cental banking

8/2/2019 Cental Banking

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INTRODUCTION

A central bank, reserve bank, or monetary authority is an institution that

manages a nation's currency, money supply, and interest rates. Central banks also

usually oversee the commercial banking system of their respective countries. In

contrast to a commercial bank, a central bank possesses a monopoly on

increasing the nation's monetary base, and usually also prints the national

currency, which usually serves as the nation's legal tender. Examples include the

European Central Bank (ECB), the Federal Reserve of the United States, and the

People's Bank of China.

The primary function of a central bank is to manage the nation's money

supply (monetary policy), through active duties such as managing interest rates,

setting the reserve requirement, and acting as a lender of last resort to the

banking sector during times of bank insolvency or financial crisis. Central banks

usually also have supervisory powers, intended to prevent commercial banks and

other financial institutions from reckless or fraudulent behavior. Central banks in

most developed nations are institutionally designed to be independent from

political interference.

The entity responsible for overseeing the monetary system for a nation (orgroup of nations). Central banks have a wide range of responsibilities,

from overseeing monetary policy to implementing specific goals such as currency

stability, low inflation and full employment. Central banks also generally issue

currency, function as the bank of the government, regulate the credit system,

oversee commercial banks, manage exchange reserves and act as a lender of last

resort. The central banking system in the U.S. is known as the Federal Reserve

System (commonly known as "the Fed"), which is composed of 12 regional

Federal Reserve Banks located in major cities throughout the country. The

main tasks of the Federal Reserve are to supervise and regulate banks,

implement monetary policy by buying and selling U.S. Treasury bonds and steer

interest rates. Ben Bernanke currently serves as the chairman of the Board of

Governors of the Federal Reserve.
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HISTORY OF CENTRAL BANK

Prior to the 17th century most money was commodity money, typically

gold or silver. However, promises to pay were widely circulated and accepted as

value at least five hundred years earlier in both Europe and Asia. The Song

Dynasty was the first to issue generally circulating paper currency, while theYuan

Dynasty was the first to use notes as the predominant circulating medium. In

1455, in an effort to control inflation, the succeeding Ming Dynasty ended the use

of paper money and closed much of Chinese trade. The medieval European

Knights Templar ran an early prototype of a central banking system, as their

promises to pay were widely respected, and many regard their activities as having

laid the basis for the modern banking system.

As the first public bank to "offer accounts not directly convertible to coin", the

Bank of Amsterdam established in 1609 is considered to be the precursor to

modern central banks.The central bank of Sweden ("Sveriges Riksbank" or simply

"Riksbanken") was founded in Stockholm from the remains of the failed bank

Stockholms Banco in 1664 and answered to the parliament ("Riksdag of the

Estates") thus making it the oldest central bank still operating today. One role of

the Swedish central bank was lending to the government,[6]

which was likewise

true of the Bank of England, created in 1694 by Scottish businessman William

Paterson in the City of London at the request of the English government to help

pay for a war. The War of the Second Coalition led to the creation of the Banque

de France in 1800.

Although central banks today are generally associated with fiat money, the 19th

and early 20th centuries central banks in most of Europe and Japan developed

under the international gold standard, elsewhere free banking or currency boards

were more usual at this time. Problems with collapses of banks during downturns,

however, was leading to wider support for central banks in those nations which

did not as yet possess them, most notably in Australia.

The US Federal Reserve was created by the U.S. Congress through the passing of

The Federal Reserve Act in the Senate and its signing by President Woodrow
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Wilson on the same day, December 23, 1913. Australia established its first central

bank in 1920, Colombia in 1923, Mexico and Chile in 1925 and Canada and New

Zealand in the aftermath of the Great Depression in 1934. By 1935, the only

significant independent nation that did not possess a central bank was Brazil,

which subsequently developed a precursor thereto in 1945 and the present

central bank twenty years later. Having gained independence, African and Asian

countries also established central banks or monetary unions.

The People's Bank of China evolved its role as a central bank starting in about

1979 with the introduction of market reforms, which accelerated in 1989 when

the country adopted a generally capitalist approach to its export economy.

Evolving further partly in response to the European Central Bank, the People's

Bank of China has by 2000 become a modern central bank. The most recent bank

model, was introduced together with the euro, involves coordination of the

European national banks, which continue to manage their respective economies

separately in all respects other than currency exchange and base interest rates.

