154 INTRODUCTORY ECONOMICS

24 BANKING

The word ‘banking’ is said to have derived from the Greek word ‘banque’, meaning bench. The
German word ‘banc’ means a joint stock firm. In modern days, commercial banking occupies an
important place in every economy. It is an important constituent of a country’s financial system.
Origins of modern banking dates back to ancient times. The New Testament mentions about the
activities of money changers in Jerusalem. In ancient Greece, famous temples of Ephesus, Delphi
and Olympia were used as depositories, where people who have surplus funds deposited their
money. These temples were the sits of money-lending transactions. In India, the ancient Hindu
scriptures refer to money lending transactions in the Vedic period. Banking became a full
fledged activity during the periods of Ramayana and Mahabharata. Vaish community during Smriti
period (period after Vedic and Epic age) carried on business of banking extensively. The bankers
of Smriti period performed most of those functions which are performed by modern banks such as
accepting of deposits, granting secured and unsecured loans, acting as treasurer and banker to the
state and issuing and managing the currency of the country. It was only in the nineteenth century
that the modern commercial banking system developed in the leading countries of the world.

COMMERCIAL BANKS
A bank is a financial institution which lend and accepts money. It is an institution which deals
mainly in money. Thus, a bank is a financial institution that accepts deposits of money from the
public, which can be withdrawn by cheques. Banks utilize money collected for lending to the
households, the firms and the government. People deposit their surplus money in banks for two
reasons—safety of money and earning some interest amount. According to Banking Regulation
Act, 1949, “accepting for the purpose of lending or investing of deposits of money from the
public, repayable on demand or otherwise, and withdrawable by cheques, draft, order or
otherwise”, comes under the purview of a bank.
On analysis of the above definitions, it is clear that a bank is a financial institution that deals
in money. It accepts people’s surplus money and advance loans to the borrowers.

FUNCTIONS OF COMMERCIAL BANKS

Commercial banks, today, perform a variety of functions and provide a number of services to their
customers. The important functions of commercial banks can be discussed under the following heads:
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1. Accepting of Deposits: The most important function of commercial banks is to

accept deposits from the public. Banks withdraw surplus funds from people or
depositors. Banks accept deposits mainly by opening accounts in the name of their
customers. They accept deposits in two forms—demand deposits and term or fixed
deposits. Demand deposits can be withdrawn any time but term deposits are
withdrawable only after the expiry of time period for which deposits are made. The
three important forms of accounts, in which people like to deposit their money are—
current account, savings bank account and fixed deposit account. Current accounts
are particularly meant for business people who wish to deposit or withdraw their
money many times in a single day. These deposits are therefore payable on demand.
Banks do not pay any interest on these accounts but charge a maintenance or service
fee known as incidental charge from the customers for providing various services.
Savings bank accounts are also payable on demand. Banks impose a limit on the
amount and number of withdrawals during a particular period of time. These accounts
are opened by general public. A reasonable interest is paid on such deposits. Under
fixed deposit accounts, money is kept for certain fixed period of time, say, a year, five
years or six months. These deposits carry a higher rate of interest but are not
withdrawable on demand. In other words, amount of such deposits can be withdrawn
only at the time of maturity. One should note that such deposits can be withdrawn
by presenting fixed deposit receipt (FDR) issued at the time of commencement of the
account. Cheques cannot be used in place of FDR. These deposits are also known
as time deposits. A variant of fixed deposit accounts is recurring deposit account
under which a person has to make payment for a regular period at equal time
intervals. For example, a person can choose five year term as maturity period and
make a certain sum of money every month for five years. Such deposits also carry
a high rate of interest.
2. Advancing of Loans: Another important function of commercial banks is to extend
loans and advances to their customers. Banks charge interest from the borrowers,
which is relatively higher than the interest they pay on deposits to their customers.
Banks make profits out of such transactions. Banks provide advances in various
ways. They provide term loans for a fixed period by crediting the entire amount
sanctioned as loan to borrower’s current account. The borrower pays interest on the
entire amount borrowed. Cash credit is another way to provide loans particularly to
businessmen. Under this system, the sanctioned amount is not given at a time but an
account is opened and the borrower is allowed to withdraw amount as and when he
requires. The bank charges interest only on the amount which is actually withdrawn
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from the account. Through overdraft facility also, banks provide loans to their customers.
A customer, getting this facility, is allowed to withdraw amount in excess of the
balance standing to his credit to the extent of overdraft limit permitted. Overdraft can
be made only in respect of current accounts. The banks charge interest only on the
amount overdrawn. Another important form of lending is through discounting of bills
of exchange. A bill is drawn by the creditor on the debtor mentioning the amount of
debt and also the date when it becomes payable. Such bills are generally issued for
156 INTRODUCTORY ECONOMICS

