Commercial Bank and Central Bank

What is Commercial Bank?

A commercial bank is a kind of financial institution which carries all the operations related to deposit and withdrawal of money for the general public, providing loans for investment, etc. These banks are profit-making institutions and do business only to make a profit.

The two primary characteristics of a commercial bank are lending and borrowing. The bank receives the deposits and gives money to various projects to earn interest (profit). The rate of interest that a bank offers to the depositors are known as the borrowing rate, while the rate at which banks lends the money is called the lending rate.

Function

The main functions of the commercial banks can be summed up in one sentence: the banks borrow to lend. To receive deposits and to advance loans are thus the two main functions of all commercial banks. They borrow in the form of deposits and lend in various types of advances.

Besides, there are other miscellaneous functions of commercial banks which have developed according to the needs of the society:

(a) Accepting Deposits:

The banks borrow in the form of deposits. This function is important because banks mainly depend on the funds deposited with them by the public.

The deposits received by the banks may be of the following types:

(i) Demand Deposits or Current Account Deposits:

If a depositor deposits money in the bank in the current account (i.e., demand deposits), he can withdraw it in part or in full at any time he likes without notice. These accounts are generally kept by businessmen whose require­ments of making business payments are quite uncertain. Usually no interest is paid on them, because the bank cannot utilise these short-term deposits for lending purposes and must keep almost cent per cent reserve against them.

But in return for these current account deposits, the banks offer some facilities or concessions to the account holders. The most important is the cheque facility made available to them, that is, the account holders make payment to the parties through cheques on these accounts. Further, on behalf of the holders of current account deposits, banks collect cheques, drafts, dividend warrants, postal orders, etc.

(ii) Fixed Deposits or Time Deposits:

These deposits are made for a fixed period of time, which varies from fifteen days to a few years. These deposits cannot, therefore, be withdrawn before the expiry of that period. However, a loan can be taken from the bank against the security of these deposits within that period. A higher rate of interest is paid on the fixed deposits. As the fixed deposits carry a good rate of interest, they are a good source of investment by the people who are in a position to save.

In India, the increase in the rates of interest on fixed deposits of various durations has attracted a good deal of savings in the banks. Since June, 1998, the interest on these deposits for 6 months and above but less than 1 year is 8 per cent, on deposits for one year and above is not regulated by RBI but varies from 9 per cent to 12 per cent depending on the period.

(iii) Savings Bank Deposits:

In this case the depositor can generally withdraw money usually once a week. Sometimes there are also restrictions as to the total amount that can be withdrawn at one time and the total amount that can be placed in one deposit. These deposits are generally made by the people of small means, usually, people with fixed salaries, for holding their short-term savings. Like the current account deposits, the saving bank deposits are payable on demand and also they can be drawn upon through cheques.

But in order to discourage people to use the savings bank deposits very frequently, there are some restrictions on the number of times withdrawals (through cheque or otherwise) that can be made from these accounts. The saving deposits carry lower rate of interest than the fixed deposits. At present in India interest on savings bank deposits in India is 3.5 per cent per annum.

(b) Advancing Loans:

Another function of the bank is to give loans to others. If the bank does not lend the deposited money to others, how can it pay the interest on the deposits to depositors? Banks give loans to businessmen and firms usually for short periods only. This is so because the bank must keep itself ready to meet the demands of the people who have deposited money for short period only. In advancing loans, the bank has to shoulder a heavy responsibility.

The bank makes profit by advancing loans. But the bank deals in other people’s money and it has to keep some ready cash to meet the depositors’ demands. Hence a great care has to be exercised in the matter of lending and keeping resources.

The bank must strike a fine balance between liquidity and profitability. If it keeps its assets in too liquid a form, it loses profit and if it tries to make too much profit, it may not be able to meet the depositor’s demand. It must aim at both liquidity and profitability.

Banks advance loans in the following ways:

(i) By allowing an overdraft:

Those people who keep current account with the banks are sometimes given the right to overdraw their accounts. In other words, people make arrangements with the banks that if a cheque has been drawn by them which is not covered by the deposit, then the bank should grant the overdraft and honour the cheque.

Thus under overdraft arrange­ments, people can get more than they have deposited but they have to pay interest on the extra amount which has to be paid back within a short period. Overdraft facilities are generally granted to businessmen who can pay off the money after the sale of the goods.

(ii) Cash-Credit Loan:

Under the cash-credit system, borrower is sanctioned a credit limit up to which he can borrow from the bank. But before granting a credit limit the bank satisfies itself about the credit-worthiness of the borrower. However the actual utilisation of the credit limit by the borrower depends on his withdrawing power.

Withdrawing power of a borrower is determined by his current assets which consists of stocks of goods, that is, stocks of raw ma­terials, semi-finished goods and his bargaining power. The interest payable by the borrower is a calculated on the amount of the credit limit actually drawn.

