Banking: NBSE Class 12 Economics questions, answers

Introduction

Banking plays a pivotal role in a country’s economy. Banks act as financial intermediaries that accept deposits from savers and channel these funds as loans to borrowers. This facilitates business activity and capital formation. Some key functions performed by banks include accepting deposits, advancing loans, discounting bills, and providing payment services. Banks create money through credit creation which expands the money supply.

Banks provide multiple services like overdraft facilities, remittances, locker facilities etc. They also act as agents for customers for activities like tax payments and insurance premium collection. Thus banks promote trade, commerce and economic growth by facilitating financial transactions.

Banks have a two-tier structure consisting of commercial banks and the central bank. Commercial banks deal directly with the public for banking business. The central bank regulates the banking system and controls money supply. It issues currency, acts as banker and lender to the government and commercial banks.

The central bank uses policy rates, reserve ratios and open market operations as instruments to regulate credit and money supply. It holds the foreign exchange and gold reserves of the country. The central bank oversees the stability of the currency and banking system.

Textual questions and answers

A. Very short-answer questions (answer in one word/one sentence)

1. What is a commercial bank?

Answer: A commercial bank is a financial institution which performs the functions of accepting deposits from the general public and giving loans for investment with the aim of earning profit.

2. Define a Central Bank.

Answer: The Central Bank is the apex institution of monetary and banking system of a country.

3. Define primary deposits.

Answer: Primary deposits are new(initial) deposits in cash by people.

4. What are secondary deposits?

Answer: Secondary deposits are deposits which arise on account of loans given by the bank.

5. What are the functions of a Commercial Bank?

Answer: The functions of a Commercial Bank are acceptance of deposits, advancing loans, discounting bills of exchange, overdraft facility, agency function, performing general utility services and credit creation.

6. Define credit.

Answer: Credit is purchasing power extended by a creditor to a debtor.

7. What is credit creation?

Answer: Credit creation is the process by which commercial banks create money (credit) by giving loans, mainly in the form of demand deposits.

8. What is money multiplier?

Answer: Money multiplier is the multiple by which total deposit increases due to initial (primary) deposit.

B. Short-answer questions-I (answer in 30-50 words)

1. What are the functions of a commercial bank?

Answer: The functions of a commercial bank are acceptance of deposits, advancing loans, discounting bills of exchange, overdraft facility, agency functions like transfer of funds, collection of funds, payments of bills etc., performing general utility services and credit creation.

2. What are the “general utility” services of a bank?

Answer: The “general utility” services provided by a bank include:

Traveller’s cheques. Banks issue traveller’s cheques and gift cheques.
Locker facility. Customers can keep their ornaments and important documents in lockers for safe custody.
Underwriting securities issued by government, public or private bodies.
Purchase and sale of foreign exchange (currency).

3. Explain the discounting bills of exchange function of a bank.

Answer: A bill ofexchange represents a promise to pay afixed amount ofmoney at a specific point of time in future. It can also be encashed earlier through discounting process of a commercial bank. It is a paper asset signed by the debtor and the creditor for a fixed amount payable on a fixed date.

4. What is the role of money multiplier in credit creation?

Answer: The money multiplier is the multiple by which total deposits increase due to an initial deposit. It plays a crucial role in credit creation by determining how much new credit a bank can generate based on its reserve requirements. Specifically, if the Legal Reserve Ratio (LRR) is 10%, the money multiplier would be 1/10 = 10. This means the bank can create credit that is 10 times the initial deposit.

5. What are primary deposits of a bank?

Answer: Primary deposits are new (initial) deposits in cash by people. Indirectly, primary deposits reflect savings of people in banks.

6. How is credit creation related to LRR?

Answer: Credit creation by commercial banks is determined by two factors: (i) the amount of initial (primary) deposits and (ii) the Legal Reserve Ratio (LRR), which is the minimum ratio of deposits that is legally compulsory for commercial banks to keep as cash or in liquid form. When a bank receives cash deposits, it keeps a fraction as cash reserve (LRR) and uses the remaining amount for giving loans. In the process, banks create money (credit) through secondary deposits many times more than the initial deposits. The money multiplier, which quantifies the total credit created, is the inverse of the LRR.

C. Short-answer questions-II (answer in 60-80 words)

1. “Currency is issued by the Central Bank yet we say that commercial banks create money.” Explain. How is this money creation by commercial banks likely to affect national income?

Answer: While the Central Bank has the monopoly of issuing currency, commercial banks create money through the process of credit creation. When commercial banks give loans, they create demand deposits, effectively increasing the money supply. This is known as credit creation.

As for its impact on national income, increased money creation by commercial banks leads to more loans and investments. Higher investment levels can stimulate economic activity and raise national income through the multiplier effect.

2. Reserve Bank of India has reduced CRR from 4.25% to 4%. Will this step help control inflation in India? Name any one value violated in the question.

Answer: Reducing the Cash Reserve Ratio (CRR) from 4.25% to 4% is unlikely to help control inflation. Lowering the CRR releases more funds for commercial banks to lend. As lending increases, money creation in the economy expands, thus increasing the money supply. An increase in the money supply could potentially fuel inflation rather than control it.

As for the value violated in the question, it could be argued that the question assumes that reducing the CRR would control inflation, which is misleading.

