Introduction to Banking Unit 2 Function of Bank

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Introduction to Banking Unit 2 Function of Bank

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Function of Bank



1. Which of the following is not a function of a Bank?

(a) To accept deposits.

(b) To waive loans.

(c) To grant advances.

(d) To supply input to farmers.

Ans: (b) To waive loans.

2. Which bank is called lender of last resort?

(a) Commercial bank.

(b) Agricultural bank.

(c) Industrial bank.

(d) Central bank.

Ans: (d) Central bank.

3. Which bank is known as banker’s bank?

(a) RBI.

(b) SBI.

(c) PNB.


Ans: (d) NABARD.

4. What is the primary function of a bank?

(a) Accepting Deposits.

(b) Fixed Deposits.

(c) Current Deposits.

(d) Savings Deposits.

Ans: (a) Accepting Deposits.

5. What is India’s most recent commercial bank?

(a) Axis Bank.

(b) AU Small Finance Bank.

(c) HDFC Bank.

(d) IDFC First Bank.

Ans: (d) IDFC First Bank.

6. Function of a clearing house is to.

(a) Control Credit.

(b) Rediscount Bills.

(c) Monitor loans.

(d) Clear cheques of member banks.

Ans: (d) Clear cheques of member banks.

7. Clearing House reduces the amount of.

(a) Plastic money.

(b) Gold and Silver.

(c) Credit Instruments.

(d) Currency.

Ans: (d) Currency.

8. Banks usually act as custodian of customer’s.

(a) Property.

(b) Valuables.

(c) Business.

(d) Cash.

Ans: (d) Cash.

9. A bill of exchange is usually accepted by:

(a) Buyer.

(b) Banker.

(c) Central Bank.

(d) Seller.

Ans: (a) Buyer.

10. Following is not a method of selective credit control.

(a) Legislation.

(b) Rationing of Credit.

(c) Publicity.

(d) Direct action.

Ans: (b) Rationing of Credit.

(B) Fill in the Blanks:

1. Central Banks advance loans to Commercial Banks by______.

Ans: Rediscounting bills of exchange.

2. Central Bank is Banker’s Bank because it ______.

Ans: Rediscounts bills.

3. ________ is not a credit instrument.

Ans: Prize Bond.

4. _________ is used as a measure of credit control.

Ans: Bank Rate.

5. Monopoly of Note issue is a characteristic of _______.

Ans: Central Bank.

6. A bill of exchange can be cashed from the bank before maturity by _______.

Ans: discounting bill.

7. Clearing House is managed and supervised by _______.

Ans: Central bank.

8. Which bank is known as banker’s bank _______ ?

Ans: RBI.

9. ______________ is a credit facility granted by commercial banks to current account holders.

Abs: e.

10. Currency notes are issued by _______.

Ans: RBI.


1. Which bank can issue notes?

Ans: The Reserve Bank.

2. What is issue of bank?

Ans: The central bank is the bank of issue. It has a monopoly of note issue. Notes issued by it circulate as legal tender money. It has its issue department which issues notes and coins to commercial banks. Coins are manufactured in the Government mint but they are put into circulation through the central bank.

3. What is soiled note?

Ans: Soiled notes are those which have become dirty and slightly cut. Notes which have numbers on two ends, i.e. notes in the denomination of Rs. 10 and above which are in two pieces, are also treated as soiled note. The cut in such notes, should, however, not have passed through the number panels.

4. Why is central bank known as the lender of last resort?

Ans: The Central Bank can act as a lender of last resort to prevent the government from suffering a liquidity shortage and failing to meet is short-term spending commitments. Then the government would fail to sell sufficient bonds on this particular auction; this would cause a temporary shortage of money for the government.

5. Are bank notes a liability?

Ans: A promissory note (IOU) that you signed would be your liability, but it would be an asset for the note’s holder or owner. Similarly, a bank deposit is a liability for the bank but an asset for the depositor.

6. What is lender of last resort in banking?

Ans: A lender of last resort is whoever you turn to when you urgently need funds and you’ve exhausted all your other options. Banks typically turn to their lender of last resort when they cannot get the funding they need for their daily business. In situations like that, central banks act as the lender of last resort.

7. State the meaning of Banker’s clearing house.

Ans: As the custodian of the cash reserves of the commercial banks, the Central Bank acts as the clearing house for these banks. Since all banks have their accounts with the central bank, the central bank can easily settle the claims of various banks.

8. Name the primary functions of a bank.

Ans: The two primary functions of a bank are:

(i) Acceptance of deposits, and.

(ii) Advancing of loans.

9. What are the primary functions of a commercial bank?

Ans: The primary functions of a commercial bank are accepting deposits and also lending funds. Deposits are savings, current, or time deposits. Also, a commercial bank lends funds to its customers in the form of loans and advances, cash credit, overdraft and discounting of bills, etc.

10. What are the secondary functions of a commercial bank?

Ans: The secondary functions of a commercial bank are acting as an agent to its customers and also providing general utility services.

11. What is the most important function of a Bank?

Ans: The most important function of a bank is to collect deposits from the public and lend those deposits for the development of business, agriculture, trade and commerce.

