Banking

Commercial Bank
Commercial Bank is an institution that performs the functions of accepting deposits, granting loans, and making
investments, to earn profits. Commercial Bank is the primary unit of the Indian Banking System.

Functions Of A Commercial Bank

Primary Functions
1.​ Accepting Deposits - It is the most important function of commercial banks. They accept
deposits in several forms according to the requirements of different sections of society. The main
kinds of deposits are -
●​ Current Account Deposits - These deposits refer to those deposits which are repayable
by the banks on demand. They are generally maintained by businessmen to make
frequent transactions. They can be drawn upon by a cheque without restriction. Banks
charge fees on such accounts and do not provide interest.
●​ Fixed Deposits - Fixed deposits refer to those deposits in which the amount is deposited
with the bank for a fixed period. They cannot be withdrawn or deposited by cheque. They
carry a high rate of interest.
●​ Saving Deposits - These deposits combine features of both current account deposits
and fixed deposits. The depositors are given a cheque facility to withdraw money from
their accounts. But there are restrictions on the number of withdrawals and deposits. They
carry a rate of interest lower than interest on fixed deposits.
2.​ Advancing Of Loans - The deposits received by banks are not allowed to remain idle. So, after
keeping certain cash reserves, the balance is given to needy borrowers and interest is charged to
them, which is the main source of income for commercial banks. Different types of loans and
advances made by commercial banks are -
●​ Cash Credit - Cash credit refers to a loan given to the borrower against his current assets
like shares, stocks, bonds, etc. A credit limit is sanctioned and interest is charged on the
amount withdrawn.
●​ Demand Loans - Demand loans refer to those loans which can be recalled on demand
by the bank at any time. The entire sum of the demand loan is credited to the account and
interest is payable on the entire sum.
●​ Short-Term Loans - They are given as personal loans against some collateral security.
The money is credited to the account of the borrower and the borrower can withdraw
money from his account and interest is payable on the entire sum of the loan granted.
Secondary Functions
1.​ Overdraft Facility - It refers to the facility in which a customer is allowed to withdraw his current
account up to an agreed limit. This facility is given to respectable and reliable customers for a
short period. Customers have to pay interest to the bank on the amount overdrawn by them.
2.​ Discounting Bills Of Exchange - It refers to a facility in which the holder of a bill of exchange
can get the bill discounted with the bank before maturity. After deducting the commission, the
bank pays the balance to the holder.
3.​ Agency Functions - Commercial banks also perform certain agency functions and charge some
commission from their clients. Some of the agency functions are -
●​ Transfer Of Funds - Banks provide the facility of economical and easy remittance of
funds from place to place with the help of instruments like demand drafts, mail transfers,
etc.
●​ Collection And Payment Of Various Items - Commercial banks collect cheques, bills,
interests, dividends, etc. on behalf of their customers and also make payments such as
taxes, insurance premiums, etc. on standing instructions of their clients.
●​ Purchase And Sale of Foreign Exchange - Some commercial banks are authorized by
the central bank to deal in foreign exchange, They buy and sell foreign exchange on
behalf of their customers and help in promoting international trade.
●​ Purchase And Sale Of Securities - Commercial Banks buy and sell stocks and shares
of private companies as well as government securities on behalf of their customers.
 ●​ Income Tax Consultancy - They also advise their customers on matters relating to
income tax and even prepare their income tax returns.
●​ Trustee And Executor - Commercial banks preserve the wills of their customers as
trustees and execute them after their death as executors.
●​ Letter Of Reference - They give information about the economic position of their
customers to traders and provide similar information about other traders to their
customers.
4.​ General Utility functions - Commercial Banks render some general utility services like -
●​ Locker Facility - Commercial Banks provide a facility of safety vaults or lockers to keep
valuable articles of customers in safe custody.
●​ Traveller’s Cheque - Commercial banks issue traveler’s cheques to their customers to
avoid the risk of taking cash during their journey.
●​ Letter of Credit - They also issue letters of credit to their customers to certify their
creditworthiness.
●​ Underwriting Securities - Commercial banks also undertake the task of underwriting
securities. As the public has full faith in the creditworthiness of banks, the public does not
hesitate in buying the securities underwritten by banks.
●​ Collection Of Statistics - Banks collect and publish statistics relating to trade,
commerce, and industry. Hence, they advise customers on financial matters.

