Banking: One Mark Questions, Book Back Answers and Notes

About Banking

Medium ~120 min study

A bank takes money from people who have more than they need right now and lends it to people who want to spend or invest. That simple job has big effects. Because banks lend out most of what they receive, they end up creating money, and the central bank has to keep that process under control so prices stay stable.

The chapter moves in that order. First come commercial banks: their primary functions (accepting deposits, giving loans) and secondary functions (agency and general utility services). Then credit creation, where a single cash deposit turns into several times its value in deposits across the system. After that the Reserve Bank of India, the tools it uses to control credit, and the aims of monetary policy. The last part deals with special institutions for agriculture and industry, such as NABARD, IFCI and IDBI, and with recent changes like RTGS, NEFT, payments banks and demonetisation.

The book back questions test definitions closely. Expect questions on the credit multiplier, on which tools are quantitative and which are qualitative, on when NABARD was set up and what it does, and on the meaning of terms like repo rate, CRR and NPA. Get these clear and most of the one-mark questions in this unit become straightforward.

What you'll learn

• List the primary and secondary functions of a commercial bank with examples.
• Explain credit creation step by step and work out the credit multiplier from a given reserve ratio.
• Describe the main functions of the Reserve Bank of India.
• Sort the tools of credit control into quantitative and qualitative methods and explain how each works.
• State the functions of NABARD and the other rural and industrial finance institutions.
• Compare cheap money and dear money policy and say when each is used.
• Explain recent banking developments such as RTGS, NEFT and payments banks, and the aims of demonetisation.

Before you start

• The meaning and functions of money from the earlier unit on money.
• Basic ideas of national income, aggregate demand and inflation.
• A general idea of how households, firms and banks interact in the economy.

Banking explained

How the Banking System Works

Commercial Banks and Credit Creation

Commercial banks accept deposits from the public and lend to households, traders and firms, earning the gap between the interest they charge and the interest they pay. Their special power is credit creation. When a bank lends, the loan is spent and comes back into some bank as a new deposit, which can again be lent. The initial cash deposit is called the primary deposit; the deposits that arise from loans are derived deposits.

The process stops because each bank must keep a fixed part of every deposit as reserves. The credit multiplier is the reciprocal of this reserve ratio. For example, with a primary deposit of Rs. 1,000 and a reserve ratio of 20 per cent, the multiplier is 1/0.20 = 5, so total deposits can grow to Rs. 5,000. A higher reserve ratio means less credit, a lower one means more.

The Reserve Bank of India and Credit Control

The RBI is the central bank of India. It issues currency notes (one-rupee notes and coins are issued by the Government of India), acts as banker to the government, is the banker's bank and lender of last resort, keeps the country's foreign exchange reserves and supervises the banks.

To control credit it uses two kinds of tools. Quantitative or general tools change the total volume of credit: bank rate, open market operations, cash reserve ratio and statutory liquidity ratio. Qualitative or selective tools decide where credit goes: margin requirements, credit rationing, regulation of consumer credit, moral suasion, publicity and direct action. Selective tools can push credit towards priority sectors and away from speculation.

Rural and Industrial Finance

Farmers and industries need long-term loans that ordinary commercial banks are not always able to give. NABARD, set up in July 1982 by an Act of Parliament, is the apex bank for agricultural and rural credit. It mainly refinances state cooperative banks, regional rural banks and commercial banks, which in turn lend to farmers. For industry, bodies such as IFCI, ICICI, IDBI and the State Financial Corporations provide long-term capital and underwrite share issues.

Monetary Policy

Monetary policy is the central bank's management of money supply and interest rates to keep prices stable, support growth and employment and keep the exchange rate steady. In a recession the central bank follows a cheap money policy: it lowers rates and makes credit easier so that people borrow, spend and invest. During inflation it follows a dear money policy: it raises rates and tightens credit so that demand falls and prices settle.

Recent Developments

Banking has moved from the branch counter to electronic channels. ATMs, RTGS (for large, real-time transfers), NEFT, internet and mobile banking and payments banks have made transactions faster. The chapter also discusses problems and reforms: non-performing assets, mergers of public sector banks into larger banks, and the demonetisation of Rs. 500 and Rs. 1,000 notes announced on 8 November 2016.

Common mistakes to avoid

• Mixing up CRR and SLR. CRR is cash kept with the RBI; SLR is the share of deposits a bank keeps itself in cash, gold or approved securities.
• Assuming a change in bank rate works instantly and fully. Its effect depends on how much banks rely on the RBI and on market conditions.
• Treating NABARD and Regional Rural Banks as the same thing. NABARD mainly refinances other institutions, while RRBs lend directly to rural borrowers.
• Writing that cheap money policy controls inflation. Cheap money is used in a recession; dear money is used to control inflation.
• Calling any bank loss an NPA. An NPA is a loan or advance whose interest or principal has been overdue for 90 days or more.
• Placing moral suasion or margin requirements under quantitative methods. Both are qualitative (selective) tools.

Test yourself on these with the practice test, then check the worked reasoning in the solved MCQs.

Frequently asked questions

How do commercial banks create credit?

A bank keeps part of each deposit as a reserve and lends the rest. The borrower spends the loan, and the money is deposited again in some bank, which keeps its reserve and lends the remainder. This repeats, so a primary deposit gives rise to derived deposits several times larger. The limit is set by the credit multiplier, 1/reserve ratio.

What is the difference between bank rate and repo rate?

Bank rate is the rate at which the RBI rediscounts eligible bills of exchange or lends to commercial banks, usually for longer periods. Repo rate is the rate at which the RBI lends to banks for short periods against government securities, which the bank agrees to buy back. Repo rate is the RBI's main tool for signalling changes in interest rates.

How does the cash reserve ratio affect bank lending?

CRR is the share of deposits that banks must keep as cash balances with the RBI. If the RBI raises CRR, banks have less money left to lend and credit contracts. If it lowers CRR, lendable funds increase and credit expands.

What does NABARD do?

NABARD, the National Bank for Agriculture and Rural Development, was set up in July 1982. It is the apex institution for rural credit. It mainly provides refinance (short, medium and long term) to state cooperative banks, regional rural banks and commercial banks rather than lending to farmers itself. It also supervises cooperative banks and RRBs and supports rural development projects.

What are non-performing assets?

A non-performing asset is a loan or advance on which interest or instalment of principal has remained overdue for 90 days or more. NPAs cut a bank's income, force it to set aside provisions from its capital and leave less money to lend to productive sectors.

How does dear money policy control inflation?

Under dear money policy the central bank raises policy rates, increases reserve ratios and sells government securities in the open market. Banks then have less to lend and loans become costlier. Households spend less, firms postpone investment, aggregate demand falls and prices come down.

What is demonetisation and why was it done in India?

Demonetisation means withdrawing the legal tender status of a currency unit. In India, the Rs. 500 and Rs. 1,000 notes were demonetised from 8 November 2016 and replaced by new notes. The stated aims were to remove black money, check corruption, stop terror funding and eliminate counterfeit notes.