Inside the Banking System:

The Major function of the bank is accepting deposits from depositors and giving loans or credit to borrowers. Banks are able to perform these functions effectively with their ability to create money in the banking system. 

Banking System: Functions and Impact

• Reserve Requirements: Banks keep only a small proportion of their deposits as cash with themselves. 
• Example: Banks in India these days hold about 15 percent of their deposits as cash.
  • This is kept as the provision to pay the depositors who might come to withdraw money from the bank on any given day.
  • The bank can manage its cash effectively as only a few depositors withdraw cash on a specific day.
• Creation of Money: Banks can create money in a similar manner to the story of Lala we saw above , as they lend to individuals without expecting all depositors to withdraw at the same time. 
  • When a new deposit is opened, the money supply increases to old deposits plus new deposits (plus currency). 
• Balance Sheet: A fictional balance sheet for a single bank can be constructed, recording assets and liabilities. 
  • Assets are things a firm owns or can claim from others, such as loans given to the public. 
• Reserves: These are deposits held by commercial banks with the Central Bank, the Reserve Bank of India (RBI). 
  • These reserves are partly cash and partly in the form of financial instruments issued by the RBI. 
  • Reserves are similar to deposits we keep with banks, as they can be withdrawn by us.
  • Commercial banks like the State Bank of India (SBI) keep their deposits with RBI and these are called Reserves. 

Assets = Reserves + Loans 

• Liabilities: For any firm, Liabilities are its debts or what it owes to others. 
  • For a bank, the main liability is the deposits which people keep with it. 

Liabilities = Deposits

• Net Worth: The accounting rule states that both sides of the account must balance. 
  • Hence if assets are greater than liabilities, they are recorded on the right-hand side as Net Worth. 

Net Worth = Assets – Liabilities

• In the banking system, this process ensures stability and effective management of cash reserves.

Balance Sheet of a Fictional Bank in the Banking system:

• Consider an example of a fictional bank in the Banking system, with deposits (liabilities) equal to Rs 100. 
• This could be because Ms Fernandes has deposited Rs 100 in the bank.  
• Let this bank deposit the same amount with RBI as reserves. 
• Given table  represents its balance sheet.
• Suppose that there is no currency in circulation, then the total money supply in the economy will be equal to Rs 100. 

               M1 = Currency + Deposits = 0 +100 =100

Banking System: Analyzing CRR, SLR, and Money Multiplier

• Reserves: Suppose Mr. Mathew is applying for a Rs 500 loan from a bank, which would increase the total bank deposits and money supply. 
• • However, there is a limit to money or credit creation by banks, determined by the Central Bank (RBI). Such limits are called reserves. 
• Cash Reserve Ratio (CRR): The RBI sets a percentage of deposits that banks must keep as reserves to prevent over-lending, known as the ‘Required Reserve Ratio’ or ‘Reserve Ratio’ or ‘Cash Reserve Ratio’ (CRR).

Cash Reserve Ratio (CRR) = Percentage of deposits which a bank must keep as cash reserves with the bank.

• Statutory Liquidity Ratio or SLR: Apart from the CRR, banks are also required to keep some reserves in liquid form in the short term. This ratio is called Statutory Liquidity Ratio or SLR.
  • In a hypothetical scenario with a reserve ratio of 20%, a bank with a deposit of Rs 100 needs to keep Rs 20 (20% of 100) as cash reserves. 
  • The remaining amount, Rs 80 (100 – 20 = 80), can be used for loans. 

• Impact of Reserve Ratio: The reserve ratio limits the amount of credit banks can create.
  • Example: if a bank starts with a deposit of Rs 100, it must keep Rs 80 (100 – 20) as cash reserves. 
    • The bank can lend out Rs 80 to Jaspal Kaur, resulting in a total of Rs 180 as deposits.
    • The bank must keep Rs 36 as cash reserves, so it can lend Rs 64 again, resulting in Rs 64 as deposits.
    • The required reserves will only be Rs 100 when the total deposits reach Rs 500.
• The process is illustrated in the above Table.
  • The first column lists each round. The second column depicts the total deposits with the bank at the beginning of each round. 
  • 20% of these deposits need to be deposited with the RBI as required reserves (column 3). 
  • What the bank lends in each round gets added to the deposits with the bank in the next round. 
  • Column 4 indicates the Loans made by the banks.