12. What is cash credit?

Ans: A cash credit is an arrangement through which a banker permits his customer having current account to borrow money upto certain limit against an agreement supported by a bond of credit against securities.

13. What is Loan?

Ans: Loan is an advance in a lump sum amount the whole of which is withdrawn and is supposed to be repaid generally wholly at one time.

14. What is overdraft?

Ans: An overdraft is an arrangement by which the customer is allowed to overdraw his account. It is granted against some collateral securities. The facility to overdraw is allowed through a current account only. Interest is charged on the exact amount overdrawn subject to the payment of a minimum amount by way of interest.

15. State the meaning of Banker’s clearing house.

Ans: As the custodian of the cash reserves of the commercial banks, the Central Bank acts as the clearing house for these banks. Since all banks have their accounts with the central bank, the central bank can easily settle the claims of various banks.

16. What is custodian of foreign exchange reserves?

Ans: The RBI acts as the custodian of the country’s foreign exchange reserves, manages exchange control and acts as the agent of the government in respect of India’s membership of the IMF.

17. What is custodian of cash reserve?

Ans: Commercial banks are required by law to keep reserves equal to a certain percentage of both time and demand deposits liabilities with the central banks. Thus the central bank acts as the custodian of the cash reserves of commercial banks and helps in facilitating their transactions.

18. Why was the SDR created?

Ans: The SDR was created as a supplementary international reserve asset in the context of the Bretton Woods fixed exchange rate system. The SDR is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. SDRs can be exchanged for these currencies.

19. What is variation in reserve ratio?

Ans: Thus, variations in the reserve ratio reduce increases the liquidity and consequently the lending power of the banks also. Therefore, the cash reserve ratio is raised by the central bank when credit contraction is desired and lowered when credit is to be expanded.

20. Give the meaning of Rationing of Credit.

Ans: Rationing of credit refers to the policy of a central bank to prescribe the maximum limit and amount of credit that commercial banks can grant. It is a selective method of credit control of Central Bank.

21. State the meaning of Banker’s clearing house.

Ans: As the custodian of the cash reserves of the commercial banks, the Central Bank acts as the clearing house for these banks. Since all banks have their accounts with the central bank, the central bank can easily settle the claims of various banks.

22. What is Bank Rate?

Ans: The Bank rate is the rate at which the RBI rediscounts papers presented by commercial banks or make advances to them directly against approved securities. According to section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been defined as, “the standard rate as which the bank is prepared to buy or rediscount bills of exchange or their commercial papers eligible of purchase under the Act.”

23. What is CRR?

Ans: Cash Reserve Ratio (CRR) refers to the portion of total deposits of a commercial bank, which it has to keep with the RBI in the form of cash reserves. The Reserve Bank was authorised to vary the cash reserve ratio between 3 and 15% of the total demand and time liabilities. The present CRR is 6%.

24. What is SLR?

Ans: Statutory Liquidity Ratio (SLR) refers to that portion of total deposits of a commercial bank which it has to keep with itself in the form of cash reserves. The commercial banks are also required to maintain liquid assets in the form of cash, gold and approved securities equal to not less than 25% of their total deposits. This ratio is called SLR. The RBI also empowered to raise it up to 40%. On the recommendations of the committee, it was reduced continuously and brought to 25% in 1999 as a part of the financial sector reform.

25. What is Minimum Reserve System?

Ans: Minimum Reserve System is an important method of issuing notes adopted by the Reserve Bank of India. Under this system, after maintaining a minimum reserve of gold and silver as a precious metals, paper money of any value can be issued by the Government. Under this system, due to unlimited elasticity, control on issue of notes is slackened. It enhances the possibility of money-oriented inflation greatly. Non convertible paper money.

26. What is the major functions of any bank?

Ans: Major Functions of bank are:

(i) Accepting deposits from public or firm.

(ii) Lending money to public.

(iii) Transferring money from one place to another.

(iv) Credit creation.

(v) Act as trustee.

(vi) Keep valuable in safe custody.

27. What are the general utility functions of a Bank?

Ans: Modern banks render various services for their customers.

The important utility services are:

(i) Safe custody services for the valuable documents, deeds, securities, ornament, gold etc.

(ii) Dealing in foreign exchanges.

(iii) Issuing letter of credit, circular notes, travellers cheques etc.

(iv) Acting as referee about financial standing, business reputations and respectability of customer.

(v) Underwriting loans raised by government, public bodies etc.

(vi) Advisory services to customer.

(vii) Issuing credit cards etc.

(viii) A.T.M. services.

28. What are the features of No-Frills Account?

Ans: Here are the features of no-frills accounts:

(i) A no-frills account holder can open and maintain a savings bank account with a zero balance.

(ii) They can also avail of basic banking services such as internet and mobile banking, a debit card free of cost and access to ATMs across the country.

(iii) A no-frills account holder has the option to receive free quarterly account statements to their email id.

(iv) The service charges applicable will be much lower in comparison to the regular savings account.

29. How to open a No-Frills Account?

Ans: An individual can open a no-frills account at any preferable bank or branch as long as they have all the necessary documents. However, you can only open a no-frills account if you do not already have a savings account with the bank. The customer will be required to submit basic KYC documents to open this type of account. An undertaking will have to be given in case a customer wants to convert their savings account to no-frills account. In such a case, the customer will have to close the savings account within 30 days of opening a no-frills account. However, a customer can open fixed or recurring deposit accounts with the banks with the funds of no-frills account.

