Article 8: Banking – Part I

Article 7: International Financial institutions
December 9, 2018
Article 9: Banking – Part II
December 11, 2018

Current Affairs for Engineering Service Exam

Article 8: Banking – Part I

Video Lectures and Test Series for ESE 2019


  1. Concept of Banking
  2. Functions of Banks
  3. Monetary policy
  4. The monetary policy framework
  5. The Monetary Policy Committee
  6. Statutory Liquidity Ratio
  7. Cash Reserve Ratio
  8. Repo rate
  9. Reverse repo rate
  10. Liquidity Adjustment Facility
  11. Marginal Standing Facility
  12. Bank Rate
  13. Credit Ceiling
  14. Open Market Operations
  15. Marginal Cost of funds Based Lending Rate (MCLR)
  16. Reserve Bank of India
  17. Quiz

Concept of Banking

  • Banking is an industry that handles cash, credit, and other financial transactions.
  • Banks provide a safe place to store extra cash and credit.


  • A bank is a financial institution that accepts deposits from the public and creates credit.
  • They offer savings accounts, certificates of deposit, and checking accounts.
  • Banks use these deposits to make loans.
  • Lending activities can be performed either directly or indirectly through capital markets.

Functions of Banks:

A.Primary Functions:

1.Accepting Deposits

The bank collects deposits from the public. These deposits can be of different types, such as :-

  1. Saving Deposits

  • This type of deposits encourages saving habit among the public
  • This account is suitable to salary and wage earners.
  • This account can be opened in single name or in joint names.

    b.Fixed Deposits

  • Lump sum amount is deposited at one time for a specific period. Higher rate of interest is paid, which varies with the period of deposit.
  • Withdrawals are not allowed before the expiry of the period.
  • Those who have surplus funds go for fixed deposit.

    c.Current Deposits

  • This type of account is operated by businessmen.
  • Withdrawals are freely allowed.
  • No interest is paid. In fact, there are service charges.
  • The account holders can get the benefit of overdraft facility.

     d.Recurring Deposits

  • This type of account is operated by salaried persons and petty traders.
  • A certain sum of money is periodically deposited into the bank.
  • Withdrawals are permitted only after the expiry of certain period.
  • A higher rate of interest is paid.

2.Granting of Loans and Advances

  • The bank advances loans to the business community and other members of the public.
  • The rate charged is higher than what it pays on deposits.
  • The difference in the interest rates (lending rate and the deposit rate) is its profit.
  • The types of bank loans and advances are :-


  • An overdraft is an extension of credit from a lending institution when an account balance reaches zero.
  • An overdraft allows the individual to continue withdrawing money even if the account has no funds in it or not enough to cover the withdrawal.

Example:  The customer has ₹100,000 in his account and he has an OD Limit of ₹2,000,000.  In this case, the customer wants to issue a cheque of ₹250,000. So, the customer can effectively use ₹150,000 from his OD account.

  b.Cash Credits

  • The client is allowed cash credit upto a specific limit fixed in advance.
  • It can be given to current account holders as well as to others who do not have an account with bank. Amount is withdrawn in excess of limit.
  • The cash credit is given against the security of tangible assets and / or guarantees. The advance is given for a longer period and a larger amount of loan is sanctioned than that of overdraft.


  • It is normally for short term say a period of one year or medium term say a period of five years.
  • Long term loans.

    d.Discounting of Bill of Exchange

  • The bank can advance money by discounting or by purchasing bills of exchange – both domestic and foreign bills.

How does a Bill of Exchange Works ?

  • Suppose Mr. R wants to purchase some gears from Manufacturer (Mr. S), but he has no money.
  • Manufacturer (Mr. S) agrees to sell the items to Mr. R on 60 days credit.
  • To ensure the payment on due date, Mr. S draws a bill of exchange for the amount on Mr. R(drawee).
  • Before it is accepted by Mr. R it will be called draft. It will become a bill of exchange when it is accepted by Mr. R and sign it by writing the word ‘Accepted’.
  • It becomes Bill of Exchange Receivable for Mr. S and Bill of Exchange Payable for Mr. R.
  • Drawer keeps the Bill till due date and present it on due date before drawee and receive payment. It is known as realization of Bill. OR Mr. S can approach bank for money, if he needs it before the due date.
  • The bank can pay the amount to  Mr. S, even before the due date; but bank will take some commission called discount charges.
  • On maturity, the bill is presented to the Mr. R and the amount is collected by the bank.

