class 12 macroeconomics chapter 6 banking notes
Banking: Commercial Banks and the Central Bank
banking class 12 sandeep garg pdf
sandeep garg macroeconomics class 12 latest edition
sandeep garg macroeconomics class 12 banking pdf
sandeep garg microeconomics class 12
banking class 12 sandeep garg pdf
COMMERCIAL BANK
Commercial bank is an institution which performs the function of accepting deposits, granting loans and making investments, with the aim of earning profits. State Bank of India (SBI), Punjab National Bank (PNB), Bank of Baroda, Canara Bank are some example of Commercial Banks in India.
FUNCTIONS OF A COMMERCIAL BANK
The functions performed by commercial banks can be broadly categorized under two heads:
(i) Primary Function; (ii) Secondary Functions.
- Primary Functions
Commercial banks perform two primary functions:
- Accepting Deposits – It is the most important function of commercial banks. They accept deposits in several forms according to requirements of different sections of the society. The main kinds of deposits are:
(i) Current Account Deposits: These deposits refer to those deposits which are repayable by the banks on demand.
- Such deposits are generally maintained by businessmen with the intention of making transactions with such deposits.
- They can be drawn upon by a cheque without any restriction.
(ii) Fixed Deposits or Time Deposits or Term Deposits: Fixed deposits refer to those deposits, in which the amount is deposited with the bank for a fixed period of time.
- Such deposits do not enjoy chequable facility.
- These deposits carry a high rate of interest.
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 & interest is charged from them.
- 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 the amount is credited in his account.
- Demand Loans: Demand loans refer to those loans which can be recalled on demand by the bank at any time. The entire sum of 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 borrower and the borrower can withdrew money from his account and interest is payable on the entire sum of loan granted.
II. Secondary Functions
In addition to primary functions, commercial banks also perform the following secondary functions:
(i) Overdraft facility – It refers to a facility in which a customer is allowed to overdraw his current account upto an agreed limit. This facility is generally given to respectable and reliable customers for a short period.
(ii) 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 the maturity. After deducting the commission, bank pays the balance to the holder. On maturity, bank gets its payment from the party which had accepted the bill.
(iii) Agency functions – Commercial banks also perform certain agency functions for their customers. For these services, banks charge some commission from their clients. Some of the agency functions are:
- Transfer of Funds
- Collection and Payment of Various items
- Purchase and Sale of Foreign Exchange
- Purchase and Sale of Securities
- Income Tax Consultancy
- Trustee and Executor
- Letter of Reference
(iv) General Utility Functions
Commercial banks render some general utility services like
- Locker Facility
- Traveler’s Cheques
- Letter of credit
- Underwriting securities
- Collection of statistics
MONEY CREATION OR CREDIT CREATION
It is one of the most important activities of commercial banks. Through the process of money creation, commercial banks are able to create credit, which is far excess of the initial or Primary Deposits.
This process can be better understood by making two assumptions:
- 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.
Why only Fraction of deposits are kept as Cash Reserve?
Banks keep a fraction of deposits as Cash Reserve because a prudent banker, by his experience, knows two things:
- All the depositors do not approach the banks for withdrawal of money at the same time and also they do not withdrew the entire amount in one go.
- There is a constant flow of new deposits into the banks.
Refer the following table:
As seen in table, banks are able to create total deposits of Rs.5,000 with the initial deposit of just Rs.1,000. It means, total deposits become ‘five times’ of the initial deposit. Five times is nothing but the value of ‘Money Multiplier’.
Money Multiplier or Credit Multiplier or Deposit Multiplier
Money multiplier is the number by which total deposits can increase due to a given change in deposits. It is inversely related to legal reserve ratio. In other words, Money Multiplier is the process by which the commercial banks create credit, based upon the reserve ratio and initial deposits. It is calculated as:
Money Multiplier or Credit Multiplier or Deposit Multiplier = 1/LRR
In the given example, LRR I s20% or 0.2, So,
Money Multiplier = 1/0.2
= 5
It signifies that for every unit of money kept as reserves, banks are able to create 5 units of money. The value of money multiplier is determined by LRR. Higher the value of LRR, lower is the value of 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 is known as the apex (supreme) body as it occupies the top most position in the monetary and banking system of the country. All the financially developed countries have their own central bank. India’s Central Bank is the Reserve Bank of India (RBI). RBI was established in April 1, 1935 under Reserve Bank of India Act passed in 1934.
