Banking: Commercial Banks and the Central Bank
How commercial banks create credit, and how the RBI regulates the money supply.
Definition
Banking is the system through which commercial banks accept deposits and extend loans, while the central bank (the RBI, in India) regulates and controls the overall supply of money and credit in the economy.
Simple Explanation
Commercial banks are where money moves and multiplies through lending; the central bank is the referee that decides how much of that multiplying is allowed to happen.
Detailed Explanation
Commercial banks accept deposits and extend loans. Because they keep only a fraction of every deposit as reserves (the Legal Reserve Ratio, or LRR) and lend out the rest, that lent money gets re-deposited elsewhere in the banking system and re-lent again, repeatedly. This chain means the banking system as a whole creates a multiple of the initial deposit in total deposits — a process called credit creation.
The size of this multiplier depends entirely on the LRR: a lower LRR means banks keep less in reserve and lend out more at each round, producing a larger credit multiplier; a higher LRR shrinks the multiplier. This inverse relationship is exactly why the LRR is the central bank's most direct lever over the total volume of credit in the economy.
The Reserve Bank of India, as the central bank, controls the total money supply using quantitative tools, which affect the overall volume of credit (Repo Rate, Cash Reserve Ratio, Statutory Liquidity Ratio, Open Market Operations), and qualitative tools, which affect the direction or purpose of credit rather than its total amount (margin requirements, moral suasion, rationing of credit).
Beyond setting these tools, the RBI performs several distinct functions that describe what it IS, not just what it DOES: it is the sole note-issuing authority, banker to the government, banker's bank and lender of last resort to commercial banks facing a liquidity crunch, and custodian of the country's foreign exchange reserves. These structural roles are tested separately from the monetary policy tools above, since they exist regardless of which way policy is currently leaning.
Real-life Examples
Credit creation
A ₹10,000 deposit in a bank with a 10% Legal Reserve Ratio can, through repeated lending and re-depositing across the banking system, expand into ₹1,00,000 of total deposits system-wide.
Repo rate hikes
When the RBI raises the repo rate, banks' own borrowing cost rises, so they raise loan interest rates too, slowing down spending — a tool used to control inflation.
Formulas
Total Credit Creation
Total Deposits = Initial Deposit × (1 / LRR)
The money multiplier effect of the banking system, given the Legal Reserve Ratio.
Legal Reserve Ratio
LRR = CRR + SLR
Sum of the Cash Reserve Ratio and Statutory Liquidity Ratio.
Tables
| Tool | Type | Effect of an increase |
|---|---|---|
| Repo Rate | Quantitative | Raises cost of borrowing, reduces money supply |
| Cash Reserve Ratio (CRR) | Quantitative | Locks more bank funds with RBI, reduces lending capacity |
| Statutory Liquidity Ratio (SLR) | Quantitative | Reduces funds available for credit creation |
| Margin requirement | Qualitative | Reduces the loan amount available against the same collateral value |
Common Mistakes
- Thinking the RBI 'prints' all money in circulation — most of the broad money supply is created by commercial banks through credit creation, not physical currency.
- Confusing CRR (kept as cash with the RBI, earns no interest) with SLR (kept as liquid assets, which can include government securities).
- Believing a higher Legal Reserve Ratio increases credit creation — it actually reduces the credit multiplier.
Board Exam Tips
- For credit creation numericals, always state the formula Total Deposits = Initial Deposit × (1/LRR) before substituting values.
- Clearly separate quantitative tools (affect the overall quantity of credit) from qualitative tools (affect the direction/purpose of credit) when listing RBI instruments.
- When asked about RBI 'functions' versus 'monetary policy tools', keep the two lists distinct — functions describe its structural role, tools describe its policy actions.
Summary
- Commercial banks create credit by lending out a fraction of every deposit repeatedly.
- The credit multiplier equals 1 divided by the Legal Reserve Ratio.
- The RBI manages money supply through quantitative and qualitative monetary policy tools.
- The RBI also performs structural functions: note issuance, banker to government, lender of last resort, and custodian of forex reserves.
Practice MCQs
1. If the Legal Reserve Ratio is 20%, the credit multiplier is:
2. Which of these is a qualitative monetary policy tool?
3. Which of the following is NOT a function of the Reserve Bank of India?
4. An increase in the Statutory Liquidity Ratio (SLR) will:
5. The RBI acting as 'lender of last resort' means it:
Previous Year Questions
Explain the process of credit creation by commercial banks with a numerical example.
Distinguish between the Cash Reserve Ratio and the Statutory Liquidity Ratio.
Explain the various functions of the Reserve Bank of India as the central bank of the country.
If the initial deposit is ₹5,000 and LRR is 25%, calculate the total credit creation by the banking system.
Distinguish between quantitative and qualitative tools of credit control, with one example of each.
Explain the 'lender of last resort' function of the RBI.
Explain the process of money creation by the banking system with the help of a numerical illustration.