UNIT 6
MONEYAND BANKING
PART 2
WRITE ALL THESE NOTES IN YOUR MACRO ECONOMICS REGISTER.
A. CENTRAL BANK
1. Define cental bank.
Central Bank :- The central bank is the apex institution of a country’s monetary
system. The design and control of the country’s monetary policy is its main
responsibility. India’s central bank is the Reserve Bank of India.
2. Name the System of Note-issue in India.
Ans: In India, the system of note issue is the Minimum Reserve System. The RBI
is required to keep minimum reserves of Rs 200 crores.
3. Define open Market operation.
Ans: Open Market operations refer to the purchase or sale of government
securities in the open market by the central bank of the country.
4. Name the additional facility which the businessman gets in the current
deposit account of the bank.
Ans: The businessman gets the facility of overdraft (OD) in the current
account of the bank.
5. Why only a fraction of deposits is kept as Cash Reserve?
a) All depositors do not withdraw the money at the same time.
b) There is constant flow of new deposits into the banks.
6. Explain LRR.
Legal Reserve Ratio: R.B.I. can influence the credit creation power of
commercial banks by making changes in CRR and SLR.
LRR= CRR+SLR.
Cash Reserve Ratio (CRR): It refers to the minimum percentage of deposits of
commercial banks (net demand and time liabilities) to be kept by commercial
banks with central bank. Reserve Bank increases CRR during inflation and
decreases the same during deflation.
Statutory Liquidity Ratio (SLR): It refers to minimum percentage of deposits of
commercial banks (net demand and time liabilities) which commercial banks
required to maintain with themselves. SLR is increased during inflation or excess
demand and decreased during deflation or deficient demand.
Functions of central bank:
1. ISSUE OF CURRENCY:
The central bank has the sole monopoly of note issue in almost every country.
The currency notes printed and issued by the central bank become unlimited
legal tender throughout the country. Central Bank is obliged to back the currency
with assets of some proportion of currency value (usually gold coins, gold
bullions, foreign securities etc.,) All the currency issued by the central bank is its
monetary liability.
in India, one rupee notes are issued by the Ministry of Finance and all other
notes are issued by the Reserve Bank of India.
The main advantages of giving the monopoly right of note issue to the central
bank are given below:
(i) It brings uniformity in the monetary system of note issue and note circulation.
(ii) The central bank can exercise better control over the money supply in the
country. It increases public confidence in the monetary system of the country.
(iii) Monetary management of the paper currency becomes easier. Being the
supreme bank of the country, the central bank has full information about the
monetary requirements of the economy and, therefore, can change the quantity
of currency accordingly.
(iv) It enables the central bank to exercise control over the creation of credit by
the commercial banks.
(v) The central bank also earns profit from the issue of paper currency.
(vi) Granting of monopoly right of note issue to the central bank avoids the
political interference in the matter of note issue.
2. Banker to the Government
The central bank functions as a banker, agent and financial adviser to the
government,
(a) As a banker to government, the central bank performs the same functions for
the government as a commercial bank performs for its customers. It maintains
the accounts of the central as well as state government; it receives deposits from
government; it makes short-term advances to the government; it collects
cheques and drafts deposited in the government account; it provides foreign
exchange resources to the government for repaying external debt or purchasing
foreign goods or making other payments,
(b) As an Agent to the government, the central bank collects taxes and other
payments on behalf of the government. It raises loans from the public and thus
manages public debt. It also represents the government in the international
financial institutions and conferences,
(c) As a financial adviser to the lent, the central bank gives advise to the
government on economic, monetary, financial and fiscal Matters such as deficit
financing, devaluation, trade policy, foreign exchange policy, etc.
3. Bankers' Bank:
The central bank has the same relationship with the commercial banks as the
commercial bank has with the general public. Commercial banks are required to
keep a part of their deposits with the central bank in the form of cash. This is
