question_answer

Explain the 'bankers' bank' function of the central bank.

Or

Explain the process of credit creation by commercial banks.

 

Answer:

As a banker?s bank it works in a similar way as commercial banks deals with its customers. It accepts deposits from the commercial banks and offers them loans. The central bank also provides ?clearing house? facility to the commercial banks. It is a cheque clearing facility provided at one centre to all the banks. Central bank 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.

Or

The process of credit creation by commercial bank can be easily understood by taking an example. Suppose a person, say X, deposits Rs 2000, with a bank and the LRR is 10% which means the bank keeps only the minimum required Rs. 200 as cash reserve. The bank can use remaining amount Rs. 1800 (\[=2000-200\]) for giving loan to someone. The bank lends Rs. 1800 to, say F, for their purpose an account is opened in the name of Y and amount is credited in his account. This is the first round of credit creation in the form of secondary deposit (Rs. 1800). Which equals 90% of the initial deposit. Now again from the deposit of Y bank keep 10% or LRR i.e. 180 and remaining Rs. 1620 is advanced to, say Z. The bank get new demand deposit. This is the second round of credit creation till secondary deposit becomes zero. In the end volume of total credit created in this way becomes multiple of initial deposit. The quantitative outcome is called money multiplier. In short, money (or credit) creation by commercial banks depends on two factors (i) amount of initial deposit (ii) and, LRR. Symbolically:

Total credit creation = Initial deposit \[X\frac{1}{LRR}\]