Class 12th Chapter 4 - Banking
notes
1️⃣ INTRODUCTION TO BANKING
This chapter explains the following topics:
- Meaning and functions of Commercial Banks
- Credit (Deposit) Creation by Commercial Banks
- Meaning and functions of the Central Bank
- Monetary policy tools used by the Central Bank
Banking plays a crucial role in the economy by:
- Mobilising savings
- Providing credit
- Controlling money supply
- Maintaining economic stability
2️⃣ COMMERCIAL BANK
Meaning
A commercial bank is a financial institution which:
- Accepts deposits from the public
- Gives loans and advances
- Makes investments
- Works with the motive of earning profit
Key Functions
- Accepting deposits
- Advancing loans
- Credit creation
- Agency services (cheque collection, remittance, etc.)
3️⃣ CREDIT (DEPOSIT) CREATION BY COMMERCIAL BANKS
Meaning
Credit creation refers to the multiple expansion of bank deposits on the basis of a primary deposit.
ASSUMPTIONS OF CREDIT CREATION
- Entire banking system is treated as one unit
- All receipts and payments are routed through banks
- Payments are made by cheque
- Banks keep only the minimum required reserves
- There is no cash leakage
LEGAL RESERVE RATIO (LRR)
Banks are legally required to keep a fraction of deposits as reserves.
LRR has two components:
- CRR (Cash Reserve Ratio) – kept with the Central Bank
- SLR (Statutory Liquidity Ratio) – kept by banks themselves
STEP-BY-STEP CREDIT CREATION PROCESS
Step 1: Initial Deposit
- Initial deposit = ₹1000
- LRR = 10%
- Cash reserve = ₹100
- Loan available = ₹900
Step 2: First Round
- ₹900 loan is withdrawn and spent
- Money returns to banks as deposits
- New deposits = ₹900
- Total deposits = ₹1900
Step 3: Second Round
- 10% of ₹900 kept as reserve = ₹90
- Loan = ₹810
- Deposits rise to ₹2710
Step 4: Continuous Rounds
- Each round creates deposits equal to 90% of the previous one
- Process continues until total reserves equal the original deposit
FINAL RESULT
- Total deposit creation = ₹10,000
- Initial deposit = ₹1,000
- Deposit expansion = 10 times
MONEY MULTIPLIER / CREDIT MULTIPLIER
When a primary deposit leads to multiple expansion of deposits, it is called:
- Money Multiplier
- Credit Multiplier
WHY BANKS KEEP ONLY FRACTIONAL RESERVES?
- Not all depositors withdraw money at the same time
- There is a continuous inflow of new deposits
4️⃣ CENTRAL BANK
Meaning
The Central Bank is the apex institution of a country’s monetary system.
➡ In India, the Central Bank is the Reserve Bank of India (RBI).
Main Responsibility
- Formulation and control of Monetary Policy
5️⃣ FUNCTIONS OF CENTRAL BANK
(A) CURRENCY AUTHORITY
- Sole authority to issue currency notes
- Currency issued is legal tender money
- Everyone is legally bound to accept it
- Central Bank has a separate Issue Department
Note (India):
- ₹1 notes and coins → Government of India
- All other currency notes → RBI
(B) BANKER, AGENT AND ADVISER TO GOVERNMENT
(i) Banker to Government
- Accepts government deposits
- Makes payments on behalf of the government
- Advances short-term loans
- Provides foreign exchange
(ii) Fiscal Agent
- Manages public debt
- Collects taxes
- Represents government in IMF and World Bank
(iii) Adviser
- Advises on deficit financing
- Advises on trade policy
- Advises on exchange rate policy
- Advises on devaluation
(C) BANKER’S BANK AND SUPERVISOR
(i) Banker’s Bank
a) Custodian of Cash Reserves
- Commercial banks keep CRR with the Central Bank
b) Lender of Last Resort
- Banks borrow from Central Bank during emergencies
- Through rediscounting of bills and securities
c) Clearing Agent
- Settles inter-bank claims
- Known as Clearing House Function
(ii) Supervisor of Banks
- Licensing of banks
- Control over branch expansion
- Inspection of banks
- Mergers and liquidation
(D) CONTROLLER OF MONEY SUPPLY & CREDIT
MONETARY POLICY TOOLS
1️⃣ QUANTITATIVE (GENERAL) TOOLS
(i) Bank Rate
Rate at which Central Bank lends to commercial banks without collateral.
Inflation (Excess Demand):
- Bank Rate ↑ → Loans ↓ → Investment ↓ → Demand ↓
Deflation (Deficient Demand):
- Bank Rate ↓ → Loans ↑ → Investment ↑ → Demand ↑
(ii) Repo Rate
- Rate at which banks borrow by selling securities to RBI
- Higher repo rate → credit contraction
- Lower repo rate → credit expansion
(iii) Reverse Repo Rate
- Rate at which RBI borrows from banks
- Higher reverse repo → banks park funds → credit ↓
- Lower reverse repo → banks lend more → credit ↑
(iv) Open Market Operations (OMO)
- Buying and selling of government securities
- Sell securities → credit ↓
- Buy securities → credit ↑
(v) Cash Reserve Ratio (CRR)
- Minimum percentage of deposits kept with RBI
- CRR ↑ → credit ↓
- CRR ↓ → credit ↑
(vi) Statutory Liquidity Ratio (SLR)
- Minimum percentage of deposits kept by banks themselves
- SLR ↑ → credit ↓
- SLR ↓ → credit ↑
2️⃣ QUALITATIVE (SELECTIVE) TOOLS
(i) Margin Requirements
- Difference between value of security and amount of loan
- Margin ↑ → borrowing ↓
- Margin ↓ → borrowing ↑
(ii) Moral Suasion
- Persuasion and advice given by the Central Bank to banks
(iii) Selective Credit Controls (SCCs)
- Restricts credit for speculative activities
- Encourages credit to priority sectors
6️⃣ WORDS THAT MATTER (VERY IMPORTANT FOR EXAM)
- Commercial Bank – Accepts deposits and gives loans for profit
- Legal Reserve Ratio (LRR) – CRR + SLR
- Money Multiplier – Multiple deposit expansion
- Central Bank – Apex monetary authority
- Quantitative Tools – Control total credit
- Qualitative Tools – Control direction of credit
- Bank Rate – Long-term lending rate
- Repo Rate – RBI lends to banks
- Reverse Repo Rate – RBI borrows from banks
- Open Market Operations (OMO) – Buying and selling securities
- Cash Reserve Ratio (CRR) – Cash kept with RBI
- Statutory Liquidity Ratio (SLR) – Liquid assets kept with banks
- Margin Requirement – Gap between security value and loan amount
- Moral Suasion – Persuasion by the Central Bank
- Selective Credit Controls – Sector-wise control of credit
