Banking: Commercial Banks and the Central Bank
Introduction
Banks hold a key position in shaping the Indian financial structure. The banking system is mainly made up of commercial banks and a central bank. Commercial banks handle daily banking activities such as deposits and loans, while the central bank acts as the top authority that controls and guides the entire banking structure. The smooth working of both types of banks is essential for a strong economy and proper implementation of monetary policies.
Commercial Banks
Meaning and Role
A commercial bank refers to an organisation that collects money from individuals in the form of deposits and lends it to others with the goal of making profit. Some well-known commercial banks in India are State Bank of India (SBI), Punjab National Bank (PNB), Canara Bank, and Allahabad Bank.
These banks act as a link between people who save money and those who need money for productive work. They pay interest on deposits (called the borrowing rate) and charge interest on loans (called the lending rate). The difference between these two rates, known as the spread, is the main income of the bank.
Functions of Commercial Banks
Commercial banks perform two main categories of functions:
1. Primary Functions
a) Accepting Deposits
Commercial banks accept deposits in different forms:
- Current Account Deposits: These accounts are mostly used by business people. They allow unlimited withdrawals and provide cheque facilities but don’t offer any interest. Banks may charge service fees.
- Fixed Deposits (Time Deposits): Money is deposited for a specific time period and cannot be withdrawn before maturity. These deposits earn higher interest but don’t provide cheque facilities.
- Savings Deposits: These accounts offer moderate interest and limited cheque facilities. Withdrawals are restricted to encourage savings.
b) Providing Loans
After keeping a required portion as reserves, banks lend the remaining amount in the following forms:
- Cash Credit: A certain limit is fixed, and interest is applied only on the portion that is actually withdrawn.
- Demand Loans: Interest is payable on the entire sanctioned amount.
- Short-Term Loans: Given for a short period against security. The entire loan is credited to the borrower’s account, and interest is paid on the whole amount.
2. Secondary Functions
Besides the basic functions, commercial banks also perform additional tasks:
- Overdraft Facility: Allows trusted customers to withdraw more than the balance in their current accounts up to a set limit.
- Discounting of Bills of Exchange: Banks buy bills before they mature, deducting a commission. They collect the full payment on maturity.
- Agency Functions: These include transferring funds, collecting payments like cheques or dividends, handling foreign exchange (for authorised banks), and providing services like tax consultation and managing trusts or estates.
- General Utility Functions: These include locker facilities, issuing traveller’s cheques, providing letters of credit, underwriting securities, and publishing reports related to trade and finance.
Credit Creation or Money Creation
One of the most important functions of commercial banks is credit creation. This means banks can lend more money than the actual cash they have, by keeping only a fraction of deposits as reserves. This system is called fractional reserve banking.
- Money Multiplier: This shows how much total money can be created from an initial deposit. For example, if the Legal Reserve Ratio (LRR) is 20% (or 0.2), then the money multiplier is 1/0.2 = 5. So, a ₹1,000 deposit can create ₹5,000 in total deposits.
- Process of Credit Creation: Banks lend out a part of the deposits, and that money again comes back as deposits after being spent. This process continues and multiplies the original amount.
- Impact: It increases investment, raises income levels, and boosts economic growth through the multiplier effect.
Central Bank
Meaning and Role
The central bank is the highest authority in a country’s banking and monetary system. In India, the Reserve Bank of India (RBI) serves as the central bank, established in 1935. It manages and controls the entire banking system and ensures monetary stability in the economy.
Functions of the Central Bank
i) Currency Issuer
The RBI has the sole right to issue currency notes in India (except ₹1 notes and coins, which are issued by the government). These notes are backed by assets like gold, foreign exchange, and government bonds.
ii) Banker to the Government
The central bank acts as the government’s banker, agent, and advisor. It maintains government accounts, makes and receives payments, manages loans, and gives short-term advances when needed.
iii) Banker’s Bank and Supervisor
- Custodian of Cash Reserves: Commercial banks must keep a portion of their deposits as Cash Reserve Ratio (CRR) with the RBI.
- Lender of Last Resort: In times of financial crisis, the RBI lends money to commercial banks.
- Clearing House: It settles payments between different banks.
- Supervisor: It monitors banks by setting rules, giving licenses, inspecting operations, and overseeing management.
iv) Controller of Money Supply and Credit
The central bank controls the availability and cost of credit in the economy through monetary policy tools:
- Repo Rate: An increase in the repo rate discourages borrowing by commercial banks.
- Bank Rate: Rate for long-term loans from RBI to banks. A rise in the bank rate discourages borrowing.
- Reverse Repo Rate: A higher reverse repo rate motivates banks to park funds with RBI, limiting their lending capacity.
- Open Market Operations (OMO): The central bank’s activity of buying or selling government bonds to control the liquidity in the economy.
- Legal Reserve Requirements:
- CRR (Cash Reserve Ratio): A part of commercial banks’ deposits that must be maintained with the central bank in cash form.
- SLR (Statutory Liquidity Ratio): A set portion of bank deposits that should be kept in the form of liquid assets like gold or approved securities.
- Margin Requirements: Sets how much a bank can lend against security values.
- Moral Suasion and Selective Credit Control: RBI persuades or directs banks to lend in specific sectors and control speculative loans.
v) Custodian of Foreign Exchange Reserves
The central bank holds and manages the country’s reserves of gold and foreign currencies.
👉((Class 12th Money notes))👈
Difference Between Central Bank and Commercial Bank
| Feature | Central Bank | Commercial Bank |
|---|---|---|
| Meaning | Regulator of the banking system | Provides deposit and loan services |
| Status | Supreme institution in finance | Works under the central bank |
| Ownership | Government-owned | Government or private ownership |
| Main Aim | Public welfare | Earning profits |
| Currency Issuance | Has the sole authority | Not allowed |
| Public Dealing | No direct contact with public | Deals directly with the public |
| Number | Only one (RBI in India) | Many (e.g., SBI, PNB, etc.) |
Conclusion
Both commercial banks and the central bank play essential roles in a country’s economy. While commercial banks collect savings and give loans to promote investment and development, the central bank maintains financial stability, controls inflation, and regulates all banks. Together, they ensure that the financial system operates efficiently, supporting economic growth and development.