B. Secondary Functions of Banks

The bank performs a number of secondary functions, also called as non-banking functions.

1.Agency Functions

  1. Transfer of Funds
  2. Collection of Cheques
  3. Periodic Payments
  4. Portfolio Management
  5. Periodic Collections
  6. Other Agency Functions

2.General Utility Functions

  1. Issue of Drafts, Letter of Credits, etc.
  2. Locker Facility
  3. Underwriting of Shares
  4. Dealing in Foreign Exchange
  5. Project Reports
  6. Social Welfare Programmes
  7. Other Utility Functions

Monetary policy:

  • Monetary policy is the process by which monetary authority of a country, generally central bank controls the supply of money in the economy by its control over interest rates in order to maintain price stability and achieve high economic growth.
  • In India, the central monetary authority is the Reserve Bank of India.

Main elements of the monetary policy:

  • It regulates the stocks and the growth rate of money supply.
  • It regulates the entire banking system of the economy.
  • It determines the allocation of loans among different sectors.
  • It provides incentives to promote savings and to raise the savings-income ratio.
  • It ensures adequate availability of credit for growth and tries to achieve price stability.

The monetary policy framework:

  • The framework aims at setting the policy (repo) rate based on an assessment of the current and evolving macroeconomic situation.
  • Repo rate changes transmit through the money market to the entire the financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth.
  • Once the repo rate is announced, the operating framework designed by the Reserve Bank envisages liquidity management on a day-to-day basis through appropriate actions.
  • The liquidity management framework was last revised significantly in April 2016.

The Monetary Policy Committee

  • The Monetary Policy Committee (MPC) is the body of the RBI, headed by the Governor, responsible for taking the important monetary policy decision about setting the repo rate.


Structure of the MPC

  1. The Monetary Policy Committee (MPC) is formed under the RBI with six members.
  2. Three of the members are from the RBI while the other three members are appointed by the government.
  3. Members from the RBI are the Governor who is the chairman of the MPC, a Deputy Governor and one officer of the RBI.
  4. The Committee is to meet at least four times a year and make public its decisions following each meeting.
  5. Under MPC, the governor has a casting vote and doesn’t enjoy veto power.
  6. Decisions will be taken on the basis of majority vote.

Function of the MPC

  • The main responsibility of the MPC will be to keep the inflation targets set by the RBI.
  • The MPC decides the changes to be made to the policy rate (repo rate) to contain inflation within the target (based on CPI) level set under India’s inflation targeting regime.
  • To publish a Monetary Policy Report every six months, elaborating inflation forecasts and inflation sources for the next six to eighteen months.

Monetary Policy Tools

Quantitative tools

1.Statutory Liquidity Ratio:

  • Statutory Liquidity Ratio (SLR) is defined as ‘the share of bank’s total deposit that it needs to maintain itself as liquid assets’.

Components of SLR:

  1. Liquid Assets: These are assets that can be easily converted into cash
  2. Net Demand and Time Liabilities (NDTL): NDTL refers to the total demand and time liabilities (deposits) that is held by the banks of public and with other banks.

Objectives of SLR:

  1. To control the expansion of bank credit. By changing the level of SLR, the Reserve Bank of India can increase or decrease bank credit expansion.
  2. To ensure the solvency of commercial banks. Solvency is the ability of the company to meet its long-term financial obligations.
  3. To compel the commercial banks to invest in government securities like government bonds.

Example – An Individual deposits say Rs 1000 in bank. Then Bank receives Rs 1000 and has to keep some percentage of it as SLR. If the prevailing SLR is 20% then they will have to invest Rs 200 in Government Securities. Remaining 800 only banks could use for its business.

  • SLR Limit: The SLR has an upper limit of 40% and a lower limit of 23%.

2.Cash Reserve Ratio:

  • Cash Reserve Ratio (CRR) is the share of a bank’s total deposit that is mandated by the Reserve Bank of India (RBI) to be maintained with the RBI in the form liquid cash.

CRR and its relationship with Inflation

For example, you deposit Rs 100 in your bank. The bank can’t use the entire Rs 100 for lending or investment purpose. They have to maintain a certain percentage of their deposits in the form of cash and can use only the remaining amount for lending/investment. This minimum percentage which is determined by the central bank is known as Cash Reserve Ratio. ie If the cash reserve ratio is 9%, the banks will have to hold Rs 9 with RBI and Bank will be able to use only Rs 91 for investments and lending or credit purpose.