a period of 90 days. This means that creditor cannot get money from debtor before
90 days. However, if the creditor needs money before this period, he can sell (called
discounted by bank) to a bank. The bank makes payment specified on the bill after
deducting commission or discount. The matured bill amount is obtained by the bank
from the debtor.
3. Transfer of Funds: Banks help in the remittance or transfer of funds from one place
to another through the use of various credit instruments such as cheques, drafts, mail
transfers, online communications, etc.
4. Agency Functions: Banks provide various agency functions to their customers. The
banks charge a very nominal fee for these services. The important agency services are
the following:
(i) Collection of cheques, drafts, bills of exchange, hundies etc;
(ii) Payments and collection of insurance premia, pensions, scholarships, dividends,
interest etc. on behalf of customers;
(iii) Sale and purchase of securities. They provide investment services to the companies
by acting as underwriters and bankers for new issues of securities to the public;
(iv) Obtaining and selling of foreign currency on behalf of customers;
(v) Acting as trusties and executors. For example, they keep safe the wills of their
customers and execute the same after their death.
5. Miscellaneous Services: Banks provide services like locker facilities for safe custody
of jewellery and other valuables, issue of travelers cheques, gift cheques, credit cards,
ATM (Automated Teller Machine), internet banking services, tax assistance and
investment advice.
6. Credit Creation: A very important function of modern banks is to create credit in the
economy. Banks have the capacity of credit creation. They are able to create credit
by accepting deposits from and providing loans and advances to their customers. In
simple words, banks are able to multiply the initial deposits to a great extent which is
called credit creation.
Credit creation is the process of multiplying initial deposits of banks into a huge amount.
Banks create credit by advancing loans to its customers out of what they have received in the
form of deposits from the public. They also grant loans, discount bills, provide overdraft facilities
to create credit. All commercial banks are required to keep a certain percentage of their cash
reserves with the central bank. To explain how banks create credit in the economy, let us assume
that the cash reserve ratio (CRR) is 20% of total deposits a bank has to maintain with the central
bank. Further, let us suppose that the SBI receives Rs. 1000 as deposits. This is called primary
deposit of the bank. SBI keeps Rs. 200 (20% of Rs. 1000) as cash reserves and advances the
balance amount of Rs. 800 as loans to a businessman, say Mr. X. The person deposits this amount
(in cheque) in the Indian bank. It means the Indian bank receives Rs. 800 as primary deposits
and keeps Rs. 160 (20% of Rs. 800) as cash reserves and grants the balance amount of Rs. 640
as loans. In the same way, the loan of Rs. 640 is deposited in Allahabad bank, which keeps Rs.
128 (as CRR) and the excess cash of Rs. 512 is lent.
BANKING 157

Thus, an initial deposit of Rs. 1000 with the SBI has created deposits of Rs. 2952 (= 1000
+ 800 + 640 + 512). The process of credit creation goes on and come to an end when deposits
become too small to generate any new loan. The entire banking system will create credit of Rs.
5000 with the initial deposit of Rs. 1000. This has been worked out using the deposit multiplier
formula as under:
1
d = × ∆D
r
where r = CRR (20%) and AD = initial change in the volume of deposits (Rs. 1000). 1/r is the
deposit or credit multiplier. Thus,
1
d = × 1000
20%
100
d = × 1000
20
d = Rs. 5000
This means all other banks will make deposits of Rs. 2048 (5000 – 2952).
But there are limitations to credit creation by banks. These are the following:
1. The total amount of cash reserves in the banking system. Larger the cash reserves
more will be the credit creation.
2. Cash reserve ratio fixed by the central bank. More is the ratio, less is the power to
create credit and vice versa.
3. Banking habits of the people of the country. It means banking transactions through
cheques, drafts, bills etc. Good banking habit results in keeping smaller amount of cash
with the banks and therefore, more can be lent. This will create large credit.

