Modern economies run on credit. When you take a home loan, pay with a card, or receive a salary in your bank account — you are using the banking system. Banks perform an extraordinary function: they take deposits and lend most of it out, thereby creating new money that did not previously exist. This process of credit creation is one of the most important mechanisms in macroeconomics. Above all banks sits the Reserve Bank of India (RBI) — the central bank — which regulates the entire banking system and uses powerful tools to control the money supply and achieve macroeconomic objectives. For CBSE Class 12, this topic generates consistent questions on commercial bank functions, the credit creation process (with calculations), and the monetary policy tools used by RBI to control inflation and growth.
1. Commercial Banks — Meaning and Functions
A Commercial Bank is a financial institution that accepts deposits from the public and provides loans — making profit from the difference between interest earned on loans and interest paid on deposits.
Functions of Commercial Banks
| Category |
Function |
Example |
| Primary |
Accepting Deposits — savings, current, fixed, recurring |
SBI Savings Account; FD at HDFC Bank |
| Granting Loans and Advances — term loans, overdraft, cash credit, discounting bills |
Home loan, business loan, overdraft facility |
| Credit Creation — lending a multiple of deposits (see Section 2) |
₹1,000 deposit → ₹10,000 total credit (at CRR=10%) |
| Secondary |
Agency functions: collect cheques, pay bills, transfer funds, act as executor/trustee |
NEFT/RTGS transfer; paying utility bills |
| Remittance: transfer money across locations through drafts and NEFT |
Demand Draft; IMPS transfer |
| Safe custody: safe deposit lockers for valuables |
Bank locker for jewellery and documents |
| Foreign exchange: buying/selling foreign currency |
Exchanging USD for INR at airport |
| Underwriting securities: subscribing to IPOs and government bonds |
Banks underwrite company IPOs |
2. Credit Creation by Commercial Banks
Credit Creation is the process by which commercial banks create new deposits (and thus money) through the act of lending. It is one of the most important functions of banks.
How Credit Creation Works
Key principle: Banks keep only a fraction of deposits as reserves (CRR) and lend the rest. The loans become deposits in other banks, which again lend a fraction, and so on.
Formula:
Round-by-Round: Initial Deposit ₹1,000, CRR = 10%
| Round |
New Deposit (₹) |
Reserve (10%) |
New Loan |
| 1 | 1,000 | 100 | 900 |
| 2 | 900 | 90 | 810 |
| 3 | 810 | 81 | 729 |
| … continues … | | | |
| Total | 10,000 | 1,000 | 9,000 |
Total deposits = ₹1,000 × (1/0.10) = ₹10,000
Total credit created = ₹10,000 − ₹1,000 = ₹9,000
Total reserves = ₹10,000 × 10% = ₹1,000 = initial deposit ✓
Effect of CRR on Credit Creation
- Higher CRR → Lower multiplier → Less credit created
- Lower CRR → Higher multiplier → More credit created
This is the mechanism through which RBI controls credit by changing CRR.
3. Central Bank — Reserve Bank of India (RBI)
The Central Bank (RBI in India, established 1935) is the apex monetary institution — it issues currency, controls money supply, regulates the banking system, and acts as banker to the government.
Functions of RBI
| Function |
Explanation |
| Issue of Currency |
RBI has the sole right to issue currency notes in India (except ₹1 notes, issued by Ministry of Finance). All currency notes are legal tender. |
| Banker to the Government |
Maintains government accounts, manages public debt, provides short-term advances to government, acts as financial advisor. |
| Banker's Bank |
Keeps reserves of commercial banks (CRR), lends to them as lender of last resort, clears inter-bank payments. |
| Controller of Credit |
Uses quantitative and qualitative tools to regulate credit in the economy — expanding or contracting money supply. |
| Custodian of Foreign Exchange Reserves |
Manages India's foreign exchange reserves and stabilises the rupee exchange rate. |
| Clearing House |
Settles inter-bank cheque clearances and fund transfers through the RTGS/NEFT system. |
Central Bank vs Commercial Bank
| Basis |
Central Bank (RBI) |
Commercial Bank (SBI, HDFC) |
| Objective | Public welfare — price stability, growth | Profit maximisation |
| Currency issue | Only institution that can issue currency | Cannot issue currency |
| Number | One per country | Many in an economy |
| Customers | Government and commercial banks | General public and businesses |
| Control | Controls commercial banks | Controlled by central bank |
4. Monetary Policy Tools
Monetary policy is the use of money supply and interest rate tools by RBI to achieve macroeconomic objectives. Tools are of two types:
A. Quantitative (General) Tools — affect total volume of credit
| Tool |
Definition |
To EXPAND credit |
To CONTRACT credit |
CRR
(Cash Reserve Ratio) |
Minimum % of net demand and time liabilities (NDTL) that banks must keep with RBI as cash |
↓ CRR → more funds for lending |
↑ CRR → less funds for lending |
SLR
(Statutory Liquidity Ratio) |
Minimum % of NDTL that banks must maintain in liquid assets — gold, cash, or approved government securities |
↓ SLR → more funds for lending |
↑ SLR → less funds for lending |
| Repo Rate |
Rate at which RBI lends short-term funds to commercial banks against government securities |
↓ Repo → cheaper for banks → lending rates fall → more borrowing |
↑ Repo → costlier for banks → lending rates rise → less borrowing |
| Reverse Repo Rate |
Rate at which RBI borrows from (accepts deposits from) commercial banks — always lower than Repo rate |
↓ RRR → banks earn less parking with RBI → more incentive to lend |
↑ RRR → banks earn more parking with RBI → less incentive to lend |
| Open Market Operations (OMO) |
RBI buys or sells government securities in the open market to inject or absorb money |
Buy securities → injects money into banking system → credit expands |
Sell securities → absorbs money → credit contracts |
B. Qualitative (Selective) Tools — direct specific sectors
| Tool |
Explanation |
| Margin Requirements | Minimum percentage of collateral value the borrower must fund themselves. High margin → less borrowing against assets. Used to control speculative borrowing. |
| Moral Suasion | RBI persuades/advises banks informally to follow certain lending policies — not legally binding but influential. |
| Rationing of Credit | RBI fixes maximum limits on credit to certain sectors or institutions. |
| Direct Action | RBI can take action against banks that don't comply — restrict lending, impose penalties. |
Practice Questions (CBSE Board Level)
Q1 (3 marks): A bank receives an initial deposit of ₹5,000. If the Cash Reserve Ratio (CRR) is 20%, calculate the total credit that can be created by the commercial banking system. Show the calculation of the money multiplier.