Objectives of CRR:

  1. To  ensures that a part of the bank’s deposit is with the Central Bank and is hence, safe. It means banks do not have access to that much amount for any economic activity or commercial activity
  2. To keep the liquidity in banks, by ensuring some liquid money against the deposits received, to meet the customer demands.
  3. Combating inflation – is secondary purpose – to allow the RBI to control liquidity and rates in the economy

Difference between CRR & SLR

Both CRR & SLR are the components of the monetary policy. However, there are a few differences between them. The following table gives a glimpse into the dissimilarities:

Statutory Liquidity Ratio (SLR) Cash Reserve Ratio (CRR)
In case of SLR, banks are asked to have reserves of liquid assets which include both cash and gold. The CRR requires banks to have only cash reserves with the RBI
Banks earn returns on money parked as SLR Banks don’t earn returns on money parked as CRR
SLR is used to control the bank’s leverage for credit expansion. The Central Bank controls the liquidity in the Banking system with CRR.
In case of SLR, the securities are kept with the banks themselves which they need to maintain in the form of liquid assets. In CRR, the cash reserve is maintained by the banks with the Reserve Bank of India.

3.Repo Rate

  • Repo rate refers to the rate at which commercial banks borrow money from the Reserve Bank of India (RBI) in case of shortage of funds.
  • It is basically used by RBI to keep inflation under control.

How it works?

  • Banks deposits the government securities with RBI and take money.
  • Banks agree to repurchase the same government securities at a future date at a predetermined price
  • RBI manages this rate, called repo rate, which is nothing but the cost of credit for the bank.

Example – If repo rate is 5%, and bank takes loan of Rs 1000 from RBI , when they buyback the securities, say, at the end of 1 year, they will pay Rs.1050. It means they pay interest of Rs 50 to RBI.

  • The higher the repo rate higher the cost of short-term money and vice versa.
  • Higher repo rate may slow down the growth of the economy.
  • If the repo rate is low then banks can charge lower interest rates on the loans taken by us.

4. Reverse repo rate

  • Reverse repo rate is the rate of interest offered by RBI, when banks deposit their surplus funds with the RBI for short periods.
  • When banks have surplus funds but have no lending (or) investment options, they deposit such funds with RBI. Banks earn interest on such funds.

Example – If Reverse repo rate is 4% , and RBI  takes loan of Rs 1000 from Banks , then RBI will pay interest of Rs 40 to Banks.

Difference between Repo and Reverse Repo Rates:

Repo Rate Reverse Repo Rate
It is the rate at which RBI lends money to banks It is the rate at which RBI borrows money from banks
It is higher than reverse repo rate It is lower than repo rate
It is used to control inflation It is used to control money supply
It involves sale of securities which would be repurchased in future. It involves transfer of money from one account to another.

5.Liquidity Adjustment Facility

  • Liquidity Adjustment Facility (LAF) is the primary instrument of Reserve Bank of India for modulating liquidity and transmitting interest rate signals to the market.
  • It refers to the difference between the two key rates viz. repo rate and reverse repo rate.

How it works?

  • The LAF as its name suggests is a liquidity adjustment mechanism for the banking system.
  • It can inject liquidity into the system.
  • Also it can absorb liquidity when there is excess liquidity.
  • The LAF is operating on a daily basis.

Example, Banks which have liquidity shortages, approach the RBI , gives government securities to it and obtain loans. On the other hand, during the time of excess liquidity, the commercial banks will be parking money with the RBI and thus will be earning an interest rate (at reverse repo rate).  

6.Marginal Standing Facility:

  • Marginal Standing Facility is a new Liquidity Adjustment Facility (LAF) window created by Reserve Bank of India in its credit policy of May 2011.
  • MSF is the rate at which the banks are able to borrow overnight funds from RBI against the approved government securities
  • MSF window was created for commercial banks to borrow from RBI in certain emergency conditions when inter-bank liquidity dries up completely and there is a volatility in the overnight interest rates.
  • To curb this volatility, RBI allowed them to pledge G-secs and get more funds from RBI at a rate higher than the repo rate.

For example, imagine that a bank has securities holding just 19.5 % (of NDTL). This is equal to its mandatory SLR holding. So bank can’t borrow using the repo facility. But as per the MSF, the bank can borrow upto 1 %(the rate may change) below SLR liabilities from the RBI. 

