Central Bank :-

• Central Bank is a very important institution in a modern economy. Almost every country has one central bank. India got its central bank in 1935. Its name is the ‘Reserve Bank of India‘. 
• Central bank has several important functions. It issues the currency of the country. It controls money supply of the country through various methods, like bank rate, open market operations and variations in reserve ratios.
• It acts as a banker to the government.
• It is the custodian of the foreign exchange reserves of the economy.
• It also acts as a bank to the banking system, which is discussed in detail later.
• From the point of view of money supply, we need to focus on its function of issuing currency. This currency issued by the central bank can be held by the public or by the commercial banks, and is called the ‘high-powered money’ or ‘reserve money’ or ‘monetary base’ as it acts as a basis for credit creation.

finally, It is an apex body that controls, operates, regulates and directs the entire banking and monetary structure of the country.

Commercial Bank:- Commercial bank is an institution which performs the functions of accepting cheque able deposits and providing loans and making investments, with the aim of earning profits and has the power to create money using demand deposits. E.g. Punjab National Bank, Canara Bank etc.

Commercial banks are the other type of institutions which are a part of the money-creating system of the economy. In the following section we look at the commercial banking system in detail. They accept deposits from the public and lend out part of these funds to those who want to borrow. The interest rate paid by the banks to depositors is lower than the rate charged from the borrowers. This difference between these two types of interest rates, called the ‘spread’ is the profit appropriated by the bank.

All banks are financial institutions but all financial institutions are not banks. Banks should accept chequeable deposits and give out loans.

Functions of commercial Bank :-

1. It excepts deposit :- A commercial bank is a deals in short term credit. It collects the surplus balance of the individual firms and finances the temporary needs of commercial transaction deposits are of the there types :-
   1. Saving Account Deposit :- These are the deposit whose main objects is to save. Saving account is most suitable for the individual house holds. Bank gives cheque facility with restricted withdrawals to the account holders.
   2. Current Account Deposits :-Such deposits are payable on demand and therefore called demand deposits. These can be withdrawn by the deposits at any time. The bank does not pay any interest on these deposits these accounts are generally maintained by businessman.
   3. fixed term deposit :- These are deposits for fixed term period of time

Example :- From 46 days to 5 years. They can be withdrawn only after the maturity of the specified fixed period. They carry higher rate of interest.

2. It gives loans and Advances :- The second major function of a commercial bank is to give loans and particularly to business and entrepreneurs to earn profit/interest.

These are as follow :-

• Cash credit :- An ineligible borrow is first sanctioned a credit limit and within that limit. He is allowed to withdraw a certain amount on a given security.
• Demand Loans:- A loan which can be recalled on demand is called demand loans. These is no stated maturity the crediting it to the loan account of the borrower.
• Over draft facility :- overdraft is an advance given by allowing a customer keeping current account to over drawn his current account upto an agreed limit. It is a facility to depositor for over drawing the amount then the balance amount in his account.
• Discounting bills of exchanges or hundies :- A bill of exchange is a document acknowledging an amount of money owned in consideration of goods received. It is a paper asset signature by the debtor and the creditor for a fixed amount payable on a fixed date.

 

Agency functions of the Bank :-

These are as follow :-

• Transfer of fund :- It provides facility for cheap and easy remittance of funds from place to place through demand drafts, mail transfers, telegraphic transfer etc.
• Collection of funds :- It collects funds through cheques, bills, hundies and demand draft on behalf of its customers.
• Payments of various Items :- It makes payment of taxes, insurance premium bills etc. As per directions of its customers.
• Purchase and sale of shares and securities :- It buys, sells and keeps in safe custody and shares on behalf of its customers.
• Collection of dividends :- It collects interest on shares and debentures on behalf of its customers.
• Act as a trusty and executor of property :- Commercial bank acts as a trusty and executor of property of its customers on advice of its customers

 

 