30. What are the advantages of No-Frills Account/Basic Saving Bank Deposit Accounts?

Ans: Advantages of No Frills Account / Basic Saving Bank Deposit Accounts are:

(i) Zero or Meagre minimum balance is required for such bank accounts.

(ii) This service is considered as a regular banking service and is available to all.

(iii) It includes deposit and withdrawal services at bank branches or ATMs.

(iv) There is no limit on the number of deposits.

(v) An account holder can withdraw money maximum of four times a month, including withdrawal from ATMs.

(vi) Facilities of ATM cum Debit cards are available free of cost.

(vii) No charges are levied if the bank account remains non-operational or inactive for an extended period.

(viii) Some banks also provide nomination facilities.

(ix) Some banks may also provide other facilities such as Internet.

(x) Banking Services, but the banks have authority over the charges.

31. Write about the Eligibility and Documents required in No-Frills Account.

Ans: Eligibility for No-Frills Account: Anyone who fulfils the following eligibility criteria can open a no-frills account:

(i) The person must be a citizen of India.

(ii) Should have valid KYC documents.

(iii) Single or joint mode of operation is permitted.

(iv) Individuals, including minors who are 10 years old, as well as pensioners are eligible to open a BSBDA.

(v) NRIs, organisations and institutions are not eligible.

Documents Required for No-Frills Account: Here are the documents that are required for opening a no-frills bank account:

(i) Address proof such as voter card, Aadhar card, ration card, PAN card, etc.

(ii) Proof of date of birth such as an Aadhaar card, voter card, ration card, etc.

(iii) Documents for KYC verification such as PAN card.

32. State the meaning of Selective credit control.

Ans: Regulation or control of credit for specific purposes or branches of economic activity is termed as selective or Qualitative credit control. It attempts to distinguish between productive and unproductive uses to which bank credit is put. It encourages credit for essential purposes and discourages credit for non-essential purposes. It aims at regulating not only the total volume of credit but also the amount of credit available for each sector of the economy. Selection credit control affects both lenders as well as borrower in a particular manner. The selective credit control resources are Margin requirement, Regulation of Consumer credit, Moral Suasion, Rationing of Credit, Directives, Direct action, Publicity etc.

33. What are the functions of loan and advances?

Ans: This is not only very important functions but also the chief sources of profit to most of the banks in a modern economy. The bank gives loans and advances to businessmen, traders and others against documents of title to goods and marketable securities. Loans are also given against the personal security of the borrower with or without a surety. The bank selects such investments from where money can be easily called bank. Therefore, a bank is able to help not only merchant but also those who, in turn, may use funds not only to their advantage but also to the advantage of the community.

According to Sec.20 of the Banking Regulation Act 1949, there are some restrictions on loans and advances. According to this said Sec. a banking company shall not-

(a) Grant any loans or advances on the security of its own shares, or 

(b) Enter into any commitment for granting any loans or advances to on behalf of-

(i) Any of its director.

(ii) Any firm in which any of its directors is interested as partner, manager, employee or guarantor or,

(iii) Any company of which any of the director of the banking company is a director, manager, employee or guarantor or in which he holds substantial interest, or 

(iv) Any individual in respect of whom any of its directors is a partner or guarantor.

34. State the meaning of Selective credit control.

Ans: Regulation or control of credit for specific purposes or branches of economic activity is termed as selective or Qualitative credit control. It attempts to distinguish between productive and unproductive uses to which bank credit is put. It encourages credit for essential purposes and discourages credit for non-essential purposes. It aims at regulating not only the total volume of credit but also the amount of credit available for each sector of the economy. Selection credit control affects both lenders as well as borrower in a particular manner. The selective credit control resources are Margin requirement, Regulation of Consumer credit, Moral Suasion, Rationing of Credit, Directives, Direct action, Publicity etc.


1. Explain the Primary functions of Bank.

Ans: All banks have to perform two major primary functions namely:

(A) Accepting of deposits.

(B) Granting of loans and advances.

(A) Accepting of Deposits: A very basic yet important function of all the commercial banks is mobilising public funds, providing safe custody of savings and interest on the savings to depositors. 

Bank accepts different types of deposits from the public such as:

(i) Saving Deposits: It encourages saving habits among the public. It is suitable for salary and wage earners. The rate of interest is low. There is no restriction on the number and amount of withdrawals. The account for saving deposits can be opened in a single name or in joint names. The depositors just need to maintain minimum balance which varies across different banks. Also, Bank providers ATM cum debit card, cheque book, and Internet banking facility. Candidates can know about the types of Cheques at the linked page.

(ii) Fixed Deposits / Term Deposit / Time Deposit: Also known as Term Deposits. Money is deposited for a fixed tenure. No withdrawal money during this period allowed. In case depositors withdraw before maturity, banks levy a penalty for premature withdrawal. As a lump-sum amount is paid at one time for a specific period, the rate of interest is high but varies with the period of deposit.Under this account deposits are accepted for a fixed period say one, two, four or five years or above. The money deposited in this account cannot be normally withdrawn before the expiry of the agreed period. The rate of interest on this account is higher than on other accounts.