Explanation:
Money Multiplier = = = 5
Total Deposits Created = Initial Deposit × Money Multiplier
Total Deposits = ₹5,000 × 5 = ₹25,000
Total Credit Created (Total Loans) = Total Deposits − Initial Deposit
Total Credit = ₹25,000 − ₹5,000 = ₹20,000
This means the initial primary deposit of ₹5,000 enables the entire banking system to create exactly ₹20,000 of brand new, additional credit through successive rounds of lending and re-depositing.
Q2 (3 marks): A bank receives ₹2,000 as an initial deposit. Assume CRR is 25%. Show the mathematical progression of the first three rounds of credit creation in a table and calculate the total deposits generated.
Explanation:
| Round |
New Deposit (₹) |
Cash Reserve (25%) (₹) |
New Loan Created (₹) |
| 1 (Initial) |
2,000.00 |
500.00 |
1,500.00 |
| 2 |
1,500.00 |
375.00 |
1,125.00 |
| 3 |
1,125.00 |
281.25 |
843.75 |
| Infinite Total |
8,000.00 |
2,000.00 |
6,000.00 |
Money Multiplier = = 4
Total Deposits = Initial Deposit (₹2,000) × Multiplier (4) = ₹8,000
Q3 (4 marks): Explain any four primary functions of the Reserve Bank of India (Central Bank).
Explanation:
- Issue of Currency (Bank of Issue): The RBI holds the sole, exclusive authority to print and issue currency notes in India (all denominations above ₹1). This absolute monopoly ensures a uniform, standardized money supply and builds public faith in the national currency.
- Banker to the Government: The RBI acts as the official banker, agent, and financial advisor to both the central and state governments. It maintains their accounts, manages the massive public debt by issuing government bonds, and provides short-term emergency credit (Ways and Means Advances).
- Banker's Bank and Lender of Last Resort: All commercial banks are legally required to keep a specified fraction of their deposits as cash reserves with the RBI (CRR). If commercial banks ever face severe, unexpected liquidity crises and cannot borrow from anywhere else, the RBI steps in to provide emergency funds, preventing bank failures and systemic economic collapse.
- Controller of Credit and Money Supply: The RBI actively manages the volume and direction of credit in the economy to maintain price stability. It uses quantitative tools (CRR, SLR, Repo Rate, Open Market Operations) and qualitative tools (margin requirements) to expand credit during recessions and contract it during periods of high inflation.
Q4 (MCQ — 1 mark): When the RBI explicitly increases the Repo Rate, the immediate macroeconomic effect is:
A) Commercial banks can lend more money at lower interest rates
B) Commercial banks' cost of borrowing from RBI increases → they raise lending rates
C) The overall money supply in the economy automatically increases
D) The central government's tax revenue increases
Answer: B) Commercial banks' cost of borrowing from RBI increases → they raise lending rates.
Explanation: The Repo Rate is the benchmark interest rate at which the RBI lends short-term funds to commercial banks. When the RBI raises this rate, borrowing becomes significantly costlier for the banks. To maintain their profit margins, banks inevitably pass this higher cost onto their customers by raising their own lending rates (like home loans and business loans). Consequently, borrowing by businesses and households falls, investment and consumption heavily decline, and Aggregate Demand contracts. This mechanism is primarily used to control rampant inflation (excess demand).
Q5 (2 marks): Distinguish precisely between CRR and SLR.
Explanation:
| Basis |
CRR (Cash Reserve Ratio) |
SLR (Statutory Liquidity Ratio) |
| Form of Reserve |
Must be maintained exclusively in the form of pure cash. |
Must be maintained in designated liquid assets (gold, cash, or approved government securities). |
| Maintained With |
Kept externally, deposited directly with the Reserve Bank of India (RBI). |
Kept internally, maintained by the commercial bank itself in its own vaults/accounts. |
| Earning Potential |
The bank earns absolutely no interest on the cash deposited as CRR. |
The bank earns interest on the portion of SLR held as government securities. |
Q6 (MCQ — 1 mark): Open Market Operations (OMO) in which the RBI actively sells government securities to the public and banks will inherently:
A) Inject massive amounts of new money into the banking system
B) Reduce the money supply and contract credit availability
C) Lower the prevailing market interest rates
D) Directly increase government tax revenue
Answer: B) Reduce the money supply and contract credit availability.
Explanation: When the RBI sells government securities in the open market, commercial banks and the public buy them. To pay the RBI for these securities, they must transfer cash out of the commercial banking system. This massive payment drains cash reserves from the banks. With fewer cash reserves, their ability to create credit (lend money) sharply falls. As credit contracts, the overall money supply decreases. This is a deliberate, contractionary monetary policy move used explicitly to combat excess aggregate demand and curb inflation.