3. Can low interest rates benefit the government? If yes, how?

Answer: Low interest rates can benefit the government in several ways. Firstly, they reduce the cost of borrowing, making it cheaper for the government to finance public projects and manage its debt. Secondly, low interest rates can stimulate economic activity by encouraging consumer spending and business investment. This can lead to higher tax revenues for the government. Lastly, increased economic activity can improve employment rates, reducing the need for government spending on social welfare programs. Overall, low interest rates can contribute to a healthier fiscal position for the government.

4. What is the difference between demand deposits and time deposits?

Answer: The difference between demand deposits and time deposits is as follows:

Demand Deposits: Deposits which can be withdrawn on demand by depositors by issuing cheques are called demand deposits. For example, current account deposits and savings account deposits are demand deposits because they are payable on demand. No interest is paid on current deposits. They are highly liquid and are a part of the money supply.

Time Deposits: Time deposits (also called fixed deposits or term deposits) are deposits kept with the bank for a fixed period and can be withdrawn only after the expiry of the specified period. These are non-chequable and are not payable on demand. They carry interest that varies directly with the period of time and are less liquid.

5. Explain the meaning of credit creation.

Answer: Credit creation refers to the process by which commercial banks increase the money supply in the economy through lending activities. When a person deposits money in a bank, the bank is required to keep only a fraction of it as cash reserve based on the Legal Reserve Ratio (LRR) and is free to lend the remaining amount. For example, if a man deposits Rs.2,000 and the LRR is 10%, the bank keeps Rs.200 as cash reserve and lends Rs.1,800. This loan is not given in cash but is credited to a demand deposit account in the borrower’s name. This is the first round of credit creation. The process continues, leading to the creation of new demand deposits, which are a part of the money supply.

6. State the functions of the Central Bank.

Answer: The functions of the Central Bank are as follows:

Issuer of Currency: The Central Bank has the monopoly of issuing currency to secure control over the volume of currency and credit. It issues currency on the basis of the Minimum Reserve System.

Banker to Government: It functions as a banker to the government, providing banking facilities similar to what commercial banks offer to the public.

Banker’s Bank: The Central Bank acts as a source of great strength to the banking system, providing loans and discounting trade bills for member banks.

Controller of Credit and Money Supply: It controls credit and money supply through its monetary policy, aiming for price stability and full employment.

Exchange Control: It stabilizes the external value of the national currency and acts as the custodian of foreign exchange reserves.

Lender of Last Resort: The Central Bank provides temporary financial accommodation to save the financial structure of the country from collapse.

Custodian of Foreign Exchange Reserves: It keeps a certain minimum amount of gold and foreign currency against note issue and to meet emergency requirements of foreign exchange.

Clearing House Function: It acts as a clearing house for its member banks, providing facilities for banks to come together every day and set off their chequing claims without physical movement of cash.

Collection and Publication of Data: It collects and publishes financial and economic data.

7. What are open market operations?

Answer: These refer to buying and selling of government securities by the Central Bank to the public and banks. This is done to influence money supply in the country. Mind, sale of government securities to commercial banks means flow of money into the Central Bank which reduces cash reserves. Consequently, credit availability of commercial banks is curtailed/ controlled. When the Central Bank buys securities, it increases cash reserves of the banks and their ability to give credit.

D. Long-answer questions-I (answer in 90-120 words)

1. What is a commercial bank? State the functions of a commercial bank?

Answer: A commercial bank is a financial institution that performs the functions of accepting deposits from the general public and giving loans for investment with the aim of earning profit. In essence, commercial banks are profit-seeking institutions that generally finance trade and commerce with short-term loans. They charge a high rate of interest from borrowers but pay much less rate of interest to their depositors.

Functions of Commercial Banks:

Acceptance of Deposits: They accept deposits in the form of current, savings, and fixed deposits.
Advancing Loans: They provide various types of loans to individuals and businesses.
Discounting Bills of Exchange: They discount trade bills for their customers.
Overdraft Facility: They provide overdraft facilities to current account holders.
Agency Functions: They act as agents for their customers for various financial activities.
General Utility Services: They provide various general utility services like locker facilities, money transfer, etc.
Credit Creation: They have the ability to create credit based on the deposits they receive.

2. What is a Central bank? What are the functions of a Central bank?

Answer: The Central Bank is the apex institution of the monetary and banking system of a country. Its primary role is to control, supervise, regulate, and organize the financial and the monetary system of the economy.

Functions of a Central Bank: Issue of Currency/Bank of Issue: The Central Bank is given the monopoly of issuing currency in order to secure control over the volume of currency and credit.

Banker to Government: The Central Bank functions as a banker to the government. It accepts deposits from the government and gives loans to the government. It also manages the public debt of the country.

Banker’s Bank and Supervisor: The Central Bank acts as a banker’s bank. It is the custodian of the cash reserves of commercial banks and is the lender of the last resort to them.

Controller of Credit and Money Supply: The Central Bank controls credit and money supply through its monetary policy.

Custodian of Foreign Exchange Reserves: The Central Bank functions as the custodian of the country’s foreign exchange reserves.

Clearing House Function: The Central Bank acts as a Clearing House for its member banks.

Collection and Publication of Data: The Central Bank has also been entrusted with the task of collecting and publishing data.

