B.

Tech 3rd Year

Economics for Engineers (HMTS - 3201)

Module 2 B

Banking

What is Credit?

Credit is a finance made available by one party(lender/ seller/ shareholder) to another

(borrower/ buyer/ corporate firm)
Credit is simply the opposite of debt . Debt is the obligation to make future payments . Credit
is the claim to receive these payments. Both are created in the same act of borrowing and
lending .
Credit must be carefully distinguished from money . Even bank credit is not the same thing as
money. Their nature and functions are not the same.
Money is an asset of the holding public. It is the liability of the banking system and the
government. However it is not all the liabilities of the banking system that are money but
only those that serve as a medium of exchange , namely currency and demand deposits. Bank
Credit on the other hand a liability of the borrowing public to banks and an asset of banks.
Then money serves as the commonly accepted medium of exchange and the unit of account.
Bank credit itself not serve as bank money. What serves as a bank money is the demand
deposit of a bank on which cheques can be drawn in the settlement of payments. Bank Credit
only allows the borrower to claim to such a deposit upto a certain sanctioned amount.

What is a Commercial Bank?

Commercial Banks are the single most important source of institutional credits in India.

What is a bank?

A bank is an institution that accepts deposits of money from the public withdrawable by
cheque and used for lending.
Thus two essential functions which make a financial institution bank:
1. Acceptance of chequeable deposits (of money) from the public. And
2. Lending
The former is its unique and most distinctive function. The word lending is used here broadly
to include both direct lending to borrowers and indirect lending through investment in open
market securities.

In this sense, Post Office , LIC etc are not banks.

Functions of Commercial banks:

1. Acceptance of money on deposit from the public: The first primary function of a
commercial bank is to accept deposits in the form of current, savings and fixed
deposits. It collects the surplus balances of the individuals, firms and finances the
temporary needs of commercial transactions. Therefore, the first task of the bank is
the collection of the savings of the public. The bank does this by accepting deposits
from its customers. Deposits are the lifeline of banks. Deposits are of three types i.e.
(i) Current Account Deposits: Such deposits are payable on demand and are,
therefore, called demand deposits.
(ii) Fixed Deposits (Time deposits): Fixed deposits have a fixed period of maturity
and are referred to as time deposits. They can be withdrawn only after the maturity of
the specified fixed period and
(iii) Savings Account Deposits: These are deposits whose main objective is to save
and savings account is most suitable for individual households. They combine the
features of both current account and fixed deposits.
2. Grant to credit to all sectors of the economy: The second major function of a
commercial bank is to give loans and advances particularly to businessmen and
entrepreneurs and earn interest from them. This is, in fact, the main source of income
of the bank. A bank keeps a certain portion of the deposits with itself as reserve and
gives (lends) the balance to the borrowers as loans and advances in the form of cash
credit, demand loans, short-run loans, overdraft.
3. Collection of cheques , drafts, bills, hundis, and other instruments for their
depositors: The commercial banks provide the facility of discounting bills to its
depositors. A bill of exchange represents a promise to pay a fixed amount of money at
 a specific point of time in future. It can also be encashed earlier through the
discounting process of a commercial bank. Alternatively, a bill of exchange is a
document acknowledging an amount of money owed in consideration of goods
received. It is a paper asset signed by the debtor and the creditor for a fixed amount
payable on a fixed date.

4. Credit Creation: Credit creation is one of the most important functions of the
commercial banks. Like other financial institutions, they aim at earning profits. In this
function of commercial banks they accept deposits and advance loans by keeping
small cash in reserve for day-to-day transactions. When a bank advances a loan, it
opens an account in the name of the customer and does not pay him in cash but allows
him to draw the money by cheque according to his needs. By granting a loan, the bank
creates credit or deposit.
5. Safe Custody Service: Provision of facilities of safe custody of deeds and securities
and safe deposits vaults.The customers can keep their ornaments and important
documents in lockers for safe custody.
6. Overdraft Facility: An overdraft is an advance given by allowing a customer keeping
a current account to overdraw his current account up to an agreed limit. In this
function of a commercial bank, bank provides the facility to a depositor for
overdrawing the amount rather than the balance amount in his account. In other
words, depositors of current account make arrangements with the banks that in case a
cheque has been drawn by them which are not covered by the deposit, then the bank
should grant overdraft and honour the cheque. Difference between overdraft facility
and loan is that in the case of overdraft it is made without security in current account
the borrower is given the facility of borrowing only as much as he requires and but on
the other hand loans are given against security and the borrower has to pay interest on
full amount sanctioned.
7. Miscellaneous services :issue of travellers cheque , gift cheque, provision of tax
assistance, investment advice etc.

