Banks : Commercial Bank and Central Bank

WHAT IS A BANK?
A bank is a financial institution that accepts deposits of money from the public,
withdrawable by cheque or otherwise and uses the money so collected for
lending. Indian Banking Regulation Act, 1949, defines the activity of the bank as
“accepting for the purpose of lending or investing of deposits of money from the
public, repayable on demand or otherwise, and withdrawable by cheque, draft,
pay-order or otherwise."
3 Essential Functions of Bank:
1. Accepts deposits from the public
2. Lending and investment in securities.
3. Creation of money
For example, Post Office Savings Banks, Bajaj Finance are not regarded as bank
TYPES OF BANKS
1. Central Bank: The central bank is the apex institution in the banking and
financial Structure-of-the-country. It is the central bank which issues currency in
the country. It also controls and regulates the banking and financial structure of
the country. There is usually one central bank in every country. In India, the
Reserve Bank of India is the central bank of the country.

2. Commercial Banks: Commercial banks accept deposits from the public and
give mainly short-period loans to individuals, traders and business institutions.
Commercial banks operate largely for earning profits. State Bank of India,
Union Bank of India, Bank of Baroda, Punjab National Bank, Canara Bank, ICICI
Bank, etc. are some of the important commercial banks operating in India.

3. Cooperative Banks: These banks are run on a cooperative basis. These banks
were originally started in rural areas in the form of cooperative societies for the
purpose of granting easy credit to the farmers. Cooperative banks have now been
established in the urban areas as well. The Bihar State Co-operative Bank Ltd.

4. Regional Rural Banks: These banks have been set up in the rural areas to meet
the needs of the weaker sections of the rural population like small farmers, rural
artisans, etc. That is why they are called small man's banks. They are basically
scheduled commercial banks. Assam Gramin Vikash Bank
5. Land Development Banks: Land development banks, also known as land
mortgage banks, have been established with a view, to provide long-term credit
to the farmers for a variety of purposes such as improvement of land, purchase
of costly agricultural equipments like tractors, construction of wells, fencing, etc.
Loans are given against the security of landed property. These loans are given at
concessional rates.

6. Exchange Banks: Exchange banks help people engaged in foreign trade. They
finance foreign trade and carry on foreign exchange business. They do so by
purchasing, selling, discounting and accepting bills of exchange arising out of
foreign trade. They give loans also to the people engaged in foreign trade.

7. Exim Banks: Exim banks, popularly known as 'Export-Import Banks', have

been set up to provide long-term finance to exporters and importers to meet
their financial needs related to international trade.

8. Development Banks: Development banks have been set up in the country to

promote development of industrial activities. They grant long-term loans and
provide various types of development services such as underwriting the new
issues, provision of technical advice, market information, etc. to the private
sector industries. Industrial Financial Corporation of India (IFCI), Industrial
Credit and Investment Corporation of India (ICICI) and Small Industries
Development Bank of India (SIDBI) are some of the important types of
development financial institutions.

STRUCTURE OF COMMERCIAL BANKS IN INDIA

The oldest banks were the Bank of Bengal, the Bank of Bombay and Bank of
Madras.These three banks were amalgamated into Imperial Bank of India in
1921, which was subsequently nationalised into the State Bank of India (SBI) in
1955.
Commercial banks in India were entirely private banks before Independence. At
the time of Independence, the banking sector in India was relatively small and
extremely weak with a few scheduled banks. These banks were largely confined
to urban areas. They granted loans largely to industrial and trading sectors.
The banking sector in India underwent a major structural transformation after
1969 when 14 major commercial banks were nationalised in July 1969, and six
more in April 1980. The objectives behind nationalisation of commercial banks
were spreading banking structure in rural areas, to provide cheap financial
assistance to priority sectors like agriculture and weaker sections, to prevent
concentration of banking capital in the hands of big business houses, to provide
funds for the public sector, etc. At the present juncture, Indian commercial
banks (89 scheduled commercial banks) can be classified into three broad
categories:

1. Public Sector Banks: Public sector banks are those banks which are owned
and managed by the government or some agency of the government. Public
sector banks include State Bank of India (SBI) and nationalised .Public sector
banks occupy a dominant position in the banking system in India. They
accounted for 73 per cent of total commercial bank branches .SBI is the largest
commercial bank in the country with 25 per cent market share of the total loans
and advances, and is ranked as one of the top five banks worldwide.
2. Private Banks: Private sector banks are banks which are in the hands of
private bankers. As on 31 March, 2020, there were 22 private sector banks with
over 33,160 branches. The major private sector banks in India are ICICI Bank,
HDFC Bank, Axis Bank, ING Vysya Bank. These private sector banks have come
to be known as new-generation tech-savy banks.

