Banking Notes Class 12 Macroeconomics

It is an institution that performs the functions of accepting deposits, granting loans & making instruments to earn profits. Here are the banking notes class 12.

Functions of a Commercial Bank

Primary Functions of Commercial Banks

These are the main functions performed by a commercial bank & includes –

a) Accepting Deposits

It is the most important function of the commercial bank. They accept deposits in several forms according to the requirements of different sections of society.
The main kinds of deposits are:

b) Advancing of Loans

The deposits received by banks are not allowed to remain idle so, after keeping certain reserves the balance is given to the needy borrowers & interest is charged by them which is the main source of income for commercial banks.

There are mainly 3 types of loans paid by commercial banks:

• Cash Credit: It refers to a loan given to the borrower against his current assets like shares, stock, bonds, etc.
• Demand Loan: These refer to a loan that can be recalled by the banks at any time on demand.
• Short-Term Loans: They are given as personal loans against some collateral security.

Secondary Functions of Commercial Bank

1) Overdraft Facility

It is a facility in which a customer is allowed to overdraw his current A/c up to an agreed limit.

This facility is generally given to respectable & repayable customers for a short period. The bank charges interest on the amount overdrawn by the customer.

2) Discounting Bills of Exchange

It refers to a facility in which the holder of a bill of exchange can get bills discounted with the bank before maturity.

The bank discounts the bill and provides funds after deducting the discounting charges. On the date of maturity, the bank gets the payment from the party that had accepted the bill.

3) Agency Function

Commercial banks perform certain agency functions for their customers. For these services banks charge some commission from their client.

Some of the agency functions are:

• Transfer of Funds: The Bank provides the facilities of easy remittances of funds from place to place with the help of various instruments like demand draft, and mail transfer.
• Collection & Payments of Various Items: Commercial banks collect cheques, bills, interest, dividends, subscriptions & other periodical receipts on behalf of their client & also make various payments like payment of taxes, insurance premiums, etc.
• Purchase & Sale of Securities: Commercial banks buy and sell stock & shares of private companies as well as government securities on behalf of their customers.
• Income Tax Consultancy: They also advise their customer on matters relating to income & even prepare their income tax returns.

4) General Utility Function

Commercial banks provide some general utility services like –

• Locker Facilities: Commercial banks provide facilities like the safety vault or vouchers to keep valuable articles of customers in safe custody.
• Traveller’s Cheque: Commercial banks issue travelers’ cheques to their customers to avoid the risk of taking cash during their journey.
• LOC (Letter of Credit): Banks issue letters of credit to their customer to certify their creditworthiness.

Money Class 12 Notes Macroeconomics

Central Bank

The central bank is an apex body that controls, operates, regulates & directs the entire banking & monetary structure of the country.

Every country has its central bank. India’s central bank is RBI(Reserve Bank of India). It was established on 1st April 1935.
e.g. UK – Bank of England

Functions of Central Bank

1) Currency Authority/Bank of Issue

The central bank has the sole authority of issuing currency in the country. In India, RBI has the sole right to issue paper currency notes.

All the currency issued by the central bank is its monetary liability i.e., the central bank is obliged to back the currency with assets of equal value.

Advantages of Sole Authority with RBI:

• It leads to uniformity in note circulation.
• It gives the central bank power to influence the money supply.
• It ensures public faith in the currency system.
• It enables the government to have supervision over the central bank concerning the issue of notes.

Note: In India, one rupee note & coins are issued by the Ministry of Finance.

2) Banker to the Government

RBI acts as a banker, agent, and financial adviser to the central & state governments. As a banker, it maintains a current A/c of government, accepts receipts & makes payments for the govt., and it also gives loans & advances to the govt. for a temporary period.

As an agent, the central bank has the responsibility of managing public debt.

As a financial advisor, the central bank advises the government on economic, financial & monetary matters from time to time.

3) Banker’s Bank & Supervisor

Central bank bears the same relation with a commercial bank which the commercial bank bears with the public.

Being the apex body, the central bank acts as a banker to the other banks because it is necessary to regulate & supervise the proper functioning of commercial banks.

