BEST HIGHER SECONDARY SCHOOL

CHAPTER - : MONEY AND BANKING

Q.1: Define Bank / Commercial Bank and Discuss the functions of Commercial Banks. Ans. A) MEANING AND DEFINATION OF COMMERCIAL BANK :

In modern economy commercial Banks Play an important role in the financial sector. A Bank is an institution dealing in money and credit. Credit money is the major component of money supply in a modern economy. Commercial banks are the creators of credit. The strength of economy of any country basically depends on a sound and solvent banking system. A Commercial bank is a profit seeking business firms dealing in money or rather claims to money. It safeguards the savings of the public and give loans and advances. The Banking Companies Act of 1949, defines banking company as accepting for the purpose of lending or investment of deposit money from the public, repayable on demand or otherwise and withdrawable by cheque, drafts, order or otherwise. B) FUNCTIONS OF COMMERCIAL BANKS :Modern commercial banks perform a variety of functions. They keep the wheels of commerce, trade and industry always revolving. Major functions of a commercial bank are: Primary or Banking functions and Secondary or Non-Banking functions. FUNCTIONS OF COMMERCIAL BANKS

Primary

Secondary

Subsidiary Activities

Deposits

Loans & Advances

Agency Services

Utility Services

I.

Primary / Banking Functions :Commercial banks have two important banking functions. One is accepting deposits and other is advancing loans. 1) Deposits :-

a)

b)

c)

d)

2)

a)

One of the main function of a bank is to accept deposits from the public. Deposits are accepted by the banks in various forms. Current Account Deposits :Current Accounts are usually opened by businessmen who have a number of regular transactions with the bank, both deposits and withdrawls. There is no restriction on number and amount of deposits. There is also no restriction on withdrawls. No interest is paid on current deposits. Banks may even charge interest for providing this facility. These accounts are also known as demand deposits as amount can be withdrawn on demand. Saving Account Deposits :Saving Accounts are opened by salaried and other less income people. There is no restriction on number and amount of deposits. withdrawls are subject to certain restrictions. It earns Interest but less than fixed deposits. It encourages saving habit among salary earners and others. Saving deposits are an important source of funds for banks. Fixed Account Deposits :Deposits in fixed account are time deposits. Money under this account is deposited for a certain fixed period of time varying from 15 days to several years. A high rate of interest is paid. If money is withdrawn before expiry date, the depositor receives lower rate of interest. Deposits can be renewed for further period. Many banks sanction loans against security of fixed deposits. Recurring Account Deposits :In Recurring deposit, a specified amount is regularly deposited by account holder, at an internal of usually a month. This is to form the habit of small savings among the people. At the end of maturity period, the account holder gets a substantial amount. Interest on this type of deposit is almost equal to fixed deposits. Thus by creating variety of deposits, banks motivate people in a variety of ways and encourage savings in the economy. Loans And Advances :Banks not only mobilize money but also lend to its credit worthy customers for maximizing profits. Loans and Advances are granted To :Business And Trade :Commercial banks grant short-term loans to business and trade activities in following forms:Overdraft :Commercial banks grant overdraft facility to current account holders Under this system a borrower is allowed to draw more than what is deposited in his account. The borrower is granted to a fixed additional amount against collateral security. Interest is charged for actual amount drawn. Cash Credit :Cash credit is given by the bank to any businessman to meet regular working capital needs, against the security of goods or personal security. Interest is charged on actual amount drawn by the customer. Discounting Of Bills :When the holder of the bill is not in a position to wait till the maturity of the bill and requires cash urgently, he sells the bill of exchange to bank. Bank advance credit by discounting bills of exchange, government securities or any other approved financial instruments. The bank purchases the instruments at a discount. Money At Call :-

i)

ii)

iii)

iv)

v)

b)

c)

d)

e)

Banks also grant loans for a very short period, generally not exceeding 7 days. Such advances are repayable immediately at a short notice hence they are called as Money at Call or Call money. These loans are given to dealers or brokers in stock market against Collateral Securities. Direct Loans :Loans are given to customers against the security of moveable properties. Their maturity varies from 1 to 10 years. Interest has to be paid on entire loan amount sanctioned. Loans are of many types like :- personal loans, term loans, call loans, participative loans, collateral loans etc. Loans to Agriculture :Banks grant short-term credit to agriculture at a lower rate of interest. Loans are granted for irrigation, purchase of equipments, inputs, cattle etc. Loans To Industries :Banks grant secured loans to small and medium scale industries to meet their working capital needs. The time period may be from one to five years. It may be in the form of Overdraft, cash credit or direct loan. Loans To Foreign Trade :Loans are granted to export and import in the form of direct loans, discounting of bills, guarantee for deferred payments etc. Here the rate of interest is low. Consumer Credit / Personal loans :Banks also grant credit to household in a limited amount to buy some durable consumer goods like television sets, refrigerators, washing machine etc. Such consumer credit is repayable in installments. Under 20-point programme, the scope of consumer credit has been extended to cover expenses on marriage, funeral etc., as well.

f)

II.