FUNCTIONS OF CENTRAL BANK
As the Central Bank of the country, The Reserve Bank of India performs the following functions:
- Currency Authority (or Bank of Issue) – Central Bank has the sole authority for issuing currency in the country. In India, Reserve Bank of India (RBI) has the sole right to issue paper currency notes (except one-rupee notes and coins, which are issued by the Ministry of Finance). The One Rupee note bears the signature of Finance Secretary, while other currency notes bear the signature of Governor of RBI.
Advantages to Sole Authority of Note issue with RBI
- It leads to uniformity in note circulation.
- It gives the central bank power to influence money supply because currency with public is a part of money supply.
- It enables the government to have supervision and control over the central bank with respect to issue of notes.
- It ensures public faith in the currency system.
- It helps in stabilization of internal and external value of currency.
2. Banker to the Government – The Reserve Bank of India acts as a banker, agent and a financial advisor to the Central Government and all the State Governments.
As a banker, it carries out all banking business of the government.
- It maintains a current account to keep their 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.
3. Banker’s Bank and Supervisor – There are a number of commercial banks in a country. There should be some agency to regulate and supervise their proper functioning. Being the apex bank, the central bank (RBI) acts as the banker to other banks.
- Custodian of Cash Reserves – Commercial banks are required to keep a certain proportion of their deposits (known as Cash Reserve Ratio or CRR) with the central bank.
- Lender of the Last Resort – When commercial banks fail to meet their financial requirements from other sources, i.e. in case of a financial emergency, they approach the central bank to give loans and advance as lender of the last resort.
- Clearing House – As central bank holds the cash reserves of all the commercial banks, it becomes easier and more convenient for it to act as their clearing house. All commercial bank have their accounts with the central bank.
4. Controller of Money Supply and Credit – The Reserve Bank of India (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 economy in the direction of credit control or money supply.
i. country (RBI in case of India) lends money to commercial banks to meet their short-term needs. The central bank advances loans against approved securities or eligible bills of exchange.
ii. Bank Rate (or Discount Rate) – Bank rate is the rate at which the central bank of a country (RBI in case of India) lends money to commercial banks to meet their long-term needs.
iii. Reserve Repo Rate (or Reverse Repurchase Rate) – This is the exact opposite of Repo Rate. Reserves Repo Rate is the rate of interest at which commercial banks can deposit their surplus funds with the Central Bank, for a relatively shorter period of time.
iv. Open Market Operations – Open market operations (OMO) refer to buying and selling of government securities by the Central Bank from/to the public and commercial banks.
v. Legal Reserve Requirements (Variable Reserve Ratio Method) – According to Legal reserve requirements, commercial banks are obliged to maintain reserves. It is a very quick and direct method for controlling the credit creating power of commercial banks. Commercial Banks are required to maintain reserves on two accounts:
- Cash reserve ratio (CRR) – It refers to the minimum percentage of net demand and time liabilities, to be kept by commercial banks with the central bank.
- Statutory Liquidity Ratio (SLR) – It refers to a minimum percentage of net demand and time liabilities which commercial banks are required to maintain with themselves.
vi. Margin Requirements – Margin is the difference between the amount of loan and market value of the security offered by the borrower against the loan. It the margin fixed by the Central Bank is 40%, then commercial banks are allowed to give a loan only up to 60% of the value of security.
CENTRAL BANK VS COMMERCIAL BANK
Short Answer Type Questions
- Explain the process of money creation by commercial banks, giving a numerical example.
Answer: Commercial banks create money through lending. When a bank receives a deposit, it keeps a fraction as Legal Reserve Ratio (LRR) and lends the rest. The loan amount is credited to the borrower’s account, which becomes a new deposit, allowing further lending. Total money creation = Initial Deposit multiplied by (1 divided by LRR).
2. What is meant by a central bank? Why is it known as the apex body?
Answer: A central bank is the supreme monetary institution that regulates the entire banking system of a country. It is called an apex body because it occupies the highest position in the monetary structure and has final authority over currency and credit.