3. State and explain the instruments of money policy.

Answer: The instruments of Money Policy are:

Repo Rate: This is the rate of interest at which the Central Bank lends funds to commercial banks. It is, in a way, the cost of borrowing. Cheap credit promotes investment, whereas dear money discourages it. In a situation of excess demand and inflationary pressure, the Central Bank increases the repo rate. High bank rate forces the commercial banks to raise, in turn, the rate of interest, which makes credit dear. A decrease in repo rate will have the opposite effect.

Open Market Operations: These refer to the buying and selling of government securities by the Central Bank to the public and banks. Sale of government securities to commercial banks means the flow of money into the Central Bank, which reduces cash reserves. When the Central Bank buys securities, it increases cash reserves of the banks and their ability to give credit.

Cash Reserve Ratio (CRR): Commercial banks are required under the law to keep a certain percentage (ratio) of their total deposits with the Central Bank in the form of cash reserves. This ratio is called CRR. It is a powerful instrument to control credit and lending capacity of the banks.

4. How does a Central bank act as a ‘lender of the last resort’?

Answer: In times of emergency when commercial banks fail to meet the obligations of their depositors due to a liquidity crisis, they approach the Central Bank as the last resort for getting loans. As the lender of the last resort, the Central Bank guarantees solvency and provides financial accommodation to commercial banks in two ways:

By rediscounting their eligible securities and bills of exchange.
By providing loans against their securities.

This role of the Central Bank saves banks from possible failure and protects the banking system from a possible breakdown.

5. State any five functions of a Central bank.

Answer: the following five functions of a Central Bank:

Issue of Currency/Bank of Issue: The Central Bank is given the monopoly of issuing currency in order to secure control over the volume of currency and credit.

Banker’s Bank and Supervisor: The Central Bank acts as a banker’s bank. It is the custodian of the cash reserves of commercial banks and is the lender of the last resort to them.

Custodian of Foreign Exchange Reserves (Forex): The Central Bank functions as the custodian of the country’s foreign exchange reserves. It is responsible for stabilizing the external value of the national currency.

Clearing House Function: The Central Bank acts as a Clearing House for its member banks. It provides clearing facilities for banks to come together every day and set off their chequing claims without physical movement of cash.

6. How Central bank is different from a commercial bank?

Answer: The Central Bank serves as the apex institution in the money market of a country. Its primary aim is to focus on general public welfare rather than profit-making. It has the exclusive right to issue currency notes and does not deal directly with the public. The Central Bank also acts as a banker to the government, managing its accounts and providing loans. Moreover, it is responsible for deciding the country’s monetary policy with the aim of achieving economic stability and full employment. Additionally, the Central Bank acts as the custodian of the nation’s gold and foreign exchange reserves.

On the other hand, a Commercial Bank is just a unit within the broader banking structure of the country. Unlike the Central Bank, it does not have a responsibility towards the state’s welfare. Commercial Banks are often regulated by the Central Bank and play a supplementary role in the financial system. They deal directly with the public and business firms, offering services like accepting deposits and providing loans. Unlike the Central Bank, Commercial Banks do not have the function of acting as a banker to the government.

E. Long-answer questions-II (answer in 130-200 words)

1. Explain the functions of commercial banks.

Answer: The primary functions of commercial banks include:

Acceptance of Deposits: Commercial banks accept deposits in various forms such as current, savings, and fixed deposits. They collect surplus balances from individuals and firms, thereby serving as a repository for public savings.

Advancing Loans: Banks provide loans for various purposes, including business investment and personal needs. They charge interest on these loans, which is a primary source of their revenue.

Discounting Bills of Exchange: Commercial banks discount bills of exchange, providing immediate cash to businesses and thereby facilitating trade.

Overdraft Facility: Banks offer overdraft facilities that allow customers to withdraw more money than they have in their accounts, up to a certain limit.

Agency Function: Banks act as agents for their customers, performing tasks like collecting payments, paying bills, and transferring money.

Performing General Utility Services: Banks offer various utility services such as issuing traveler’s checks, providing safe deposit lockers, and facilitating money transfers.

2. What is credit creation? Explain the process of credit creation with an example.

Answer: Credit creation is a unique function performed by commercial banks that allows them to increase the supply of money in the economy. The process of credit creation is determined by two factors: (i) Primary deposits, which are the initial cash deposits made by the public, and (ii) Legal Reserve Ratio (LRR), the minimum ratio of deposits that banks are legally required to keep in cash or liquid form.

Example:

Suppose a man, say X, deposits ₹2,000 with a bank and the LRR is 10%. The bank is required to keep only ₹200 as a cash reserve (LRR) and is free to lend the remaining ₹1,800. The loan is not given in cash but is redeposited in the bank as a demand deposit in favor of a borrower. In this case, the bank lends ₹1,800 to another individual, say Y. A demand deposit account is opened in Y’s name, and the loan amount is credited to his account. This is the first round of credit creation in the form of a demand deposit of ₹1,800.

The bank then keeps 10% of Y’s deposit (₹180) as a cash reserve and is free to lend the remaining ₹1,620 to another individual, say Z. This is the second round of credit creation. The process continues, each time retaining a fraction as a reserve and lending out the rest, until the derivative deposit becomes zero.

In the end, the total volume of credit created becomes a multiple of the initial deposit, a phenomenon known as the money multiplier. For example, if the bank succeeds in creating a total credit of ₹18,000, it means the bank has created nine times the initial deposit of ₹2,000.