known as cash reserve ratio. The central bank uses these reserve to meet the
cash requirement of individual commercial banks.
The central bank acts as the bankers' bank in three capacities:
(a) custodian of the cash reserves of the commercial banks; As a custodian of
the cash reserves of the commercial banks the central bank maintains the cash
reserves of the commercial banks
(b) as the lender of the last resort; in case the commercial banks are not able
to meet their financial requirements from other sources, they can, as a last resort,
approach the central bank for financial accommodation.
(c) as clearing agent. central bank acts as the clearing house for these banks.
Since all banks have their accounts with the central bank, the central bank can
easily settle the claims of various banks against each other with least use of
cash..
As a banker’s bank, central bank supervises, regulates and controls the
commercial banks. Supervision relates to licensing, management and branch
expansion.RBI periodically inspects commercial banks.
4. Lender of Last Resort:
As the supreme bank of the country and the bankers' bank, the central bank acts
as the lender of the last resort. In other words, in case the commercial banks are
not able to meet their financial requirements from other sources, they can, as a
last resort, approach the central bank for financial accommodation. The central
bank provides financial accommodation to the commercial banks by
rediscounting their eligible securities and exchange bills. The main advantages of
the central bank's functioning as the lender of the last resort are :
(i) It increases the elasticity and liquidity of the whole credit structure of the
economy.
(ii) It enables the commercial banks to carry on their activities even with their
limited cash reserves.
(iii) It provides financial help to the commercial banks in times of emergency.
(iv) It enables the central bank to exercise its control over banking system of the
country.
5. Clearing Agent:
As the custodian of the cash reserves of the commercial banks, the central bank
acts as the clearing house for these banks. Since all banks have their accounts
with the central bank, the central bank can easily settle the claims of various
banks against each other with least use of cash. The clearing house function of
the central bank has the following advantages:
(i) It economies the use of cash by banks while settling their claims and counterclaims.
(i) It reduces the withdrawals of cash and these enable the commercial banks to
create credit on a large scale.
(ii) It keeps the central bank fully informed about the liquidity position of the
commercial banks.
OR
Q . Central bank performs the function of a clearing house. How?
Ans. Every bank keeps cash reserves with the central bank. The claims of banks
against one another can be easily and conveniently settled by simple transfers
from and to their account. Supposing, Bank A receives a cheque of Rs 10,000
drawn on Bank B and Bank Breceives a cheque of Rs. 15000 drawn on Bank A.
The most convenient method of settling or clearing their mutual claims is that
Bank A should issue a cheque amounting to Rs 5000 in favour of Bank B, drawn
on central Bank. As a result of this transference, a sum of Rs 5000 will be
debited to the account of Bank A and credited to the account of B. There is
not need of cash transactions between the banks concerned. It facilitates cash
transaction across the entire banking system, it also reduces requirement of cash
reserves of thecommercial banks.
6. CREDIT CONTROL
Credit control is one of the most important responsibility of a central bank.
Central bank
of a country can control credit by following two methods.
(1) Qualitative controls (2) Quantitative controls
QUANTITATIVE CONTROLS/TOOLS
Quantitative controls are used to expand or contract the total quantity (overall
size) of credit. These controls are of the following kinds:
1. Bank rate policy
2. Open market operations
.
3. Legal reserve ratios
4. Repo rate and reverse repo rate
These are explained as under.
i. Bank Rate
Bank rate is the rate at which central bank rediscounts bill of exchange or
provides credit to commercial banks. For controlling credit central bank may
increase or decrease bank rate. When bank rate is raised, other
bank's interest rates on advances also move up. When bank rate is decreased,
other banks' interest rates on advances also go down. Borrowing from banks is
discouraged when bank rate increases and
deposits increase leading to contraction in money supply. Or borrowing is
encouraged when bank rate is decrease and deposits decrease, as a result
money supply in the economy increases.
2. Open Market Operation