Functions of Central Bank

1. Currency Authority (Bank of Issue):-

• Central bank has the sole authority for issue of currency in the country:-  In India RBI has the sole right of issuing paper currency notes (except one-rupee note and coins which are issued by Ministry of Finance). Withdrawal and putting currency into circulation is also the responsibility of RBI.
• All the currency issued by the RBI is its monetary liability, i.e. central bank is obliged to back the currency with assets (which consists of gold coins, gold, foreign securities etc.) of equal value.
•  Advantages of this functions are:

1. It leads to uniformity in note circulation.
2. It gives the central bank power to influence money supply and ensures public faith in the currency system.
3. It enables the government to have supervision and control over the central bank with respect to issue of notes. It helps in stabilizing the internal and external value of currency.

2. Banker to the government: RBI acts as a banker, agent and financial adviser to the central and the state government.

• As a banker it carries out all banking business of the government.

1. Government maintains its cash balances in the current account with RBI.
2. RBI accepts receipts and make payments on behalf of the government and carries out other banking operations for the government.
3. The Central Bank also provides short-term credit to the government so that the government can meet any shortfalls in receipts over disbursements. The government carries on short term borrowings by selling ad-hoc treasury bills to the central bank.

• As an agent the central bank also has the responsibility of managing the public debt. This means that the central bank has to manage all new issues of government loans.
• As a financial advisor the central bank advises the government from time to time on economic, financial and monetary matters.

 

3. Banker’s bank and supervisor: As a banker to the banks, the central bank functions in three respects:

1. 1. Custodian of cash reserves: Commercial banks are required to keep a certain percentage of their deposits with the central bank. In this way the central bank acts as a custodian of cash reserves of commercial banks. (The sole aim of these reserves is to enable central bank to provide financial assistance to commercial banks in times of financial emergency).
2. Central bank is the lender of the last resort: When commercial banks need more funds in order to be able to create more credit, they may go to market for such funds or go to the Central Bank. Central bank provides them funds through various instruments. The central bank helps them through discounting approved securities and bills of exchange. This role of RBI, that of being ready to lend to banks at all times is another important function of the central bank, and due to this central bank is said to be the lender of last resort.         
3. Clearing house function: All commercial banks have their accounts with the central bank. Therefore, the central bank can easily settle claims of various commercial banks against each other, by making debit and credit entries in their accounts.

Central bank as a supervisor, supervises regulates and controls the activities of commercial banks. The regulation of banks may be related to their licensing, branch expansion and mergers of banks. The control is exercised by periodic inspection of banks and the returns filed by them.

4. Custodian of foreign exchange reserves :- The central bank acts as the custodian of the country’s stock of gold and reserves of foreign exchange. This function enables the central bank to exercise a reasonable control on foreign exchange. As all foreign exchange transactions must be routed through RBI. It helps the bank in stabilizing the external value of currency and pursuing a coordinated policy towards the balance of payments situation of the country.

5. Controller of money supply and credit:- Central bank controls money supply by using various quantitative and qualitative instruments.

Quantitative instruments and Qualitative instruments :-

The RBI controls the money supply in the economy in various ways. The tools used by the Central bank to control money supply can be quantitative or qualitative.

Quantitative instruments aim at controlling the volume of credit and money supply in the economy. Quantitative tools, control the extent of money supply by changing the CRR, or bank rate or open market operations

a) Bank rate:- The rate at which the central bank lends money to commercial banks for its long-term needs is known as bank rate.

• An increase in bank rate increases the cost of borrowing from the central bank. As a result, commercial banks will increase the rate of interest at which they lend to public (lending rate) thereby making credit costlier. This discourages the public to borrow from commercial banks, which reduces the flow of credit or money supply in the economy.
• A decrease in bank rate will have the opposite effect.

b) Legal reserve requirement:- Commercial banks are legally required to maintain reserves on two accounts-

i) Cash Reserve Ratio (CRR) :- It refers to the percentage of the net demand and time deposits that commercial banks are legally required to keep as cash reserves with RBI.