Miscellaneous Advances :Banks also gives advances like packing credits to exporters, export bill purchased or discounted, import finance, finance to self-employed, credit to weaker sections of society at concessional rates etc. Secondary / Non-banking Functions :Banks gives various forms of services to public. Such services are termed as non- banking or secondary functions :1. Agency Services:Banks perform certain functions on behalf of their customers. While performing these services, banks act as agents to their customers, hence these are called as agency services. Important agency functions are :a) Collection :Commercial banks collect cheques, drafts, bills, promissory notes, dividends, subscriptions, rents and any other receipts which are to be received by the customer. For these services banks charge a nominal amount. b) payment :Banks also makes payments on behalf of their customers like paying insurance premium, rent, taxes, electricity and telephone bills etc for such services commission is charged. c) Income Tax Consultant :Commercial banks acts as income-tax consultants. They prepare and finalise the income tax returns of their clients. d) Sale And Purchase Of Financial Assets :-

As per the customers instruction banks undertake sale and purchase of securities, shares and any other financial assets. Nominal charges are charged by a bank. e) Trustee, Executor And Attorney :As a trustee, banks becomes the custodian and manager of customer funds. Bank also acts as executor of deceased customers will. As an Attorney the banks sign the documents on behalf of customer. f) E- Banking :Through Electronic Banking, a customer can operate his bank account through internet. He can make payments of various bills. He can even transfer money from one place to another. 2. Utility Services :Modern Commercial banks also performs certain general utility services for the community, such as :a) Letter Of Credit :Banks also deal in foreign trade. They issue letter of credit and provide guarantee to foreign traders for the soundness of their customers. b) Transfer Of Funds :Banks arrange transfer of funds cheaply and safely from one place to another. Transfer can be in the form of Demand draft, Mail transfer Travellers cheques etc. c) Guarantor :Banks offer a guarantee of payment on behalf of importer to facilitate imports with deferred payments. d) Underwriting :This facility is provided to Joint Stock Companies and to government to enable them to raise funds. Banks guarantee the purchase of certain proportion of shares, if not sold in the market. e) Locker Facility :Safe Lockers are provided to the customers. So that they can deposit their valuables like Jewellary, Securities, Shares and otherdocuments. f) Referee :Banks may act as referee with respect to financial standing, business reputation and respectability of customers. g) Credit Cards :Credit card facility have been introduced by commercial banks. It enables the holder to minimize the use of hard cash. Credit card is a convenient medium of exchange which enables its holder to buy goods and services from member establishment without using money. III. Subsidiary Activities :Many commercial banks also undertakes subsidiary activities such as :1) Housing Finance :Housing finance is provided against the security of immoveable property of land and buildings. Many banks such as SBI, Bank of India etc. have set up housing finance subsidiaries. 2) Mutual Funds :A Mutual fund is a financial intermediary that pools the savings of investors for collective investment in diversified portfolio securities Many banks like SBI, Indian Bank etc. have set up mutual fund subsidiaries. 3) Merchant Banking :A variety of services are offered by merchant banking like :Management, Marketing and Underwriting of new issues, project promotion, corporate advisory services, investment advisory services etc.