Buying and selling of government securities by the central bank with a view to
influencing money supply is called open market operations.
Govt. securities are sold by the central bank in open market. This withdraws
additional purchasing power. There will be contraction of credit, less money will
flow in the system. This way central bank can control money supply.
On the other hand central bank purchases govt. securities, this way it injects
additional purchasing power in the system money supply in market increases.
3. Legal reserve ratios = CRR+SLR:- Banks are obliged to maintain reserves
with the central bank on two accounts. One is the cash reserve ratio [ definition]
and the other is Statutory Liquidity Ratio [definition]. Varying CRR and SLR are
tools of monetary and credit control.
In order to control credit and money supply in the market CRR and SLR are
increased. This reduces the money availability with banks for lending purposes
and central bank can contract money supply from the system.
On the other hand in order to increase money supply in the system, central bank
reduces CRR and SLR, availability of money for lending purposes increases with
commercial banks. And money supply can be expanded in the system.
4. Repo rate:
Repo rate is the rate at which the central bank of a country lends money to
commercial banks in the eent of any short fall of funds. The central bank
advances loans against approved securities or eligible bills of exchange.
RBI /central bank actively uses repo rate to control credit. An increase in repo
rate increases the costs of borrowing from the central bank.it forces the
commercial banks to increase their lending rates, which discourages borrowers
from taking loans. It reduces the ability of commercial banks to create credit. A
decrease in repo rate will have the opposite effect.
5. Reverse repo rate
This is exactly the opposite of repo rate. Reverse repo rate is the rate at whichch
reserve bank of India borrows from commercial banks.
RBI/central bank uses this tool when it feels that there is excess of money supply
in the banking system.
Banks are happy to lend their money to RBI as their money is in dafe hands with
good interest.
. II) Qualitative Credit Control :A) 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. The advantages of this instrument
are manifold.
Margin requirement is increased in order to decrease money supply and vice
versa.
B) 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.
C) Selective credit controls :- These can be applied in both a positive as well
as a negative manner. In a positive manner measures can be used to encourage
credit to particular sectors, usually the priority sectors. And in negative manner,
measures can be used to restrict the flow of credit to particular sectors.
D. Direct action: the central bank may take firect aacction against the banks in
case they do not follow directives. Direct action includesrefusal of loan,
derecongnition of bank etc.
MONEY CREATION/DEPOSIT CREATION/CREDIT CREATION BY
COMMERCIAL BANK
It is most significant function of the commercial banks. While sanctioning a loan
to a customer, a bank does not provide cash to the borrower Instead it opens a
deposit account from where the borrower can withdraw. In other words while
sanctioning a loan a bank automatically creates deposits. This is known as a
credit creation from commercial bank.
Let us understand the process of credit creation with the following example.
Suppose there is an initial deposit of Rs. 1000 and L.R.R. is 20% i.e., the banks
have to keep.
Rs. 200 and lend Rs. 800/-. All the transactions are routed through banks. The
borrower
withdraws his Rs. 800/- for making payments which are routed through banks in
the form of deposits account. The Bank receives Rs. 800/- as deposit and keeps
20% of Rs.800/- i.e., Rs.160/- and lends Rs.640/- . Again the borrower uses this
for payment which flows back into the banks thereby increasing the flow of
deposits.
Deposits (in Rs.)
Loans (in Rs.)
Legal Reserve Ratio
(20%)
Initial deposit
1000
800
200
First round
800
640
160
Second round
640
512
128
----------
Total
5000
4000
MONEY MULTIPLIER:
1000
Money Multiplier = 1/LRR.
In the above example LRR is 20% i.e., 0.2, so money multiplier
is equal to 1/0.2=5
credit creation =1/LRR*INITIAL DEPOSIT
1/20%*1000=5000
Difference between central bank and commercial bank:
1. Function
 The main function of a Commercial Bank is to accept deposits from public
for the purpose of lending to industry and others.
 The Central Bank regulates money supply in the country. It also acts as a
banker to the government and to the other banks operating in a country.
2. Printing of Currency