3. What is the role of a Central bank in the banking process?

Answer: The role of a Central bank in the banking process are:

Banker’s Bank and Supervisor: The Central Bank is the custodian of the cash reserves of commercial banks. Banks are required to keep a certain percentage of their deposits with the Central Bank. It also acts as a supervisor to regulate and ensure the proper functioning of commercial banks.

Lender of the Last Resort: In times of emergency, when commercial banks face a liquidity crisis and fail to meet the obligations of their depositors, they can approach the Central Bank for loans. The Central Bank guarantees solvency and provides financial accommodation to commercial banks by rediscounting their eligible securities and bills of exchange.

Controller of Credit and Money Supply: The Central Bank controls the credit and money supply through its monetary policy. It adopts various measures like changing the Repo Rate to influence the lending capacity of commercial banks. For instance, in a situation of excess demand and inflationary pressure, the Central Bank may increase the repo rate to discourage borrowing.

Custodian of Foreign Exchange Reserves: The Central Bank is responsible for stabilizing the external value of the national currency and acts as the custodian of the country’s foreign exchange reserves.

Government’s Bank: The Central Bank accepts deposits from the government, gives loans to the government, and manages the public debt. It maintains the accounts of the government and carries out all its banking business.

Clearing House Function: The Central Bank acts as a clearing house for its member banks, providing facilities for banks to come together every day and set off their chequing claims without the physical movement of cash.

4. Discuss the functions of the Central bank.

Answer: The main functions of the Central Bank are as follows:

Issuer of Currency: The Central Bank has the monopoly of issuing notes, except for one-rupee notes, one-rupee coins, and small coins issued by the government. This allows it to control the volume of currency in circulation.

Banker to Government: The Central Bank accepts deposits from the government, gives loans to the government, and manages the public debt. It also carries out exchange, remittance, and other banking operations on behalf of the government.

Banker’s Bank and Supervisor: The Central Bank acts as the custodian of the cash reserves of commercial banks and supervises their functioning. Banks are required to keep a certain percentage of their deposits with the Central Bank.

Controller of Credit and Money Supply: Through its monetary policy, the Central Bank controls credit and money supply. It adopts both quantitative and qualitative measures, such as changing the Repo Rate, to influence the lending capacity of commercial banks.

Exchange Control: The Central Bank is responsible for maintaining the external value of the national currency. It adopts measures like exchange control systems to achieve this objective.

Lender of the Last Resort: In times of emergency, the Central Bank provides financial accommodation to commercial banks by rediscounting their eligible securities and bills of exchange.

Custodian of Foreign Exchange Reserves: The Central Bank holds the country’s foreign exchange reserves and takes steps to stabilize the external value of the national currency.

Clearing House Function: The Central Bank acts as a clearing house for its member banks, facilitating the settlement of cheques without the physical movement of cash.

Additional/extra questions and answers

1. How is the banking industry defined?

Answer: Banking is an industry that handles cash, credit and other financial transactions. It can be defined as a financial institution that accepts deposits from the public and creates credit. Banking can also be defined as a bank or an establishment authorized by a government to accept deposits, pay interest, clear cheques, make loans, act as an intermediary in a financial transaction and provide other financial services to its customers.

2. What is the role of the banking sector in the Indian economy?

Answer: The banking sector is considered the backbone of Indian financial stability of an economy.

3. What are the dual functions a financial institution must perform to be a commercial bank?

Answer: A financial institution must perform the dual functions of (i) accepting deposits and (ii) giving loans to be considered a commercial bank.

4. Why are post offices not considered banks?

Answer: Post offices are not banks because they do not give loans.

5. How do commercial banks earn their main profit?

Answer: Commercial banks charge a high rate of interest from borrowers but pay a much lower rate of interest to their depositors. The difference between these two rates of interest becomes the main source of profit for the banks.

6. What are the two most distinctive features of a commercial bank?

Answer: The two most distinctive features of a commercial bank are borrowing and lending, which means the acceptance of deposits and the lending of money to projects to earn interest (profit).

7. What are demand deposits? Why are they called so?

Answer: Deposits which can be withdrawn on demand by depositors by issuing cheques are called demand deposits. For example, current account deposits and savings account deposits are called demand deposits because they are payable on demand.

8. What are time deposits? Why are they considered less liquid?

Answer: Time deposits, also called fixed deposits or term deposits, are deposits which are kept with the bank for a fixed period and can be withdrawn only after the expiry of the specified period. Time deposits are less liquid as they become liquid only after the maturity of the fixed period.

9. State any two differences between demand deposits and time deposits.

Answer: Two differences between demand deposits and time deposits are:

(i) Demand deposits do not carry interest whereas time deposits carry a fixed rate of interest.
(ii) Demand deposits are highly liquid whereas time deposits are less liquid.

10. What is a bill of exchange? How do banks facilitate its early encashment?

Answer: A bill of exchange represents a promise to pay a fixed amount of money at a specific point of time in the future. It can be encashed earlier through the discounting process of a commercial bank.

11. What is the overdraft facility provided by a commercial bank?

Answer: An overdraft is an advance given by allowing a customer with a current account to overdraw his current account up to an agreed limit. It is a facility for a depositor to withdraw more money than the balance amount in his account for a short period.