• An increase in CRR means that commercial banks have to keep a higher percentage of their deposits as reserves with RBI which reduces the credit availability with them. This decreases their lending capacity which in turn decrease the flow of credit or money supply in the economy.
• A decrease in CRR will have the opposite effect.

ii) Statutory Liquidity Ratio (SLR) :- It is the percentage of net demand and time deposits which commercial banks are legally required to keep in the form of designated liquid assets (such as govt. securities) with themselves.

• An increase in SLR reduces the ability of banks to give credit and hence reduces lending and the flow of credit or money supply in the economy.
• A decrease in SLR will have the opposite effect.

c) Open market operations :- It refers to buying and selling of government securities or bonds by the central banks from or to the commercial banks or public.

• Sale of securities by the central bank will reduce the reserves with commercial banks when the bank gives the central bank a cheque for the securities which will reduce the banks ability to create credit and reduce lending in the economy and therefore decrease the money supply in the economy.
• In order to expand the flow of credit in the economy central bank purchases securities from the commercial banks and in return gives the banks a cheque drawn on itself in payment for the securities. When the cheque clears, the central bank increases the reserves of the bank by the particular amount thereby increasing their ability to create credit and lend more and therefore money supply increases in the economy.

d) Repo (Repurchase) rate:- There is another type of operation in which when the central bank buys the security, this agreement of purchase also has specification about date and price of resale of this security. This type of agreement is called a repurchase agreement or repo. It is the interest rate at which the commercial banks can borrow from the central bank to meet their short-term needs.

• • An increase in the repo rate will make borrowings from central bank costlier, as a result banks will lend to public at a higher lending rate. Thus, borrowings will be discouraged as credit is costlier leading to decrease in money supply in the economy.
  • A decrease in repo rate will have the opposite effect.

 

e) Reverse repo rate :- It is the interest rate which the commercial banks get for depositing their surplus funds with the central bank.

• • Raising RRR gives incentives to the commercial banks to park their funds with RBI. This reduces credit availability with the commercial banks and adversely affect their lending capacity leading to decrease in money supply.
  • Lowering RRR discourages the commercial banks from parking their funds with the central bank. This will increase credit availability with the commercial banks and their credit creation power leading to increase in money supply.

 Note :- The Reserve Bank of India conducts repo and reverse repo operations at various maturities: overnight, 7 -day, 14 – day, ete. This type of operations have now become the main tool of monetary policy of the Reserve Bank of India.

Qualitative instruments

Qualitative tools include persuasion by the Central bank in order to make commercial banks discourage or encourage lending which is done through moral suasion, margin requirement, etc.

a) Margin requirement :- It is the difference between the amount of loan and the market value of the security offered by the borrower against the loan.

By changing the margin requirement reserve bank can alter the amount of loans made against securities by the bank.

• To expand money supply in an economy margin requirement is reduced which means more loan is given against the same value of security which encourages borrowing and therefore increases the flow of credit or money supply in the economy.
• To reduce money supply in an economy margin requirement is increased which means less loan is given against the same value of security which discourages borrowing and therefore decreases the flow of credit or money supply in the economy.

(b) Moral Suasion

• • Moral suasion implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank.
  • In a situation of excess demand leading to inflation, it appeals for credit contraction.
  • In a situation of deficient demand leading to deflation, it appeals for credit expansion.

(c) Selective Credit Controls (SCCs)

• • In this method the central bank can give directions to the commercial banks not to give credit for certain purposes or to give more credit for particular purposes or to the priority sectors.
  • In a situation of excess demand leading to inflation, the central bank introduces rationing of credit in order to prevent excessive flow of credit, particularly for speculative activities. It helps to wipe off the excess demand.
  • In a situation of deficient demand leading to deflation, the central bank withdraws rationing of credit and make efforts to encourage credit.