Definition of Central Banking

A bank that is constituted by a government or international organization to

issue and regulate currency, regulate banks under its jurisdiction, act as a lender

of last resort, and generally ensure a sustainable monetary policy. Oftentimes,

central banks are charged with one or more specific duties such as attemptingfull

employment or a certain exchange rate for the currency. Most commonly,

however, central banks are charged with finding the balance between

maintaining low inflation and high economic growth. They do this primarily by

setting interest rates at which they lend to banks under its jurisdiction which, inturn, highly influences interest rates throughout the country or region. Prominent

central banks include the Federal Reserve, the Bank of England, the European

Central Bank, the Bank of Japan, and the People's Bank of China.
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How the Bank Influences an Economy

A central bank can be said to have two main kinds of functions:

(1)Macroeconomic when regulating inflation and price stability and

(2)Microeconomicwhen functioning as a lender of last resort.

Macroeconomic Influences

As it is responsible for price stability, the central bank must regulate the

level of inflation by controlling money supplies by means of monetary policy. The

central bank performs open market transactions that either inject the market

with liquidity or absorb extra funds, directly affecting the level of inflation. To

increase the amount of money in circulation and decrease the interest rate (cost)

for borrowing, the central bank can buy government bonds, bills, or othergovernment-issued notes. This buying can, however, also lead to higher inflation.

When it needs to absorb money to reduce inflation, the central bank will sell

government bonds on the open market, which increases the interest rate and

discourages borrowing. Open market operations are the key means by which a

central bank controls inflation, money supply, and price stability. If you'd like to

learn more about this subject, see this The Federal Reserve (the Fed) Tutorial.

Microeconomic Influences

The establishment of central banks as lender of last resort has pushed the

need for their freedom from commercial banking. A commercial bank offers funds

to clients on a first come, first serve basis. If the commercial bank does not have

enough liquidity to meet its clients' demands (commercial banks typically do not

hold reserves equal to the needs of the entire market), the commercial bank can

turn to the central bank to borrow additional funds. This provides the system with

stability in an objective way; central banks cannot favor any particular commercial

bank. As such, many central banks will hold commercial-bank reserves that are

based on a ratio of each commercial bank's deposits. Thus, a central bank may

require all commercial banks to keep, for example, a 1:10 reserve/deposit ratio.

Enforcing a policy of commercial bank reserves functions as another means to

control money supply in the market. Not all central banks, however, require
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commercial banks to deposit reserves. The United Kingdom, for example, does

not have this policy while the United States does.

The rate at which commercial banks and other lending facilities can

borrow short-term funds from the central bank is called the discount rate (which

is set by the central bank and provides a base rate for interest rates). It has been

argued that, for open market transactions to become more efficient, the discount

rate should keep the banks from perpetual borrowing, which would disrupt the

market's money supply and the central bank's monetary policy. By borrowing too

much, the commercial bank will be circulating more money in the system. Use of

the discount rate can be restricted by making it unattractive when used

repeatedly.

Transitional Economies

Today developing economies are faced with issues such as the transition

from managed to free market economies. The main concern is often controlling

inflation. This can lead to the creation of an independent central bank but can

take some time, given that many developing nations maintain control over their

economies in an effort to retain control of their power. But governmentintervention, whether direct or indirect through fiscal policy, can stunt central

bank development. Unfortunately, many developing nations are faced with civil

disorder or war, which can force a government to divert funds away from the

development of the economy as a whole. Nonetheless, one factor that seems to

be confirmed is that, for a market economy to develop, a stable currency

(whether achieved through a fixed or floating exchange rate) is needed. However,

the central banks in both industrial and emerging economies are dynamic because

there is no guaranteed way to run an economy regardless of its stage ofdevelopment.
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Naming of central banks

There is no standard terminology for the name of a central bank, but many

countries use the "Bank of Country" form (for example: Bank of England, Bank of

Canada, Bank of Mexico). Some are styled "national" banks, such as the National

Bank of Ukraine; but the term "national bank" is more often used by privately-

owned commercial banks, especially in the United States. In other cases, central

banks may incorporate the word "Central" (for example, European Central Bank,

Central Bank of Ireland); but the Central Bank of India is a (government-owned)

commercial bank and not a central bank. The word "Reserve" is also often

included, such as the Reserve Bank of India,Reserve Bank of Australia,Reserve

Bank of New Zealand, the South African Reserve Bank, and U.S. Federal Reserve

System. Many countries have state-owned banks or other quasi-government

entities that have entirely separate functions, such as financing imports and

exports.

