Functions of Central Bank and Credit Control Methods, Functions of Commercial Banks and methods of credit creation

 Central Bank: The Apex Body of Financial Regulation

A Central Bank, the apex body in charge of controlling, operating, regulating, and directing a country's banking and monetary structure, holds a unique and critical position in the financial landscape. It is essential to note that each country typically has only one Central Bank, which plays a pivotal role in shaping the nation's economic policies and ensuring financial stability. Developed countries, such as the UK with the Bank of England and India with the Reserve Bank of India (RBI), boast their respective Central Banks.

The Establishment of the Reserve Bank of India

The Reserve Bank of India (RBI), often referred to as the Central Bank of India, was established on April 1, 1935, under the Reserve Bank of India Act, 1934. Since its inception, the RBI has been at the forefront of managing India's monetary and financial system, carrying out various vital functions.

Functions of the Reserve Bank of India

1. Currency Authority (Bank of Issue): The RBI holds the exclusive authority to issue currency in India, with the exception of one rupee notes and coins, which are issued by the Ministry of Finance. The currency issued by the RBI represents its monetary liability and is backed by assets such as gold coins, foreign securities, domestic government's local currency securities, and gold bullions. This backing instills public confidence in the value of the paper currency and its stability.

   Advantages of Sole Authority of Note Issue with RBI:

   • Ensures uniformity in note circulation
   • Upholds public faith in the currency system
   • Stabilizes internal and external currency value
   • Empowers the Central Bank to influence money supply in the economy as currency is in public circulation
   • Facilitates government supervision and control over note issuance, ensuring responsible financial management.

2. Banker to the Government: The RBI functions as a banker, agent, and financial advisor to both the Central Government and State Governments, including Union Territories like Puducherry and Jammu and Kashmir. In its capacity as a banker, the RBI handles various banking operations of the government.

   The role of RBI as a banker to the government includes:

   • Maintaining current accounts to manage cash balances of the Central and State Governments
   • Processing receipts and payments for the government, including exchange and remittance services
   • Providing loans and advances to the government for temporary financial requirements, with the government issuing treasury bills in exchange for funds, a process known as Deficit Financing or Monetizing the Government's Debt.
   • As an agent, the RBI is responsible for managing public debt on behalf of the government.
   • The RBI also offers financial advice to the government on matters related to finance, monetary policies, and the broader economy.

3. Banker's Bank and Supervisor: Being the apex bank, the RBI plays a pivotal role as the banker to other banks operating within the country, similar to the relationship between commercial banks and the general public.

   Functions of RBI as the banker's bank include:

   • Custodian of Cash Reserves: Commercial banks are required to maintain a certain portion of their deposits as Cash Reserve Ratio (CRR) with the RBI. By holding these reserves, the RBI acts as a custodian of cash for the banks.
   • Lender of the Last Resort: When commercial banks face financial difficulties and cannot secure funds from other sources, they can approach the RBI for loans and advances as the lender of the last resort. The RBI provides this assistance by discounting approved securities and bills of exchange.
   • Clearing House: With the RBI holding the cash reserves of all commercial banks, it conveniently serves as a clearinghouse, enabling banks to settle their claims against each other through credit and debit entries in their respective accounts.

   RBI's role as a supervisor of commercial banks includes:

   • Regulating and overseeing various aspects of commercial bank operations, such as branch expansion, licensing, management, mergers, liquidity of assets, and winding up.
   • Conducting periodic inspections and reviewing returns filed by commercial banks to ensure compliance with established guidelines.

   Advantages of Centralised Cash Reserves with the Central Bank:

   • Effective utilization of the country's cash reserves.
   • Central bank's control over credit creation by commercial banks through adjustments in cash reserve requirements.
   • Reinforcement of public confidence in the strength of the country's banking system.
   • Availability of financial assistance to commercial banks during temporary difficulties.
   • However, this system is not favored by commercial banks as it reduces their liquid funds and offers no interest on reserves.

4. Controller of Money Supply and Credit: The RBI holds a monopoly on the issuance of currency, granting it the power to control money supply and credit during economic fluctuations.