12. List any two agency functions performed by a commercial bank.

Answer: Two agency functions performed by a commercial bank are:

(i) Transfer of funds: It provides a facility for cheap and easy remittance of funds from place-to-place through demand drafts, mail transfers, telegraphic transfers, etc.
(ii) Collection of funds: It collects funds through cheques, bills, hundies and demand drafts on behalf of its customers.

13. Mention any two general utility services offered by commercial banks.

Answer: Two general utility services offered by commercial banks are:

(i) Traveller’s cheques: Banks issue traveller’s cheques and gift cheques.
(ii) Locker facility: Customers can keep their ornaments and important documents in lockers for safe custody.

14. What are primary deposits? What do they reflect?

Answer: Primary deposits are new (initial) deposits in cash by people. Indirectly, primary deposits reflect the savings of people in banks.

15. What are secondary deposits? How do they arise?

Answer: Secondary deposits, also known as demand deposits, are deposits which arise on account of loans given by the bank.

16. What two factors determine the extent of money creation by commercial banks?

Answer: Money creation by commercial banks is determined by two factors: (i) Primary deposits, i.e., initial cash deposits and (ii) Legal Reserve Ratio (LRR).

17. What is the Legal Reserve Ratio (LRR)?

Answer: The Legal Reserve Ratio (LRR) is the minimum ratio of deposits which is legally compulsory for commercial banks to keep as cash or in liquid form.

18. How does money creation by banks affect the national income?

Answer: Demand deposits are created by commercial banks by lending to people, especially to investors. The more the number of demand deposits and the amount of loan therein, the more will be the investment. Increased investment in the economy leads to a rise in national income through the multiplier effect.

19. When was the Reserve Bank of India established? When was it nationalised?

Answer: The Reserve Bank of India was established in 1935 as a shareholders’ bank and was nationalised on 1st January, 1949.

20. What is the Minimum Reserve System for issuing currency in India?

Answer: The Central Bank issues currency on the basis of the Minimum Reserve System. According to this system, the RBI maintains a minimum reserve of ₹200 crore, of which ₹115 crore is in the form of gold and the remaining ₹85 crore is in the form of foreign securities.

21. Who has the authority to issue one-rupee notes and coins in India?

Answer: One-rupee notes and coins are issued by the Central Government.

22. How does the Central Bank act as a banker to the government?

Answer: The Central Bank functions as a banker to the government by providing banking facilities similar to what commercial banks provide to the public. It accepts deposits from the government, gives loans to the government, and maintains the government’s accounts, carrying out all its banking business. The Government keeps its cash balances in a current account with the Central Bank, which also accepts receipts and makes payments on behalf of the government. Additionally, the Central Bank carries out exchange, remittance, and other banking operations, gives loans and advances for temporary periods, and manages the public debt of the country.

23. In what way does the Central Bank act as a custodian of commercial banks’ cash reserves?

Answer: The Central Bank acts as the custodian of commercial banks’ cash reserves. Banks in the country are required to keep a certain percentage of their deposits with the Central Bank. In this way, the Central Bank is the ultimate holder of the cash reserves of commercial banks.

24. What is the main objective of the credit control function of the Central Bank?

Answer: The main objective of the credit control function of the Central Bank is price stability along with full employment (level of output).

25. What is the Repo Rate? How does it affect the cost of borrowing?

Answer: The Repo Rate is the rate of interest at which the Central Bank lends funds to commercial banks. It is, in a way, the cost of borrowing. Cheap credit, resulting from a lower repo rate, promotes investment, whereas dear money, from a higher repo rate, discourages it.

26. What are Open Market Operations?

Answer: Open Market Operations refer to the buying and selling of government securities by the Central Bank to the public and banks. This is done to influence the money supply in the country.

27. How is the Bank Rate different from the Repo Rate?

Answer: The Bank Rate and Repo Rate are almost similar, except that the bank rate is applicable for a long-term period (and emergency) and the Repo Rate is applicable for a short-term period.

28. What is the Cash Reserve Ratio (CRR)?

Answer: Commercial banks are required under the law to keep a certain percentage (ratio) of their total deposits with the Central Bank in the form of cash reserves. This ratio is called the Cash Reserve Ratio (CRR).

29. How does the Central Bank perform its exchange control function?

Answer: The Central Bank performs its exchange control function to see that the external value of the currency is maintained. Under the exchange control system, every citizen of India has to deposit with the Reserve Bank of India all foreign currency or exchange that he receives. Any foreign exchange he might need has to be secured from the Reserve Bank by making an application in the prescribed form.

30. What is the clearing house function of the Central Bank?

Answer: The Central Bank acts as a Clearing House for its member banks. It provides clearing facilities for banks to come together every day and set off their chequing claims against each other without the physical movement of cash.

31. State two points of difference between a commercial bank and a central bank.

Answer: Two points of difference between a commercial bank and a central bank are:

A central bank’s primary aim is general public welfare, whereas a commercial bank’s primary aim is to make profits.
A central bank cannot deal with the public, whereas a commercial bank directly deals with the public and business firms.

32. Explain the meaning of a commercial bank. Why is it referred to as a profit-seeking institution?

Answer: A commercial bank is a financial institution which performs the functions of accepting deposits from the general public and giving loans for investment with the aim of earning profit.

