CBSE Class 12 Economics - Banking: Commercial and Central banks

Banking

COMMERCIAL BANK

Commercial Bank is an institution who accept money as deposits and grant loans with the aim of making profits.

For Example - State Bank of India, Punjab National Bank, ICICI, HDFC etc.

Commercial Bank can be both public as well as private

Functions of Commercial Banks

Primary Functions

The two main functions of commercial banks are-

a. Accepting Deposits

b. Advancing of Loans

Accepting Deposits - Commercial Bank accepts deposits in various forms according to the requirement of different people. The main kind of deposits are:

1)Current Account Deposits OR Demand Deposits - These are the deposits which are repayable by the bank on demand.

These accounts are maintained by Businessman for making a business transaction.

There is no limit on withdrawal by cheque
Bank does not pay any interest on such deposits rather they charge a service charge for running these accounts.

2) Saving Deposit - The Basic type of account which allows customers side of a portion of income for the motive of earning some monetary return that is interested.

There is a restriction on the number of withdrawal to discourage frequent use of saving deposits
The interest rate for such account is generally less

3) Fixed Deposits - Understood deposit a particular amount is deposited for a fixed period of time.

The amount cannot be withdrawn before maturity of specific period
The rate of interest on such deposits is generally Hai depending upon time period.

Advancing of Loans - The Amount deposited by different people are not allowed to remain idle. So after keeping a specified amount as a reserve, the remains are used to lend to those people who are in need in exchange for some interest.

Different types of loans and advances are given below -

Cash Credit - Cash credit is amount given to borrower against the security of current assets like share bonds etc. The amount is credit in the account of borrower and interest is charged only on the amount withdrawn instead of the full amount.
Demand Loan- Demand loan referred to those loans which can be recalled by the bank at any time on a notice of 24 hours. It is also called lunette call or money at call. Your interest is charged on full time irrespective of the amount withdrawn.
Short Term Loan - These loans are given against some Collateral security. The money is a credit to the account of the borrower and he can withdraw at any time, fully or partially. however, interest is charged on full amount irrespective of the amount withdrawn.

Secondary Function

In addition to primary function commercial banks performs some secondary functions also:

1) Overdraft Facility- Under the facility Bank allows is a customer to withdraw an amount more than what actually standing in his account. This facility is given to reliable and credit for the customer for a short period. The customer has to pay interest to the bank on the amount withdrawn by them.

2) Discounting Bills of Exchange- It refers to a facility where a holder of a bill of exchange can get the bill discounted before dating of maturity. For providing the service Bank deduct some Commission out of the total amount of bill of exchange. Adding the date of maturity, the bank received his payment from the 2nd partner who accepts the bill.

Agency Function-

Commercial Banks also provide some agency functions for their customers and chat some Commission for these services. some agency functions are-

Transfer of Funds- a customer of the bank can easily transfer his funds from one bank to another using instruments like demand draft, mail transfer, etc.
Collection and Payment of various items- commercial banks collect cheques, bills, interest, dividend on behalf of their clients and can make payment of taxes, rent, insurance premium, etc on standing instructions of their clients.
Purchase and Sale of Foreign Exchange - some commercial banks are authorized by Central Bank to deal in foreign exchange in order to promote foreign trade. These authorized commercial banks buy and sell foreign exchange on behalf of their clients.
Purchase and Sale of Securities- commercial banks also buys and sells the shares of all companies on behalf of their clients.
Income Tax Consultancy- the commercial bank also advise on matters relating to Income Tax to their customers and even prepare their income tax returns.
Trustee and Executors- commercial banks also preserve bills of their customers as Trustee and execute them after the death as executor.
Letter of Reference- they also gives information about the economic position of the client to traders and provide similar information about other traders to their clients.

General Utility Functions

These banks also render some general utility functions like -

Locker Facility- Commercial banks provide safety vaults all lockers to keep their valuables safe like jewelry important documents and other valuables.
Travelers Cheques- commercial banks also issues. Traveler's cheques to their customers to avoid the risk of taking cash during their journey.
Letter of Credit- letter of credit is issued by the banks to certify creditworthiness of their customers. this mechanism used in international trade.
Underwriting Securities- commercial banks also do the task of underwriting securities. sister creditworthiness of banks is high the people by the securities underwritten by banks easily without hesitation.
Collection of Statistics- banks collect and publish statistics relating to trade commerce and industry. advise customers and financial matters.