(iii) Current Deposits or Demand deposit: Under this account the depositor can withdraw the money whenever he requires it. Normally no interest is paid by the bank because the bank cannot  utilise this money in earning and he must keep himself ready to meet the demand of the customer. He must keep cent percent reserve against the deposit. In this account the depositor has to maintain minimum balance. Occasionally a small interest is paid  to the people who keep large balances. Under this account the depositor is not free to withdraw any amount like current account. He can withdraw only a specified sum of money in a week. Here the depositor gets less interest in comparison to Fixed Account They are opened by businessmen. The account holders get an overdraft facility on this account. These deposits act as a short term loan to meet urgent needs. Bank charges a high-interest rate along with the charges for overdraft facility in order to maintain a reserve for unknown demands for the overdraft.

(iv) Recurring Deposits: A certain sum of money is deposited in the bank at a regular interval. Money can be withdrawn only after the expiry of a certain period. A higher rate of interest is paid on recurring deposits as it provides a benefit of compounded rate of interest and enables depositors to collect a big sum of money. This type of account is operated by salaried persons and petty traders.

(v) No Frills Account: These are savings accounts that don’t need any minimum balance month after month. The account holder gets access to internet banking, debit card and access to ATMs across the country with 0 balance. As the name suggest, these accounts don’t have any unnecessary rules or ‘frills’. The account can be opened by any Indian above the age of eighteen. This was until the Reserve Bank of Indian introduced a “no-frills Account” which aims at providing all necessary banking facilities to consumers at minimum or nil charges. No-frills bank facilities such as withdrawals and ATM and Debit card facilities at zero charges to enable universal access to banking facilities. No-frills bank accounts are now known as Basic Saving Bank Deposit Accounts.

(vi) Flexi Deposits/ Auto Sweep/ Hybrid Deposits: Hybrid deposits or flexi deposits which combine the features of demand and term deposits. These deposits are introduced in recent by some banks to meet customers’ financial needs and convenience and are known by different names in different banks. These deposits are a combination of demand and fixed deposits for meeting customer’s financial needs in a flexible manner. Hence these are hybrid deposits or flexi-deposits. For example: Quantum Deposit Scheme of ICICI Bank and Multi Option Deposit Scheme (MODS) of SBI. The flexi deposits show a fusion of demand and fixed deposits.

(B) Granting of Loans & Advances: The deposits accepted from the public are utilised by the banks to advance loans to the businesses and individuals to meet their uncertainties. Bank charges a higher rate of interest on loans and advances than what it pays on deposits. The difference between the lending interest rate and interest and Advances:

(i) Long-term loan: Long-term financing refers to borrowing or issuing equity shares for more than one year. It is typically used for large projects, financing, and company expansion. Long-term financing usually involves a high amount of capital. The sources of long-term financing include equity capital, preference capital, debentures, term loans, and retained earnings.

(ii) Short-term loans: Personal loans given to borrowers against some collateral security are known as short-term loans. The amount taken as a loan is credited to the account of the borrower, and he can withdraw that money from his account. Interest is charged on the entire sum of the loan granted.

(iii) Bank Overdraft: This facility is for current account holders. It allows holders to withdraw money anytime more than available in bank balance but up to the provided limit. An overdraft facility is granted against collateral security. The interest for overdraft is paid only on the borrowed amount for the period for which the loan is taken.

(iv) Cash Credits: A short term loan facility up to a specific limit fixed in advance. Banks allow the customer to take a loan against a mortgage of certain property (tangible assets and/ guarantee). Cash credit is given to any type of account with a bank. Interest is charged on the amount withdrawn in excess of the limit. Through cash, a larger amount of laon is sanctioned than of overdraft for a period.

(v) Loans: Banks lend money to the customer for short term or medium periods of say 1 to 5 years against tangible assets. Nowadays, banks do lend money for the long term. The borrower repays the money either in a lump-sum amount or in the form of instalments spread over a pre-decided time period. Bank charges interest on the actual amount of loan sanctioned, whether withdrawn or not. The interest rate is lower than overdrafts and cash credits facilities.

(vi) Discounting the Bill of Exchange: It is a type of short term loan, where the seller discounts the bill from the bank for some fees. The bank advances money by discounting or purchasing the bills of exchange. It pays the bill amount to the drawer (seller) on behalf of the drawee (buyer) by deducting usual discount charges. On maturity, the bank presents the bill to the drawee or acceptor to collect the bill amount.

2. Explain the Secondary functions of Bank.

Ans: Apart from the basic or primary functions commercial banks render various other services which are known as secondary functions. These services can be broadly classified into agency services and general utility services.

1. Agency Functions: There are some agency functions performed by commercial banks for which they charge some commission from their clients. Some of these functions are:

(i) Transfer of Funds: Banks issue demand drafts, bankers’ cheques, travelers’ cheques, etc. and help in transfer of funds from one place to another. Customers need not carry cash. They can just forward the draft issued by the bank to the receiving institution. A small commission is collected by banks for this service.

(ii) Collection and Payment of Cheques: On behalf of customers bank collect the cheques deposited into the accounts of customers from other banks and deposit cash in the customers’ accounts. Similarly cheques issued by a customer is honoured and the amount paid as directed by the customers.

