Chapter 6 Banking: Commercial Banks and The Central Banks
Banking
Meaning: Bank refers to a financial institution which accepts deposits & lends money for earning profit. It is also called Financial intermediary.Commercial Bank
Meaning: Commercial Bank performs various types of function like accepting deposits, giving loans, locker facility etc.Central Banks
Meaning: It is the apex body of Indian financial and monitory system which governs printing of currency notes along with other functions.OR
Meaning: Central banks is an Apex body that controls, operates, regulates and directs the entire banking and monitory structure of a country.
Functions of Central Banks
1. Issue of Currency: RBI has got solmonopoly for the printing of currency notes in India. This monopoly of printing of currency notes helps in two ways:(a). It brings uniformity in the currency notes being printed.
(b). It gives central bank a direct control over money supply.
2. Banker to the Government:
(a). Central Bank act as a banker to the govt. and its departments.
(b). It also lends money to the government & helps in international settlement of payments.
(c). RBI also helps govt. in their financial matters and investment decisions.
3. Banker's Bank & Supervisor:
(a).RBI acts as a banker to the commercial bank by acting as lender of last resorts.
(b).RBI also helps in settlement of the cheque by performing the function of cleaning house.
(c). RBI also helps commercial banks in settlement of disputes between commercial banks by acting as a supervisor.
(d). RBI also maintains the reserves for commercial banks by maintaining CRR( cash reserve ratio) & SLR( statutory liquidity ratio) which is collectively called as LRR( legal reserve ratio)
4. Lender of last resort: Central Bank acts as a lender of last resort for commercial Banks by advancing loans to them against government securities etc. It is a obligation of central bank to give loan to commercial bank as per banking law.
5. Cleaning House function: RBI act as a cleaning house for the cheques being circulated or exchange between different parties. This function is being performed by RBI for commercial bank.
6. Controller of Credit & Money Supply: RBI forms monitory policy to control the supply of money into the economy with the help of monitory policy it can inject money into the economy or can take out excessive money from the economy. This policy helps in controlling the situation of inflation and deflation.
Difference Between the Central bank And Commercial Bank
Controller of Money Supply and Credit
1. Bank Rate: It refers to the rate at which central Bank lends money to commercial banks to meet their long-terms needs.At the time of inflation: When there is excessive flow of money in the economy, RBI increases the bank rate which makes loans costlier & flow of money in the economy is reduced.
At the time of Deflation: When the money flow in economy is less, bank rate is reduced loans become cheaper & the flow of money is boosted.
2. Repo Rate: It is rate at which the central bank lends money to commercial banks to meet their short-terms needs.
At the time of Inflation: An increase in repo rate increase the cost of borrowings from the central bank. It forces the commercial banks to increase their lending rate, which discourages borrowers from taking loans. It reduces the ability of commercial banks create credit.
At the time of Deflation: Decrease in repo rate, decrease the cost of borrowings from the central bank. It forces the commercial banks to decrease their lending rate, which encourages borrowers from taking loans. It increase the ability of commercial banks create credit.
3. Legal Reserve Requirements: Banks are obliged to maintain reserves with the central bank on two accounts:
(a). Cash Reserve Ratio: It refers to the Minimum % of net demand and time liabilities, to be kept by commercial banks with central banks.
At the time of Inflation: An increase in CRR as the effect of reducing the banks excess reserves and thus curtail their ability to give to give credit.
At the time of Deflation: An decrease in CRR as the effect of increasing the banks excess reserves and thus it increase their ability to give credit.
(b). Statutory Liquidity Ratio (SLR): It refers to the minimum % of net demand and time liabilities which central banks are required to maintain with themselves.
At the time of Inflation: This effects their freedom to increase the quantum of credit and therefore the money supply increasing the SLR reduces the ability banks to give credit.
At the time of Deflation: This effects their freedom to decreases the quantum of credit and therefore the money supply decreases the SLR increases the ability banks to give credit.
4. Open Market Operation: refers to buying and selling of government securities by the central banks from to the public and commercial banks.
At the time of inflation: RBI sells securities to commercial banks & general public so that it can reduce the excessive flow of money.
At the time of Deflation: RBI buys these securities & gives money to the people & banks.
5. Margin Requirement: Refers to the difference between the loan value & market value.
At the time of Inflation: This margin is increased so that people can be discouraged from taking loans.
At the time of Deflation: This margin is reduced so that people are encouraged to take loans.
Credit Creation Or Money Multiplier
Commercial banks are known as factories of the credit. They generate & multiply money in the economy. The phenomenon of multiplying money is called as money multiplier. On the basis of initial deposit they create secondary deposits. This process has been explained below.Working of multiplier is based on some assumption:-
1. There is a single banking model.
2. Each & every person deposits money into the bank.
The value of money multiplier is inversely related to LLR which means higher the LLR lower would be the value of money multiplier & vice versa.
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