In some countries, particularly in some Communist countries, the term

national bank may be used to indicate both the monetary authority and the

leading banking entity, such as the Soviet Union's Gosbank (state bank). In other

countries, the term national bank may be used to indicate that the central bank's

goals are broader than monetary stability, such as full employment, industrial

development, or other goals.

Main objectives of RBI

* To manage the monetary and credit system of the country.

* To stabilizes internal and external value of rupee.

* For balanced and systematic development of banking in the country.

* For the development of organized money market in the country.

* For proper arrangement of agriculture finance.

* For proper arrangement of industrial finance.

* For proper management of public debts.
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* To establish monetary relations with other countries of the world and

international financial institutions.

* For centralization of cash reserves of commercial banks.

* To maintain balance between the demand and supply of currency.

The central bank of the country is the Reserve Bank of India (RBI). It was

established in April 1935 with a share capital of Rs. 5 crores on the basis of the

recommendations of the Hilton Young Commission. The share capital was divided

into shares of Rs. 100 each fully paid which was entirely owned by private

shareholders in the begining. The Government held shares of nominal value of Rs.

2,20,000.

Reserve Bank of India was nationalised in the year 1949. The general

superintendence and direction of the Bank is entrusted to Central Board of

Directors of 20 members, the Governor and four Deputy Governors, one

Government official from the Ministry of Finance, ten nominated Directors by the

Government to give representation to important elements in the economic life of

the country, and four nominated Directors by the Central Government to represent

the four local Boards with the headquarters at Mumbai, Kolkata, Chennai and New

Delhi. Local Boards consist of five members each Central Government appointed

for a term of four years to represent territorial and economic interests and the

interests of co-operative and indigenous banks.

The Reserve Bank of India Act, 1934 was commenced on April 1, 1935.

The Act, 1934 (II of 1934) provides the statutory basis of the functioning of the

Bank.

The Bank was constituted for the need of following:

To regulate the issue of banknotes To maintain reserves with a view to securing monetary stability and To operate the credit and currency system of the country to its advantage.


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Functions of Reserve Bank of India

The Reserve Bank of India Act of 1934 entrust all the important functions of a

central bank the Reserve Bank of India.

Bank of Issue:Under Section 22 of the Reserve Bank of India Act, the Bank has the sole

right to issue bank notes of all denominations. The distribution of one rupee

notes and coins and small coins all over the country is undertaken by the Reserve

Bank as agent of the Government. The Reserve Bank has a separate Issue

Department which is entrusted with the issue of currency notes. The assets and

liabilities of the Issue Department are kept separate from those of the Banking

Department. Originally, the assets of the Issue Department were to consist of notless than two-fifths of gold coin, gold bullion or sterling securities provided the

amount of gold was not less than Rs. 40 crores in value. The remaining three-

fifths of the assets might be held in rupee coins, Government of India rupee

securities, eligible bills of exchange and promissory notes payable in India. Due to

the exigencies of the Second World War and the post-was period, these

provisions were considerably modified. Since 1957, the Reserve Bank of India is

required to maintain gold and foreign exchange reserves of Ra. 200 crores, of

which at least Rs. 115 crores should be in gold. The system as it exists today is

known as the minimum reserve system.

Banker to GovernmentThe second important function of the Reserve Bank of India is to act as

Government banker, agent and adviser. The Reserve Bank is agent of Central

Government and of all State Governments in India excepting that of Jammu and

Kashmir. The Reserve Bank has the obligation to transact Government business,

via. to keep the cash balances as deposits free of interest, to receive and to make

payments on behalf of the Government and to carry out their exchange

remittances and other banking operations. The Reserve Bank of India helps the

Government - both the Union and the States to float new loans and to manage

public debt. The Bank makes ways and means advances to the Governments for


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90 days. It makes loans and advances to the States and local authorities. It acts as

adviser to the Government on all monetary and banking matters.

Bankers' Bank and Lender of the Last ResortThe Reserve Bank of India acts as the bankers' bank. According to the

provisions of the Banking Companies Act of 1949, every scheduled bank was

required to maintain with the Reserve Bank a cash balance equivalent to 5% of its

demand liabilites and 2 per cent of its time liabilities in India. By an amendment of

1962, the distinction between demand and time liabilities was abolished and

banks have been asked to keep cash reserves equal to 3 per cent of their

aggregate deposit liabilities. The minimum cash requirements can be changed by

the Reserve Bank of India.