Commercial banks, as their name suggests, are profit-seeking institutions, meaning they do banking business to earn profit. They generally finance trade and commerce with short-term loans. They charge a high rate of interest from borrowers but pay a much lower rate of interest to their depositors. The difference between these two rates of interest becomes the main source of profit for the banks.

33. Differentiate between demand deposits and time deposits based on their liquidity and role in money supply.

Answer: Demand deposits are deposits which can be withdrawn on demand by depositors by issuing cheques. Since demand deposits are chequable deposits and highly liquid cash, they are treated as a part of the money supply.

Time deposits, also called fixed deposits or term deposits, are deposits which are kept with the bank for a fixed period and can be withdrawn only after the expiry of the specified period. Time deposits are less liquid as they become liquid only after the maturity of the fixed period, so they are not treated as a part of the supply of money.

The key differences based on liquidity and money supply are:

(i) Demand deposits are highly liquid whereas time deposits are less liquid.
(ii) Demand deposits are a part of money supply whereas time deposits are not.

34. Describe the ‘advancing loans’ function of a commercial bank. What forms can these loans take?

Answer: The second major function of a commercial bank is to give loans and advances, particularly to businessmen and entrepreneurs, and thereby earn interest. This is the main source of income for the bank. A bank keeps a certain portion of the deposits with itself as a reserve and lends the balance to borrowers as loans and advances. These can be in the form of cash credit, demand loans, short-run loans, and overdraft.

35. Explain the agency functions performed by a commercial bank for its customers.

Answer: The bank acts as an agent of its customers and gets a commission for performing agency functions as under:

(i) Transfer of funds—It provides a facility for cheap and easy remittance of funds from place-to-place through demand drafts, mail transfers, telegraphic transfers, etc.
(ii) Collection of funds—It collects funds through cheques, bills, hundies and demand drafts on behalf of its customers.
(iii) Payments of various items—It makes payment of taxes, insurance premium, bills, etc., as per the directions of its customers.
(iv) Collection of dividends, interest on shares and debentures is made on behalf of its customers, etc.

36. Describe the general utility services that commercial banks provide to the public.

Answer: Banks provide many general utility services, some of which are as under:

(i) Traveller’s cheques. Banks issue traveller’s cheques and gift cheques.
(ii) Locker facility. Customers can keep their ornaments and important documents in lockers for safe custody.
(iii) Underwriting securities issued by government, public or private bodies.
(iv) Purchase and sale of foreign exchange (currency).

37. Explain the distinction between primary deposits and secondary deposits in the banking system.

Answer: The distinction between primary and secondary deposits is as follows:

(i) Primary deposits are new (initial) deposits in cash by people. Indirectly, primary deposits reflect the savings of people in banks.
(ii) Secondary deposits (Demand deposits) are deposits which arise on account of loans given by the bank. These are called demand deposits because loans are not given in cash but a demand deposit account is opened in the name of the borrower. In other words, secondary deposits indicate deposits of borrowers in the bank.

38. What is a money multiplier? How is its value determined by the Legal Reserve Ratio?

Answer: The money multiplier is the multiple by which the total deposit increases due to an initial (primary) deposit.

The value of the money multiplier is determined by the Legal Reserve Ratio (LRR). The money multiplier is the inverse of the Legal Reserve Ratio. For example, if the LRR is 10%, or 10/100, then the money multiplier will be 1 / (10/100), which equals 10.

39. Explain the role of the Central Bank as the ‘Bank of Issue’. What system does it follow for this?

Answer: As the ‘Bank of Issue’, the Central Bank is given the monopoly of issuing currency in order to secure control over the volume of currency and credit. These notes circulate throughout the country as legal tender money.

The Central Bank issues currency on the basis of the Minimum Reserve System. According to this system, the RBI maintains a minimum reserve of ₹200 crore, of which ₹115 crore is in the form of gold and the remaining ₹85 crore is in the form of foreign securities.

40. Describe the role of the Central Bank as the ‘Banker’s Bank and Supervisor’.

Answer: In a country with hundreds of banks, there should be an agency to regulate and supervise their proper functioning. This duty is discharged by the Central Bank, which acts as a banker’s bank in the following three capacities:

(i) It is the custodian of their cash reserves. Banks of the country are required to keep a certain percentage of their deposits with the Central Bank; and in this way, the Central Bank is the ultimate holder of the cash reserves of commercial banks.
(ii) The Central Bank is lender of the last resort. Whenever banks are short of funds, they can take loans from the Central Bank and get their trade bills discounted. The Central Bank is a source of great strength to the banking system.
(iii) It acts as a Clearing House for its member banks. Thus, it is a bank of central clearance, settlements and transfers.

41. How does the Central Bank use the Repo Rate as an instrument of monetary policy to control credit?

Answer: The Repo Rate is the rate of interest at which the Central Bank lends funds to commercial banks. It is, in a way, the cost of borrowing. In a situation of excess demand and inflationary pressure, the Central Bank increases the repo rate. A high bank rate forces the commercial banks to raise, in turn, the rate of interest, which makes credit dear. As a result, demand for loans and other purposes falls. Thus, an increase in the repo rate by the Central Bank adversely affects credit creation by commercial banks. A decrease in the repo rate will have the opposite effect. By changing the repo rate, the Central Bank can increase or decrease the money supply and credit availability.