(iii) Acting as Executors, Trustees and Attorneys: Banks act as executors of will of the customers and implement their will after their death. As a trustee a bank takes care of the funds of the funds of the customers. Banker signs transfer deed of the properties of the customers in the capacity of attorney to customers.

(iv) Bills of exchange and promissory notes: Bills of exchange and promissory notes are written commitments between two parties that confirm a financial transaction has been agreed upon. Bills of exchange are more often used in international trade, whereas promissory notes are used most often in domestic trade.

A bill of exchange is a written agreement between two parties- the buyer and the seller- used primarily in international trade. It is documentation that a purchasing party has agreed to pay a selling party a set sum at a predetermined time for delivered goods. The buyer or seller typically employs a bank to issue the bill of exchange due to the risks involved with international transactions. For this reason, bills of exchange are sometimes also referred to as bank drafts.

Promissory notes are similar to bills of exchange in that they, too, are a financial instrument that is a written promise by one party to pay another party. They are debt notes that provide financing for either a company or an individual from a source other than a traditional lender, most commonly one of the parties in a sales transaction.

(v) Execution of standing instructions: A Standing Instruction (SI) is a service offered to customers of a bank, wherein regular transactions that the customer want to make are processed as a matter of course instead of initiating specific transactions each time. Once initiated, a standing instruction may go on for many months, or even years, with each cycle being processed automatically. Standing Instructions is a scheduled payment order/ instruction set by Bank customers to ensure regular funds transfer on a specific date. Standing instructions are a way of making an automatic payment of a fixed amount on regular intervals by debiting your Operative account.

(vi) Periodic Payment of Premiums, Rent, etc.: After instruction from the customers, banks undertake the monthly payment of insurance premium, rent, telephone bill, etc. from the accounts of customers. Now a days these payments are made through electronic clearing system facility offered by the banks.

(vii) Purchase and Sale of Foreign Exchange: The central bank gives authority to commercial banks to deal in foreign exchange. Commercial banks, on the behalf of their customers, buy and sell foreign exchange and also helps in promoting international trade.

(viii) Purchase and Sale of the Securities: Commercial banks on behalf of their customers, purchase and sell government securities and stocks and shares of private companies.

(ix) Income Tax Consultancy: Commercial banks provide advice to their customers related to income tax. They also help them in the preparation of their income tax returns.

(x) Acting as Correspondent: Banks act as correspondent of customers and receive travel ticket, passport, etc.

II. General utility functions: In addition to primary, secondary and agency functions, commercial banks offer some services for the general welfare of the customers. They are called general utility services. They are as follows:

(i) Safe Custody: Bankers are in the business of providing security to the money and valuables of the general public. Which security of money is taken care of through offering various type of deposit schemes, security of valuable is provided through making secured space available to general public for keeping these valuables. These spaces are available in the shape of lockers. The lockers are small compartments with dual locking facility strong room and are fully secure. Lockers can neither be opened by the hirer or the bank individually. Both must come together and use their respective keys to open the locker. To make this facility available to its customers, the bank must provide:

(i) Physical structures to house the lockers.

(ii) locker cabinets.

(iii) security arrangements. and 

(iv) record of access to lockers.

Hiring of lockers is a losing proposition for the banks if seen in isolation as it involves major expenditure on buying the cabinets, for providing a secure place to keep them, and for manning the facility so that the customers are serviced immediately. Banks offer this facility as a Standard Operating Procedure (SOP) to attract deposits.

(ii) Safe Deposit Vault: Banks provide the facility of safe deposit vaults kept in a strong room. Lockers of different size are given to the public on hire. A locker is opened by two keys. One of the key is given to the hirer and the other i.e. master key is retained by the banker. The person has to sign the register at the time of opening the locker. The banks may not have any knowledge about the contents of the lockers.

(iii) Remittances of Funds: Apart from accepting deposits and lending money, banks also carry out on behalf of their customers the act of transfer of money, both domestic and foreign, from one place to another. This activity is known as remittance business. Banks issue demand drafts, banker’s cheques, money orders etc. for transferring the money. They also have the facility of quick transfer of money, also known as telegraphic transfer or tele cash orders. In remittance business, Bank ‘A’ at a place ‘a’ accepts money from a customer ‘C’ and makes arrangement for payment of the same amount of money to either customer ‘C’ or his ‘order’, i.e. a person or entity designated by ‘C’ as the recipient, through either a branch of bank ‘A’ or any other entity at place ‘b’.

In return for having rendered this service, the banks charge a pre-decided sum known as exchange or commission or service charge. This sum can differ from one bank to another. This also differs depending upon the mode of transfer, and the time available for effecting the transfer of money. The faster the mode of transfer, the higher the charges.

(iv) Pension Payments: Under the facility of disbursement of pension through authorised banks available to pensioners, a pensioner is entitled to receive his/ her pension by getting it credited to a savings / current bank account operated individually by him / her. Paragraphs 4.1, 4.2 and 12.9 of the “Scheme for Payment of Pension for “Central Government Civil Pensioners Through Authorised Banks” outline the present procedure for credit of pension to bank account of the pensioner. However, operation of a joint account is not permitted under the existing scheme. The matter, whether pensioners should be given an option to receive pension by getting it credited to their savings or current bank accounts operated jointly with their spouse, has been under consideration.

