What is Banking?

Banking is directly or indirectly connected with the trade of a country and the life of each
individual. It is an industry that manages credit, cash, and other financial transactions. In
banking, the commercial bank is the most influential institution for any country’s economy or
for providing any credit to its customers.
In India, a banking company is responsible for transacting all the business transactions
including withdrawal of cheques, payments, investments, etc. In other words, the bank is
involved in the deposit and withdrawal of money, repayable on demand, savings, and earning
a decent amount of profits by lending money.
Banks also help to mobilise the savings of an individual, making funds accessible to businesses
and help them to start a new venture.
However, unlike commercial banks, private sector banks are owned, operated, and regulated
by private investors and have the right to operate according to the market forces.
Types of Banking
Banks are further segregated into four types.
Commercial banks: These banks are regulated by Banking Regulation Act, 1949. They accept
the public deposit from the public for lending or investment.
Cooperative banks: Cooperative banks are undertaken by the State Cooperative Societies Act
and give cheap credit to their members. The rural population is dependent on the cooperative
banks for its financial backup.
Specialised banks: These banks provide financial help to special industries, foreign trade, etc.
Few examples of specialised banks are foreign exchange banks, export and import banks,
development banks, etc.
Central banks: These banks manage, check, and monitor all the activities of the commercial
banks of a country.
Functions of Commercial Banks
(1) Acceptance of deposits
• Banks provide the loans only based on the amount deposited by the public.
• They lend money and get interested in them.
• They get funds for lending through deposits in current and savings accounts.
• They pay interest on deposits according to the rates decided by RBI.
(2) Lending of funds
• Providing loans to the public is an important function of banks.
• Advances can be made in the form of overdrafts, cash credits, term loans, etc.
(3) Cheque facilities
• Banks provide cheque facilities to the owners of savings and current accounts to
withdraw their money.
• It is the most developed form of credit instrument.
• Banks also encash the cheques drawn on another bank.
• There are two types of cheques.
(a) Bearer cheques that are cashable immediately
(b) Crossed cheques that are to be credited to the payee’s account
(4) Remittance of funds
• Banks also provide the function of money transfer.
• It provides money transfer facilities through drafts, pays orders, net banking,
NEFT/RTGS, etc., on nominal commission charges.
• A payee can present the cheques in the drawer bank to collect the funds.
Types of Commercial Banks
(1) Public sector banks
• Public sector banks are those banks in which the major holding is of the government.
• Examples: SBI, PNB, OBC, etc.
(2) Private sector banks
• Private sector banks are those banks that are owned, controlled, and managed by private
promoters.
• They operate according to the market forces.
• Examples: HDFC, ICICI, Kotak Mahindra, etc.

Function of Commercial Bank:

The functions of commercial banks are classified into two main divisions.
• Accepts deposit : The bank takes deposits in the form of saving, current, and fixed
deposits. The surplus balances collected from the firm and individuals are lent to the
temporary requirements of the commercial transactions.
• Provides loan and advances : Another critical function of this bank is to offer loans and
advances to the entrepreneurs and business people, and collect interest. For every bank, it
is the primary source of making profits. In this process, a bank retains a small number of
deposits as a reserve and offers (lends) the remaining amount to the borrowers in demand
loans, overdraft, cash credit, short-run loans, and more such banks.
• Credit cash: When a customer is provided with credit or loan, they are not provided with
liquid cash. First, a bank account is opened for the customer and then the money is
transferred to the account. This process allows the bank to create money.
• Overdraft facility: It is an advance given to a customer by keeping the current account to
overdraw up to the given limit.
• Locker facilities: A bank provides locker facilities to the customers to keep their
valuables or documents safely. The banks charge a minimum of an annual fee for this
service.