• Since the bank is only expected to keep 20% of its deposits as reserves, thus, reserves of Rs 100 (20% of 500 = 100) can support the deposits of Rs 500.
  • It means our bank can give a loan of Rs 400. 
  • Above Table  demonstrates its balance sheet. 
  • M1 = Currency + Deposits = 0 + 500 = 500 
• Thus, the money supply increases from Rs 100 to Rs 500. Given a CRR of 20 per cent, the bank cannot give a loan beyond Rs 400. Hence, the requirement of reserves acts as a limit to money creation. The banking system thus operates within these constraints set by reserve requirements.

Loan activities in the Banking System: Bridging Deposits and Economic Demands

• Banks as Intermediaries for Loans and Deposits:
  • Banks use the major portion of the deposits to extend loans. 
  • There is a huge demand for loans for various economic activities. 
  • Banks make use of the deposits to meet the loan requirements of the people. 
• Meeting Economic Demands: Banks mediate between those who have surplus funds (the depositors) and those who are in need of these funds (the borrowers).
• Profit Mechanism: Banks charge a higher interest rate on loans than what they offer on deposits. 
  • The difference between what is charged by borrowers and what is paid to depositors is their main source of income. 
  • It illustrates how banks within the banking system efficiently use deposits to meet a variety of loan requirements.

Different Credit Situations within the Banking system

• Credit: It is an agreement where a lender provides money, goods, or services to a borrower in exchange for a promise of future payment.
• Example 1: 
  • During a festival season a manufacturer gets a credit based on an agreement- where a lender provides money, goods, or services to a borrower in exchange for a promise of future payment. 
  • Credit therefore plays a vital and positive role in this situation.
• Example 2:
  • Swapna, a small farmer, takes a loan from a moneylender to cultivate groundnut. Despite pests and expensive pesticides, she cannot repay the loan. 
  • The debt grows, and she takes a fresh loan. 
  • Despite a normal crop, Swapna’s earnings are insufficient to cover the old loan, forcing her to sell land. 
  • Credit in this case pushes the borrower into a situation from which recovery is very painful.
• Credit Dynamics (Prosperity or Debt Traps): Credit can either increase earnings and improve an individual’s situation or, due to crop failure, can lead to a debt trap.
• Agricultural Credit in Rural Areas: In rural areas, credit is primarily needed for crop production, which involves significant costs such as seeds, fertilisers, pesticides, water, electricity, and equipment repair within the banking system.

Terms of Credit within the Banking system

• Loan agreements: It specifies an interest rate, principal payment, and collateral requirements for the borrower, with lenders potentially demanding collateral for loans.
• Collateral: It is an asset that the borrower owns (such as land, building, vehicle, livestock, and deposits with banks) and uses this as a guarantee to a lender until the loan is repaid. 
• Lender’s Recourse in Case of Loan Default: If the borrower fails to repay the loan, the lender can sell the collateral, such as property, deposits, or livestock, to obtain payment.
• Terms of Credit: Interest rate, collateral and documentation requirement, and the mode of repayment together comprise what is called the terms of credit.
• The terms of credit vary substantially from one credit arrangement to another. 
  • They may vary depending on the nature of the lender and the borrower.

These terms play a pivotal role in shaping the credit landscape within the banking system.

Cooperatives in the Banking System: Empowering Rural Credit

• Rural Credit: The major source of cheap credit in rural areas is the cooperative societies (or cooperatives). Members of a cooperative pool their resources for cooperation in certain areas. 
• Cooperative Societies: There are several types of cooperatives possible such as farmers cooperatives, weavers cooperatives, industrial workers cooperatives, etc. are pivotal in the Banking system.
  • Cooperatives accept deposits from its members. 
  • With these deposits as collateral, the Cooperatives obtain a large loan from the bank. 
  • These funds are used to provide loans to members.
  • Once these loans are repaid, another round of lending can take place.

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