The scheduled banks can borrow from the Reserve Bank of India on the basis

of eligible securities or get financial accommodation in times of need or

stringency by rediscounting bills of exchange. Since commercial banks can always

expect the Reserve Bank of India to come to their help in times of banking crisis

the Reserve Bank becomes not only the banker's bank but also the lender of the

last resort.

Controller of CreditThe Reserve Bank of India is the controller of credit i.e. it has the power toinfluence the volume of credit created by banks in India. It can do so through

changing the Bank rate or through open market operations. According to the

Banking Regulation Act of 1949, the Reserve Bank of India can ask any particular

bank or the whole banking system not to lend to particular groups or persons on

the basis of certain types of securities. Since 1956, selective controls of credit are

increasingly being used by the Reserve Bank.

The Reserve Bank of India is armed with many more powers to control the

Indian money market. Every bank has to get a licence from the Reserve Bank of

India to do banking business within India, the licence can be cancelled by the

Reserve Bank of certain stipulated conditions are not fulfilled. Every bank will

have to get the permission of the Reserve Bank before it can open a new branch.


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Each scheduled bank must send a weekly return to the Reserve Bank showing, in

detail, its assets and liabilities. This power of the Bank to call for information is

also intended to give it effective control of the credit system. The Reserve Bank

has also the power to inspect the accounts of any commercial bank.

As supereme banking authority in the country, the Reserve Bank of India,

therefore, has the following powers:

(a) It holds the cash reserves of all the scheduled banks.

(b) It controls the credit operations of banks through quantitative and qualitative

controls.

(c) It controls the banking system through the system of licensing, inspection and

calling for information.

(d) It acts as the lender of the last resort by providing rediscount facilities to

scheduled banks.

Custodian of Foreign ReservesThe Reserve Bank of India has the responsibility to maintain the official rateof exchange. According to the Reserve Bank of India Act of 1934, the Bank was

required to buy and sell at fixed rates any amount of sterling in lots of not less

than Rs. 10,000. The rate of exchange fixed was Re. 1 = sh. 6d. Since 1935 the

Bank was able to maintain the exchange rate fixed at lsh.6d. though there were

periods of extreme pressure in favour of or against the rupee. After India became

a member of the International Monetary Fund in 1946, the Reserve Bank has the

responsibility of maintaining fixed exchange rates with all other membercountries of the I.M.F.

Besides maintaining the rate of exchange of the rupee, the Reserve Bank

has to act as the custodian of India's reserve of international currencies. The vast

sterling balances were acquired and managed by the Bank. Further, the RBI has

the responsibility of administering the exchange controls of the country.


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Supervisory functionsIn addition to its traditional central banking functions, the Reserve bank has

certain non-monetary functions of the nature of supervision of banks and

promotion of sound banking in India. The Reserve Bank Act, 1934, and the

Banking Regulation Act, 1949 have given the RBI wide powers of supervision and

control over commercial and co-operative banks, relating to licensing and

establishments, branch expansion, liquidity of their assets, management and

methods of working, amalgamation, reconstruction, and liquidation. The RBI is

authorised to carry out periodical inspections of the banks and to call for returns

and necessary information from them. The nationalisation of 14 major Indian

scheduled banks in July 1969 has imposed new responsibilities on the RBI for

directing the growth of banking and credit policies towards more rapid

development of the economy and realisation of certain desired social objectives.

The supervisory functions of the RBI have helped a great deal in improving the

standard of banking in India to develop on sound lines and to improve the

methods of their operation.

Promotional functionsWith economic growth assuming a new urgency since Independence, the

range of the Reserve Bank's functions has steadily widened. The Bank now

performs a varietyof developmental and promotional functions, which, at one

time, were regarded as outside the normal scope of central banking. The Reserve

Bank was asked to promote banking habit, extend banking facilities to rural and

semi-urban areas, and establish and promote new specialised financing agencies.