3. State the main functions of a Central Bank.
Answer:
- Currency Authority.
- Banker to the Government.
- Banker’s Bank and Supervisor.
- Controller of Money Supply and Credit. 5. Custodian of Foreign Exchange Reserves.
4. State any three points of distinction between Central Bank and Commercial Banks.
Answer:
- Central Bank is the apex body, while Commercial Banks operate under it.
- Central Bank works for public interest, whereas Commercial Banks work for profit.
- Central Bank has the power to issue currency, but Commercial Banks do not.
5. Explain the function of a Central Bank as a banker to the government.
Answer: The Central Bank manages the accounts of the government, accepts deposits, and makes payments on its behalf. It also acts as an agent and financial advisor to the government on economic matters.
6. What are open market operations? What is their effect on availability of credit?
Answer: It refers to the buying and selling of government securities by the Central Bank. Buying securities increases the reserves of commercial banks, increasing credit availability. Selling securities reduces bank reserves, decreasing credit availability.
7. Explain the ‘lender of last resort’ function of the Central Bank.
Answer: When commercial banks fail to get financial help from any other source, they approach the Central Bank as a last resort. The Central Bank provides them with loans against approved securities to ensure stability.
8. Explain Central Bank’s function as currency authority.
Answer: The Central Bank has the sole monopoly to issue currency notes in the country. This ensures uniformity in the monetary system and allows the Central Bank to control the total money supply.
9. Elaborate the ‘Bankers’ Bank and Supervisor’ function performed by the Reserve Bank of India.
Answer: As a banker’s bank, it holds the cash reserves of commercial banks and provides them with short-term credit. As a supervisor, it regulates bank licensing, mergers, and periodic inspections.
10. Explain the effect of an increase in bank rate on credit creation by commercial banks.
Answer: An increase in bank rate makes borrowing from the Central Bank expensive for commercial banks. To compensate, they increase their lending rates, which discourages borrowing by the public and reduces credit creation.
11. Define cash reserve ratio and statutory liquidity ratio. How can they be used to control the situation of excess money supply?
Answer: Cash Reserve Ratio (CRR) is the percentage of deposits that banks must keep with the Central Bank. Statutory Liquidity Ratio (SLR) is the percentage of assets that banks must maintain with themselves in liquid form.
12. Explain the following function of the central bank: (i) Bank of issue; (ii) Banker’s bank.
Answer: (i) Bank of issue: It means the central bank has the exclusive right to issue currency notes.
(ii) Banker’s bank: It means the central bank manages the reserves of other banks and provides them financial aid.
13. Calculate the total deposit created by commercial banks if reserve ratio is 10% and primary deposit is Rs.1,250 crores.
Answer: Total Deposit = Primary Deposit multiplied by (1 divided by Reserve Ratio). Total Deposit = 1,250 multiplied by (1 divided by 0.10) = 12,500 crores.
14. If total deposit created by commercial banks is Rs.20,000 crores and the primary deposit is Rs.2,500 crores, what is the value of money multiplier and reserve ratio?
Answer: Money Multiplier = Total Deposit divided by Primary Deposit = 20,000 divided by 2,500 = 8. Reserve Ratio = 1 divided by Money Multiplier = 1 divided by 8 = 12.5 percent.
15. “The process of credit creation by commercial banks comes to an end when the total of required reserves become equal to the initial deposits.” With the help of a numerical example, prove that the given statement is true.
Answer: If initial deposit is 100 and LRR is 10 percent, the bank keeps 10 as reserve and lends 90. This continues until the total of all reserves in each round equals 100. At this point, the bank cannot lend further, and total deposits reach 1,000.
16. Explain the distinction between ‘Statutory liquidity ratio’ and ‘Legal reserve ratio.’
Answer: Legal Reserve Ratio (LRR) is the total reserve requirement (CRR plus SLR). SLR is specifically the part that banks keep with themselves in liquid form.
17. Explain any two methods of credit control used by central bank.
Answer:
1. Repo Rate: Changing the interest rate for loans to banks.
2. Open Market Operations: Buying or selling securities to change bank reserves.
18. What is legal Reserve Ratio? Explain its components.
Answer: It is the minimum percentage of deposits that banks must legally keep as reserves.
