This post covers all the aspects of Central bank and Commercial Banks Class 12 AHSEC . It includes Meaning, functions, credit creation by commercial banks and money multipliers. Revise as much as possible.
Central Bank
It is an apex bank. It controls, operates, directs, and regulates the entire banking system of the country.
India got its central bank in 1935 (Recommended by the Hilton Young Commission). Its name is the Reserve Bank of India. It was nationalized in 1949. Its headquarters is in Mumbai.
Functions of central bank
It issues the currency of the country
It has the monopoly of note issue.
Currency notes printed and issued by the central bank are an unlimited legal tender of money.
It keeps gold, silver, and other things as reserves against the notes issued.
Control of Money Supply
It controls the money supply of the country through various methods like the bank rate, open market operations, and variation in reserve ratios.
It acts as the banker of the government
It acts as the banker of both the central and state governments.
Governments keep their cash balances in the central bank. The central bank accepts receipts and makes payments on behalf of the government. It manages all government transactions.
It is the custodian of foreign exchange reserves of the economy
All the foreign currency received by the citizens has to be deposited with the central bank.
It also keeps gold and bullion reserves.
Banker's Bank
It also acts as a bank to the banking system.
Lender of the last resort
When commercial banks face an extreme liquidity crisis, they approach the central bank as the lender of last resort.
The central bank provides temporary financial assistance and saves the bank from possible failure.
It also acts as the clearing house
A clearing house is an organization where the mutual claims of banks are offset.
The central bank, as a banker to the banks, keeps their cash reserves and settles the claims.
Agent and advisor of the government
As an agent, it advises the government on all economic and monetary matters.
Meaning and Functions of Commercial Banks | Central Bank and commercial Banks class 12
Commercial Bank Meaning
A commercial bank is a profit-based institution that accepts deposits and grants loans. Under the Banking Companies Act 1949, these institutions operate to serve the financial needs of the public.
Examples: State Bank of India (SBI), Punjab National Bank (PNB), etc.
Other Information
- The word Bank is derived from the Latin word “BANKO or BANKUS”, which means a bench over which transactions happened in ancient times.
- Banks act as the bridge between the surplus and deficit units of the economy.
- They are also called Joint stock banks.
Functions of Commercial Banks (Core Topic of Central Bank and commercial Banks class 12)
Explanation of Each Function
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Accepting Deposits
Commercial banks accept deposits from those who have surplus funds and want to deposit them. Deposits are the lifeline of banks. There are different types of deposits:
- Saving Deposit: These types of deposits are payable on demand. Certain restrictions are imposed on the amount of money to withdraw and the number of transactions. Banks pay interest at nominal rates.
- Current Deposit: These types of deposits are payable on demand. Any amount can be withdrawn by cheque. There is no restriction on the number of withdrawals. The bank doesn't pay any interest on this account; rather, it can charge some fee as a service charge. It is generally used by businessmen.
- Fixed Deposit (or Time Deposits): Money is deposited for a fixed period of time. This deposit is not payable on demand. Banks pay a comparatively higher interest rate on this type of deposit.
-
Granting Loans
From the amount it receives as deposits, some portion of it is granted as a loan, which further creates credit. Different loans are provided at different rates of interest. It is the main source of income for commercial banks. Generally, a loan is provided against security or collateral.
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Agency Services
- It provides an overdraft facility to reliable customers.
- It makes payments on behalf of the customer.
- It discounts bills and other cheques.
- Collection of claims (cheques, dividends, etc.).
- Provides Income Tax facility.
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General Utility Services
- It provides a locker facility to keep gold, silver, and other precious metals safe.
- Issuance of Letters of Credit.
- Facilitates Foreign Exchange Transactions.
Some Important Banking Concepts(Central bank and commercial banks Class 12 )
1. Spread
The difference between the interest paid by the bank to the depositors and the rate charged by the bank from the borrowers is called “Spread”.
Example: If the bank pays 5% interest and gets 8% interest, then the Spread = 8 - 5 = 3%.