(v) Acting as a Dealer in Foreign Exchange: The banks also deal in foreign exchange transactions. The commercial community receives facilities for its dealings with foreign national. This is also a profitable bills of exchange. Sometimes, a bank has to arrange for the transport, insurance and warehousing of goods. Therefore, many commercial banks have a freight and insurance departments.

(vi) Letters of credit: The commercial banks issue letters of credit to enable the traders to buy goods on credit. A letter of credit is a document or order by a banker in one place, authorising some other banker in some other place, to honour the drafts or cheques of the person whose name appears in the document. The amount is chargeable to the issues of the letter of credit. A bank’s letter of credit helps a businessman, because of the better credit standing of a bank compared with his personal credit.

(vii) Underwriter/ Underwriting: The commercial bank also acts as an underwriter for issue of shares and debentures of any public and private limited company. The banks guarantee the purchase of certain proportion of shares, if not sold in the market.

(viii) ATM facility, credit card, debit card: It is an electronic delivery system. It is a convenient method of withdrawing money from bank without going to the bank through automated/ automatic teller machines. It enables people to do their banking transactions at any hour of the day. Credit card is a plastic card issued by bank to its customers. It facilitates the card holders to use it for purchase on credit or draw cash. Debit card can be used for the purchase of goods and services. The amount gets debited from the debit card holders account automatically.

3. Explain the process of creation of credit by Commercial Banks.

Ans: Credit creation is an important function of Commercial Banks. The power of commercial banks to expand deposit through expanding their loans and advances is known as credit creation. The famous economist Sayers has rightly said “Banks are not merely purveyors but also, in an important manufacturers of money. “A modern bank creates deposits in two ways. Firstly in a passive way which results in primary or passive deposits and secondly in a more active way which results in active or derivative deposits. The primary deposit do not make any net addition to the stock of money in the economy. The derivative deposits are created by the bank by opening an account in the name of the person who borrows funds from the bank. In short the process of credit creation is as under.

When the borrower is granted a loans by the bank, an account is opened in the name of the loanee and the loan money is credited to his deposit account. The loan money is not paid to the borrower in cash. The borrower can withdraw the amount either in full or as per his needs. When the borrower pays to his creditors, a cheque is drawn upon his account with the bank The creditor on receipt of the cheque may deposit in his account in another bank. The other bank which receives the primary deposit in the from of cheque drawn upon the first bank. After keeping some cash, as per cash reserve ratio, the second bank can create derivative deposit by giving loan to some other borrower. The second borrower may make the payment out of his account to another creditors, who may have an account to another creditors, who may have an account with the third bank, which in turn will receive the primary deposit in the  form of cheque drawn on the second bank. This process goes on creating a multiple of initial amount deposited with the first bank. In this way commercial banks are able to multiply loan and investments and thus multiply deposits. Credit creation can thus be defined as the expansion of bank deposits through the process of more loans and advances and investments.

A simple example is given below to illustrate the process by which multiple credit creation by a commercial bank takes place.

Suppose the cash reserve ratio is 20%. A new deposit of Rs. 1000/- has been made with Bank A. The bank’s balance sheet has the following position-

Balance sheet of Bank A


Mr. ‘X’ approaches bank A for a loan. The bank keeps 20% of the initial deposit as reserves and advances the remaining 80% as loan to Mr. X. After having given the loan, the balance sheet of Bank A has the following position.

Balance sheet of Bank A

Deposit1000Cash Loans to X200800

‘X’ who is indebted to Y given him the cheque of Rs.800 which Y deposits with his Bank ‘B’. The balance sheet of Bank ‘B’ appears as follows-

Balance sheet of Bank B


Z approaches bank ‘B’ for a loan, Bank ‘B’ keeps 20% as reserves and lends out 80% of its deposits. The balance sheet of Bank B now appears as follows-

Balance sheet of Bank B

Deposits800Cash Loan to Z160640

Now Z pays rs. 640 by cheque to P who deposits it with bank ‘C’ and so on.

4. What is credit control? Explain the objectives of credit control.

Ans: Credit control is the regulation of credit by the central bank for achieving some definite objectives. Modern economy is a credit economy because credit has come to play a major role in setting all kinds of monetary and business transactions in the modern economic system.

Changes in the volume of credit influence the level of business activity and the price level in the economy.

Unrestricted credit creation by the commercial banks, by causing wide fluctuations in the purchasing power of money, may pose a serious threat to the national economy. Hence, it becomes necessary for the central bank to keep the creation of credit under control in order to maintain stability in the economic system.

Objectives of Credit Control:

The important objectives of credit control are given below:

(a) Price Stability: Violent price fluctuations cause disturbances and maladjustments in the economic system and have serious social consequences. Hence, price stability is an important objective of credit control policy. The central bank, by regulating the supply of credit in accordance with the commercial needs of the people, can bring about price stability in the country.

(b) Economic Stability: Operation of the business cycle brings instability in a capitalist economy. The objective of the credit control policy of the central bank should be to eliminate cyclical fluctuations and ensure economic stability in the economy.