(iii) Demand Loans:

Demand loans granted by a bank are those loans which can be recalled on demand by the bank any time. The entire sum of a demand loan granted to a borrower is paid in lump sum by crediting it to his account. Therefore, the interest is payable on the entire sum of the demand loan granted. Demand loans are usually granted to stock-brokers whose need for credit fluctuates from day to day.

(c) Discounting Bills of Exchange or Hundies:

A very important function of a modern bank is to discount bills or hundies of businessmen. It is like this, a businessman buys goods and is granted credit, say, for a month. The seller of the goods draws a bill of exchange which the purchaser is asked to sign.

The bill orders the purchaser to pay a certain sum after the expiry of one month. If the seller goes on selling goods on this basis, he will soon find that all his stock is gone and he has got only these hundies in his cash box.

Unless these hundies are changed into cash, his business will come to a standstill. He, therefore, does not keep these hundies with him till they mature for payment. But he takes them to the bank and gets the present worth of the hundies, leaving the bank to realise them when the date of payment comes. This is called discounting a bill. It is obvious that the bank has advanced money to the businessman for the period of the currency of the bill.

Bill discounting is considered a very suitable investment for a bank. The bills are certain to be paid on maturity. They can be rediscounted with the central bank, if necessary. They set up a regular flow of incomings and outgoings of cash. Being negotiable instruments, the bills do not create any difficulty at the time of payment and do not involve the bank in any litigation.

It represents a short-term investment, which suits the bank very well because most of its deposits are also of short term. For all these reasons this form of advance represents the most suitable investment from the bank’s point of view. That is why it is sometimes remarked that a good banker knows the difference between a bill and a mortgage.

(d) Transfer of Money:

Banks transfer money from one place to another for their customers. Banks remit the funds of the people by means of a bank draft or a cheque. This is a cheap as well as safe method of transferring money from one place to another.

(e) Miscellaneous Functions:

A bank now-a-days serves its customers in various other ways. It has lockers or ‘safe deposit vaults’. They are meant to keep the valuables of customers in safe custody. Further, a bank collects interest on behalf of its customers as well as pays dividends on behalf of joint-stock companies. It purchases and sells stocks and shares of companies for its clients. It pays insurance premium on behalf of their customers from their deposits. It executes the wills of deceased customers and acts for them as a trustee.

From the above discussion it follows that these days the functions of banks are many and varied. Banks are not merely the traders of money but they are also the manufacturers of money. In other words, they not only deal in money, i.e., borrow and lend money but also manufacture or make money. They create money through credit creation. Bank deposits these days are as much money as any other form of money.

What is Central Bank?

Central bank is an apex institution in the banking system. The main objective of the Central bank is to control, regulate and stabilise the banking and monetary structure of the country. India’s Central bank is the Reserve Bank of India which was set up in 1935. The Central bank has no direct link with the public. The Central bank is the bankers’ bank. It is also the banker to the government.

Function

The main function of a central bank is to act as governor of the machinery of credit in order to secure stability of prices.

It regulates the volume of credit and currency, pumping in more money when the market is dry of cash, and pumping out money when there is an excess of credit.

In India RBI have two departments, namely. Issue department and Banking department.

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We discuss below its main functions:

1. Issue of Currency:

The central bank is given the sole monopoly of issuing currency in order to secure control over volume of currency and credit. These notes circulate throughout the country as legal tender money. It has to keep a reserve in the form of gold and foreign securities as per statutory rules against the notes issued by it.

It may be noted that RBI issues all currency notes in India except one rupee note. Again, it is under the directions of RBI that one rupee notes and small coins are issued by government mints. Remember, the central government of a country is usually authorised to borrow money from the central bank.

When the central government expenditure exceeds government revenue and the government is unable to reduce its expenditure, then it borrows from the RBI. This is done by selling security bills to RBI which creates new currency notes for the purpose. This is called monetisation of budget deficit or deficit financing. The government spends new currency and puts it into circulation to meet its expenditure.

2. Banker to Government:

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Central bank functions as a banker to the government—both central and state governments. It carries out all banking business of the government. Government keeps their cash balances in the current account with the central bank. Similarly, central bank accepts receipts and makes payment on behalf of the governments.

Also, central bank carries out exchange, remittance and other banking operations on behalf of the government. Central bank gives loans and advances to governments for temporary periods, as and when necessary and it also manages the public debt of the country. Remember, the central government can borrow any amount of money from RBI by selling its rupees securities to the latter.

3. Banker’s Bank and Supervisor:

There are usually hundreds of banks in a country. There should be some agency to regulate and supervise their proper functioning. This duty is discharged by the central bank.