Accordingly, the Reserve Bank has helped in the setting up of the IFCI and the SFC;

it set up the Deposit Insurance Corporation in 1962, the Unit Trust of India in

1964, the Industrial Development Bank of India also in 1964, the AgriculturalRefinance Corporation of India in 1963 and the Industrial Reconstruction

Corporation of India in 1972. These institutions were set up directly or indirectly

by the Reserve Bank to promote saving habit and to mobilise savings, and to

provide industrial finance as well as agricultural finance. As far back as 1935, the

Reserve Bank of India set up the Agricultural Credit Department to provide


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agricultural credit. But only since 1951 the Bank's role in this field has become

extremely important. The Bank has developed the co-operative credit movement

to encourage saving, to eliminate moneylenders from the villages and to route its

short term credit to agriculture. The RBI has set up the Agricultural Refinance and

Development Corporation to provide long-term finance to farmers.

Classification of RBIs functionsThe monetary functions also known as the central banking functions of the RBI

are related to control and regulation of money and credit, i.e., issue of currency,

control of bank credit, control of foreign exchange operations, banker to the

Government and to the money market. Monetary functions of the RBI are

significant as they control and regulate the volume of money and credit in the

country.

Equally important, however, are the non-monetary functions of the RBI in the

context of India's economic backwardness.

The supervisory function of the RBI may be regarded as a non-monetary

function (though many consider this a monetary function). The promotion of

sound banking in India is an important goal of the RBI, the RBI has been given

wide and drastic powers, under the Banking Regulation Act of 1949 - these

powers relate to licencing of banks, branch expansion, liquidity of their assets,management and methods of working, inspection, amalgamation, reconstruction

and liquidation. Under the RBI's supervision and inspection, the working of banks

has greatly improved. Commercial banks have developed into financially and

operationally sound and viable units. The RBI's powers of supervision have now

been extended to non-banking financial intermediaries. Since independence,

particularly after its nationalisation 1949, the RBI has followed the promotional

functions vigorously and has been responsible for strong financial support to

industrial and agricultural development in the country.


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STRUCTURE OF RBI

The organization of RBI can be divided into three parts:

1) Central Board of Directors.2) Local Boards3) Offices of RBI

1. Central Board of Directors :The organization and management of RBI is vested on the Central Board of

Directors. It is responsible for the management of RBI.Central Board of Directors

consist of 20 members. It is constituted as follows.

a) One Governor: it is the highest authority of RBI. He is appointed by the

Government of India for a term of 5 years. He can be re-appointed for another

term.

b) Four Deputy Governors: Four deputy Governors are nominated by Central

Govt. for a term of 5 years

c) Fifteen Directors :Other fifteen members of the Central Board are appointed bythe Central Government. Out of these , four directors,one each from the four

local Boards are nominated by the Government separately by the Central

Government.

Ten directors nominated by the Central Government are among the

experts of commerce, industries, finance, economics and cooperation. The

finance secretary of the Government of India is also nominated as Govt. officer in

the board. Ten directors are nominated for a period of 4 years. The Governor actsas the Chief Executive officer and Chairman of the Central Board of Directors. In

his absence a deputy Governor nominated by the Governor, acts as the Chairman

of the Central Board. The deputy governors and governments officer nominee

are not entitled to vote at the meetings of the Board. The Governor and four

deputy Governors are full time officers of the Bank.


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2. Local Boards:

Besides the central board, there are local boards for four regional areas of

the country with their head-quarters at Mumbai, Kolkata, Chennai, and New

Delhi. Local Boards consist of five members each, appointed by the central

Government for a term of 4 years to represent territorial and economic interests

and the interests of co-operatives and indigenous banks. The function of the local

boards is to advise the central board on general and specific issues referred to

them and to perform duties which the central board delegates.

3. Offices of RBI:

The Head office of the bank is situated in Mumbai and the offices of local

boards are situated in Delhi, Kolkata and Chennai. In order to maintain the

smooth working of banking system, RBI has opened local offices or branches in

Ahmadabad, Bangalore, Bhopal, Bhubaneswar, Chandigarh, Guwahati,

Hyderabad, Jaipur, Jammu, Kanpur, Nagpur, Patna, Thiruvananthpuram, Kochi,

Lucknow and Byculla (Mumbai). The RBI can open its offices with the permission

of the Government of India. In places where there are no offices of the bank, it is

represented by the state Bank of India and its associate banks as the agents ofRBI.

