Chapter 6 Banking :Commercial Banks and The Central Bank class 12th Commerce

COMMERCIAL BANK

Commercial bank is an institution which performs the function of accepting deposits , granting loans and making investment with the aim of earning profits.

Functions of commercial bank

The functions of commercial bank are divided into two parts :

Primary functions and secondary functions

Commercial bank perform two primary functions:

Accepting deposit and advancing of loans

 

1 Accepting Deposit –

It is the most important function of commercial bank except a posit in certain forms according to the requirements of different sections of the society.

• Current account deposits
• Fixed deposits
• Saving Deposits

1. Current Account Deposit Or Demand Deposit-

These deposit refers to those deposits which are payable by the bank on demand.

1. Such deposit are generally maintained by businessmen with the intention of making transactions with such deposit.
2. They can be withdrawn by a cheque without any restriction.
3.  Banks do not pay any interest on these accounts.
4. Rather bank impose service charge for running these accounts.

 

2. Fixed Deposit or Time Deposit-

1. Fix deposit or time deposit refers to those deposits in which the amount is deposited with the bank for a fixed period of time. 
2. Such deposit do not provide cheque facility.
3. These deposits carry a high rate of interest.

 

Saving Deposit- Saving deposit combine features of both current account deposit and fixed deposit.

1. The depositor are given check facility to withdraw  money from their account.
2.  Some restrictions are imposed on number and amount of withdrawal in order to discourage frequent use of saving deposits.
3.  They carry less rate of interest than the interest on fixed deposit.

 

2. Advancing loans

The deposits received by banks are not allowed to remain idle so after keeping certain cash reserve the balance is given to needy borrowers and interest is charged from them which is main source of income for banks.

cash credit

demand loans

short term loans

Cash credit

1. Cash credit refers to a loan given in the borrower against his current assets like shares, stocks, bonds, etc.
2. A Credit limit is sanctioned and the amount is credited in his account.
3.  The borrower may withdraw any amount within his credit limit and interest is charged on the amount actually withdrawn.

 

Demand loans refers to those loans which can be recalled demand by the bank at any time.

1. The entire sum of demand loan is credited to the account of interest is payable on the entire self.

 

Short term loans

1. They are given as personal loans against some collateral security.
2. The money is credited to the account of borrower and the borrower can withdraw money from his account and interest is payable on the entire sum of loan granted.

 

Secondary function

1. Overdraft facilities
2. Discounting bills of exchange
3. Agency functions
4. General utility function

 

1. 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.
• Customer 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 holder of a bill of exchange can get the bill discounted with bank before the maturity.

• After deducting the commission, bank pays the balance to the holder.
• Bank gets its payment from the party which had accepted the bill.

 

3. Agency function

       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 draft and mail transactions.

 

1.  Collection and payments of various items:

        Commercial bank collect cheques, bills, interest , on behalf of their customer and also make payment of taxes, insurance premium etc. on standing instructions of clients.
 

2. Purchase and sale of foreign exchange:

        Commercial bank ae authorized by the central bank to deal in foreign exchange. They buy and sell foreign exchange on behalf of their customer and help in promoting international trade.

 

3. Income tax consultancy

        They give advices to the customer on matters relating to income tax and even prepare there income tax returns.

 

4. Trustee and executor

 Commercial bank preserves the wills of their customers as trustee and execute them after their death as executors.

 

5. Letter of reference:  

        They give information about the economic position of their customer to trade and provide the similar information about other trades to their customers.

 

4. General utility function

1. Locker facility:

Commercial bank provide facility of safety vaults or lockers to keep valuable articles of customers in safe custody.

2. Travelers cheques:

commercial bank issue travelers cheques to their customer to avoid risk of taking cash during their journey.

3. Letter of credit: 

Commercial bank also issue letter of credit to their customers to certify their worthiness.

 

MONEY CREATION OR CREDIT CREATION

Let us now explain the process,

• suppose the initial deposits in banks is Rs.1000 and the LRR is 20 percent. Further, suppose that banks keep only the minimum required, i.e., Rs.200 as cash reserve, banks are now free to lend the remainder Rs.800. Suppose they lend Rs.800. So, banks do not lend this money by giving amount in cash, rather banks open deposit accounts in the names of the borrowers who are free to withdraw the amount whenever they like.
• Suppose they withdraw the whole of amount RS800 for making payments. since all the transactions are routed through the banks, the money spent by the borrowers comes back into the banks into the deposit accounts of those who have received this payment. This increases demand deposit in banks by Rs. 800.
•  When banks receive new deposit of rs800, they keep 20 per cent of it as cash reserves and use the remaining Rs. 640 for giving loans. The borrowers use these loans for making payments. The money comes back into the accounts of those who have received the payments. Bank deposits again rise, but by a smaller amount of Rs.640.The process does not end here.
• The deposit creation continues in the above manner. The deposits go on increasing round after round. At the same time cash reserves go on increasing. The deposit creation comes to end when the total cash reserves become equal to the initial deposit.

        

 

• The total deposit creation comes to Rs.5000, five times the initial deposit as shown in the table. Five times is nothing but money multipler.

