Banking: Commercial Banks and The Central Bank

A commercial bank is a financial institution that accepts deposits from the people and offers loans for the purpose of consumption or investment.

According to Indian Banking Companies Act, “Banking company is one which transacts the business of banking which means the accepting ( for the purpose of lending or investment ) of deposits of money from the public repayable on demand or otherwise and withdrawable by cheque draft, order or otherwise.”

Banking

The rate of interest charged by the commercial banks ( for the loans they offer ) is higher than the rate of interest paid by them ( for the deposits they accept ) . The difference between the two rates is called ‘ spread ‘ , which is the source of profit for the banks . 

Spread = Rate of interest charged by the banks for the loans they offer – Rate of interest paid by the banks for the deposits they accept. 

 Basic Functions of Commercial Banks

The commercial banks generate their profits by way of ‘spread’. 

 Commercial banks perform two basic ( primary ) functions : Accepting deposits and Advancing loans 

Accepting Deposits

 A bank accepts deposits from the public. People can deposit their cash balances as chequeable deposits or non-chequeable deposits Chequeable deposits are those against which cheques can be issued ( and money can be withdrawn ) at any time. Nonchequeable deposits are those against which cheques cannot be issued (and money cannot be withdrawn) at any time. Instead, money in these deposits is kept as a reserve with the bank for some fixed period of time. Accordingly, these deposits are also called fixed deposits or term deposits. 

Advancing Loans 

Another primary function of the commercial baris is to advance loans. Banks advance loans mostly for productive purposes. Thus, loans are offered to the producers for the purchase of plants and machinery. However, loans are offered for consumption purposes as well, for the purchase of durable-use consumer goods like cars and motorbikes. 

Offering loans to the producers, the banks are a source of funds for investment. Offering loans to the consumers, the banks are a source of funds for consumption. Often, the loans are offered against some ‘collateral’ (security offered by the borrowers of loans).

Banking: Commercial Banks and The Central Bank

On the basis of cash deposits of the people, the banks build up their cash reserves. But, an interesting fact is that the banks advance loans many times more than their cash reserves. It is through this activity of the banks that they add to the supply of money in the economy. This is popularly known as ‘ Credit Creation by the banks. By creating credit (and thus adding to the supply of money) the banks are able to expand the availability of funds for purpose of investment as well as consumption.

Accordingly, new dimensions are added to the parameters of supply and demand in the economy. Both supply (the production of goods and services). and demand (the consumption of goods and services) are shifted to coincide with higher and higher levels of GDP of the economy. 

In fact, by virtue of their role as creators of credit (or creators of money) the banks act as agents of economic growth. The following section examines how banks are the creators of credit or creators of money in the economy. 

Who decides RR (reserve requirement) of the commercial bank? 

In countries like Canada and UK, it is decided and determined by the commercial banks themselves on the basis of their historical experience. In India and the USA, it is decided by the central bank of the country ( Federal Bank in the case of the USA and RBI in the case of India). It is popularly known as CRR (Cash Reserve Ratio) in the Indian Banking system. CRR is also called the legal reserve ratio. The commercial banks are legally bound to maintain the specified CRR. In India, the amount of cash (calculated according to CRR) is to be kept by the commercial banks as cash reserves with RBI. 

The Central Bank

The central bank is an apex bank. it controls the entire banking system of a country. It is the sole agency of note-issuing and controls the supply of money in the economy. It serves as a banker to the government and manages the forex ( foreign exchange ) reserves of the country. In India, the central bank is known as RBI, Bank of England in the UK, and Federal Reserve System in the USA. Although the first central bank in the world was set up in 1668 in Sweden, effective central banking came into being in 1694 with the establishment of the Bank of England. 

There is no standard definition of a central bank. The definition depends on the functions it discharges. However, a common function that the central bank performs in all economies of the world is that it controls and manages the flow of credit and supply of money in the economy  Accordingly, Samuelson says. ” Every central bank has one function. It operates to control the economy, supply of money, and credit. ” Sarkari Focus

Banking: Commercial Banks and The Central Bank

Functions of the Central Bank

 Principal functions of the central bank are as follows : 

  1. Bank of Issuing Notes: Central bank of a country has the exclusive right ( monopoly right ) of issuing notes. This is called the Currency Authority function of the central bank. Actually, till the beginning of the 20th century, the central bank was known as the Bank of issue. The notes issued by the central bank are unlimited legal tender. 
  2. Banker to the Government: Central bank is a banker, agent, and financial advisor to the government. As a banker to the government, it manages accounts of the government. As an agent to the government, it buys and sells securities on behalf of the government. As an advisor to the government, it frames policies to regulate the money market. The central bank also offers loans to the government against government Securities or treasury bills. In a situation when its revenue falls short of its expenditures ( a situation of deficit government budget ), the government often seeks loans from the central bank ( RBI ). This is called, ‘ deficit financing through borrowing from the RBI. 
  3. Bankers ‘ Bank and Supervisory Role: As a Bankers ‘ Bank, it has almost the same relationship with other banks in the country as a commercial bank has with its customers. It accepts deposits from commercial banks and offers them loans. The rate at which the central bank offers ( short period ) loans to the commercial banks is called ‘ Repo Rate ‘. The rate at which commercial banks are allowed to park their surplus funds with the RBI is called ‘ Reverse Repo Rate. The standard practice is to keep ‘ reverse repo rate lower than the ‘ repo rate by 1 %.
  4. Lender of the Last Resort: we know, commercial banks create liabilities (demand deposits) many times more than their cash reserves. This arrangement works fine so long as people have confidence in the banking system of the country. However, there may be occasions when a bank suffers a crisis of confidence. The depositors fear that the bank may run out of its cash reserves. They start withdrawing their deposits beyond what the bank can afford at a time. It is in such a situation that the central bank acts as a lender of last resort. It offers loans to the bank to cope with the crises. It also stands as a guarantor of saving its solvency. 
  5. Custodian of Foreign Exchange: Central bank is the custodian of the nation’s foreign exchange reserves. It also exercises ‘managed floating’ to ensure the stability of the exchange rate in the international money market.

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