(c) Maximisation of Employment: Unemployment is economically wasteful and socially undesirable. Therefore economic stability with full employment and high per capita income has been considered as an important objective of credit control policy of a country.

(d) Economic Growth: The main objective of credit control policy in the underdeveloped countries should be the promotion of economic growth within the shortest possible time. These countries generally suffer from the deficiency of financial resources. Hence, the central banks in these countries should solve the problem of financial scarcity through planned expansion of bank credit.

(e) Stabilisation of Money Market: Another objective of the central bank’s credit control policy is the stablisation of the money market as to reduce the fluctuations in the interest rates to the  minimum. Credit control should be exercised in such a way that the equilibrium in the demand and supply of money should be achieved at all times.

(f) Exchange Rate Stability: Exchange rate stability can also be an objective of credit control policy. Instability in the exchange rates is harmful for the foreign trade of the country. Thus, the central bank, in the countries largely dependent upon foreign trade, should attempt to eliminate the fluctuations in the foreign exchange rates through its credit control policy.

5. Explain briefly the limitations of credit creation.

Ans: The limitation of credit creation are as follows:

(i) Availability of primary deposits: The bank can create credit only when it has necessary cash in the form of primary deposits. In other words the larger the amount of cash with the bank, the larger will be its capacity to create deposits and vice varsa.

(ii) Banking habits of the people: The creation of credit also depends upon the popularity of banks among the general public. In case, the people lack banking habit, that is they like to hold more cash with them, the bank will have lower capacity to create credit.

(iii) Business conditions: In a depression period, there is fall in business activities and therefore there is less demand for bank credit. Hence, the banks will be in a position to create less credit.

(iv) Use of credit instruments: Where credit instruments like cheque, bills etc. are frequently used by the people, the banks are required to keep smaller amount of cash reserves. On the other hand, the countries where the people are using currency notes and coins to make all kinds of payments, the banks will have larger cash reserves, therefore, their power to create credit will be limited.

(v) Nature of security offered: The availability of good securities places a limit on the power of banks to create money. Every loan made by a bank is secured by some valuable form of wealth bills, shares, stocks etc. Thus, if approved securities are not available, the bank cannot create credit fearlessly.

6. Explain the different methods of credit control by the Central Bank.

Ans: The various methods or instruments of credit control used by a Central Bank may be classified into two broad categories:

(a) The quantitative or general methods. and

(b) The qualitative or selective methods.

(a) Bank rate or Discount rate (2016): It means “the rediscounting of first class bills of exchange brought to the Central Bank by the discount houses and commercial banks at a certain maximum official rate.” It also implies “the varying of the terms and conditions under which the market can have a temporary access to the Central Bank either in the form of rediscounting or through secured advances. By means of these methods, Central Bank can influence the ‘cost as well as the availability of credit. The cost of credit is influenced by changing the bank rate. The Central Bank raises the cost of credit and by lowering the bank rate, it lowers down the cost of credit. The Bank rate policy also affects the availability of credit by changing the conditions under which the central bank grants loans to commercial banks.

(ii) Open market Operation: Deliberate and direct buying and selling of securities and bills in the money by the central bank, on its own initiative, is called open market operations. It implies the purchase and sale of government and other securities. In countries where the market for government securities is limited or the supply of government securities is inadequate, open market operations include purchase and sale of securities guaranteed by the government an municipal securities also Generally open market operations are confined to the purchase and sale of government securities. Open market operations are undertaken by the central bank to exercise a stabilising influence on the money market. It has been developed as a technique of credit control only after the First World War. The considerable increase in the volume of government securities has helped the open market operations to become a strong and successful weapon of credit control. In wider sense, open market of government securities, other securities, bankers acceptances and foreign exchange.

(iii) Variable reserve ratio: Variable reserve ratio refers to the system of credit control under which it is necessary for every bank to maintain a definite percentage of its deposits with the central bank. The central bank is free to vary the percentage within the limits defined in the statute.

When the Central Bank varies the reserve ratio, the cash reserves of the banks get altered which affect to the volume of credit. If the central bank raises the reserve ratio, the banks have to maintain more cash reserves reducing the capacity of the banks to lend. If the reserve ratio is lowered, the banks have to ruducs the reserves with the central bank. This increases the cash with the banks and they are enabled to lend more.

(b) The important qualitative methods of credit control are:

(i) Margin requirement: According to this method, the commercial banks do not lend money to the borrower to the full value of the collateral securities provided by them against the loans. The general practice is to lend money upto a certain limit, and thus a margin is left. Suppose, the banks decide to fix the margin as 25% and if a borrower furnishes security work Rs. 100 then against such security, a bank will give credit only upto Rs. 75. This is done primarily for two reasons- 

(a) There is a possibility of default in payment of interest as well as the principal amount.

(b) Another is that the value of securities furnished does not remain constant. The volume of credit can be increased or decreased by making necessary changes in the margin requirement.

(ii) Rationing of credit: This method refers to the policy of a central bank can grant. It may be called as variable capital asset ratio, means the central bank fixes the ratio which the capital of the commercial bank should have to the total assets of the bank.

