Core Economic Concepts: Banking & Credit Creation
Money and banking are complementary. Banks act as financial intermediaries accepting public deposits, creating credit through fractional reserves, and fueling economic activities.
Meaning of Bank, Banking & Primary Functions
Formal Definitions
A Bank is an institution that accepts money from the public as deposits and advances loans to borrowers.
Banking refers to accepting deposits of money from the public for the purpose of lending or investment, payable on demand or otherwise, withdrawable by cheque, draft, order, or otherwise.
3 Primary Functions of a Bank:
1. Accepting Deposits: Opens individual accounts, issues cheques, pays interest.
2. Giving Loans: Advances funds for expensive consumer goods (TV, car, house) or business expansion.
3. Keeping Valuables: Provides safe locker facilities for jewelry and property documents.
Practical Banking Operations
- • Account Opening: Bank assigns a unique account number to record deposits and cash withdrawals.
- • Cheque Books: Issued to depositors to withdraw cash or transfer funds seamlessly without physical currency.
- • Borrowing & Repayment: Borrowers get funds today based on their verified future repayment capability.
Meaning of Credit & Primary vs. Secondary Deposits
Credit is defined as the claim to receive payments in the future. Credit creation occurs through the dual acts of lending and borrowing, expanding total bank deposits far beyond initial cash receipts.
Primary Deposit
The initial deposit created when a customer deposits physical cash directly into a bank account.
Secondary Deposit
The deposits created automatically as a result of loans sanctioned by the bank in successive lending rounds.
Process of Credit Creation & Multiplier Formula
Banks know from experience that depositors do not withdraw all their cash at once. Thus, banks keep a fraction called the Cash Reserve Ratio (CRR) as cash reserves and lend out the remaining surplus.
Example: With Initial Deposit = ₹100 and CRR = 20% (0.2): Total Credit = \(100 \times \frac{1}{0.2} = ₹500\).
Textbook Numerical Schedule (Initial Deposit = ₹100, CRR = 20%)
| Round / Step | Increase in Deposit (₹) | Cash Reserve (20%) (₹) | Loan Sanctioned (80%) (₹) |
|---|---|---|---|
| Step 1 (Person A) | ₹ 100.00 | ₹ 20.00 | ₹ 80.00 |
| Step 2 (Person B) | ₹ 80.00 | ₹ 16.00 | ₹ 64.00 |
| Step 3 (Person C) | ₹ 64.00 | ₹ 12.80 | ₹ 51.20 |
| Step 4 | ₹ 51.20 | ₹ 10.24 | ₹ 40.96 |
| Step 5 | ₹ 40.96 | ₹ 8.19 | ₹ 32.77 |
| Total (End Condition) | ₹ 500.00 | ₹ 100.00 | ₹ 400.00 |
4 Major Types of Banks in India
1. Reserve Bank of India (RBI)
Apex Central BankHeadquartered in Mumbai. Regulates all Indian banks. Issues currency notes (₹2, ₹5, ₹10, ₹50, ₹100, ₹500, ₹1000) bearing Governor's signature. Acts as banker to central & state governments.
2. Commercial Banks
Profit-MotivatedAccept deposits and grant loans to general public/businesses to earn profit via interest rate spreads and service fees.
• Public Sector: SBI, PNB, Bank of India, Canara Bank, Bank of Baroda, Indian Bank.
• Private Sector: ICICI Bank, HDFC Bank, Yes Bank.
3. Cooperative Banks
Cooperative LawsRun by cooperative societies under state laws. Divided into Agricultural (rural) and Non-agricultural (urban).
• Rural/Agri: Credit for farming, cattle, fishery (e.g. PACS, District Central Coop).
• Urban/Non-Agri: Self-employment, small industry, durables, personal finance.
4. Development Banks
Long-Term CapitalProvide long-term credit to private companies and public sector undertakings to set up industries and build infrastructure.