Components are CRR (kept with Central Bank) and SLR (kept with the bank itself).
19. What is Repo Rate Policy? How does it work as a method of credit control?
Answer: Repo rate is the rate at which Central Bank lends to commercial banks. To reduce credit, the Central Bank increases the Repo Rate, making loans costlier for the public.
20. “To boost falling demand in the economy, the Reserve Bank of India recently reduced Repo rate.” Elaborate the rationale behind the steps taken by the Central Bank.
Answer: Reducing Repo rate makes borrowing cheaper for banks. Banks then lower their lending rates for consumers. This encourages people to take loans and spend more, increasing demand.
21. Define Reserve Repo Rate. Discuss briefly, how this instrument helps in controlling credit creation by commercial banks.
Answer: It is the rate at which Central Bank borrows from commercial banks. Increasing this rate encourages banks to park more money with the Central Bank instead of lending it to the public, thus reducing credit.
22. How the following tools can be used for credit control by the central bank in an economy: (a) Open Market Operations; (b) Margin Requirements.
Answer:
1. Open Market Operations: Selling securities reduces cash with banks.
2. Margin Requirements: Increasing the margin means borrowers get less loan against their collateral, reducing credit demand.
23. Explain how ‘Repo Rate’ can be helpful in controlling credit creation.
Answer: Increasing the Repo Rate increases the cost of funds for banks, leading to higher interest rates for the public, which reduces the volume of credit.
24. Using a hypothetical numerical example, explain the effect of rise in Reserve Ratio on credit creation by the commercial banks.
Answer: A rise in Reserve Ratio (LRR) means banks must keep more money as reserves. This reduces the amount of surplus funds available for lending, thereby decreasing credit creation.
25. How does change in margin requirements affect availability of credit in an economy? Explain briefly.
Answer: Increasing margin requirements forces borrowers to provide more collateral for a smaller loan, which discourages borrowing and reduces credit availability.
26. If Legal Reserve Ratio is 0.2 and new deposits are 1,000, explain the process
of money creation b the commercial banks.
Answer: Initial Deposit = 1,000. LRR = 0.2. Total Money Creation = 1,000 multiplied by (1 divided by 0.2) = 5,000. The banking system creates 4,000 additional deposits through lending.
27. “As per announcement made by the Governor of the Reserve Bank of India (RBI) on 4th May, 2022, it has been decided to increase the Cash Reserve Ratio (CRR) by 50 basis points from 4% to 4.5%. Analyze the impact of RBI increasing CRR from 4 percent to 4.5 percent.
Answer: This increase means banks must keep more cash with the RBI. It reduces the lendable resources of the banks, leading to a decrease in the overall credit creation and money supply.
28. How will Reverse Repo Rate and Open Market Operations control excess money supply in an economy?
Answer: Increasing Reverse Repo Rate pulls money out of banks into the RBI. Selling securities via Open Market Operations also absorbs liquidity from the banking system.
29. What is monetary policy? State any three instruments of monetary policey.
Answer: It is the policy of the central bank to regulate money supply and interest rates. Instruments: 1. Bank Rate. 2. CRR. 3. SLR.
30. Distinguish between ‘Qualitative and Quantitative tools’ of credit control may be used by a Central Bank.
Answer: Quantitative tools (like Repo Rate, OMO) affect the overall volume of credit. Qualitative tools (like Margin Requirements, Moral Suasion) affect the direction or use of credit.
31. What is legal reserve ratio? How does it influence the process of credit creation?
Answer: It is the mandatory reserve percentage. There is an inverse relationship: higher the LRR, lower the credit creation; lower the LRR, higher the credit creation.
32. An increase in credit creation capacity has a direct impact on money supply. Discuss.
Answer: When banks create more credit, more money flows into the economy through loans. This increases the total deposits and purchasing power in the hands of the public, thus increasing money supply.
33. Money multiplier plays a vital role in determining credit creation power. Elaborate.
Answer: Money multiplier (1 divided by LRR) determines how many times the initial deposit will be expanded. A higher multiplier means banks can create much more money from the same initial deposit.