3. Foreign Banks: Foreign banks operating in India are the wholly owned
subsidiaries/ branches incorporated in foreign countries.
There were 41 foreign banks with 315 branches as on 31st March, 2020. Ex: ABN-
AMRO Bank, American Express Bank Ltd Citibank Standard Chartered Bank,
Barclays Bank, Deutsche Bank.

FUNCTIONS OF COMMERCIAL BANKS

1. Acceptance-of-Deposits: The primary function of a commercial bank is to
accept deposits from the public. This is an important function as it helps in the
mobilisation of savings for productive purposes. Banks accept mainly three
types of deposits:
(i) Current Account Deposits: Deposits in current account are payable on
demand. That is why current accounts are also known as demand deposits.
Money from these deposits can be withdrawn by cheques without any restriction
on the amount or number of withdrawals made. These accounts are mostly held
by traders and businessmen who use these for making business payments and
for receiving payments through cheques. Cheque payments have facilitated the
business and trade transaction. Banks do not pay any interest on deposits in
these accounts as they are not able to utilise these short-term deposits for
lending purpose due to frequent withdrawals from such deposits. Banks provide
various services to the current account holders such as making payment through
cheques, collection of cheque payments, issuing drafts on behalf of the account
holders, etc. Banks, in fact, levy certain service charges on the customers for the
services rendered by them.

(ii) Saving Account Deposits: Saving account deposits (Saving bank accounts) are
payable on demand and money can be withdrawn by cheques. But there are
certain restrictions imposed on the depositors of this account. Banks impose a
limit on the amount and number of withdrawals made from this account during
a particular period. However, in practice these restrictions may be relaxed by the
banks. Some minimum balance has to be maintained in saving bank account for
availing cheque facilities. These accounts are held by households, general public,
salaried class and retired persons, who have idle cash for a short period and
want to earn some interest income from their savings and retain adequate
liquidity at the same time.

(iii) Fixed Deposit Accounts: Money in these accounts is deposited for a specified
period like 6 months, one year, two years, five years or more. These deposits are
not payable on demand. They do not enjoy cheque facilities. These deposits are
also known as time deposits as the money deposited in these accounts cannot be
withdrawn before the expiry of the period for which the deposit is made.
Fixed deposits are interest-earning deposits. The interest on these deposits is
higher than on saving deposits
Recurring (or cumulative) deposits are one type of fixed deposits. In this case, a
depositor makes a regular deposit of a given sum (say, ₹2,000 per month) for a
specific period (say, 2 years). Such deposits are designed to motivate the small
savers to save a particular amount regularly.

2. Advancing of Loans: The second primary function of the commercial banks is

to extend loans and advances.
(i) Cash Credit :Cash credit is a type of loan which is given to the borrower
against his current assets such as shares, bonds, stock of goods, etc. In this case,
the entire sanctioned amount of loan by the bank is not given to the borrower at a
particular time. The bank opens an account in the name of the borrower and
allows him to withdraw the borrowed amount as and when he requires the
money. The bank charges interest not on the entire amount of loan sanctioned,
but only on the actual amount withdrawn from the bank. Cash credit is very
popular with the Indian businessmen.

(ii) Outright Loans and Advances: Banks provide outright loans for a fixed
period. The loans are advanced for short term and medium term. In this case, the
entire amount of the loan sanctioned is credited in lumpsum to the borrower's
current account. The borrower has to pay interest on the entire amount he has
borrowed from the bank, no matter how much amount is actually used by the
borrower.

(iii) Overdraft Facilities: In many cases, banks provide overdraft facilities to

their customers who maintain, a current account with the bank. When a
customer gets an overdraft facility from a bank, this means that he is allowed to
draw cheques in excess of the balance standing in his credit (account) to the
extent of the amount of overdraft. Overdraft facilities are provided for a short
period.