4) Venture Capital Fund :Venture capital fund provides start-up share capital to new ventures of little known, unregistered, risky, young and small private business, especially in technology oriented and knowledge intensive business. Many commercial banks like SBI, Canara Bank etc. have set up venture Capital Fund Subsidiaries. 5) Factoring :Factoring is a continuing arrangement between a financial intermediary (factor) and a business concern (client) where by the factor purchases the clients accounts recieveable. Banks like SBI and Canara Bank have established subsidiaries to provide factoring services. Thus various services are provided by commercial Banks. Q.2: Explain the process of multiple credit creation of commercial banks. OR Write note on multiple credit creation by commercial banks. Every loan creates a Deposit. Discuss. Ans. A) MULTIPLE CREDIT CREATION BY COMMERCIAL BANKS:Creation of credit is an important function of a commercial bank. Prof. Sayers said Banks are not merely purveyors of money but, also in an important sense manufacturers of money. In a modern economy Banks deposits form a major proportion of total money supply. A banks demand deposits arise mainly from :- Cash deposits by customers and Bank Loans and Investments. 1. Cash Deposits By Customers :These are termed as primary deposits as they arise from the actual deposits of cash in a bank made by its customers. In receiving such deposits, the bank plays a passive role. The creation of primary deposits, however is nothing but transforming the currency money in to deposit money. 2. Bank Loans And Investments :These are termed as derivative or active deposits. The derivative deposits are lent in the form of loans or advances, discounting of bills or used for purchasing securities or other assets. Deposit account in the name of the customer or seller, credits him with the amount of loan granted or value of security purchased, subject to withdrawl by cheque, as required. Hence loans advanced or purchases of securities creates deposits. Thus every loan creates a deposit. They increase the quantity of bank money. The size of derivative demand deposits is determined by the banks lending and investment activities. There will be a constant inflow and outflow of cash with the banks. For the sake of liquidity and safety some proportion of total deposit must be maintained in cash, for e.g. :- 10% to 20% to meet the demand for cash at the counter. This is known as Cash Reserve Ratio. Primary deposits serve as a basis for creating derivative deposits, that is credit creation, and for increasing money supply. Commercial banks are profit seeking institutions and when they find that large volume of cash received lies Idle, they use these resources for advancing loans or for making investment in securities, shares etc. there by earning high rate of interest. The creation of credit also depends on excess cash reserves or cash reserve ratio. The derivative deposits are used as working capital. When the borrower withdraws money from his loan account by cheque it is deposited by the payee in some other bank. Those banks again create deposit on the basis of fresh deposits received after keeping required reserves. Ultimately, the total volume of credit or derivative deposits

or bank money created by all banks would be a multiple of the original amount of new cash reserves in the system. Thus multiple expansion of credit takes place. Example :Suppose the Cash Reserve Ratio is 20% and a person deposits Rs. 10,000/- with Bank of India. This is primary deposit. The bank keeps Rs. 2000 as CRR and balance of Rs. 8000 is used for granting credit. Now suppose Bank of India lends Rs. 8000 to Mr. A and Mr. A pays a cheque of Rs. 8000 to Mr. B, who has an account in Bank Of baroda. Then Bank Of Baroda receives Rs. 8000 as primary deposit. It keeps Rs. 1,600 (20%) as CRR and excess amount of Rs. 6,400 is used for giving credit. Now if, Mr. C is granted this loan and Mr.C gives a cheque of Rs. 6,400 to another person who may deposit it in Bank of Maharashtra. Bank of Maharashtra will keep Rs. 1,280 as CRR and issue a loan of Rs. 5,120. This process continues until the original excess reserves of Rs. 8000 with the first Bank of India, have been parceled out among various banks and have been required resources. As a result, the aggregate of derivative deposits in the entire banking system, approximates 5 times the initial derivative deposit over a period of time. Let us explain with the help of table:PROCESS OF MULTIPLE EXPANSION OF CREDIT BANKS PRIMARY DEPOSIT CRR 20% 2000 1,600 1,280 10,000 Credit Creation or Creation of Derivative Deposits 8000 6,400 5,120 40,000

Bank of India Bank of Baroda Bank of Maharashtra Total of all Banks

10,000 8,000 6,400 50,000

In the above Eg., the credit expansion is five times the initial excess reserve of Rs. 8,000 when CRR is 20%.
PD PCR TC = CRR X 100

Symbolically,

Where TC = Total Credit PD = Primary Deposit. PCR = Primary cash Reserve. CCR = Cash Reserve Ratio. Cash Creation =
10000 2000 X 100

8000 X 100 = ` 40,000

20

20

The Credit Multiplier depends on CRR.

r = CRR If CRR is 20 % then, credit multiplier will be

The Multiple expansion of credit is the inverse of CRR maintained by banks. Higher the CRR, Lower the expansion of credit and vice versa.
C) ASSUMPTIONS :-

1) 2) 3) 4) 5) 6) 7) 8)