   Methods of credit control used by RBI:

   • Repo (Repurchase) Rate: The rate at which the RBI lends money to commercial banks for short-term financial needs. An increase in the repo rate leads to higher borrowing costs for banks, resulting in increased lending rates to borrowers, thus reducing credit availability.
   • Reverse Repo Rate: The rate at which the RBI borrows money from commercial banks. An increase in the reverse repo rate encourages banks to lend more to the RBI, thereby reducing money supply in the economy.
   • Bank Rate (or Discount Rate): The rate at which the RBI lends money to commercial banks for long-term financial needs. An increase in the bank rate impacts credit in the same way as the repo rate.
   • Open Market Operations (OMO): The RBI buys and sells government securities in the open market to influence commercial banks' reserves. Selling securities reduces commercial banks' reserves, leading to decreased credit creation, while purchasing securities increases their reserves, facilitating credit creation.

   Legal Reserve Requirements (Variable Reserve Ratio Method): Commercial banks are obligated to maintain reserves in the form of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). By altering these ratios, the RBI controls credit creation. An increase in the ratios reduces credit creation, and vice versa.

   Margin Requirements: The difference between the loan amount and the market value of the security offered by the borrower against the loan is known as the margin requirement. By changing margin requirements, the RBI influences the loan amount granted by commercial banks against securities.

5. Custodian of Foreign Exchange Reserves: The RBI acts as the custodian of the country's foreign exchange reserves and gold stock, granting it reasonable control over foreign exchange transactions. All foreign exchange transactions must be routed through the RBI, ensuring a coordinated policy towards the nation's balance of payment situation and the stability of the currency's external value.

Other Instruments of Credit Control:

1. Moral Suasion: The RBI uses persuasion and pressure, referred to as moral suasion, to influence commercial banks' behavior and align them with the Central Bank's credit policies. This is achieved through letters, discussions, hints, and speeches. Commercial banks often cooperate as the RBI serves as their lender of last resort, but no punitive actions are taken if banks do not follow the RBI's advice.

2. Selective Credit Controls: The RBI employs this instrument to direct commercial banks on granting or withholding credit for specific sectors or purposes. It can be used positively to channelize credit towards priority sectors like exports, agriculture, and small-scale industries, or negatively to restrict credit flow to certain sectors.

Conclusion

In conclusion, a Central Bank, exemplified by the Reserve Bank of India, holds a crucial position in a country's financial system. Through its multifaceted functions, the Central Bank exercises significant influence over currency issuance, government finances, commercial banks' operations, credit creation, and foreign exchange reserves. By employing various quantitative and qualitative credit control methods, the Central Bank strives to maintain monetary stability, foster economic growth, and ensure the overall well-being of the country's financial ecosystem.

Credit control refers to the measures taken by the Reserve Bank of India (RBI) to manage the amount of money banks can lend to borrowers. It helps regulate the flow of credit in the economy and influences economic activity. There are two main types of credit control methods used by the RBI:

1. Quantitative Credit Control: This method aims to control the overall amount of credit available in the economy. It includes three tools:

(a) Bank Rate: The RBI sets a minimum rate at which it lends money to commercial banks. When this rate is increased, borrowing becomes more expensive for banks, so they lend less money to businesses and individuals. This reduces the overall credit in the economy and helps control inflation.

(b) Open Market Operations: The RBI buys and sells government securities in the market. When it buys securities, it puts more money into circulation, leading to more credit availability. When it sells securities, it takes money out of circulation, reducing credit availability.

(c) Variable Reserve Ratio (VRR): Commercial banks are required to keep a certain percentage of their deposits as reserves with the RBI. If the reserve ratio is increased, banks have less money to lend, which restricts credit. Conversely, if the reserve ratio is reduced, banks have more money to lend, increasing credit availability.

2. Qualitative Credit Control: This method focuses on directing credit to specific sectors and controlling its use. It involves various tools:

(a) Varying Margin Requirements: When banks lend against securities, they keep a margin (difference between the security's value and the loan amount). The RBI can increase or decrease this margin, which affects the amount banks can lend. A higher margin reduces lending, while a lower margin increases it.

(b) Regulation of Consumer's Credit: RBI can control the credit given to consumers for purchasing durable goods like cars and appliances. It sets rules on down payments, maximum loan duration, and specific goods covered by credit.

(c) Control through Directives: The RBI can issue instructions to banks on credit allocation. This guides banks to lend more to certain sectors or discourage lending to others.

(d) Rationing of Credit: In some cases, RBI may limit the amount of credit each bank can lend. This prevents excessive lending and promotes responsible credit distribution.

(e) Direct Action and Moral Suasion: In extreme situations, the RBI may directly intervene by refusing credit facilities to banks or using moral persuasion to encourage responsible lending.