Functions of the Central Bank

Central bank is regarded as an apex financial institution in the banking system. It is considered
as an integral part of the economic and financial system of a nation. The central bank functions
as an independent authority and is responsible for controlling, regulating and stabilising the
monetary and banking structure of the country.
In India, the Reserve Bank of India is regarded as the central bank. It was set up in 1935. Central
banks are responsible for maintaining the financial stability and economic sovereignty of the
country.
The functions of a central bank can be discussed as follows:
1. Currency regulator or bank of issue
2. Bank to the government
3. Custodian of Cash reserves
4. Custodian of International currency
5. Lender of last resort
6. Clearing house for transfer and settlement
7. Controller of credit
8. Protecting depositor’s interests
Currency regulator or bank of issue: Central banks possess the exclusive right to
manufacture notes in an economy. All the central banks across the world are involved in issuing
notes to the economy.
This is one of the most important functions of the central bank in an economy and due to this
the central bank is also known as the bank of issue.
Earlier all the banks were allowed to publish their own notes which resulted in a disorganised
economy. To avoid this situation the government around the world authorised the central banks
to function as the issuer of currency, which resulted in uniformity in circulation and balanced
supply of money in the economy.
Bank to the government: One of the important functions of the central bank is to act as the
bank to the government. The central bank accepts deposits and issues funds to the government.
It is also involved in making and receiving payments for the government. Central banks also
offer short term loans to the government in order to recover from bad phases in the economy.
In addition to being the bank to the government, it acts as an advisor and agent of the
government by providing advice to the government in areas of economic policy, capital market,
money market and loans from the government.
In addition to that, the central bank is instrumental in formulation of monetary and fiscal
policies that help in regulation of money in the market and controlling inflation.
Custodian of Cash reserves: It is a practice of the commercial banks of a country to keep a
part of their cash balances in the form of deposits with the central bank. The commercial banks
can draw that balance when the requirement for cash is high and pay back the same when there
is less requirement of cash.
It is for this reason that the central bank is regarded as the banker’s bank. Central bank also
plays an important role in the credit creation policy of commercial banks.
Custodian of International currency: An important function of the central bank is to
maintain a minimum balance of foreign currency. The purpose of maintaining such a balance
is to manage sudden or emergency requirements of foreign reserves and also to overcome any
adverse deficits of balance of payments.
Lender of last resort: The central bank acts as a lender of last resort by providing money to
its member banks in times of cash crunch. It performs this function by providing loans against
securities, treasury bills and also by rediscounting bills.
This is regarded as one of the most crucial functions of the central bank wherein it helps in
protecting the financial structure of the economy from collapsing.
Clearing house for transfer and settlement: Central bank acts as a clearing house of the
commercial banks and helps in settling of mutual indebtedness of the commercial banks. In a
clearing house, the representatives of different banks meet and settle the inter bank payments.
Controller of credit: Central banks also function as the controller of credit in the economy. It
happens that commercial banks create a lot of credit in the economy that increases the inflation.
The central bank controls the way credit creation by commercial banks is done by engaging in
open market operations or bringing about a change in the CRR to control the process of credit
creation by commercial banks.
Protecting depositors interests: Central bank also needs to keep an eye on the functioning of
the commercial banks in order to protect the interests of depositors.
Credit creation by banks
The process of credit creation is considered one of the most important functions performed by
a commercial bank.
 The central bank of a country is responsible for ensuring the supply of money in the economy
by circulating the currency. It also ensures that for fulfilling all the transactions, there should
be appropriate currency in the system.
This process cannot be implemented by the central bank alone. For this, they require the help
of commercial banks and their reserves. Commercial banks perform the function of credit
creation in an economy.
Therefore, the money that is created by commercial banks is known as credit money. This is
achieved by the commercial banks in the form of purchasing securities and providing loans.
The commercial banks facilitate the loans by utilising the deposits that are obtained from the
public.
There are restrictions on the amount of money that can provide credits from the total deposits
that a bank obtains from the public. As per the rule, the commercial banks need to maintain a
certain portion of the public deposits as reserves with the central bank that will be used for
meeting the immediate cash requirements of the depositors.
Only after keeping aside the required amount of those reserves the commercial banks are
permitted to lend those amounts to individuals or businesses.
Formula for determining the Credit creation
The following formula can be used to determine the total credit creation.

Total credit creation = Original deposit ✕ Credit multiplier coefficient

Where,
Credit multiplier coefficient = 1/r
r = Cash reserve requirement also known as cash reserve ratio (CRR)
Let us understand this with an example.
If the money deposited in a bank is ₹10,000 and the bank has a CRR of 10%, then what will be
the credit multiplier coefficient?
Credit multiplier coefficient = 1/10%
= 1/0.1
= 10