(iv) Discounting Bills of Exchange: A bill of exchange is drawn by a creditor on

the debtor specifying the amount of debt and also the date when it becomes
payable. Such bills of exchange are normally issued for a period of 90 days. This
means that the creditors cannot get it encashed from the debtors before the
expiry of the 90 days period. He can get it discounted from a commercial bank.
The bank makes payment to the creditor after deducting its commission. When
the bill matures, the bank will get payment directly from the banker of the debtor
who has accepted the bill.

3. Facilitation of Payments through Cheques: Banks have provided a very

convenient system of payment in the form of cheques. We can receive payments
from others through cheques and deposit these cheques in our bank. These
cheques may be drawn on some other commercial banks, but our bank will
collect payment from these banks on our behalf. Similarly, we can make
payments to others through cheques. The cheque is the principal method of
payment in business in recent times. It is convenient, cheap and safe means of
making payments.
4. Transfer of Funds: Banks help in the remittance or transfer of funds
expeditiously and safely from one place to another through the use of various
credit instruments like cheques, drafts, pay orders, mail transfers, telegraphic
transfers, e-mail, etc.

5. Agency Functions: Banks provide various types of agency functions for their
customers. The banks charge commission or service charge for such functions.
The main agency functions are:
(i) The commercial banks collect payments made through cheques, drafts, bills
of exchange, hundies and other financial instruments on behalf of their
customers.
(ii) They make and collect various types of payments on behalf of their
customers. Banks make payments of insurance premia, taxes, etc. on behalf of
their customers from their deposits. They receive payments of insurance claims,
pensions, dividends and interest on shares and debentures on behalf of their
customers and credit them to their account.
(iii) The commercial banks act as agents of their customers in the sale and
purchase of stock and shares. They provide investment services to the
companies by acting as underwriters and bankers for the new issues of securities
to the public.
(iv) They render agency services of various types such as buying and selling
foreign currency, national savings certificates and units of UTI, investment in
mutual fund on behalf of their customers.
(v) Some commercial banks are authorised by the central bank to deal in foreign
trade. In this process, they issue letter of credit, extend credit, discount foreign
bills of exchange and provide guarantees to exporters and importers for the
soundness of their customers.
(vi) The commercial banks act as trustees and executors. For instance, they keep
the wills of their customers and execute them after their death.

6. General Utility Services: Commercial banks provide various general utility

services such as providing locker facilities for safe custody of jewellery and other
valuables, issuing travellers' cheques and gift cheques, providing credit cards,
helping their customers in providing tax assistance and investment and finance
advice, etc.
7. Credit Creation: In the process of acceptance of deposits and granting of loans,
commercial banks are able to create credit. This means that they are able to
grant more loans than the amount of initial or primary deposits made by the
customers.

CREDIT CREATION BY COMMERCIAL BANKS

two facts :
1. Banks create deposits in the process of advancing loans to its customers. In
fact, bank deposits are created in two ways. One, when customers deposit
currency or cash with commercial banks. Such deposits are known as 'primary
deposits. Banks play a passive role in creation of such deposits since it is the
decision of the customers which determines how much cash would be deposited
by them in the banks.
The second way by which banks create deposits is when they grant loans. When
banks advance loans or provide overdraft facilities, they do not pay the amount
of loans in cash. But they open an account (current account) in the name of the
borrowers and allow them to withdraw the required sum by cheques. In this way,
banks create deposits. These deposits are known as 'derivative deposits'. These
derivative deposits are actively created by banks through their lending and
investing activities. It is the creation of derivative deposits which is known as
creation of credit by the commercial banks.

2. Second important fact to be noted is that commercial banks are able to extend
loans and advances by an amount which is many times more than the cash they
get in the form of primary deposits. Banks have learnt from their experience
that all depositors do not withdraw their money from the bank at the same
time. Banks are able to meet the day-to-day cash requirements by keeping a
small fraction of deposits as cash reserves and using the surplus amount in
advancing loans. Banks keep a certain fraction or percentage of total deposits as
cash reserves for this purpose. This fraction is called the cash reserve ratio. It is
essential for the banks to maintain this reserve ratio because otherwise they may
not be able to meet the cash demand of the depositors; and the failure to meet
the cash demand of depositors could result in the failure of banks. Thus, banks
able to create credit by keeping a small amount of cash in reserve and lending the
remaining amount. If banks keep 100 per cent cash reserve against deposits, they
would not be able to create credit. Thus, loans given by banks create deposits. It
is in this sense that credit is created by commercial banks.
Process of Credit Creation
following assumptions:
(i) We take a situation, as is the case in the real world, of multiple banking
system.
(ii) It is assumed that minimum legal cash reserve ratio is 20 per cent.
(iii) Excess (over 20 per cent) cash reserve is used in extending loans and
advances.
(iv) One particular bank, say Bank of Baroda, receives a cash deposit of ₹1,000
from its customers.
(v) For the sake of simplified presentation, it is assumed that the amount of loan
drawn by a customer of one bank somehow is transferred in full to the second
bank, and that of the second bank to the third bank, and so on.
(vi) Each bank starts with an initial deposit which is deposited by its depositor as
a result of payment received from the borrower of the other bank.