Meaning of NPAs:

A performing asset is an advance which generates income to the bank by way of interest and
other charges. A non-performing asset in the banking sector may be referred to an asset not
contributing to the income of the bank or which does not generate income for the bank. In
other words, an advance account, which ceases to yield income, is a non-performing asset. If
the customers do not repay principal amount and interest for a certain period of time then
such loans become non-performing assets (NPA). In a narrow sense, a non-performing asset
may be defined as an asset which does not directly contribute to the corporate profits or yield
any positive returns. This may be appropriate when applied to loans and advances. However,
there are other assets such as cash balances held which are certainly require for business
operations but do not yield any direct return.

Definition of NPAs :

Definition as per Narasimham Committee: Narasimham Committee clearly defined that an

asset may be treated as Non-performing Asset (NPA), if interest or installments of principal
or both remain unpaid for a period of more than 180 days. However, with effect from March
2004, default status is given to a borrower account if dues not paid for a period of 90 days.

Credit creation by Banks:

An increase in Reserves:

Suppose you sell a government bond to the RBI at Rs. 1000 (the central bank as you know
buys and sells government securities ) . In exchange for the bond, the RBI would have given
you a cheque drawn on itself for Rs 1000 . As soon as you deposited that Rs 1000 cheque
your bank's demand deposit liabilities increased by the same amount . By sending that
cheque back to the RBI , your bank would have its reserve account with the RBI credited for
Rs. 1000 of added reserves.

By purchasing a bond from you, the RBI has increased the volume of reserves available to
your bank and to the entire commercial banking system by Rs. 1000. With a 25% reserve
ratio the volume of demand deposit money may increase by a multiple of the increase in
reserves .

The reserve ratio is the proportion of reserves to the demand deposits i.e., the deposits which
can be withdrawn on demand. It cannot be used to make loans.
Now consider a situation in which your bank , say A bank is having Rs. 1000 of new reserves
and 25% reserve ratio . Now A bank has Rs. 750 excess reserves which it can lend. Creating
Rs 750 more of new demand deposits in the process.
When this Rs. 750 loan recipient spends this money the recipient of that spending will put the
money in bank B , whose demand deposit liabilities and reserves are increased by Rs. 750.
With a 25% reserves ratio, the second bank has Rs. 562.50 of excess reserves which it can
lend . On making a Rs. with a 562.50 loan, it creates Rs. 562.50 of new demand deposit
money which, when spent , will be transferred to a 3rd bank which , in turn , will have some
Rs. 421.88 of excess reserves , and so the process goes on.

The Total increases in money supply due to RBI purchase of rs. 1000 bond would be ,

∆𝑀 = 1000 + 750 + 562. 50 + 421. 88 + 316. 41 +...................

= 1000 + 1000 × 0.75 +1000 × (0.75)2 + 1000 × (0.75)3 + 1000 × (0.75)4
+.................
1 1
= 1000( 1 − 0.75 ) = 1000( 0.25 ) = 4000
1
( 0.25 ) = deposit expansion multiplier or bank multiplier . It is the reciprocal of the

reserve ratio.

With the reserve ratio value of 0.25 a Rs. 1000 increase in reserves resulted in Rs. 4000
increase in the money stock.

The deposit expansion multiplier or a bank multiplier is the relationship between an original
deposit and the potential addition it can make to the total money supply. It is the number by
which the increase in original deposit has to be multiplied to get the total increase in bank
deposit.