The Commercial Banks cannot print currency notes and make coins.
The Central Bank of India (i.e. RBI) has the power to print currency notes
from Rs.2 and above.
3. Acceptance of Deposit


The Commercial Bank accepts deposits from the public.
The Central Bank doesn’t accept any deposit from the public.
4. Provision of Loans


The Commercial Bank provides loans to the industry and to the public.
The Central Bank provides loans to scheduled banks and financial
institutions.
5. Ownership


Commercial Banks can be owned by private and / or Government
agencies.
Central Bank of India (RBI) is owned and controlled by Government of
India.
6. Total Number
 There are several Commercial Banks currently operating in India.
 However, there is only one apex Central Bank (i.e RBI) in India.
7. Framing Monetary Policy


Commercial Banks do not frame monetary policy of the country.
Central Banks frames monetary policy of a country.
8. Monitory Control


Commercial Bank does not have any control over Central Bank.
Central Bank monitors the working of all commercial banks.
9. Registration and Establishment


In India, Commercial banks are registered under the Banking Regulation
Act of 1949.
The Central Bank of India (RBI) is established under RBI Act of 1934.
10. Account Holders
 Individuals and organisations are the account holders of Commercial
Banks.
 Banks and Government are the account holders of a Central Bank.

KEEP THE PRINT OUT OF THE FOLLOWING NOTES WITH YOU.NEED NOT
WRITE THE FOLLOWING NOTES. DO NOT WRITE OF PASTE IN REGISTER.
B. FUCNTIONS O COMMERCIAL BANKS
Commercial Banks performs various primary functions some of them are given
below
Accepting Deposits
Making Advances
Credit creation
Primary Functions:The primary functions of the commercial banks include the
following:
A. Acceptance of Deposits
Commercial bank accepts various types of deposits from public especially from
its clients. It includes saving account deposits, recurring account deposits, fixed
deposits, etc. These deposits are payable after a certain time period
1. Time Deposits: These are deposits repayable after a certain fixed period.
These deposits are not withdrawn able by cheque, draft or by other means. It
includes the following.
(a) Fixed Deposits:
The deposits can be withdrawn only after expiry of certain period say 3 years, 5
years or 10 years. The banker allows a higher rate of interest depending upon
the amount and period of time.
(b) Recurring Deposits:
In recurring deposit, the customer opens an account and deposit a certain sum of
money every month. After a certain period, say 1 year or 3 years or 5 years, the
accumulated amount along with interest is paid to the customer. It is very helpful
to the middle and poor sections of the people. The interest paid on such deposits
is generally on cumulative basis.
2. Demand Deposits: These are the deposits which may be withdrawn by the
depositor at any time without previous notice. It is withdraw able by cheque/draft.
It includes the following:
(a) Savings Deposits:
The savings deposit promotes thrift among people. The savings deposits can
only be held by individuals and non-profit institutions. The rate of interest paid on
savings deposits is lower than that of time deposits. But there are some
restrictions on withdrawals. Corporate bodies and business firms are not allowed
to open SB Accounts.
(b) Current Account Deposits:
These accounts are maintained by the people who need to have a liquid balance.
Current account offers high liquidity. No interest is paid on current deposits and
there are no restrictions on withdrawals from the current account. These
accounts are generally in the case of business firms, institutions.
B. Advancing of Loans
The commercial banks provide loans and advances in various forms. They are
given below:
1. Overdraft:
This facility is given to holders of current accounts only. This is an arrangement
with the bankers thereby the customer is allowed to draw money over and above
the balance in his/her account. This facility of overdrawing his account is
generally pre-arranged with the bank up to a certain limit. It is a short-term
temporary fund facility from bank and the bank will charge interest over the
amount overdrawn. This facility is generally available to business firms and
companies.
2. Cash Credit:
Cash credit is a form of working capital credit given to the business firms. Under
this arrangement, the customer opens an account and the sanctioned amount is
credited with that account. The customer can operate that account within the
sanctioned limit as and when required. It is made against security of goods,
personal security etc. One advantage under this method is that bank charges
interest only on the amount utilized and not on total amount sanctioned or
credited to the account.
3. Discounting of Bills:
An accepted draft or bill of exchange sold for early payment to
a bank or credit institution at less than face value after the bank deducts fees and
applicable interest charges. The bank or credit institution then collects
full value on the draft or bill of exchange when payment comes due.
4. Loans and Advances:
It includes both demand and term loans, direct loans and advances given to all
type of customers mainly to businessmen and investors against personal security
or goods of movable or immovable in nature. The interest is charged for the full
amount whether he withdraws the money from his account or not.
Classification of Money :- It is classified on the basis of value of money as money
and value of money as commodity as following :1. Full bodied money.
This is the form of money where the money value of money and the commodity
value
of
money
is
the
same
for
example
gold
coins.
2. Representative full bodied money.
Face value of this money is grater than commodity money. It is fully convertible.
3.
Credit
money.
The money whose value as money is greater than the commodity value with
which
it
is
made
of.
Q.What
monetary
system
does
India
Ans.
India
is
at
present
on
the
paper
currency
Q7.Give
example
of
near
Ans.
Bonds,
Equity,
Shares,
NSC
follow?
standard.
money.
etc.
Q3.
How
the
Bank
rate
control
the
credit?
Ans. Bank rate is the rate of interest at which Central bank lends to Commercial
banks. By raising the bank rate central bank raises the cost of borrowing. This
forces the Commercial banks to raise in turnthe rate of interest from the public.
As lending rate rises demand for loan for investment and other purposes falls.