Total credit creation = 10,000 ✕ 10 = 1,00,000

Limitations of Credit Creation

The following are some of the limitations that are experienced by the commercial banks during
the credit creation process.
1. Cash amount present in the bank
The higher the amount of deposits made by the public, the higher credit creation from the
commercial banks can be seen. However, there is a certain limit on the amount of cash that can
be held by the banks at a time.
This limit is determined by the central bank, as the central bank may contract or expand this
limit by selling or purchasing the securities.
2. Cash reserve ratio or CRR
It refers to the amount of money in the form of reserve that needs to be kept with the central
banks by the commercial banks. This amount is used for meeting the cash requirements of the
users. Any fall in the CRR will lead to more credit creation.
3. Excess reserve
This takes place when a country faces recession, at that time the banks find it conducive in
maintaining reserves in place of lending that leads to less credit creation.
4. Currency drainage
It refers to the situation when the public is not depositing money in the banks. This results in
reduced credit creation in the economy.
5. Borrower availability
Credit creation will flourish if there are borrowers. The credit creation will not be done if there
are no borrowers of the money in an economy.
6. Prevalent business conditions
If an economy is witnessing a depression, then the businesses will not be seeking credit that
leads to contraction of credit creation. Whereas, if a nation is prospering, then the businesses
will seek new funds in the form of credit from the banks that would lead to credit creation.
Instruments of credit control
The different instruments of credit control used by the Reserve Bank of India are Statutory
Liquidity Ratio (SLR), Cash Reserve Ratio (CRR), Open Market Operations (OMOs).
Statutory Liquidity Ratio
Statutory Liquidity Ratio or SLR is the minimum percentage of deposits that a commercial
bank has to maintain in the form of liquid cash, gold or other securities. It is basically the
reserve requirement that banks are expected to keep before offering credit to customers. The
SLR is fixed by the RBI and is a form of control over the credit growth in India.
Why is the SLR fixed?
• To check the expansion of bank credit.
• To ensure the solvency of commercial banks.
• To compel banks to invest in government securities like bonds.
 • To fuel growth and demand; this is done by decreasing the SLR so that there is more
liquidity with the commercial banks.
Cash Reserve Ratio (CRR)
Cash Reserve Ratio (CRR) is a specific part of the total deposit that is held as a reserve by the
commercial banks and is mandated by the Reserve Bank of India (RBI). This specific amount
is held as a reserve in the form of cash or cash equivalent which is stored in the bank’s vault or
is sent to the RBI. CRR ensures that the banks do not run out of money.
Cash Reserve Ratio in India is decided by the Monetary Policy Committee (MPC) under the
periodic Monetary and Credit Policy. If the CRR is low, the liquidity with the bank increases,
which in turn goes into investment and lending and vice-versa. Higher CRR creates a negative
impact on the economy and also lowers the availability of loanable funds. As a result, it slows
down the investment and reduces the supply of money in the economy.
CRR is an important tool of the Monetary Policy which provides the following benefits:
• CRR regulates the money supply and the level of inflation in the country.
• CRR ensures the security of the reserved amount as the specific amount of the bank’s
deposit is stored with the Reserve Bank of India which can be readily available as per the
need of the customers.
• CRR also has a major role to play during high inflation. During high inflation, the Reserve
Bank of India increases the CRR rate to reduce the amount of money that is available with
the banks. This reduces the excess flow of money in the economy.
• During the need of funds, the government can lower the rate of the CRR to help the banks
in providing loans to various businesses and industries for investment. A low rate of CRR
also increases the growth rate of the economy.
Repo Rate and Reverse Repo Rate
Repo rate can be defined as an amount of interest that is charged by the Reserve Bank of India
while lending funds to the commercial banks.
Reverse Repo Rate
The reverse repo rate is the rate of interest that is provided by the Reserve bank of India while
borrowing money from the commercial banks. In other words, we can say that the reverse repo
is the rate charged by the commercial banks in India to park their excess money with RBI for
a short-term period. The current reverse repo rate in India as of May 2022 is 3.35%.
Open market operations
An Open Market Operation (OMO) is the buying and selling of government securities in the
open market, hence the nomenclature. It is done by the central bank in a country (the RBI in
India). When the central bank wants to infuse liquidity into the monetary system, it will buy
government securities in the open market. This way it provides commercial banks with
liquidity. In contrast, when it sells securities, it curbs liquidity. Thus, the central bank indirectly
controls the money supply and influences short-term interest rates.
Role of banking in economy
The banking system plays an important role in the modern economic world. Banks collect the
savings of the individuals and lend them out to business- people and manufacturers. Bank loans
facilitate commerce.
Manufacturers borrow from banks the money needed for the purchase of raw materials and to
meet other requirements such as working capital. It is safe to keep money in banks. Interest is
also earned thereby. Thus, the desire to save is stimulated and the volume of savings
increases. The savings can be utilised to produce new capital assets.
Thus, the banks play an important role in the creation of new capital (or capital formation) in
a country and thus help the growth process.
Banks arrange for the sale of shares and debentures. Thus, business houses and manufacturers
can get fixed capital with the aid of banks. There are banks known as industrial banks, which
assist the formation of new companies and new industrial enterprises and give long-term loans
to manufacturers.
The banking system can create money. When business expands, more money is needed for
exchange transactions. The legal tender money of a country cannot usually be expanded
quickly. Bank money can be increased quickly and used when there is need of more money. In
a developing economy (like that of India) banks play an important part as supplier of money.
The banking system facilitates internal and international trade. A large part of trade is done on
credit. Banks provide references and guarantees, on behalf of their customers, on the basis of
which sellers can supply goods on credit. This is particularly important in international trade
when the parties reside in different countries and are very often unknown to one another.
Trade is also assisted by the grant of loans by discounting bills of exchange and in other ways.
Foreign exchange transactions (the exchange of one currency for another) are also done through
banks.
Finally, banks act as advisers, counsellors and agents of business and industrial organisations.
They help the development of trade and industry.