MONEY CREATION

Commercial Banks receives the deposit from the public and use it to give loans. However, loans offered are many times more than the deposits received by banks. this function is known as credit creation or money creation.

To understand this process we have to make two assumptions:

1) The entire commercial banking system is one unit and is termed as banks.

2) All the payments are receipts are made through banks i.e all payments are made to check and all receipts are deposited in the banks.

Deposits received by banks are used for giving loans. However, banks cannot lend an entire amount to customers. It is legally compulsory for banks to keep some amount as a reserve. This transaction is called legal Reserve Requirement and it is fixed by Central Bank.

Let us understand the process of credit creation through an example -

Suppose initial deposit of Rs 10,000 is received by bank and LRR is assumed to be 10%. So the bank will keep 10% of 10000 as Reserves i.e 1,000 and will lend remaining 9000 Some Borrower who are free to withdraw this amount anytime.
Suppose the borrower withdraws this amount of 9000 and make payment to some, and for doing this he will deposit this amount in the account of that person to whom he is making the payment.
Now the bank will receive 9000 and it will again keep 10% of 9000 that is 900 as a reserve, and will lend remaining 8100 to other borrowers.
This 8100 is again deposited in some other account out of which 10% of 8100 that is 810 would be kept as a reserve and remaining 7290 would be provided as a loan.
The deposits keep on increasing in each round by 90% of last deposits, similarly, cash reserves also go on increasing its time by 90% of last cash reserve.
Deposit creation comes to end when total cash reserve becomes equal to the initial deposit

	DEPOSITS	LOANS	CASH RESERVES ( LRR= 10%)
INITIAL DEPOSITS	10,000	9,000	1000
ROUND I	9,000	8100	900
ROUND II	8100	7290	810
ROUND III	7290	6561	729
-	-	-	-
-	-	-	-
-	-	-	-
TOTAL	1,00,000	90,000	10,000

It is clear from table that banks are able to create total deposits of 100000 with initial deposits of 10000. it means deposits becomes 10 times which is nothing but value of money multiplier which can be calculated as follow
Money Multiplier- 1/LRR

= 1/10%

= 100/10 = 10 times.

It signifies that for every single unit of money kept, banks are able to create 10 units. higher the LRR, Lower the Money created by banks.
Lower the LRR, higher the money created by banks.

CENTRAL BANK

Central Bank is an Apex body that controls operates, regulates and direct the entire banking and monetary structure of the country.
India's central bank is Reserve Bank of India RBI was established on April 1, 1935, under Reserve Bank of India Act passed in 1934.

Functions of Central Bank

Currency Authority ( Bank of Issue)

Central Bank enjoys the sole authority for issue for currency in the country. In India Reserve Bank of India, issues all the paper currency( except one rupee notes and coins which are issued by Ministry of Finance)

Benefits of the sole authority of note issue:

i. It leads to uniformity in Note circulation

ii. It ensures public faith in the currency system.

iii. Health Stabilisation of the internal and external value of the currency.

iv. Give the central bank power to influence money supply because currency with the public is part of the money supply.

BANKER TO GOVERNMENT

The central bank acts as a Banker, Agent and a Financial advisor to the central government, and all the state government (except Jammu and Kashmir).

The following functions are performed by RBI for government-

i. It maintains the current account for keeping cash balances.

ii. It accepts receipts and makes payment for the government and carries out exchange remittance and other banking operations.

iii. Also gives loans and advances to the government for a temporary period. the government borrows money by selling treasury bills to Central Bank.

As an agent, Central Bank also has the responsibility of managing the public deposit.
As a financial advisor, the central bank advises the central government from time to time on economic-financial and monetary matters.

Bankers, Bank and Supervisor

All the commercial banks are regulated and supervised by Central Bank. Central Bank being Apex Bank, it acts as the banker to the other banks. It bears the same relationship with commercial banks as commercial banks maintain with the general public.

The central bank performs the following function-

A. Custodian of Cash Reserves- Commercial banks are required to keep a fixed percentage out of the deposits as the reserve is known as cash reserve ratio with Central Bank. Hence, central banks act as a custodian of cash reserve.

B. Lender of Last Resort-

When commercial banks fail to meet their financial requirements from other sources, the approach Central Bank to give loans and advances as Lender of Last Resort. Steven sends banks to discounting of approved securities and bills of exchange.