Main features of the MSF:

  1. All Scheduled Commercial Banks having Current Account and SGL Account with Reserve Bank will be eligible to participate in the MSF Scheme.
  2. The rate of interest on amount availed under this facility will be 100 basis points above the LAF repo rate, or as decided by the Reserve Bank from time to time.
  3. Requests will be received for a minimum amount of Rs. one crore and in multiples of Rs. one crore thereafter.
  4. As in the case of repo, the bank has to mortgage the securities with the RBI.

Difference between MSF and the LAF Repo:

  • Under LAF Repo, banks can borrow from RBI at the Repo rate by pledging government securities over and above the statutory liquidity requirements.
  • Under MSF, a bank can borrow one-day loans form the RBI, even if it doesn’t have any eligible securities excess of its SLR requirement.

7.Bank Rate:

  • Bank Rate refers to the official interest rate at which RBI will provide loans to the banking system which includes commercial / cooperative banks, development banks etc.
  • Such loans are given out either by direct lending or by rediscounting (buying back) the bills of commercial banks and treasury bills.

8.Credit Ceiling

  • Under the credit ceiling, RBI informs the banks to what extent / limit they would be getting credit.
  • When RBI imposes a credit limit, the banks will get tight in advancing loans to public. Further, RBI may also direct the banks to provide certain fractions of their loans to certain sectors such as farm sector or priority sector.

How does it works?

  • Whether a borrower has a line of credit or a credit card, the credit limit works the same way. Essentially, a borrower may spend up to the credit limit, but if they exceed that amount, they typically face fines or penalties in addition to their regular payment. If a borrower has spent less than the limit, they can continue to use the card or line of credit until they reach the limit. Credit limit and available credit are not the same thing.

9.Open Market Operations

  • Open Market Operations (OMO) refer to the purchase and sale of the Government Securities (G-Secs) by RBI from / to market.
  • The objective of OMO is to adjust the rupee liquidity conditions in the economy on a durable basis.

10.Marginal Cost of funds Based Lending Rate (MCLR)

  • The marginal cost of funds based lending rate (MCLR) refers to the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the RBI.
  • It is an internal benchmark or reference rate for the bank.
  • MCLR actually describes the method by which the minimum interest rate for loans is determined by a bank – on the basis of marginal cost or the additional or incremental cost of arranging one more rupee to the prospective borrower.

How does it work?

  • While calculating the lending rate, banks have to consider the changed cost conditions or the marginal cost conditions.
  • For banks, the costs for obtaining funds is basically the interest rate given to the depositors.
  • The repo rate is also included in the calculation of lending rate.

Base Rate vs MCLR

  • Base rate calculation is based on cost of funds, minimum rate of return, i.e margin or profit, operating expenses and cost of maintaining cash reserve ratio while the MCLR is based on marginal cost of funds, tenor premium, operating expenses and cost of maintaining cash reserve ratio.
  • Marginal cost is charged on the basis of following factors- interest rate for various types of deposits, borrowings and return on net worth.

2. Qualitative instruments of monetary policy

  • Qualitative instruments uses non-quantifiable measures like- Margin requirements, consumer credit regulation, RBI guidelines, Moral suasion and direct action etc.
  • Margin requirements denotes the difference between the securities offered and amount borrowed by the banks.
  • Consumer credit regulation refers to issuing rules regarding down payments and maximum maturities of instalment credit.
  • RBI Guidelines are the oral, written statements, appeals, guidelines, warnings etc. to the banks by RBI.
  • Rationing of the credit refers to control over the credit granted / allocated by commercial banks.
  • Moral Suasion refers to a request by the RBI to the commercial banks to take certain measures as per the trend of the economy.
  • Direct Action is taken by the RBI against banks that don’t fulfill conditions and requirements.

Reserve Bank of India

  • RBI started its operations from April 1, 1935.
  • It was established via the RBI act 1934, so it is also known as a statutory body.
  • From January 1, 1949, RBI started working as a government owned bank.
  • It is headquartered in Mumbai.

Functions of RBI

  • To work as monetary authority and implement its Monetary Policy
  • To serve as issuer of bank notes
  • Serve as banker to central and state governments
  • Serve as debt manager to central and state governments
  • Provide ways and means advances to the state governments
  • Serve as banker to the banks and lender of last resort (LORL) for them
  • Work as supervisor and regulator of the banking & financial system
  • Management of Foreign Exchange Reserves of the country
  • Support the government in development of the country


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