By using these credit control measures, the RBI aims to maintain price stability, control inflation, and support the overall health of the economy.

A Commercial Bank is an institution that provides services like accepting deposits, giving loans, and making investments to earn profits. It plays a vital role in the economy by acting as a middleman between people who save money and those who need money for productive purposes.

Primary Functions of Commercial Banks:

1. Accepting Deposits: Commercial banks accept various types of deposits from customers, including current account deposits for everyday transactions, fixed deposits for a specific period, and savings deposits that offer some interest but with restrictions on withdrawals.

2. Advancing Loans: Banks lend the money collected from deposits to individuals and businesses in the form of cash credit, demand loans, and short-term loans. They charge interest on these loans, which is a major source of their income.

Secondary Functions of Commercial Banks:

1. Overdraft Facility: Banks allow customers to withdraw more money than what is available in their current account up to a certain limit, known as an overdraft facility. Customers pay interest on the extra amount withdrawn.

2. Discounting Bills of Exchange: Banks offer a service where they buy bills of exchange from customers before their maturity date and pay the amount after deducting a commission.

3. Agency Functions: Banks provide services like fund transfer, collection and payment of various items, purchase and sale of foreign exchange, and underwriting securities on behalf of their customers.

4. General Utility Functions: Commercial banks offer services such as locker facilities, traveler's cheques, letter of credit, and income tax consultancy to assist customers in various financial matters.

Importance of Commercial Banks:

1. Assisting Consumers: Banks provide credit to consumers for buying durable goods, boosting demand for products.

2. Finance and Credit Source: They are crucial for industries and trade, providing necessary funds for growth and expansion.

3. Capital Formation: Encouraging savings and channeling them to productive investments leads to capital formation and economic development.

4. Balanced Regional Development: By opening branches in backward areas, commercial banks promote balanced regional growth by making credit accessible to rural communities.

5. Promoting Entrepreneurship: Banks support new ventures, helping entrepreneurs by providing financial assistance and underwriting securities.

Commercial banks play a significant role in the economy by mobilizing savings and providing credit to stimulate growth and development in various sectors.

Credit creation is the process by which commercial banks create new money through lending. When banks issue loans, they effectively create new deposits in the borrower's account, which can then be used as money to make payments or withdraw cash. There are two primary methods of credit creation:

1. Fractional Reserve Banking: Fractional reserve banking is the foundation of credit creation. When a bank receives deposits from its customers, it is required to keep only a fraction of those deposits as reserves (cash or deposits with the central bank). The remaining amount is considered excess reserves, which the bank can use to extend loans.

For example: Let's assume Bank X has a reserve requirement of 10% and receives a deposit of $1,000 from a customer. The bank is required to keep $100 (10% of $1,000) as reserves and can lend out the remaining $900.

Now, the borrower uses the $900 to make a purchase from another person, who deposits the money into Bank Y. Bank Y also keeps 10% ($90) as reserves and lends out the remaining $810. This cycle continues, leading to multiple rounds of credit creation.

2. Credit Multiplier: The credit multiplier is a concept that describes the expansion of credit beyond the initial deposit due to the reserve requirement. It is calculated as the reciprocal of the reserve ratio. The formula for the credit multiplier is:
3. Credit Multiplier = 1 / Reserve Ratio
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5. Using the example above, where the reserve ratio is 10% (0.10), the credit multiplier would be:
6. Credit Multiplier = 1 / 0.10 = 10
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8. This means that for every $1 deposited in the banking system, $10 of credit can be created through lending.
9. It is important to note that credit creation is constrained by the reserve requirement set by the central bank. If the central bank increases the reserve ratio, banks can create less credit as they need to hold more reserves. Conversely, if the reserve ratio is decreased, banks can create more credit with the same amount of reserves.
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11. Overall, credit creation plays a crucial role in the expansion of the money supply and stimulating economic activity. However, it is essential for central banks to monitor and regulate credit creation to maintain financial stability and control inflationary pressures.

Limitations of Credit Creation The following are some of the limitations that are experienced by the commercial banks during the credit creation process. 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. 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. 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. 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. 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. 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. Conditions Essential for Credit Creation The following conditions are essential for credit creation in an economy. Willingness of public depositing money into the commercial banks Willingness of commercial banks to lend money to individuals or businesses in the form of credit Willingness of individuals or businesses in seeking money from the commercial banks in the form of credit .