Long Answer Type Questions
- Explain the process of money creation by the commercial banks with the help of a numerical example.
Answer: Banks create money by using their primary deposits to give loans. Assume: Initial Deposit = 1,000 and LRR = 10 percent.
Step 1: Bank keeps 100 as reserve and lends 900.
Step 2: This 900 is deposited back in the system. Bank keeps 90 (10 percent) and lends
810.
Step 3: This continues until total reserves become equal to the initial deposit of 1,000.
Total Deposits = Initial Deposit multiplied by (1 divided by LRR).
Total Deposits = 1,000 multiplied by (1 divided by 0.10) = 10,000.
The money multiplier is 10, and the system has created 9,000 of additional money.
2. Explain any two functions of central bank.
Answer:
1. Currency Authority: The central bank has the sole right to issue paper currency. This
ensures uniformity in the money used across the country and allows the bank to control
the total supply of money.
2. Banker to the Government: It acts as a banker, agent, and financial advisor. It carries out
government transactions, manages public debt, and advises on monetary matters to
maintain economic stability.
3. Discuss the differences between a central bank and a commercial bank.
Answer:
1. Primary Goal: Central Bank works for public welfare and economic stability. Commercial Banks work for profit maximization.
2. Number: Every country has only one apex Central Bank, while there are many commercial banks.
3. Power to Issue Currency: Central Bank can issue notes, but commercial banks have no such power.
4. Dealing with Public: Central Bank deals with the governmentand other banks. Commercial banks deal directly with the general public.
4. Briefly discuss the following functions of central bank: (i) Currency Authority;
(ii) Banker to the Government; (iii) Banker’s Bank and Supervisor.
Answer:
(i) Currency Authority: Exclusive right to issue currency. It gives the bank power to maintain the value of the currency and control inflation.
(ii) Banker to the Government: It manages the government’s cash balances and provides short-term loans.
(iii) Banker’s Bank and Supervisor: It keeps the reserves of other banks, lends to them as a last resort, and supervises their operations to ensure the banking system is healthy.
5. What is meant by margin requirement? How can it be used to control the money supply? Explain with the help of an example.
Answer:
Margin requirement is the difference between the value of the security and the loan amount granted. Example: If you give a house worth 100 lakhs as security and the bank gives a loan of 80 lakhs, the margin is 20 percent.
To reduce money supply (Inflation): The Central Bank increases the margin to 40 percent. Now the borrower only gets 60 lakhs, which discourages borrowing.
To increase money supply (Deflation): The Central Bank decreases the margin to 10 percent. Now the borrower gets 90 lakhs, encouraging borrowing.
6. How does a central bank influence credit creation by commercial banks through open market operations? Explain.
Answer:
Open Market Operations involve buying and selling government securities.
1. Sale of Securities: When the central bank sells securities, commercial banks buy them, and their cash reserves decrease. This reduces their ability to give loans, thus decreasing credit creation.
2. Purchase of Securities: When the central bank buys securities, it pays the banks, increasing their cash reserves. This increases their capacity to give loans and create more credit in the economy.
7. How is bank rate used by central bank in influencing credit creation by commercial banks? Explain.
Answer:
Bank rate is the rate at which the central bank lends to commercial banks. Increase in Bank Rate: This makes borrowing from the central bank expensive. Commercial banks then increase their own lending rates for the public. Higher interest rates lead to a fall in the demand for loans, reducing credit creation. Decrease in Bank Rate: Borrowing becomes cheaper for banks, so they lower their lending rates. This encourages the public to take more loans, increasing credit creation.
8. Describe any two methods by which Reserve Bank of India can regulate money supply.
Answer:
1. Repo Rate: By increasing the Repo Rate, the RBI makes it expensive for banks to get funds. This leads to higher interest rates for consumers and a decrease in money supply.
2. Cash Reserve Ratio (CRR): By increasing CRR, the RBI forces banks to keep more cash with the central bank. This leaves less money with the banks to lend to the public, effectively reducing the money supply in the economy.
class 12 macroeconomics chapter 6 banking notes
banking class 12 macroeconomics notes
sandeep garg macroeconomics pdf
NCERT WEBSITE
