 (2A) of Banking Regulation Act, 1949.

SLR LIQUID ASSETS WITH COMMERCIAL BANK CRR DEPOSIT MONEY SUPPLY CONTROL INFLATION

SLR LIQUID ASSETS WITH COMMERCIAL BANK CRR DEPOSIT MONEY SUPPLY CONTROL DEFLATION
 OBJECTIVE 15.04.2021

 TO KNOW THE DEFINTIONS OF VARIOUS INSTRUMENTS (Bank rate,

repo rate, reverse repo rate, cash reserve ratio, statutory liquidity ratio, open
market operations.) WITH THEIR CURRENT RATES.
 TO UNDERSTAND VARIOUS QUALITATIVE INSTRUMENTS (Margin
requirements, Moral suasion, Rationing of credit)
 6. OPEN MARKET OPERATIONS:
 Open market operations is the sale and purchase of government securities and treasury bills by RBI or the
central bank of the country.
 The objective of OMO is to regulate the money supply in the economy.
 When the RBI wants to increase the money supply in the economy, it purchases the government securities
from the market and it sells government securities to suck out liquidity from the system.

 RBI carries out the OMO through commercial banks and does not directly deal with the public.
 OMO is one of the tools that RBI uses to smoothen the liquidity conditions through the year and minimize
its impact on the interest rate and inflation rate levels.
 6. OPEN MARKET OPERATIONS:

SELLING SECURITIES CREDIT CREATION MONEY SUPPLY

CONTROL INFLATION

BUYING SECURITIES CREDIT CREATION MONEY SUPPLY

CONTROL DEFLATION
 QUALITATIVE INSTRUMENTS

SELECT SECTORS
(principal source of instability in the economy)

INCREASE MONEY SUPPLY DECREASE

MONEY SUPPLY
 1. MARGIN REQUIREMENTS
Definition: It refers to the difference between current value of the security offered for loan
(called collateral) and the value of loan granted.

MARGIN REQUIREMENT DEMAND FOR CREDIT SUPPLY OF MONEY

CONTROL INFLATION

MARGIN REQUIREMENT DEMAND FOR CREDIT SUPPLY OF MONEY

CONTROL DEFLATION

The margin requirement is kept high for speculative ( trading)

activities.
 2. RATIONING OF CREDIT
 DEFINITION: The Credit Rationing is a measure undertaken by the central bank to
limit or deny the supply of credit based on the investor’s creditworthiness and an
increased loan demand.
 It is introduced when the supply of credit is to be checked particularly for speculative
activities in the economy.
 RBI fixes credit quota for different business activities.

INTRODUCTION OF CREDIT RATIONING SUPPLY OF MONEY INFLATION IS CONTROLLED

RATIONING / WITHDRAW OF CREDIT RATIONING SUPPLY OF MONEY DEFLATION IS

CONTROLLED
 3. MORAL SUASION
DEFINITION: Rendering an advice to the commercial banks by the RBI to follow its
directives. The banks are advised to restrict loans during inflation, and be liberal in lending
during deflation.
QUESTIONS
1. Commercial banks do not have the note issuing authority, but they do
contribute to money supply in the economy. Comment.
2. If CRR is lowered, Investment demand must rise. Defend or refute.
3. How improvement in banking habits of the people pushes up credit
availability from the commercial bank?
4. Analyze the economic condition in terms of (i) the households (ii) investors
(iii) the economy, if the government reduces the repo rate from 6.5% to 6%.
5. How is quantitative credit control different from qualitative credit control?
END