Money Creation Or Credit Creation

Through the process of credit creation, commercial banks can create credit, which is in far excess of the initial or
primary deposits. There are two assumptions under credit creation -
●​ The entire commercial banking system is one unit and is termed as ‘banks’.
●​ All receipts and payments in the economy are routed through the banks, i.e., all payments are
made through cheques and all receipts are deposited in the banks.
The deposits held by banks are used for giving loans. Commercial banks grant loans to the borrower by crediting the
amount in their accounts. This is called Secondary Deposit. However, banks cannot use the whole of the deposit for
lending. It is legally compulsory for banks to keep a certain minimum fraction of their deposits as reserves. This
fraction is called the Legal Reserve Ratio or Reserve Deposit Ratio or Reserve Ratio and is fixed by the central
bank. Banks do not keep 100% reserves against deposits. They keep reserves only to the extent indicated by the
Central Bank.
Example-
●​ Suppose, initial or primary deposits in banks are Rs. 1000 and LRR is 20%. It means, banks are
required to keep only Rs. 200 as cash reserve and are free to lend Rs. 800. Suppose they lend
Rs. 800. Banks do not lend this money by giving amounts in cash. Rather, they open the
accounts in the names of borrowers, who are free to withdraw the amount whenever they like.
●​ Suppose borrowers withdraw the entire amount of Rs. 800 for making payments. As all the
transactions are routed through the banks, the money spent by the borrowers comes back into
the banks in the form of deposits of those who have received this payment. It will increase the
demand deposits by banks by Rs. 800
●​ With new deposits of Rs. 800, banks keep 20% as cash reserves and lend the balance of Rs.
640. Borrowers use these loans for making payments, which again come back into the accounts
of those who have received the payments. This time, bank deposits rise by Rs. 640.
●​ The deposits keep on increasing in each round by 80% of the last round deposits. At the same
time, cash reserves also go on increasing, each time by 80% of the last cash reserve. Deposit
creation comes to an end when total cash reserves become equal to the initial deposit.
Rounds Deposits (Rs.) Loans (Rs.) Cash Reserves (Rs.)

Initial Deposit 1000 800 200

Round-1 800 640 160

Round-2 640 512 128

- - - -

Total 5000 4000 1000

Money Multiplier - Money Multiplier is the number by which total deposits can increase due to a given change in
deposits. It is inversely related to the legal reserve ratio. Money Multiplier = 1/LRR.
It signifies that for every unit of money kept as reserves, banks can create 5 units of money. The value of the money
multiplier is determined by LRR. The higher the value of LRR, the lower the value of the money multiplier, and less
money is created by the banking system.

Central Bank
Central Bank is an ‘Apex” body that controls, operates, regulates, and directs the entire banking and monetary
structure of the country. It occupies the topmost position in the monetary and banking system of the country. All
financially developed countries have their central bank. India’s Central bank is the Reserve Bank Of India (RBI). RBI
was established on April 1, 1935, under the Reserve Bank of India Act of 1934.