C). Clearinghouse-

All Central Bank who is the Reserve of all commercial bank, it becomes easy and more convenient for it to act as their clearinghouse. All commercial banks have their account with Central Bank. Therefore the central bank can easily set with claims of various commercial banks against each other. By making debit and credit entries in their accounts.

As a supervisor, Central Bank regulates and controls the commercial banks. Regulation of banks may be related to their licensing, branch expansion, liquidity of asset winding up, etc. The control is exercised by periodic inspection of pants and the return filed by them.

Controller of Money Supply and Credit

Due to economic fluctuations, RBI controls the money supply and credit in the best interest of the economy. As RBI has the sole authority of currency issue, it can control credit and supply of money. For these two types of methods are used by RBI-

A) Repo Purchase Rate- is the rate at which Central Bank lends money to Commercial Bank to meet their short term needs.

An increase in repo rate increases the cost of borrowing from Central Bank. it forces the commercial banks to increase their lending rates which discourage borrowers from taking loans. it reduces the ability of commercial banks to create credit. a decrease in repo rate will have the opposite effect.

B) Bank Rate (discount rate) - Bank rate is the rate at which the central bank of a country lends money to commercial banks to meet the long-term means an increase in bank rate increase the cost of borrowing. inherit commercial banks are forced to reduce credit availability. a decrease in bank rate will have the opposite effect.

C) Reverse Repo Rate- it refers to the rate at which Central Bank of a country borrows money from commercial banks. whenever Central Bank wants to reduce its credit. In borrows, some money from commercial banks and hence the amount available with commercial banks to provide loans to general public false and hence credit is reduced. a decrease in reverse repo rate will have an opposite effect.

D). Open Market Operations- It refers to buying and selling of government securities to or from the general public or commercial bank. A sale of a security by Central Bank reduces the reserves of the commercial bank. adverse effects the bank's ability to create credit and decrease the money supply in the economy. Purchase of security by Central Bank increases the Reserves Andres Bankability to give credit.

QUALITATIVE METHOD

E) Legal Reserve Requirement variable reserve ratio method- Commercial banks are required to maintain reserve it is a very quick and direct method for controlling the credit creating powers of commercial bank commercial banks are required to maintain two accounts -

I. Cash Reserve Ratio - it refers to the minimum percentage of total deposits, to become a commercial bank with the central bank. If the central bank reduces the credit, it increases CRR which leads to rise in resorts and hence commercial banks can lend less money.

II. Statutory Liquidity Ratio- it refers to the minimum percentage of total deposits to be kept by commercial banks with themselves. an increase in SLR reduced beauty of banks to give credit and vice versa. The Reserve Bank of India can influence the credit creation power of the banks by making changes in CRR or SLR.

QUANTITATIVE METHOD

1. Margin Requirements- Margin is a difference between the Mount of securities offered an amount of loan granted against it. An increase in margin requirement reduces the Boring capacity as well as money supply where is a reduction in Majid requirement will increase the availability of credit and money supply.

2. Moral Suasion- it refers to persuasion and pressure that send to bank employees and other banks in order to get them active, in a manner in line with its policy. it is made to discussions letters and hints to banks.

Generally, Central Bank succeeds in convincing the banks as it acts as the lender of last resort however no punitive action is taken in case they do not follow the advice or request.

3. Selective Credit Controls- Under this technique RBI gives direction to other banks to give or not to give credit for short and purposes to particular sectors.

BASIS	CENTRAL BANK	COMMERCIAL BANK
MEANING	Central bank is a n apex body that controls, operates, regulates and directs the entire banking and monetary structure of the country.	Commercial bank is an institution which performs the functions of accepting deposits and granting loans with the objective of earning profits.
STATUS	It is an apex institution in the money market.	It is merely a unit in the banking structure of the country and operates under the control of the central bank.
OWNERSHIP	It is generally owned and governed by the government.	It can be owned and governed by the government or private sector.
OBJECTIVE	It operates in public interest without profit motive.	It aims to maximize profits.
ISSUE OF CURRENCY	It has the sole authority to issue currency.	It has no power issue currency.
PUBLIC DEALING	It does not deal directly with the public.	It deals directly with the public.
NUMBER OF BANKS	There is only one central bank in a country due to the peculiar nature of its activities. For example- RBI in India.	There is a number of commercial banks in a country. For example - SBI, PNB, HDFC, ICICI, etc.

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