Central bank acts as banker’s bank in three capacities:

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(i) It is the custodian of their cash reserves. Banks of the country are required to keep a certain percentage of their deposits with the central bank; and in this way the central bank is the ultimate holder of the cash reserves of commercial banks, (ii) Central bank is lender of last resort. Whenever banks are short of funds, they can take loans from the central bank and get their trade bills discounted. The central bank is a source of great strength to the banking system, (iii) It acts as a bank of central clearance, settlements and transfers. Its moral persuasion is usually very effective so far as commercial banks are concerned.

4. Controller of Credit and Money Supply:

Central bank controls credit and money supply through its monetary policy which consists of two parts—currency and credit. Central bank has monopoly of issuing notes (except one-rupee notes, one-rupee coins and the small coins issued by the government) and thereby can control the volume of currency.

The main objective of credit control function of central bank is price stability along with full employment (level of output). It controls credit and money supply by adopting quantitative and qualitative measures as discussed in Section 8.25. Following three quantitative measures of credit control by RBI are recalled for ready reference.

Instruments of money policy:

(i) Bank Rate (02009, 10C):

This is the rate of interest at which the central bank lends to commercial banks. It is, in a way, cost of borrowing. Cheap credit promotes investment whereas dear money discourages it. In a situation of excess demand and inflationary pressure, central bank increases the bank rate. High bank rate forces the commercial banks to raise, in turn, the rate of interest which makes credit dear. As a result, demand for loans and other purposes falls.

Thus, increase in bank rate by the central bank adversely affects credit creation by commercial banks. A decrease in bank rate will have the opposite effect. At present (Feb., 2013), bank rate (also called repo rate, i.e. the rate at which banks borrow from RBI) is 7.75% and Reverse Repo Rate (rate at which banks park their surplus funds with RBI) is 7.0%.

(ii) Open Market Operations:

These refer to buying and selling of government securities by central bank to public and banks. This is done to influence money supply in the country. Mind, sale of government securities to commercial banks means flow of money into the central bank which reduces cash reserves. Consequently, credit availability of commercial banks is curtailed / controlled. When central bank buys securities, it increases cash reserves of the banks and their ability to give credit.

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(iii) Cash Reserve Ratio (CRR):

Commercial banks are required under the law to keep a certain percentage of their total deposits with the central bank in the form of cash reserves. This is called CRR. It is a powerful instrument to control credit and lending capacity of the banks. Presently (Feb., 2013), CRR is 4.0%.

To curtail the credit giving capacity of the banks, central bank raises the CRR but when it wants to enhance the credit giving powers of the bank, it reduces the CRR. Similarly, there is another measure called Legal Reserve Ratio (A2012)—LRR which has two components—CRR and SLR. According to Statutory Liquidity Ratio or SLR, every bank is required to keep a fixed percentage (ratio) of its assets in cash called liquidity ratio. SLR is raised to reduce the ability of the banks to give credit. But SLR is reduced when the situation in the economy demands expansion of credit.

5. Exchange Control:

Another duty of a central bank is to see that the external value of currency is maintained. For instance, in India, the Reserve Bank of India takes steps to ensure external value of a rupee. It adopts suitable measures to attain this object. The exchange control system is one such measure.

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Under exchange control system, every citizen of India has to deposit with the Reserve Bank of India all foreign currency or exchange that he receives. And whatever foreign exchange he might need has to be secured from the Reserve Bank by making an application in the prescribed form.

6. Lender of Last Resort:

When commercial banks have exhausted all resources to supplement their funds at times of liquidity crisis, they approach central bank as a last resort. As lender of last resort, central bank guarantees solvency and provides financial accommodation to commercial banks (i) by rediscounting their eligible securities and bills of exchange and (ii) by providing loans against their securities. This saves banks from possible failure and banking system from a possible breakdown. On the other hand, central bank, by providing temporary financial accommodation, saves the financial structure of the country from collapse.

7. Custodian of Foreign Exchange or Balances:

It has been mentioned above that a central bank is the custodian of foreign exchange reserves and nation’s gold. It keeps a close watch on external value of its currency and undertakes exchange management control. All the foreign currency received by the citizens has to be deposited with the central bank; and if citizens want to make payment in foreign currency, they have to apply to the central bank. Central bank also keeps gold and bullion reserves.

8. Clearing House Function:

Banks receive cheques drawn on the other banks from their customers which they have to realise from drawee banks. Similarly, cheques on a particular bank are drawn and passed into the hands of other banks which have to realise them from the drawee banks. Independent and separate realisation to each cheque would take a lot of time and, therefore, central bank provides clearing facilities, i.e., facilities for banks to come together every day and set off their chequing claims.

9. Collection and Publication of Data:

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It has also been entrusted with the task of collection and compilation of statistical information relating to banking and other financial sectors of the economy.

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