INSTRUMENTS OF CENTRAL BANKING POLICY

Fiduciary or paper money is issued by the Central Bank on the basis of

computation of estimated demand for cash. Monetary policy guides the Central

Banks supply of money in order to achieve the objectives of price stability (or low

inflation rate), full employment, and growth in aggregate income. This is

necessary because money is a medium of exchange and changes in its demand

relative to supply, necessitate spending adjustments. To conduct monetary policy,

some monetary variables which the Central Bank controls are adjusted-a

monetary aggregate, an interest rate or the exchange rate-in order to affect the


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goals which it does not control. The instruments of monetary policy used by the

Central Bank depend on the level of development of the economy, especially its

financial sector. The commonly used instruments are discussed below.

BANK RATE:Bank rate (also known as discount rate)is the rate at which RBI rediscounts

eligible papers like approved securities, bill of exchange and commercial papers

held by the commercial banks. Thus it is the rate at which the RBI lends money to

the commercial banks for their liquidity requirements. Changes in the bank rate

affect the banks borrowing rate from the RBI which in turn influences the banks

lending rates. Thus bank rate acts as a guideline to the banks for fixing their

interest rates. Inflation leads to increase in the bank rate recession causes it todecline.

OPEN MARKET OPERATIONS:Open Market Operations indicate the buying/selling of government securities

in the open market to balance the money supply in the economy. During inflation,

RBI sells the government securities to the commercial banks and other financial

institution. This reduces their cash lending and credit creation capacities. Thus,

Inflation can be controlled. During recessions, RBI purchases government

securities from commercial banks and other financial institution. This leaves them

with more cash balances for lending and increases their credit creation capacities.

Thus, recession can be overcome.

REPO RATES AND REVERSE REPO RATES:Repo rate and Reverse Repo rate are gaining significance in determining

interest rate trends of commercial banks.

Repo (SALE AND REPURCHASE AGREEMENT):Repo is a swap deal involving

immediate sale of securities and a simultaneous re purchase of those securities at

a future date at a predetermined price. Such deals take place between the RBI

and other commercial banks and financial institution. Commercial banks and


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financial institution also park their funds with RBI at a certain rate This rate is

called the reverse Repo Rate. Repo rates and reverse repo rate used by RBI to

make liquidity adjustments in the market.

CASH RESERVE RATIO:The money supply in the economy is influenced by the cash reserve ratio. It is

the ratio of a banks time and demand liabilities to be kept in reserve with the RBI.

The RBI is authorised to vary the CRR between 3% and 15%. A high CRR reduces

the flow of money in the economy and is used to control inflation. A low CRR

increases the flow of money and is used to overcome recession.

STATUTORY LIQUIDITY RATIO:

SLR is the ratio requirement peculiar to India. Under SLR, banks have to invest

a certain percentage of its time and demand liabilities In Government approved

securities. The reduction in SLR enhances the liquidity of commercial banks.

DEPLOYMENT OF CREDIT:The RBI has taken various measures to deploy credit in different of the

economy. The certain percentage of bank credit has been fixed for various sectorslike agriculture, export, etc.

MULTIPLE CREDIT CREATION

A bank differs from other financial institutions because it can create credit.

Banks have the ability to expand their demand deposits as a multiple of their cashreserves. This is because of the fact that demand deposits of the banks serve as

the principal medium of exchange, and, in this way, the banks manage the

payments system of the country.


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In short, multiple expansion of deposits is called credit creation and the

ability of the banks to expand the deposits makes them unique and distinguish

them from other non-bank financial institutions. Demand deposits are an

important constituent of money supply and the expansion of demand deposits

means expansion of money supply.

The whole structure of banking is based on credit. Credit means getting the

purchasing power (i.e., money) now by a promise to pay at some time in future.

In the words of Kent, "Credit may be defined as the right to receive

payment or the obligation to make payment on demand or at some future tune

on account of an immediate transfer of goods." In a sense, the words credit, debt

and loan are synonymous; credit or loan is the liability of the debtor and the assetof the bank. The word credit is derived from a Latin word 'credo', which means 'I

believe'.

The creditor believes that the debtor will return the loan and so decides to

give the loan. Advancing credit or loan essentially depends upon the (a)

confidence, (b) character, (c) capacity, (d) capital, and (e) collateral of the debtor.

Bank credit means bank loans and advances. A bank keeps a certain

proportion of its deposits as minimum reserve for meeting the demand of the

depositors and lends out the remaining excess reserve to earn income. The bank

loan is not paid directly to the borrower but is only credited hi his account. Every

bank loan creates an equivalent deposit in the bank. Thus, credit creation means

multiple expansions of bank deposits. The word 'creation' refers to the ability of

the bank to expand deposits as a multiple of its reserves.