2. Cash Reserve Ratio (CRR)
It is the percentage of deposits which a bank must keep as cash reserves with the central bank.
Example: If the total deposit is Rs 100 and CRR is 20%, the Commercial Bank will keep Rs 20 as a cash reserve with the central bank.
3. Statutory Liquidity Ratio (SLR)
It is the percentage of total deposits that a commercial bank must maintain with itself in the form of liquid assets (cash, gold, or approved securities).
Example: If total deposits are Rs 100 and SLR is 18%, the bank will keep Rs 18 as liquid assets with itself.
4. Assets
Assets are the things a firm owns or what a firm can claim from others. It includes:
- Buildings, furniture
- Loans given to the public
- Reserves: Deposits commercial banks keep with the central bank
- Cash held by the bank
5. Liabilities
What the bank owes to others.
Example: Customer Deposits.
6. Balance Sheet
A Balance Sheet is a record of the assets and liabilities of any firm. Generally, assets are recorded on the left-hand side and liabilities on the right-hand side.
Credit Creation by Commercial Banks (Central Bank and Commercial Banks Class 12 Topic)
Meaning:
The power of commercial banks to expand deposits through advancing loans and investments is known as credit creation. It is the power of commercial banks to expand secondary deposits through the process of lending.
- The whole commercial banking system is considered as a single unit.
- There are no leakages.
- Legal Reserve Ratio (LRR) is 20%.
Process of Credit Creation
Suppose a person deposits Rs 100 cash in Bank 1. The bank will keep 20% of 100 (i.e., Rs 20) as a reserve and the rest Rs 80 will be granted as a loan to Person B.
Person B again deposits the amount of Rs 80 as a payment to someone in Bank 2. Now, Bank 2 will keep 20% of 80 (i.e., Rs 16) as a reserve and the rest Rs 64 will be granted as a loan.
This process will continue until the initial Rs 100 can no longer support further lending.
| Rounds | Deposits Received (Rs) | Loans Granted (Rs) | Cash Reserves (LRR @ 20%) |
|---|---|---|---|
| Round 1 (Initial) | 100 | 80 | 20 |
| Round 2 | 80 | 64 | 16 |
| Round 3 | 64 | 51.2 | 12.8 |
| ... | ... | ... | ... |
| Total | 500 | 400 | 100 |
Money Multiplier
How much money will be created is determined by the Money Multiplier. It is the inverse of the reserve requirement.
Money Multiplier = 1 / LRR
Here, LRR is 20% (or 0.20), so:
1 / 0.20 = 5
It means total credit creation will be 5 times the initial deposit.
- Total Credit Creation = Initial Deposit × Money Multiplier
- Total Credit Creation = 100 × 5 = 500
Limits to Credit Creation
- Leakage of the banking system: Transactions should be done through the banking system. Otherwise, credit creation will not work properly.
- Cash Reserve Ratio (CRR): Higher the CRR, lower the credit creation capacity, and vice versa.
- Amount of Cash: The larger the cash reserves with the bank, the larger the amount of credit that will be created.
- Banking Habit of the People: If more people are habitual with the digital economy, the credit creation will be more.
Difference Between Central Bank and Commercial Banks Class 12
| Basis of Difference | Central Bank | Commercial Bank |
|---|---|---|
| Meaning | It is an apex bank. It controls, operates, directs, and regulates the entire banking system of the country. | A commercial bank is a profit-based institution that accepts deposits and grants loans. For eg: State Bank of India, Punjab National Bank, etc. |
| Ownership | It is completely Public (Government-owned). | It may be public or private. |
| Number | There is only one Central Bank in a country. | There can be more than one commercial bank. |
| Objective | Acts as a regulatory body (Public welfare and economic stability). | Primary objective is profit making. |
| Source of Money Supply | It is the source of money supply in the economy. | It is not the source. It runs on the basis of deposits obtained from customers. |
| Issue of Notes | It has a monopoly in the issuance of notes. | It has no power of issue. |