42. Explain how Open Market Operations are used to influence the money supply in an economy.

Answer: Open Market Operations refer to the buying and selling of government securities by the Central Bank to the public and banks. This is done to influence the money supply in the country. The sale of government securities to commercial banks means a flow of money into the Central Bank, which reduces cash reserves. Consequently, the credit availability of commercial banks is curtailed or controlled. When the Central Bank buys securities, it increases the cash reserves of the banks and their ability to give credit.

43. How does a change in the Cash Reserve Ratio (CRR) affect the credit creation capacity of commercial banks?

Answer: To curtail the credit-giving capacity of the banks, the Central Bank raises the CRR. When it wants to enhance the credit-giving powers of the bank, it reduces the CRR. When the CRR falls, commercial banks keep lower reserves with the Central Bank. This releases funds for commercial banks to lend. As lending increases, money creation in the economy expands, and thus, the money supply increases.

44. Explain the ‘lender of the last resort’ function of the Central Bank. Why is it important?

Answer: In times of emergency when commercial banks fail to meet the obligations of their depositors due to a liquidity crisis, they approach the Central Bank as the last resort for getting loans. As the lender of the last resort, the Central Bank guarantees solvency and provides financial accommodation to commercial banks by rediscounting their eligible securities and bills of exchange and by providing loans against their securities.

This function is important because it saves banks from possible failure and the banking system from a possible breakdown. By providing temporary financial accommodation, the Central Bank saves the financial structure of the country from collapse.

45. What are the two major functions of a commercial bank? Explain them in detail.

Answer: The two most distinctive features of a commercial bank are borrowing and lending, i.e., acceptance of deposits and lending of money to projects to earn interest (profit). These two major functions are explained below:

Acceptance of Deposits: A commercial bank accepts deposits in the form of current, savings and fixed deposits. It collects the surplus balances of individuals, firms and finances the temporary needs of commercial transactions. The first task is, therefore, the collection of the savings of the public. The bank does this by accepting deposits from its customers. Deposits are the lifeline of banks. The two traditional forms of deposits are:

Demand deposits: These are deposits which can be withdrawn on demand by depositors by issuing cheques. For example, current account deposits and savings account deposits are called demand deposits because they are payable on demand. Since demand deposits are chequable deposits and highly liquid cash, they are treated as a part of money supply. No interest is paid on current deposits.
Time deposits: Also called fixed deposits or term deposits, these are deposits which are kept with the bank for a fixed period and can be withdrawn only after the expiry of the specified period. These are non-chequable and are not payable on demand. These carry interest that varies directly with period of time. Time deposits are less liquid as they become liquid after maturity of fixed period, so they are not treated as a part of supply of money.

Advancing Loans: The second major function of a commercial bank is to give loans and advances particularly to businessmen and entrepreneurs and thereby earn interest. 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 borrowers as loans and advances in the form of cash credit, demand loans, short-run loans, and overdraft.

46. What is a money multiplier? Explain how its value is determined and how it amplifies initial deposits.

Answer: A money multiplier is the multiple by which the total deposit increases due to an initial (primary) deposit.

The value of the money multiplier (or credit multiplier) is determined by the Legal Reserve Ratio (LRR); it is the inverse of the LRR. If LRR is 10%, i.e., 10/100, then the money multiplier = 1 / (10/100) = 10. The formula for total credit creation shows this relationship:

Total credit creation = Initial deposits x (1/LRR)

The money multiplier amplifies the initial deposits. For example, if an initial deposit of ₹2,000 is made and the LRR is 10%, the total demand deposits created in the banking system will be ₹2,000 x (1/10%) = ₹20,000. If the bank succeeds in creating total credit of ₹18,000 from this process, it means the bank has created 9 times the primary (initial) deposit of ₹2,000. This factor of nine is the value of the money multiplier in terms of credit created, while the total deposit becomes 10 times the initial deposit.

47. Describe the role of the Central Bank as the ‘Controller of Credit and Money Supply’.

Answer: The Central Bank controls credit and money supply through its monetary policy, which consists of two parts—currency and credit. The Central Bank has a monopoly on issuing notes (except one-rupee notes and coins issued by the government) and thereby can control the volume of currency. The main objective of the credit control function of the Central Bank is price stability along with full employment (level of output). It controls credit and money supply by adopting quantitative and qualitative measures.

48. Explain any three quantitative instruments of monetary policy used by the Central Bank to regulate the economy.

Answer: The following three quantitative instruments of monetary policy are used by the Central Bank:

(i) Repo Rate: This is the rate of interest at which the Central Bank lends funds to commercial banks. It is, in a way, the cost of borrowing. In a situation of excess demand and inflationary pressure, the Central Bank increases the repo rate. A high bank rate forces the commercial banks to raise, in turn, the rate of interest which makes credit dear. As a result, demand for loans falls. Thus, an increase in the repo rate adversely affects credit creation. A decrease in the repo rate will have the opposite effect, making credit cheaper and promoting investment.
(ii) Open Market Operations: These refer to the buying and selling of government securities by the Central Bank to the public and banks. This is done to influence the money supply in the country. The sale of government securities to commercial banks means a flow of money into the Central Bank, which reduces the cash reserves of commercial banks. Consequently, the credit availability of commercial banks is curtailed. When the Central Bank buys securities, it increases the cash reserves of the banks.