In nutshell, credit creation refers to the unique power of the banks lo

multiply loans and advances, and hence deposits. With a little cash in hand, the

banks can create additional purchasing power lo a considerable degree. It is

because of the multiple credits creating power that the commercial banks have

been aptly called the 'factories of credit' or 'manufactures of money'.


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In the words of Newlyn. "Credit creation refers to the power of commercial

banks to expand secondary deposits either through the process of making loans

or through investment in securities."

According to Halm, "The creation of derivative deposits is identical withwhat is commonly called the creation of credit.

CONTROL OF CURRENCY

The RBI is empowered to control the credit flow which is necessary for

accelerating the economic growth of India. Banks must keep a part of its money

as reserve money, a part of which is kept as vault cash and the rest is deposited

with The Reserve Bank of India. When commercial banks fall short of funds, they

can borrow from RBI at a rate called Bank Rate. In a monetary policy where the

Bank rate is high will discourage commercial banks from borrowing from The RBI.

As a result these banks will naturally charge higher interest rates from their

lenders. Thus in such a monetary policy, which is called Dear Monetary Policy,

money supply in the economy will reduce. On the other hand, a monetary policy,

where bank rate is low and money supply is more, will be called a CheapMonetary Policy. Thus bank rate can be an effective instrument of The RBI to

regulate the money supply in the market.

Another instrument that is frequently used by RBI for this purpose is called

Cash Reserve Ratio or CRR, which represents the fraction of deposit which

commercial banks must keep with The RBI to regulate the money supply. Similar

to CRR, Statutory Liquidity Ratio is the portion of deposits that a bank has to keep

with RBI in term of gold, bullion or Government Securities. Any modification inthe levels of CRR or, SLR therefore, will have significant impact on the economy.

For example, increasing either the SLR or CRR or, both means a decrease in

liquidity of the commercial banks. Thus with appropriate monetary policy RBI can

either siphon off the liquidity or induce more liquidity in the market. Though


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keeping reserves this way with the RBI is costly for banks, it is necessary to ensure

that they are able to pay their account holders when asked for it.

The RBI can purchase government bonds from or sell the same to the

public. When RBI buys them, excess money is infused in the economy therebyincrease the money supply. The reverse, that is, selling the bonds will suck out

excess liquidity from the market. This operation is called the open market

operation which is also a part of monetary policy of The Reserve Bank of India and

may work as complementary of bank rate policy.

The RBI is also responsible to maintain stability of foreign exchange and to

hold the foreign exchange reserve. How can foreign exchange reserve affect a

countrys economy? Suppose an investor from the US wants to invest in Indianmarket. USD doesnt work in domestic market in India. The person who sold

goods to the investor will get USD in exchange of his good. What will he do now?

He will go to one of the commercial banks and get Indian Rupee in exchange of

the USD. The bank will submit the foreign currency to The RBI which will then

credit the bank equal amount of money in domestic currency. The foreign

exchange reserve of the RBI, at the same time, increases. But money supply in

domestic market has already increased due to this foreign exchange inflow. To

adjust this The RBI will sell out Government securities of an amount equal to the

foreign exchange inflow. Thus RBI with its monetary policy also protects domestic

economy from external shocks. If money supply suddenly rises in the domestic

market without any significant rise in the supply of goods and services, the price

of goods will rise. How? Well, because a sudden increase in money supply means

an increase in the purchasing power of individuals. So people will want to buy

more goods and services with that money. But supply of goods and services

havent increased. This means, more and more people are competing for this

limited amount of resources which in turn will increase the price of those

resources. This condition is more popularly known as inflation. On the other hand,

lack of money in market is called deflation. The RBI with its monetary policy

prevents such bad things from happening to Indian economy.


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As weve already observed, monetary policies of The RBI that are directed

to controlling inflation may, at times, interfere with the economic growth of the

country. Since advances made by commercial banks play a vital role in industrial

development, any monetary policy that hinders the circulation of money will

bring the industry to a momentary halt. Moreover, most of the economic agents

that play active roles in forming the market are beyond the jurisdiction of The RBI.

This limitation is often overcome by joint effort of RBI, SEBI and other related

authorities. The RBI also has a vital role in formation and implementation of

several policy initiatives taken by Government of India for the welfare of society

and agriculture


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CENTRAL

BANKING

Rupal Solanki

Roll no: 49

T.Y. BBI

M.M.K College

cental banking

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