Banking is an important pillar for the Indian Economy, prospective UPSC candidates need to grasp the significance and practical usage of these fundamental concepts since inquiries regarding this static segment of the UPSC Syllabus can arise in both the UPSC Prelims and Mains exams.
Meaning
Banks, as financial institutions, accept deposits from the public, which are termed as the deposit rate, and lend money at a higher rate known as the lending rate.
Various classifications exist for banks in India, including:
- Central Bank
- Cooperative Banks
- Commercial Banks
- Regional Rural Banks (RRBs)
- Local Area Banks (LABs)
- Specialized Banks
- Small Finance Banks
- Payments Banks
Functions of Banks:
Secure Depository Services:
Banks offer a secure environment for individuals and businesses to deposit their funds, providing easy access to withdrawals when necessary.
Financial Assistance and Loans:
Banks extend loans to both individuals and businesses for a variety of purposes such as home purchases, business expansions, or personal financing needs.
Facilitation of Transactions:
Banks facilitate transactions through diverse payment methods including checks, debit/credit cards, and electronic transfers, ensuring smooth financial transactions for their customers.
Foreign Currency Exchange:
Many banks provide foreign exchange services, allowing customers to buy, sell, or exchange foreign currencies conveniently.
Safe Storage Solutions:
Banks offer safe deposit boxes for customers to securely store valuable items and documents, ensuring peace of mind for their clients.
Investment Opportunities:
Banks offer a range of investment products such as mutual funds, stocks, and bonds, enabling customers to grow their wealth through diverse investment avenues.
Convenient Banking Solutions:
Banks provide online and mobile banking services, offering customers easy access to their accounts, bill payments, and fund transfers, enhancing overall banking convenience.
Central Bank of India
In India, the Reserve Bank of India, established in 1935, fulfills this role, safeguarding the nation’s economic sovereignty and financial stability.
Functions of Central Bank:
Role as Currency Authority or Note Issuer:
Central banks have the exclusive authority to issue currency within an economy, ensuring uniformity and balanced supply of money.
Government’s Financial Partner:
Central Bank serve as the government’s financial institution, handling deposits, fund allocation, and financial transactions.
Custodian of Cash Reserves:
Central banks serve as the repository for cash reserves held by commercial banks, facilitating liquidity management and influencing credit creation policies.
Management of International Currency Reserves:
Central banks maintain reserves of foreign currency to manage emergency needs and balance of payments deficits.
Provider of Last Resort Lending:
Central banks act as lenders of last resort, providing financial support to member banks during periods of cash shortages to prevent economic instability.
Facilitator of Interbank Clearing and Settlement:
Central banks operate as clearing houses for commercial banks, facilitating the settlement of interbank transactions.
Credit Control Authority:
Central banks regulate credit creation by commercial banks, employing measures like open market operations or reserve requirement adjustments to manage inflation and economic stability.
Role of Banks and Credit Creation:
Central banks oversee the circulation of currency and ensure an adequate money supply for transactions within the economy. However, the actual implementation of this process relies on commercial banks and their ability to create credit.
Each bank collects deposits from its customers and utilizes these funds to extend loans to other individuals or businesses. It is mandatory for banks to reserve a fraction of these deposits as a precautionary measure.
Banks maintain only a portion of deposits in reserves because it is anticipated that not all customers will request withdrawals simultaneously. This practice enables banks to retain a fraction of the funds and lend out the remainder. If every depositor sought to withdraw funds simultaneously, banks would be compelled to retain the entire deposit rather than just a fraction.
Formula for Calculating Credit Creation
Formula for Calculating Credit Creation
Credit creation can be determined using the formula:
Total credit creation = Original deposit ✕ Credit multiplier coefficient, where the credit multiplier coefficient equals 1 divided by the cash reserve requirement (CRR).
Impact of CRR on Credit Creation
The CRR set by the central bank affects credit creation. A lower CRR leads to higher credit creation, while a higher CRR results in lower credit creation.
Prerequisites for Credit Creation
Several conditions must be met for effective credit creation, including the willingness of the public to deposit money into banks, banks’ readiness to lend, and the demand for credit from individuals and businesses.
Monetary policy is an economic strategy utilized to control the size and expansion rate of the money supply within an economy. It serves as mechanism for regulating key macroeconomic indicators like inflation and unemployment. The formulation of these policies falls under the jurisdiction of the central bank or a comparable regulatory body.
Objectives of Monetary Policy by Reserve Bank:
Inflation Management
Monetary policies aim to manage inflation rates within the economy. It is generally preferable to maintain low inflation levels for economic health. When inflation is high, contractionary policies may be implemented to address this issue.
Learn more about for inflation from here.
Unemployment Control
Monetary policies also have the capacity to influence unemployment levels. For instance, the implementation of an expansionary monetary policy typically reduces unemployment by boosting the money supply, which stimulates business activities and leads to job market expansion
Currency Exchange Rate Regulation
Through its regulatory authority, the central bank can manage exchange rates between domestic and foreign currencies. For example, by increasing the money supply through currency issuance, the central bank can lower the value of the domestic currency relative to foreign currencies, thus affecting exchange rates.
Tools of Monetary Policy used by Reserve Bank:
Statutory Liquidity Ratio (SLR)
SLR refers to the minimum percentage of deposits that commercial banks are required to maintain in the form of liquid cash or other securities.
Cash Reserve Ratio (CRR)
CRR mandates that commercial banks maintain a certain portion of their total deposits as liquid cash reserves.
Repo Rate
Repo rate signifies the interest rate at which commercial banks borrow funds from the Reserve Bank of India (RBI).
Reverse Repo Rate
Reverse repo rate indicates the interest rate at which the RBI borrows funds from commercial banks to manage liquidity in the market.
Open Market Operations (OMO)
OMO involves the simultaneous buying and selling of government securities and treasury bills by the RBI.
Bank Rate (Discount Rate)
The bank rate, also known as the discount rate, refers to the interest rate at which commercial banks borrow funds from the central bank.
Marginal Cost of Fund Based Lending
The Marginal Cost of Funds based Lending Rate (MCLR) is the minimum interest rate at which a bank is authorized to lend, supplanting the previous base rate mechanism used by commercial banks to determine lending rates.
Learn about Money and Money Supply for UPSC from here.