Additional MCQs

1: What are the two essential functions a financial institution must perform to be classified as a commercial bank?

A. Issuing currency and managing foreign exchange
B. Accepting deposits and giving loans
C. Providing locker facilities and underwriting securities
D. Clearing cheques and collecting dividends

Answer: B. Accepting deposits and giving loans

2: The deposits that can be withdrawn on demand by issuing cheques are known as:

A. Time deposits
B. Fixed deposits
C. Recurring deposits
D. Demand deposits

Answer: D. Demand deposits

3: What is the primary objective of a commercial bank?

A. To ensure financial stability of the economy
B. To act as a banker to the government
C. To earn profit
D. To control the supply of money

Answer: C. To earn profit

4: The apex institution of the monetary and banking system of a country is called the:

A. Commercial Bank
B. Joint Stock Bank
C. Central Bank
D. World Bank

Answer: C. Central Bank

5: The rate of interest at which the Central Bank lends funds to commercial banks for short-term periods is known as the:

A. Bank Rate
B. Cash Reserve Ratio
C. Repo Rate
D. Legal Reserve Ratio

Answer: C. Repo Rate

6: In India, which authority is responsible for issuing all currency notes except one-rupee notes and coins?

A. The Ministry of Finance
B. The Central Government
C. The Reserve Bank of India
D. The State Bank of India

Answer: C. The Reserve Bank of India

7: The process by which commercial banks create credit, which is a multiple of the initial deposits, is known as:

A. Money multiplier
B. Credit creation
C. Overdraft facility
D. Discounting bills

Answer: B. Credit creation

8: What is the term for an advance given by a bank that allows a customer to withdraw more than their account balance up to an agreed limit?

A. Cash credit
B. Demand loan
C. Overdraft
D. Short-run loan

Answer: C. Overdraft

9: The ratio of total deposits that a commercial bank is legally required to keep as cash with itself or the central bank is called:

A. Repo Rate
B. Legal Reserve Ratio
C. Statutory Liquidity Ratio
D. Bank Rate

Answer: B. Legal Reserve Ratio

10: Which function of a central bank involves providing loans to commercial banks during times of financial crisis?

A. Banker to the government
B. Custodian of cash reserves
C. Clearing house
D. Lender of the last resort

Answer: D. Lender of the last resort

11: Deposits that arise on account of loans given by a bank are referred to as:

A. Primary deposits
B. Time deposits
C. Secondary deposits
D. Initial deposits

Answer: C. Secondary deposits

12: The buying and selling of government securities by the Central Bank to influence the money supply is known as:

A. Open Market Operations
B. Credit Control
C. Exchange Control
D. Clearing House Function

Answer: A. Open Market Operations

13: In India, the Reserve Bank of India was nationalised in which year?

A. 1935
B. 1947
C. 1949
D. 1951

Answer: C. 1949

14: The difference between the interest rate charged from borrowers and the rate paid to depositors constitutes a bank’s:

A. Reserve
B. Liability
C. Profit
D. Asset

Answer: C. Profit

15: Which of the following is NOT a function of a commercial bank?

A. Accepting deposits
B. Advancing loans
C. Issuing currency notes
D. Providing overdraft facility

Answer: C. Issuing currency notes

16: Which of the following is NOT considered a demand deposit?

A. Current account deposits
B. Savings account deposits
C. Fixed deposits
D. Chequable deposits

Answer: C. Fixed deposits

17: All of the following are agency functions of a commercial bank EXCEPT:

A. Transfer of funds
B. Collection of dividends on behalf of customers
C. Providing locker facilities for valuables
D. Making payment of taxes and insurance premiums

Answer: C. Providing locker facilities for valuables

18: Which of the following is NOT a characteristic of time deposits?

A. They are kept for a fixed period.
B. They are highly liquid.
C. They carry a fixed rate of interest.
D. They are non-chequable.

Answer: B. They are highly liquid.

19: Which of the following is NOT a function of the Central Bank?

A. Acting as a banker to the government
B. Dealing directly with the public and business firms
C. Controlling credit and money supply
D. Acting as a lender of the last resort

Answer: B. Dealing directly with the public and business firms

20: Which of the following is NOT a quantitative measure of credit control used by a Central Bank?

A. Repo Rate
B. Open Market Operations
C. Moral persuasion
D. Cash Reserve Ratio

Answer: C. Moral persuasion

21: A financial institution is NOT considered a bank if it does not perform which of the following dual functions?

A. Accepting deposits and providing locker facilities
B. Giving loans and discounting bills of exchange
C. Accepting deposits and giving loans
D. Issuing cheques and transferring funds

Answer: C. Accepting deposits and giving loans

22: Which of the following is NOT a role of the Central Bank as a ‘Banker’s Bank’?

A. Custodian of cash reserves
B. Lender of the last resort
C. Managing public debt
D. Clearing house for member banks

Answer: C. Managing public debt

23: Which of the following statements about demand deposits is NOT true?

A. They are payable on demand.
B. They are treated as a part of the money supply.
C. A high rate of interest is paid on them.
D. They are chequable deposits.

Answer: C. A high rate of interest is paid on them.

24: Assertion (A): A commercial bank’s main source of income is the difference between the interest it charges on loans and the interest it pays on deposits.
Reason (R): Commercial banks are profit-seeking institutions that aim to maximize this interest rate differential.