Functions Of Central Bank

1.​ Currency Authority - Central bank has the sole authority for the issue of currency in the country.
In India, the Reserve Bank of India (RBI) has the sole right of issuing paper currency notes (coins
are issued by the Ministry of Finance). All currency notes bear the signature of the Finance
Secretary, while other currency notes bear the signature of the Governor of RBI. All the currency
issued by the Central Bank is its monetary liability, i.e., Central Bank is obliged to back the
currency with assets of equal value, to enhance the public confidence in paper currency.
Advantages of currency authority with RBI -
●​ It leads to uniformity in note circulation.
●​ It gives the Central Bank the power to alter money supply.
●​ It enables the government to have supervision and control over the central bank
concerning the issue of notes.
●​ It ensures public faith in the currency system.
●​ It helps in the stabilization of the internal and external value of the currency.
2.​ Banker To The Government - The Reserve Bank of India acts as a banker, agent, and financial
advisor to the Central Government and all the State Governments. It carries out the following
functions -
●​ It maintains a current account for keeping its cash balances.
●​ It accepts receipts and makes payments for the government and carries out exchange,
remittance, and other banking operations.
●​ It also gives loans and advances to the government for temporary periods. The
government borrows money by selling treasury bills to the central bank.
●​ It also has the responsibility of managing the public debt.
●​ It also gives the government advice to the government on economic, financial, and
monetary matters.
3.​ Banker’s Bank And Supervisor - There are several commercial banks in the country. There
should be some agency to regulate and supervise their proper function. Being the apex bank,
RBI acts as the banker to other banks. In this sense, it bears the same relationship with
commercial banks as commercial banks maintain with the general public. The functions of the
central bank towards commercial banks are -
●​ Custodian Of Cash Reserves - The central bank stores the Cash Reserve Ratio set
aside by the commercial banks per the central bank.
●​ Lender Of The Last Resort - When commercial banks are in a position of financial
emergency, they approach the central bank to give loans and advances as the lender of
the last resort. The central bank assists these banks through discounting of approved
securities and bills of exchange.
●​ Clearing House - As the central bank stores the cash reserve ratios and current accounts
of all commercial banks, it helps in settling claims of various commercial banks against
each other.
●​ Supervising Commercial Banks - Central Bank regulates and controls commercial
banks. The regulation of banks may be related to their licensing branch expansion,
liquidity of assets, management, merging, winding up, etc. This control is exercised by
periodic inspection of banks and the returns filed by them.
4.​ Controller of Money Supply and Credit - The RBI is empowered to regulate the money supply
in the economy through its ‘Monetary Policy’. It is the policy adopted by the Central Bank of an
economy in the direction of credit control or money supply. Since the RBI has the sole right to
issue currency, it can control the credit and supply of money. For this, RBI makes use of the
following instruments of Monetary Policy -
●​ Repo Rate - Repo rate is the rate at which the central bank of a country lends money to
commercial banks to meet their short-term needs. The central bank advances loans
against approved securities or eligible bills of exchange. An increase in the repo rate
leads to a decrease in the money supply as it forces commercial banks to increase the
rate of lending and discourages the public and business firms to borrow and a decrease in
the repo rate will result in the opposite.
●​ Bank Rate - Bank rate is the rate at which the central bank of a country lends money to
commercial banks to meet their long-term needs. An increase in the bank rate leads to a
decrease in the money supply as it forces commercial banks to increase the rate of
lending and discourages the public and business firms to borrow and a decrease in the
bank rate will result in the opposite.
●​ Reverse Repo Rate - Reverse Repo Rate is the rate at which commercial banks can
deposit their surplus funds with the Central Bank, for a relatively shorter period. An
increase in the reverse repo rate leads to a decrease in the money supply as the
commercial banks deposit more funds with the central bank, this reduces the lending
capacity of the banks and leads to an increase in the lending rates, and discourages the
public and business firms to borrow and a decrease in the reverse repo rate will result in
the opposite.
●​ Open-Market Operation - Open-Market operation refers to buying and selling of
government securities by the Central Bank from/to the public and commercial banks. The
sale of securities will lead to a decrease in the money supply as it leads to a reduction of
the reserves with commercial banks and reduces its lending power, and leads to an
increase in the lending rates and discourages the public and business firms to borrow and
purchase of securities will result in the opposite.
●​ Legal Reserve Requirements - Legal Reserve Requirements are quick and easy
methods of credit control. Commercial banks are required to maintain reserves on two
accounts -
1.​ Cash Reserve Ratio - It refers to the minimum percentage of net demand and
time liabilities, to be kept by commercial banks with the central bank. An increase
in CRR leads to a decrease in the money supply as it leads to a reduction in the
lending power of the commercial banks and leads to an increase in the lending
rates which discourages the public and business firms to borrow and a decrease
in CRR leads to the opposite.
2.​ Statutory Liquidity Ratio - It refers to the minimum percentage of net demand
and time liabilities that commercial banks are required to maintain themselves. An
increase in SLR leads to a decrease in money supply as it leads to a reduction in
the lending power of the commercial banks and leads to an increase in the lending
rates which discourages the public and business firms to borrow and a decrease
in SLR leads to the opposite.
●​ Margin Requirements - Margin is the difference between the amount of the loan and the
market value of the security/ collateral offered by the borrower against the loan. An
increase in the margin requirements will result in a decrease in the money supply as it
makes borrowings costlier and discourages the public and business firms to borrow and a
decrease in margin requirements leads to the opposite.