As the banker to the bank, the central bank functions in 3 capacities:

• Custodian of Cash Reserves: Commercial banks are required to keep a certain proportion of their deposits(CRR) with the central bank.
• Clearing House: The central bank holds the cash reserves of commercial banks therefore, it becomes convenient to act as a clearing house.
  As a commercial bank have their accounts with the central bank, therefore, the central bank can easily settle the claims of commercial banks against each other.
• Lender of the Last Resort: When a commercial bank fails to meet its financial requirement for each source, it approaches the central bank to give loans & advances as the lender of the last resort.

4) Controller of Money Supply & Credit

RBI is empowered to regulate the money supply in the economy through its monetary policy.

Monetary policy is the policy adopted by the central bank in the direction of credit control or money supply. RBI makes use of various instruments like –

• Repo Rate: It is the rate at which the central bank of a country lends money to commercial banks to meet their short-term needs.
  An increase in repo rate increases the cost of borrowing, ultimately increasing the commercial bank’s lending. As a result, it discourages borrowers from taking loans which reduces the ability of commercial banks to create credit.
• Bank Rate: It is the rate at which the central bank of a country lends money to the commercial bank to meet its long-term needs.
• Open Market Operation: Open market operation refers to the buying & selling of government securities by the central bank from/to the public & commercial banks.
  The sale of securities reduces the reserves of commercial banks’ ability to create credit & therefore decreases the money supply in the economy.
• Legal Reserve Requirements: According to legal reserve requirements, commercial banks are obliged to maintain reserve on 2 A/cs:
  a) Cash Reserve Ratio (maintained with the central bank)
  b) Statutory Liquidity Ratio (maintained with commercial bank)
• Margin Requirements: Margin is the difference between the amount of the loan & market value of the security offered by the borrower against the loan by changing the market requirement.
  RBI can alter the amount of loan made against securities by the bank. An increase in margin reduces the borrowing capacity & money supply whereas a fall in margin encourages the people to borrow more.

Note: The reverse repo rate is the rate at which the central bank provides interest to commercial banks.

5) Custodian of Foreign Exchange Reserve

The central bank also acts as the custodian of countries stock of gold & reserves of foreign exchange.

According to the regulation of foreign exchange, the transaction must be routed through RBI. It serves two objectives:

1. It helps the bank in establishing the external value of the currency.
2. It helps in pursuing a coordinated policy towards the balance of payments of the country.

Money Creation/Credit Creation

Through the process of money creation, commercial banks can create credit which is in far excess of deposits. The process is understood by making two assumptions:

• The entire commercial banking system is one unit & is termed a bank.
• All the receipts & payments in the economy are routed through banks.

The deposits held by banks are used for giving loans. However, banks cannot use the whole of the deposit for lending. It is legally compulsory for banks to keep a certain fraction of deposits as reserves.
This fraction is called LRR which the central bank fixes.

Suppose, the initial bank deposit is Rs.1000 and LRR is 20%. Now, banks are required to keep Rs.200 as cash reserves & are free to lend Rs.800.

Suppose they lend Rs.800 & borrowers withdraw the entire amount for making payments. The money spent by the borrowers is turned back into the bank in the form of deposits as all the transactions are routed through the bank.
Hence, it will increase the demand of banks by Rs.800.

With new deposits of Rs.800 banks keep 20% as cash reserves & lend the balance of Rs.640 which borrowers use by making payments that ultimately turn back into the bank.
In this round, the deposits rise by Rs.640.

The deposits keep on increasing in every round by 80% of the last round deposit. Also, cash reserves go on increasing by 80% of the last cash reserve.

The process comes to an end when total cash reserves are equal to initial deposits. Banks can create total deposits of Rs.5,000 with an initial deposit of Rs.1,000 i.e., total deposits become 5 times of initial deposit. It is the value of the money multiplier.

Money Multiplier= 1/LRR= 1/20%= 5 Times

Multiplier: The money multiplier measures the amount of money that banks can create in the form of deposits with every unit of money they keep as reserves.

Note: The higher the value of LRR lower the value of the multiplier.