1. Functions of commercial banks
- Primary: (a) accepting deposits: demand deposits (current, savings) and time deposits (recurring, fixed); (b) advancing loans: cash credit, overdrafts, discounting bills of exchange, demand and term loans.
- Secondary: agency functions (collecting cheques and dividends, paying bills and premiums, buying and selling securities for customers) and general utility functions (lockers, letters of credit, drafts, traveller's cheques, debit cards).
- A bank earns mainly from the difference between the interest it charges on loans and the interest it pays on deposits.
| Deposit | Withdrawal | Interest | Suits |
|---|---|---|---|
| Current (demand) | Any number of times, by cheque | Usually none | Traders and firms |
| Savings (demand) | Some limits may apply | Modest | Households |
| Recurring (time) | At maturity | Higher | Regular small savers |
| Fixed (time) | After the fixed period | Highest | Lump sums not needed for a while |
| Form of lending | How it works |
|---|---|
| Cash credit | Draw up to a limit against security; interest on the amount used |
| Overdraft | Draw beyond the current-account balance up to a limit |
| Discounting bills | Bank pays a bill now, less a discount, before it falls due |
| Demand and term loans | A lump sum repayable on demand or over a period |
Key terms
- Demand deposit
A deposit payable whenever the depositor asks, such as a current or savings deposit.
- Time deposit
A deposit kept for a fixed period, such as a fixed or recurring deposit.
- Overdraft
Permission to draw more than the current-account balance, up to a limit.
2. Credit creation
- Banks keep only the legal reserve ratio (LRR) of each deposit and lend the rest; the loan is spent and redeposited, so lending repeats in smaller rounds.
- Credit multiplier = 1 ÷ LRR; total deposits = initial deposit ÷ LRR; credit created = total deposits − initial deposit.
- Imagined Vasundhara Bank: ₹50,000 at 20 per cent: multiplier 5, total deposits ₹2,50,000, credit ₹2,00,000; the first four rounds alone add up to ₹1,47,600.
- Assumptions: all loans return as deposits; banks hold only the required reserve; there are enough willing, creditworthy borrowers.
| Round | Deposit (₹) | Reserve kept (₹) | Loan given (₹) |
|---|---|---|---|
| 1 | 50,000 | 10,000 | 40,000 |
| 2 | 40,000 | 8,000 | 32,000 |
| 3 | 32,000 | 6,400 | 25,600 |
| 4 | 25,600 | 5,120 | 20,480 |
| All rounds | 2,50,000 | 50,000 | 2,00,000 |
Key terms
- Legal reserve ratio
The minimum share of deposits that banks must hold as reserves.
- Credit multiplier
The number of times total deposits exceed the initial deposit: one divided by the reserve ratio.
3. Limitations of credit creation; high-powered money
- Limitations: the reserve ratio; cash drain (cash kept by the public); shortage of willing borrowers; need for sound security; central bank policy; banks may keep excess reserves.
- Raising the ratio lowers the multiplier: imagined Swarnapur, ₹1,000 crore of primary deposits, 10 per cent → ₹10,000 crore, 12.5 per cent → ₹8,000 crore.
- High-powered money (reserve money) = currency held by the public + cash reserves of banks. Imagined example: 640 + 160 = ₹800 crore.
| Reserve ratio | Credit multiplier | Total deposits from ₹1,000 crore |
|---|---|---|
| 10 per cent | 10 | ₹10,000 crore |
| 12.5 per cent | 8 | ₹8,000 crore |
| 20 per cent | 5 | ₹5,000 crore |
| 25 per cent | 4 | ₹4,000 crore |
| Limitation | Why it reduces credit creation |
|---|---|
| Legal reserve ratio | Part of every deposit must be held back |
| Cash drain | Cash kept by the public does not return as deposits |
| Willing borrowers | Banks can lend only if people want loans |
| Security | Loans need sound security from borrowers |
| Central bank policy | It can raise ratios or make credit dearer |
| Part | Imagined value (₹ crore) |
|---|---|
| Currency held by the public | 640 |
| Cash reserves of banks (vault and central bank) | 160 |
| High-powered money | 800 |
Key terms
- Cash drain
Money kept as cash by the public, which does not return to banks as deposits.
- High-powered money
Currency with the public plus banks' cash reserves; the base on which deposits are built.
4. The Reserve Bank of India: functions
- Set up in 1935 (under the RBI Act, 1934); nationalised in 1949.
- Bank of issue: sole issuer of currency notes except one-rupee notes (issued, like coins, by the Government of India).
- Banker, agent and adviser to the government: accounts, payments, management of public debt.
- Bankers' bank and supervisor: holds reserves, clears claims, regulates banks.