CLASSIFICATION OF COMMERCIAL BANKS

Commercial banks in India are classified mainly into two categories—Scheduled commercial
banks and Non-scheduled commercial banks. Scheduled commercial banks are those which are
entered in the Second Schedule of RBI Act, 1934. Such banks have a paid-up capital and reserves
of an aggregate value of not less than Rs.5 lakhs and which carry out their operations in the
interest of depositors. Non-scheduled commercial banks are those which are not entered in the
list of the Second Schedule of RBI Act, 1934. Schedule commercial banks consist of – twenty
seven public sector banks, thirty private sector banks of which twenty two are old private banks
and eight are new, forty foreign banks and one hundred ninety six regional rural banks. Public
sector commercial banks include the State Bank of India and its seven subsidiaries and other
nineteen nationalized banks.
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CENTRAL BANK
A central bank is the apex institution in the banking and financial structure of the country. It plays
a leading role in organizing, regulating, supervising and developing the banking and financial system
of a country. Every country has a central bank known by different names. For instance, in India,
it is known as Reserve Bank of India, while in England, it is the Bank of England and Federal
Reserve System in USA. Reserve Bank of India was established on April 1, 1935.
158 INTRODUCTORY ECONOMICS

Comm ercial Banks

Sche duled N on-Schedule d com mercial

com mercial bank s bank s

Public sector Private sector Foreign

banks (27) bank s (30) bank s (40)

Regional Rural
banks (196)

SBI & its O ther

subsidiaries nationalized
(8) banks (19)

A central bank is, however, different from commercial banks in many and important ways.
First, it is not a profit making institution as commercial banks are. It acts in the public interest so
as to control and regulate the banking and financial system of the country. Second, a central bank
does not perform ordinary banking functions such as accepting of deposits from general public and
lending advances to them. A central bank is owned and managed by the government of a country,
whereas, commercial banks may be owned by government or private individuals as shareholders.
Every country has one central bank but there are a number of commercial banks in the country.

FUNCTIONS OF A CENTRAL BANK

A central bank performs a number of important functions, which are discussed as under:
1. Bank of Note Issue: A central bank has been empowered to issue currency notes
in the country. Currency notes issued by the central bank are the legal tender. The issue
department of a central bank issues currency and coins. The central bank is required
to maintain a certain amount of gold and foreign securities against the issue of notes.
2. Banker and Adviser to the Government: A Central bank acts as banker, agent and
adviser to the government. As banker to the government, it receives the deposits of
cash, cheques and drafts, etc., from the governments. It provides short term loans to
the government and sells and buys foreign currencies on behalf of the government. It
also manages public debt, issues new loans, receives subscriptions to these loans, pays
interest on them and finally repays these loans. The central bank acts as the financial
adviser to the government. It advises to the government on all financial and monetary
matters and helps in formulating various economic policies.
3. Banker to Banks: As a bankers’ bank, the central bank performs several functions.
It acts as custodian of cash reserves of commercial and other banks. It also maintains
BANKING 159

deposits of cash reserves as required by the commercial banks. It also discounts bills
of commercial banks. It provides guidance to all banks and regulates their activities.
4. Custodian of Foreign Reserves: A central bank is the custodian of foreign exchange
reserves of a country. All the foreign exchange transactions of a country are done
through the central bank. It controls both the receipts and payments of foreign exchange.
It helps in maintaining stability of the exchange rate by buying and selling foreign
currencies in the market.
5. Lender of the last Resort: The central bank acts as the lender of the last resort. It
provides ultimate need of finance to all banks by discounting approved securities and
collateral loans and advances.
6. Clearing House for Transfer and Settlement: A central bank acts as a clearing
house for transfer and settlement of mutual claims of the commercial banks. Since
commercial banks keep their cash reserves with the central bank, it is easier and
convenient to clear and settle claims between them by making transfer entries in their
accounts maintained with the central bank.
7. Controller of Credit: The most important function of the central bank is to control
credit creation by the commercial banks. Supply of credit must be regulated so as to
ensure the smooth functioning of the economy. Central bank adopts quantitative and
qualitative methods to control credit in the economy. Quantitative methods aim at
controlling the cost and availability of credit, while qualitative methods influence the use
and direction of credit.
8. Promotional and Developmental Functions: Central bank develops and promotes
a strong banking system. It assists in the development of financial institutions like
developmental banks to provide investible funds for the development of agriculture,
industry and other sectors of the economy. It helps in the development of money and
capital market in the country.
Questions for Review
1. Define a commercial bank.
2. Define a central bank.
3. What are the main functions of a commercial bank?
4. What are the main functions of the central bank of a country?
5. Central bank is the ‘Lender of the last resort.’—explain.
6. Explain Gresham’s law.
7. Explain how banks create credit.
8. What are the limitations to credit creation?
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9. Distinguish between quantitative and qualitative credit control methods adopted by a central
bank.
10. Distinguish between demand deposits and time deposits.
11. What is overdraft facility?
12. What is bank rate?
13. Give the meaning of open market operations.
14. What is cash reserve ratio?
15. What is moral suasion?