 

Money Multiplier

Money multiplier refer to the process of creation of credit by the commercial bank, with the help of initial deposits made by the public and legal reserve ratio.

money multiplier = 

 

CENTRAL BANK

 

Central bank is the apex body that control , operates, regulates and direct the entire banking and monetary structure of the country.

• All the financially developed countries have their own central bank .

FUNCTIONS OF CENTRAL BANK

1. Currency authority
2. Banker to government
3. Banker’s bank and supervisor
4. Controller of money supply and credit
5. Custodian of foreign exchange reserves

 

1. Currency authority

Central bank has the sole authority for issue of currency in the country. in India reserve bank of India has the sole right of issuing paper currency notes(except one-rupee notes and coins)which are issued by the ministry of finance.

Advantages of sole authority

• It leads to uniformity in notes circulation.
• It enables the government to have control or supervision over the central bank with respect to issue of notes.
• It ensure public faith in the currency system.

 

2. Banker to government

 

The reserve bank of India acts as a banker, agent , financial advisor to the central government..

act as a banker

it carries out all banking business of the government .

• It maintain a current account for keeping their cash balance.
• It also gives loan and advance to the government for temporary periods. The government borrow money by selling treasury bills to the central bank.

 

Act as agent

        The central bank also has the responsibility of managing of managing the public debt.

 

Act as financial advisor

 The central bank advices the government from time to time on economic , financial, and monetary matters.

3. Bankers bank and supervisor

As the banker to bank the central bank function in three capacities

• Custodian of cash reserve

Commercial bank is required to keep certain proportion of their deposit (known a cash reserve ratio) with the central bank, in this ways, central bank acts as a custodian of cash reserve of commercial banks.

 

• Lender of the last resort

When commercial bank fails to meet their financial requirement from other sources, they approach the central bank to give loans and advances as a lender of the last resort.

 

• Clearing house

As central bank holds the cash reserve of all the commercial banks, it become easier and more convenient for it to act as their clearing house. All commercial banks have their accounts with the central bank.

 

 4. Custodian of foreign exchange reserve

 

the centralbank also act as the custodian of the country stock of gold and reserve of foreign exchange this functions enables the central bank to exercise a reasonable control on foreign exchange . accordingly to regulation of foreign exchange all foreign exchange transaction must be routed through RBI.

 

• It helps the bank in stabilizing the external value of currency.
• It help sin pursuing a coordinated policy toward the balance of payment situation of the country.

 

 

5. Controller of money supply and credit

Quantitative instrument

a. repo rate

b. bank rate

c. open market operations

d. legal reserve requirement

e. reverse repo rate

Qualitative instruments

1. Moral suasion
2. Marginal requirement
3. Selective credit control

 

QUANTITATIVE INSTRUMENTS

 

a.Repo rate

Repo rate is the rate at which the central banklends money to the commercial bank for the short term needs.

An increase in repo rate increases the cost of borrowing from the central bank. It forces the commercial to increase their lending rates which discourages the borrowers to take loan. It reduces the ability of commercial bank to make credit and vice versa.

 

Reverse repo rate

This is exact opposite of repo rate. When the commercial bank have surplus, they can deposit the same with the central bank and earn interest. The rate of interest paid by the central bank on such deposit is called reverse repo rate. So, it is the rate of interest at which the central bank (reserve bank of India) accepts deposit from the commercial bank .

When the reverse repo rate is raised, it encourages the commercial bank to deposit their funds with the central bank. This has the negative effect on the lending capacity of the commercial banks. Whereas decrease in reverse repo rate has the opposite effect which raised demand for borrowing from the commercial bank.

b. Bank rate

Bank rate is the rate at which central bank lends money to the commercial bank for the long term needs .

An increase in the bank rate increase the cost of borrowing from central bank, which leads to increases in lending rates of commercial bank. It discourages borrower from taking loan which reduces the ability of commercial bank to create credit and vice versa..

c. Open market operations

Open market operation refers to selling and buying of government securities by the central bank from /to commercial bank and public.

• Sales of securities by central bank reduces the reserve of  commercial banks. It adversely affect the bank ability to create credit and therefore decreases the money supply in the economy .
• Purchase of securities by the central bank increases the reserves for the commercial bank and raises the bank ability to create credit

d. Legal reserve requirement

Legal reserve requirement

Commercial bank are required to maintain two accounts :

1. CRR

It refer to the minimum percentage of net demand and time liabilities to be kept by commercial bank with the central bank.

An increase in CRR reduces the excess reserve of commercial bank and limit their credit creating power.

2. SLR

It refers to the minimum percentage of net demand and time liabilities which commercial bank maintain with themselves.

An increase in SLR reduces the ability of bank to give credit and vice versa..

Qualitative instruments

a. Margin requirement

It refers to the difference between the amount of loan and market value of the security offered by the borrower again the loan .

• an increase in margin reduces the borrowing capacity and money supply.
• A fall in margin may encourages thee people to borrow more.
• RBI may prescribe different margins for different type of borrowers against the security.
• Margin is necessary for banks because if a bank gives a loan equal to the full value of security, then bank will suffer a loss in case of fall in price of security.

b. Moral suasion

This is the combination of persuasion and pressure that central bank applies on other banks in order to get them act , in a manner in line with its policy ...

c. selective credit control

under this rbi gives directions to other bank to give or not to give certain purposes to particular sectors ….