Thus, an initial deposit of ₹1,000 with the

Bank of Baroda has resulted in the creation of
deposits by three banks amounting to ₹1,000
+ 800 + 640 = ₹2,440, and the process = of
credit creation is still going on. But this is not
a never-ending process. The entire banking
system will be able to create the new deposits
to the tune of ₹5,000 on the basis of an initial
deposit of ₹1,000.

Deposit Multiplier Formula:

The amount of credit creation by the banking system as a whole can be worked
out by the following formula:
Increase in Deposits = 1 / RR × ΔD
where RR is the required reserve ratio and ΔD is the initial change in the volume
of deposits.

Limits to Credit Creation

1. Total Amount of Cash Reserves: The total amount of cash reserves in a country
determines the amount of credit that can be created by the banks. The larger is
the cash reserves available in the economy, the larger will be the credit created
by commercial banks, and vice versa.
2. Cash Reserve Ratio: Every bank is required to keep two types of cash reserves:
One is the minimum legal reserve ratio of cash to deposits fixed by the central
bank, in terms of which every commercial bank is bound to keep a certain
proportion of its deposits in the form of cash with the central bank. Second, the
banks also keep some cash reserves with them to meet the cash demand of its
depositors. The power of the banks to create credit is determined by the amount
of cash reserves that the banks maintain. The smaller the cash reserve ratio, the
more will be the power of the banks to create credit, and vice versa.

3. Banking Habits of the People: If people are in the habit of using cheques,
drafts, bills, etc. in their business and other transactions, banks need to keep a
smaller amount of cash reserves and, therefore, their power to create credit will
be more. That is why banks are able to create more credit in the advanced
countries because people use cheques, drafts, etc. for making payments.

4. Nature of the Securities Offered: Banks generally give secured loans.If proper
securities are not available with the public, a bank cannot create credit.

5. Business Conditions; The power of the banks to create credit depends upon the
business and economic conditions in the country. During the periods of business
prosperity, investment climate is rosy and businessmen will like to undertake A
more investment by taking more loans and advances from the banks.

6. Monetary Policy of the Central Bank:. The central bank can influence the
amount of cash reserves with commercial banks by employing various measures
of credit control such as bank rate, open market operations, statutory reserve
ratio, etc.

ROLE OF COMMERCIAL BANKS IN AN ECONOMY

1. Mobilisation of Savings: the most important agency where public may deposit
their savings to earn interest income along with a high degree of security of their
funds.
2. Accelerating Rate of Capital Formation: Commercial banks help in the process
of capital formation. They help in mobilising the idle savings of the people and
make them available for productive investment.

3. Provision of Finance and Credit: Commercial banks play a vital role in

providing finance and credit for the industry and trade.

4. Assisting Foreign Trade: Banks are of great assistance in foreign trade. They
help foreign trade by providing payment arrangements for the importers and
exporters and by undertaking foreign exchange business.

5. Promoting Economic Development: Firstly, they provide funds for all types of
production activities incorporated in the plan. Secondly, they help in
accelerating capital formation by mobilising savings for productive investment.
In the third place, commercial banks promote balanced regional development in
the country by providing essential financial infrastructure and funds for
backward regions.

6. Extension of Market: Commercial banks have helped trade and industry in yet
another way. Goods are supplied by traders and manufacturers to far-off
markets on the basis of bank guarantees. Therefore, banks have enabled
commerce and industry to extend their field of operations and exploit economies
of large-sized market.

7. Developing Entrepreneurship: Banks have assumed the role of promoting

entrepreneurship in recent years, particularly in developing countries. They are
playing this role by underwriting new scripts and by granting financial assistance
to new industrial ventures.

Commercial banks play a vital role in directing economic activities in the

economic system. They are rightly considered as 'the nerve centre of economic
activity.'