(iii) Moral Suasion: As a method of credit control is used by central banks to exercise influence over the loan policy of commercial banks. In the modern age, Central Bank is considered to be the apex financial institution and acts as an advisor and guide of commercial banks. Hence a Central Bank tries to control credit by way of persuading the commercial banks to see to it  that credit is not given for unnecessary, or undesirable purposes.

(iv) Directives: According to this method, the Central Bank gives directives to commercial banks that they should follow certain lending policies or they should provide loans only for certain purposes.

(v) Direct action: This method refers to the directions and restrictions enforced on the commercial banks by the central bank with regard to their lending and investment policies. It involves as element of computation. The directions of the Central Bank have a legal sanction. The offending banks can be penalised by the central bank which may include denial of accommodation, charging off penal rate of interest etc.

(vi) Inspection and Supervision: This system is most executive. The Central Banks of different country is empowered to control the banking system of the country. According to this method the Central Bank can inspect and supervise other banks. As a result the central bank may know whether the banking business policy is efficiently managed or not and on the basis of that the Central Bank may suggest and advice.

7. Explain why the Central Bank is called Banker’s Bank.

Ans: As a banker’s bank, the central bank acts as a custodian of member bank’s cash reserves. It is customary for commercial banks to hold a part of their demand and time deposits with the Central Bank. In return, the central bank re-discounts the bills of the commercial banks, and give them remittance facilities, thereby providing credit to them on the basis of these reserves.

The advantages of centralisation of cash reserves are as follows:

(i) The centralisation of cash reserves with the central bank reinforces the confidence of the general public in the strength of the banking system of the country.

(ii) The centralisation of cash reserves in the central bank is a source of great strength to the banking system in the country.

(iii) When cash reserves accumulate with the central bank, it can make use of them in the interest of national welfare.

(iv) The centralisation of cash reserves also enables the central bank to control the creation of credit by the commercial banks.

(v) The central bank can provide additional funds on temporary basis and short term basis to commercial banks to overcome their financial difficulties.

(vi) The reserves facilitate the central bank to re-discount the bills of exchange of commercial bank.

8. Describe the methods of issuing notes by the Central Bank.

Ans: There are two schools of thought regarding the principle of note issue. One school represents the currency principle and the other, the banking principle. Combining the merits of both the banking and the currency principles, different systems of note issue have been evolved to regulate note issue.

They are as follows:

(i) Partial or fixed fiduciary system: This system was first introduced in England in 1844 and subsequently adopted by several countries. Under this system, a fixed amount laid down by law need only be covered by government securities while all notes issued in excess of this amount must be fully covered by gold. The fixed amount laid down by law is called the fiduciary system. The purpose of fixing the fiduciary limits is to conserve that amount of gold without affecting the convertibility of notes. In India notes are issued by this system in between 1861-1920.

(ii) Maximum Fiduciary System: This system fixes the maximum limit up to which the central bank can issue notes without any gold backing. The maximum limit may be altered depending on the circumstances. The system was in vogue in France before 1928 and it was introduced in England in 1939. The main features of this system is to leave to the central bank the discretion of determining the limit, in the light of the monetary requirements of the country. It is claimed that this system provides for a high degree of elasticity in the note circulation.

(iii) Proportional Reserve System: Under this system the central bank is to maintain certain percentage of the total note issue in gold. This percentage varies from 25 to 40. The rest of note issue is to be covered by sound collateral securities. This system was adopted in India in 1927-56 and in France 1938.

(iv) Minimum Reserve System: Under this system the Central Bank has to maintain minimum reserves of gold or foreign securities or both. No maximum limit is placed on the amount of note issue. The central bank is free to adjust the total volume of currency in circulation according to the needs of trade. Even the minimum reserve is prescribed only to create a sense of confidence in the minds of the people.

In 1956 the Reserve Bank of India Act amended to introduce the minimum reserve system to enable the Reserve Bank to expand the money supply to meet expenditure in connection with the implementation of the five year plans. Under the existing provision, the Reserve Bank should maintain a minimum reserve of Rs. 200 crores worth of gold and foreign securities of which the value of gold shall be not less than Rs. 115 crores and the rest may consist of foreign securities.

9. Explain the functions of a Central Bank as (a) Banker’s to the government and (b) Controller of credit.

Ans: The Central bank acts as a Banker to the government. It also acts as fiscal agents and advise the governments on fiscal matters. As a banker to the government, the central bank maintains the banking accounts of the government departments, state governments and government enterprises. The Central Bank undertakes transactions for the government with regard to purchase and sale of foreign exchange. It gives short term loans to the government and at the times of crisis makes extra ordinary advances. In its capacity as financial agent and advisor to the government, it manages the national debts and guides the government on matters pertaining to economic policy.

The ultimate responsibility for laying down the monetary policy and maintaining the monetary standard lies with the government. In the formulation of the monetary policy, the central bank is not only consulted by the government, but it is also given a free hand and assisted whenever possible by the government in carrying out such monetary policy.

The control of credit is the most important of all the functions rendered by the Central Bank. It is the function which embraces the most important questions of central banking policy and the one through which practically all the other functions are united and made to serve a common purpose. This function has assumed importance with the growing popularity of bank credit. Commercial banks have the power to alter the total amount of money in circulation through the mechanism of credit creation.

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