The bank deposit multipler, discussed above, is based on the following assumptions:There is no leakage from the banking system. All the money should remain with banking system. The banks must receive new deposits. They must be willing to make loans or buy securities. The CRR remains constant through all the stages. People must be willing to borrow. The business conditions are normal. There is no credit control policy of central bank. There should be popular banking habit in the country and a well developed banking system. Q.3: What are the limits to the power of banks to create credit ? OR Write notes on limitations of credit creation. Ans. A) LIMITATIONS OF CREDIT CREATION :Commercial banks do not have unlimited powers of deposit or credit creation, because their activities in this direction are subject to a number of restrictions, such as :Amount Of Cash :The larger the amount of cash with banking system, the greater will be the excess funds, and that larger will be the credit creation power of the bank. The banks power of creating money or credit is thus limited by cash it can get in its hands on, primarily through primary deposits. Cash Reserve Ratio :Higher the cash reserve ratio, smaller the volume of credit creation and vice versa. If CRR falls to a certain minimum, then power of the banks to create credit is limited. External Drain:External drain refers to the withdrawl of cash from the banking system by public. Every rupee in cash that is withdrawn from the banking system, lowers the reserves of the banks and thus checks further deposit expansion. Willingness To Borrow:Credit creation will be larger during a period of business prosperity and smaller during a depression. Bankers cannot create credit at will.The amount of credit is conditioned by the needs and will of the borrowers. Supply Of Collateral Securities:The availability of good securities places one more limitation on the power of banks to create money. If approved securities are not available, the bank cannot create credit without inviting trouble. The bank does not create money out of thin air, it transmutes other forms of wea lth in to money.

1)

2)

3)

4)

5)

6) Banking Habits And Banking System:In the absence of banking habits and banking system, credit creation will be impossible. The banking habit will become popular only if there is a sound, developed banking system. 7) Monetary Policy Of Control Bank:The Central bank has the power to influence the volume of money in the country and from time to time, use various methods of credit control and thus its influences the banks to expand or contract credit. Q4 Discuss / Explain the various functions of RBI. Ans. A.RESERVE BANK OF INDIA (RBI) :The Reserve Bank of India is the central bank of India it was established as a shareholders bank on 1st April 1935. Its share capital was Rs. 5 crore, divided in to 5 lakhs fully paid up shares of Rs. 100 each. On 1st January 1949 it was nationalized. Its headquarters is at Mumbai. RBI, like any other bank performs almost all traditional Central banking functions. Due to countrys development it has also undertaken developmental and promotional functions. A. FUNCTIONS OF RBI :RBI performs many functions, some of them are:1. Issue Of Currency Notes :Under section 22 of RBI Act, the bank has the sole right to issue currency notes of all denominations except one rupee coins and notes. The one-rupee notes and coins and small coins are issued by Central Government and their distribution is undertaken by RBI as the agent of the government. The RBI has a separate issue department which is entrusted with the issue of currency notes. 2. Banker To The Government :The RBI acts as a banker agent and adviser to the government. It has obligation to transact the banking business of Central Government as well as State Governments. E.g.:- RBI receives and makes all payments on behalf of government, remits its funds, buys and sells foreign currencies for it and gives it advice on all banking matters. RBI helps the Government both Central and state to float new loans and manage public debt. The bank makes ways and meets advances of the government. On behalf of central government it sells treasury bills and thereby provides short-term finance. 3. Bankers bank And Lender Off Last Resort :RBI acts as a banker to other banks. It provides financial assistance to scheduled banks and state co-operative banks in form of rediscounting of eligible bills and loans and advances against approved securities. RBI acts as a lender of last resort. It provides funds to bank when they fail to get it from other sources. It also acts as a clearing house. Through RBI, banks make interbanks payments. 4. Controller Of Credit :RBI has power to control the volume of credit created by banks. The RBI through its various quantitative and qualitative techniques regulates total supply of money and bank credit in the interest of economy. RBI pumps in money during busy season and withdraws money during slack season. 5. Exchange control And Custodian Of Foreign Reserve :-

RBI has the responsibility of maintaining fixed exchange rates with all member countries of IMF. For this, RBI has centralized all foreign exchange reserves (FOREX). RBI functions as custodian of nations foreign exchange reserves. It has to maintain external valu of Rupee. RBI achieves this aim through appropriate monetary fiscal and trade policies and exchange control. 6. Collection And Publication Of Data :The RBI collects and complies statistical information on banking and financial operations of the economy. The Reserve Bank Of India Bulletian is a monthly publication. It not only provides information, but also results of important studies and investigations conducted by reserve bank are given. The Report on currency and finance is an annual publication. It provides review of various developments of economic and financial importance. 7. Regulatory And Supervisory Functions :The RBI has wide powers of supervision and control over commercial and co-operative banks, relating to licensing, establishment, branch expansion, liquidity of Assets, management and methods of working, amalgamation, re-construction and liquidation. The supervisory functions of RBI have helped a great in improving the standard of banking in India to develop on sound lines and to improve the methods of their operation. 8. Clearing House Functions :The RBI acts as a clearing house for all member banks. This avoids unnecessary transfer of funds between the various banks.

