Commercial Banks Class 12 | Credit Creation | Central Bank | Functions |

Commercial Banks Class 12 | Credit Creation | Central Bank | Functions |

Commercial Banks

Commercial Banks Class 12 : Commercial Banks refer to those financial institutes which accept deposit and make advances with the aim of earning profit.

Credit Creation by Commercial Bank

Commercial Banks Class 12 : The Commercial Bank creates money in an economy and earns profit by providing credit after keeping a sum of reserve as cash reserve for the demand deposit. Banks know from their historic experience that all the depositors do not come to withdraw their money at once. It is also known as multiplier or credit multiplier. Before moving further, let us go through some assumptions; all the transactions in an economy are routed through banks that means all the payments are made by issuing cheques and there is only a single unit of bank in an economy that shows all the commercial banks as one.

1. Firstly bank receives cash of Rs.10000 from people which is known as primary deposit but bank can’t use full amount to provide loan to someone else, therefore bank puts an amount which is known as CRR (Cash reserve Ratio) and decided by the central bank of a country. However, bank needs to put a sum assured. Let’s assume that the percentage is 10 i.e. Rs.1000. 
2. After receiving deposit and putting cash reserve, now the bank can provide loan of Rs.9000 (10000-1000). The bank will provide this amount to someone else in the form of credit by opening a deposit account of that person. The bank will not provide him any cash but credit an amount of loan taken in his account which he can use for further payments, loan amount is rs.9000.
3. As per the assumptions, all the payments are made through cheque. The person will pay to another person who deposits the cheque in the same bank which is known as secondary deposit for there is only single bank in an economy which means that the bank has a total amount of Rs.19000 (10000 + 9000).
4. As the case before, the bank will again put an amount in the form of CRR (Cash Reserve Ratio) which means bank will keep Rs.900 from the deposit of Rs.9000 and will provide the differential amount to some another person in the form of credit which is Rs.8100 (9000-900).
5. This process continues till the cash reserve is equal to the primary deposit.

Note:  Secondary deposits are also known as Derivative Deposits.

Relation between Credit Multiplier and CRR

K (Credit Multiplier) = 1/CRR (Cash Reserve Ratio)

CRR refers to the cash amount which every commercial bank has to keep of total deposit with the RBI. In India, CRR is determined by the central bank which is RBI (Reserve Bank of India). It is also known as LRR (Legal Reserve Ratio).

As the above stated example in credit creation, it can also be solve through formulae.

The initial deposit is rs.10000, by putting the value in formulae.

K = 1/ CRR

= 1/10%

= 10 times

To calculate the total credit created by commercial bank, multiply the amount of K (Credit Multiplier) with initial deposit

Money Creation = Initial deposit * K

= 10000 * 10

= Rs.100000

Central Bank (RBI- Reserve Bank of India)

Central Bank is an apex institute of money which supplies and regulates the supply of money in an economy through its monetary policies. Every country has a central Bank which controls the entire banking system of that country.

Functions of Central Bank

• Issuer of Currency: The Central Bank of a country only has the authority to issue the currency in an economy which is known as Currency Authority function of Central Bank.
• Banker to the Government: Every central bank works as a banker, agent and financial advisor to its respective governments due to the following reasons:

It provides cash to government to pay the salaries and also handles the account of the government. Central bank also provides short-term loans to the government and supplies forex to pay the external debts. Therefore it is called as a banker to the government.

Since, Central Bank manages the public debt and collect taxes and other payments on the behalf of the government and represents the government in the International Financial Institutes like World Bank, International Monetary Fund which shows that the central bank performs the function of an agent to the government.

The central bank also performs some functions of financial advisor by advising the government on all the financial and economic matters like deficit financing devaluation of currency etc.

• Bankers’ Bank and Supervisory Role: The central bank works as a banker to the bank in three ways, namely custodian of the cash reserve and foreign exchange, the lender of the Last resort and as a clearing house agent.

As a custodian of cash reserve and foreign exchange, it keeps an eye on every Central Bank that they are keeping the amount which is fixed and also manages the float of foreign exchange in the international market.

It also works as a lender of the Last resort by solving the problem of the cash crunch of the commercial banks by providing them short term loans when commercial banks fail to meet their financial requirements from other sources.

It also clears all the debts between the two commercial banks and settles all the claims by book entries of transfer from their account, through this function it is also known as a clearing agent.