- Lender of last resort: lends to sound banks in a crisis.
- Custodian of foreign exchange reserves and controller of credit.
| Function | What the RBI does |
|---|---|
| Bank of issue | Sole issuer of currency notes, except one-rupee notes |
| Banker to government | Keeps its accounts, makes payments, manages its debt |
| Bankers' bank | Holds banks' reserves, clears their claims, supervises them |
| Lender of last resort | Lends to sound banks in a crisis |
| Custodian of foreign exchange | Holds foreign currencies and gold; steadies the rupee |
| Controller of credit | Uses quantitative and qualitative tools |
| Commercial bank | Reserve Bank of India | |
|---|---|---|
| Aim | Profit | Monetary and financial stability |
| Deals with | The public | Banks and the government |
| Currency | Cannot issue notes | Sole issuer of notes (except ₹1) |
| Credit | Creates credit | Controls credit |
Key terms
- Lender of last resort
The central bank's role of lending to banks when no other source of funds is available.
- Bank of issue
The authority with the sole right to issue currency notes.
5. Quantitative credit control
- Repo rate: rate at which the central bank lends short-term to banks against government securities (a repurchase agreement). Reverse repo rate: rate it pays when banks park surplus funds with it. Bank rate: rate for longer-term lending or rediscounting bills.
- CRR: share of deposits held as cash with the central bank. SLR: share held by banks themselves in cash, gold and approved securities.
- Open market operations: selling securities drains reserves; buying adds them.
- Against inflation: raise rates and ratios, sell securities. Against deficient demand: the reverse.
- Imagined bank: deposits 600, CRR 5 per cent, SLR 20 per cent: lendable 450 crore.
| Instrument | Meaning | Against inflation | Against deficient demand |
|---|---|---|---|
| Repo rate | Rate for short-term loans to banks against securities | Raise | Cut |
| Reverse repo rate | Rate the central bank pays on banks' surplus funds | Raise | Cut |
| Bank rate | Rate for longer-term lending or rediscounting | Raise | Cut |
| CRR | Share of deposits kept as cash with the central bank | Raise | Cut |
| SLR | Share of deposits kept by banks in liquid assets | Raise | Cut |
| Open market operations | Sale or purchase of government securities | Sell | Buy |
Key terms
- Repo rate
The rate at which the central bank lends short-term funds to banks against government securities.
- Reverse repo rate
The rate the central bank pays banks on surplus funds they place with it.
- Open market operations
Purchase and sale of government securities by the central bank.
6. Qualitative (selective) credit control
- Margin requirements: raising the margin reduces the loan available against a security.
- Credit rationing: ceilings or quotas on credit for particular purposes.
- Moral suasion: persuasion and advice to banks, without legal force.
- Direct action: penalties or denial of facilities for banks that ignore directions.
- Quantitative vs qualitative: volume and cost for all borrowers versus direction and use for particular purposes; selective tools suit price rises in a few commodities, but can be evaded.
| Qualitative tool | How it works |
|---|---|
| Margin requirements | A higher margin means a smaller loan against the same security |
| Credit rationing | Ceilings or quotas on credit for certain purposes |
| Moral suasion | Advice and persuasion of banks, without legal force |
| Direct action | Penalties or denial of facilities to banks that ignore directions |
| Quantitative | Qualitative | |
|---|---|---|
| Controls | Total volume and cost of credit | Direction and use of credit |
| Affects | All borrowers | Particular purposes or sectors |
| Examples | Repo, CRR, SLR, open market operations | Margins, rationing, moral suasion, direct action |
| Margin | Loan against pulses worth ₹10 lakh |
|---|---|
| 30 per cent | ₹7 lakh |
| 50 per cent | ₹5 lakh |
Key terms
- Margin requirement
The part of a security's value that a bank does not lend against.
- Moral suasion
The central bank's persuasion of banks to follow its policy, without legal compulsion.
- Direct action
Punitive steps against a bank that ignores the central bank's directions.
Exam tips
Common mistakes
- Saying credit created equals total deposits (subtract the initial deposit).
- Saying the SLR is kept with the central bank (only the CRR is).
- Mixing up repo (central bank lends) and reverse repo (central bank borrows).
- Writing that banks can create unlimited credit.
- Quoting current policy rates instead of explaining how a tool works.
How marks are usually awarded
- 1 mark: one correct choice or a precise term.
- 2 marks: a definition with an example, or two short points.
- 3 marks: a calculation in three steps or three distinct points.
- 5 marks: parts with working and reasons; ISC 4- and 8-mark questions are set as 2 + 2 and 4 + 4.
All banks, economies and figures in SOYL practice are imagined; state units in every answer.