Q5 Explain the quantitative and selective methods ofcredit controlused by RBI.OR Explain the Monetary Policy of RBI Imeasures takenby RBI to control credit. OR Ans. A) MONETARY POLICY OF RBI :The Monetary Policy of RBI is not merely one of credit restriction, but it has also the duty to see that legitimate credit requirements are met and at the same time credit is not used for unproductive and speculative purposes RBI has various weapons of monetary control and by using them, it hopes to achieve its monetary policy. I) General I Quantitative Credit Control Methods :In India, the legal framework of RBIs control over the credit structure has been provided Under Reserve Bank of India Act, 1934 and the Banking RegulationAct, 1949. Quantitative credit controls are used to maintain proper quantity of credit o money supply in market. Some of the important general credit control methods are:1. Bank Rate Policy :Bank rate is the rate at which the Central bank lends money to the commercial banks for their liquidity requirements. Bank rate is also called discount rate. In other words bank rate is the rate at which the central bank rediscounts eligible papers (like approved securities, bills of exchange, commercial papers etc) held by commercial banks. 2. Open market operations :It refers to buying and selling of government securities in open market in order to expand or contract the amount of money in the banking system.This technique is superior to bank rate policy.

Purchases inject money into the banking system while sale of securities do the opposite. During last two decades the RBI has been undertaking switch operations. These involve the purchase of one loan against the sale of another or, vice-versa. This policy aims at preventing unrestricted increase in liquidity. 3. Cash Reserve Ratio (CRR) The cash Reserve Ratio (CRR) is an effective instrument of credit control. Under the RBl Act of, l934 every commercial bank has to keep certain minimum cash reserves with RBI. The RBI is empowered to vary the CRR between 3% and 15%. A high CRR reduces the cash for lending and a low CRR increases the cash for lending. 4. Statutory Liquidity Ratio (SLR) Under SLR, the government has imposed an obligation on the banks to ,maintain a certain ratio to its total deposits with RBI in the form of liquid assets like cash, gold and other securities. 5. Repo And Reverse Repo Rates In determining interest rate trends, the repo and reverse repo rates are becoming important. Repo means Sale and Repurchase Agreement. Repo is a swap deal involving the immediate Sale of Securities and simultaneous purchase of those securities at a future date, at a predetermined price. Repo rate helps commercial banks to acquire funds from RBI by selling securities and also agreeing to repurchase at a later date. SELECTIVE / QUALITATIVE CREDIT CONTROL METHODS :Under Selective Credit Control, credit is provided to selected borrowersfor selected purpose, depending upon the use to which the control try to regulate the quality of credit - the direction towards thecredit flows. The Selective Controls are :1. Ceiling On Credit
II)

The Ceiling on level of credit restricts the lending capacity of a bank to grant advances against certain controlled securities. 2. Margin Requirements :A loan is sanctioned against Collateral Security. Margin means that proportion of the value of security against which loan is not given. Margin against a particular security is reduced or increased in order to encourageor to discourage the flow of credit to a particular sector. It varies from 20% to 80%. For agricultural commodities it is as high as 75%. Higher the margin lesser will be the loan sanctioned. 3. Discriminatory Interest Rate (DIR) Through DIR, RBI makes credit flow to certain priority or weaker sectors by charging concessional rates of interest. RBI issues supplementary instructions regarding granting of additional credit against sensitive commodities, issue of guarantees, making advances etc. . 4. Directives:The RBI issues directives to banks regarding advances. Directives are regarding the purpose for which loans may or may not be given. 5. Direct Action

It is too severe and is therefore rarely followed. It may involve refusal by RBI to rediscount bills or cancellation of license, if the bank has failed to comply with the directives of RBI. 6. Moral Suasion Under Moral Suasion, RBI issues periodical letters to bank to exercise control over credit in general or advances against particular commodities. Periodic discussions are held with authorities of commercial banks in this respect.