 

Difference between Central Bank and Commercial Bank

Central Bank	Commercial Bank
It is an 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 providing loans and making investments, with the aim of earning profits.
It is owned and governed by the government.	It can be owned and governed by the government or the private sector.
It operates for public welfare without profit motive.	It aims to maximize profits.
It does not do ordinary banking business with general public but only with the government.	It does ordinary banking business with general public.
It has the sole authority of printing new currency.	It has the role of credit creation.
It acts as a banker to the government.	It has no such powers.

 

Money Multiplier / Credit creation by commercial banks

Credit creation refers to the process of creation of credit by the commercial banks with the help of an initial deposit and given LRR.

Assumptions :-

a) The amount of initial deposit (assumed to be ₹ 1000)

b) The LRR or legal reserve ratio (assumed to be 20%)

Legal Reserve Ratio is the fraction of deposits that the banks have to keep compulsorily in the form of cash with the central bank or designated liquid assets like govt securities with themselves. These may be in the form of CRR or SLR.

Principle:- 

a) All transactions are routed through the banks.

b) All banking system is treated as a single ‘Bank’

Working:-

• Suppose the initial deposits in the banks are ₹ 1000. Since LRR is 20%, it means that the banks can lend out the remaining 80% to the borrowers i.e. ₹ 800. It does so by opening an account in the name of the borrower.
• If the borrowers withdraw the entire amount and make payments using ₹ 800. Since all transactions are routed through the banks, the money comes back to the banks in the form of deposits by the receivers of this money. This increases the deposits by ₹ 800. Thus, the total credit created now increases to ₹1000 + ₹800 = ₹1800.
• The bank then uses the ₹ 800 to lend after keeping reserves worth 20% i.e. Rs.160 and lends the remaining   ₹ 640 as fresh loans to borrowers which again comes back as deposits in the accounts of the receivers of this money. Hence total credit created now equals ₹1000 + ₹800 + ₹640 = ₹2440.

This continues and in each round, the deposit creation is 80% of the previous round. These increases become smaller and smaller and continue till all of the initial deposit equals the total cash reserves.

Total value of deposits created =       initial deposit = (1/20% ) 1000 = 5 x 1000 = ₹ 5000.

Thus, the initial deposit get multiplied 5 times and hence the money multiplier is  = 5.

 

Note on Demonetisation :-

Demonetization was a new initiative taken by the Government of India in November 2016 to tackle the problem of corruption, black money, terrorisms and circulation of fake currency in the economy. Old currency notes of Rs 500 , and Res 1000 were no longer legal tender. New currency notes in the denomination of Rs 500 and Rs 2000 were launched. The public were advised to deposit old currency notes In their bank account till 31 December 2016 without any declaration and upto 31 March 2017 with the RBI with declaration.

Further to avoid a complete breakdown and cash crunch, notes government had allowed exchange of Rs 4000 old currency the by new currency per person and per day. Further till 12 December 2016, old currency notes were acceptable as legal tender at petrol pumps, government hospitals and for payment of government dues, like taxes, power bills, etc.

This move received both appreciation and criticism. There were long queues outside banks and ATM booths. The shortage of currency in circulation hassle an adverse impact on the economic activities. However, things Improved with time and normalcy returned.

This move has had positive impact also. It improved tax compliance as a large number” of people were bought 1n the tax ambit. The savings of an individual were channelized into the formal financial system. As a result, banks have more resources at their disposal which can be used to provide more loans at lower interest rates. It is a demonstration of State’s decision to put a curb on black money, showing that tax evasion will n0 longer be tolerated. Tax evasion will result in financial penalty and social condemnation. Tax compliance will improve and corruption will decrease. Demonetization could also help tax administration in another way, by shifting transactions out of the cash economy into the formal payment system. Household’s and firms have begun to shift from cash to electronic payment technologies.