The central bank also supervises and controls the commercial bank of a country so that the function of banking can run smoothly through periodic inspections of the banks and licensing. 

• Controller of Money Supply and Credit: The central bank also controls the supply of money in an economy through its monetary policy, instruments and tools which restricts the flow of credit to some specific sector.

Money Supply Control by the Central Bank

The central bank adopts two major instruments to control the supply of money in an economy namely, Quantitative Instruments and Qualitative Instruments.

1. Quantitative Instruments: These are the instruments to control the credit which focuses on the overall supply of the money.

Some instruments with their brief description are as follows:

• Bank Rate: It refers to the rate of interest at which the commercial banks can get loan from RBI when instant cash is required by the commercial bank. The rate of interest of bank rate is higher than repo rate.

With the rise in the bank rate, the rate of interest also increases due to which the commercial banks have to pay more to RBI to take loan and the commercial banks are left with less money to give on credit which controls the increased money supply in an economy and inflation can be controlled through this. By decreasing the bank rate, the rate of interest also decreases due to that the commercial banks have more cash to give on credit and the decreased money supply can be increased and deflation can be controlled.

• Repo Rate: It refers to the rate at which the commercial bank get the loan from the RBI by buying the government securities in the open market.

With the increase in the rate of repo rate the demand for the credit falls and supply of money also falls by which the inflation can be controlled on the other side by decreasing the repo rate. The banks can now take more loan with lower interest by which the banks can easily give more money on credit and the supply of money in an economy is increased and deflation can be controlled.

• Reverse Repo Rate: When commercial banks have more cash and that cash cannot be utilize for the credit creation process. In that case, the commercial banks deposits the surplus amount with the RBI and the rate at which commercial banks get interest on the surplus amount is known as reverse repo rate.

During the time of deflation the rate of reverse is decreased so that commercial banks can put their majority of cash in the credit creation process through which the decreased supply of money can be increased. On the contrary during inflation, the rate of reverse repo is increased so that majority of funds of the commercial banks can be parked with the RBI and less funds are used for the credit creation process.

• Open Market Operations: It is an another instrument of the commercial bank to control the supply of money in an economy by liquidating and soaking cash from the people through public debts.

At the time of inflation the central bank sells its securities in the open market so that the money from the people can be soaked and increased money supply can be controlled. On the other side at the time of deflation the central bank purchases the securities in the open market and liquidates its cash so that the people have more money to spend.

• Cash Reserve Ratio (CRR): It refers to the minimum amount that every commercial banks have to put from its total deposits.

By increasing the rate of CRR, the banks have to put more cash in their cash deposit and are left with less cash to control the inflation in an economy whereas by decreasing the rate of CRR the commercial banks have to put less cash in their cash reserve and can supply more money in an economy to control the deflection.

• Statutory Liquidity Ratio (SLR): It is the rate at which every commercial bank have to put some liquid assets in the form of cash, gold or unencumbered securities, these are those securities on which the loan is fully repaid or free from debts.

By increasing the rate of SLR, the commercial banks have to put more cash in the SLR and are left with less cash for the credit creation by which the inflation can be controlled whereas by decreasing the SLR the commercial banks have more cash to fund in the credit creation process to control the deflection in an economy.

2. Qualitative Instruments: The qualitative instruments refers to the instruments which selects the sector of an economy.

It is further divided into three categories namely margin requirement, credit rationing and moral suasion whose description is as follows:

• Marginal Requirement: The marginal requirement refers the difference between the value of loan granted and the value of security which is put as a mortgage for that loan.

By increasing the rate of margin requirement, the demand for the credit falls by which the inflation can be controlled on the contrary by decreasing the margin requirement the demand for the credit is increased to control the deflation in an economy.

• Rationing of Credit: Rationing of the credit refers to the fixing of coaters for different business sectors.

By introducing credit rationing, the supply of credit by the commercial bank decreased which controls the inflation in an economy whereas by withdrawing the rationing of credit the credit supplies by the commercial bank increases by which the deflection can be controlled.

• Moral Suasion: Moral suasion refers to the persuasion or pressure given by the RBI to the commercial banks to follow all the rules.

With the increase of moral suasion the commercial banks are more restricted to follow all the guidelines of the RBI on the other side of the paper, at the time of deflation some liberty is given to all the commercial banks for the credit.

Difference Between Commercial and Central Bank

Kindly refer to the following chapters for better understanding and higher scores in Class 12 Economics Exam.

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