Q.(OR) Explain the mechanism of credit creation by commercial banks.
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Functions of Commercial Banks
Think of a commercial bank as a financial marketplace that sits between people who have extra money and people who need money. You already use banks — when your parents deposit their salary, when you withdraw cash for school fees, or when someone takes a loan to buy a scooter. But what exactly does a bank do with all that money?
The Core Idea
A commercial bank is a financial institution that accepts deposits from the public and uses those deposits to give loans. That's the textbook definition from NCERT. But the real magic is in the middle step: banks don't just keep your money in a vault. They lend most of it out, earn interest on those loans, and pay you a smaller interest on your deposits. The difference — called the spread — is how they make profit.
This process is called financial intermediation. Banks connect savers (who want safety and some return) with borrowers (who need capital for spending or investment). Without banks, a person with ₹10,000 saved would have to personally find someone trustworthy to lend to — which is impractical. Banks solve that problem at scale.
Primary Functions (The Two Pillars)
NCERT classifies bank functions into primary and secondary. The primary ones are non-negotiable — every commercial bank must do these.
1. Accepting Deposits
Banks offer different types of accounts for different needs:
- Savings deposits — for individuals; you can withdraw anytime but earn low interest (typically 3–4% per annum). There's usually a limit on how many withdrawals you can make per month.
- Current deposits — for businesses and institutions; you can withdraw any number of times, but you earn no interest. In return, the bank provides cheque books, overdraft facilities, and other services.
- Fixed deposits (FDs) — you lock your money for a fixed period (say 1 year or 5 years). The bank pays higher interest because it can use that money for longer loans. Early withdrawal usually incurs a penalty.
- Recurring deposits — you deposit a fixed amount every month for a fixed period. At maturity, you get the total plus interest. This is popular for building a habit of saving.
The key distinction: savings and current deposits are demand deposits (you can demand your money anytime), while fixed and recurring deposits are time deposits (you agree to leave the money for a period).
2. Granting Loans and Advances
This is where banks earn their bread. They lend money in several ways:
- Overdraft — a current account holder is allowed to withdraw more than their balance, up to a pre-approved limit. Interest is charged only on the overdrawn amount.
- Cash credit — similar to overdraft but for businesses; a credit limit is set against inventory or receivables.
- Loans — a lump sum given for a specific purpose (home loan, car loan, education loan). Repaid in equated monthly instalments (EMIs).
- Discounting bills of exchange — a business that has sold goods on credit can get immediate cash from the bank by selling its bill of exchange at a discount. The bank collects the full amount from the buyer later.
A common mistake: students think banks lend only from their own capital. In reality, banks lend mostly from depositors' money. That's why a bank run (everyone withdrawing at once) can collapse a bank — it doesn't have all the cash on hand.
Secondary Functions (Supporting Roles)
These are not mandatory but most banks offer them to attract customers and earn fee income.
Agency Functions — the bank acts as your agent:
- Collecting cheques, dividends, interest on your behalf
- Making payments (insurance premiums, utility bills, school fees)
- Buying and selling securities (shares, bonds) on your instruction
- Acting as executor or trustee of your will
General Utility Functions — services that make life easier:
- Issuing traveller's cheques and credit/debit cards
- Providing locker facilities for safe storage of valuables
- Remittance of funds (transferring money from one place to another via demand drafts, RTGS, NEFT) …
Commercial banks create credit by lending a multiple of their cash reserves, since loans return to the banking system as fresh deposits. …
Banks keep a fraction of deposits as reserves and lend the rest; the re-deposited loans multiply the initial deposit into total credit equal to initial deposit × 1/CRR.
Credit creation (or deposit multiplication) is one of the most important functions of commercial banks. It is the process by which the banking system as a whole is able to create total deposits (demand deposits are money) that are a multiple of the cash reserves it holds.
Basis of credit creation:
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Banks experience from day-to-day dealings that all depositors do not withdraw their money at the same time. So a bank needs to keep only a small fraction of its deposits as cash reserves to meet normal withdrawals; this fraction is the Cash Reserve Ratio (CRR).
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A bank can therefore lend out the remaining (excess) reserves. When it grants a loan, it does not hand over cash but opens a deposit account in the borrower's name — so 'every loan creates a deposit'.
The process (assume CRR = 20% or 0.2, initial deposit = 1,000):
- A person deposits 1,000 in Bank A. Bank A keeps 20% (= 200) as reserve and lends 800.
- The 800 lent is spent and comes back into the banking system as a deposit in Bank B. Bank B keeps 20% of 800 (= 160) and lends 640.
- The 640 returns as a deposit in Bank C, which keeps 128 and lends 512, and so on.
- This continues in diminishing rounds (1000, 800, 640, 512 ...).
Total deposits created = initial deposit × (1/CRR) = 1,000 × (1/0.2) = 1,000 × 5 = 5,000.
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Showing the 12 most recent of 19 on this concept.
- CBSE 2026Set ANNUAL1 markMCQQ.Which of the following makes a financial institution a bank?(a) Accepting deposits(b) Lending(c) Accepting demand deposits(d) Accepting time deposits
›Reveal solutionSolution
The defining feature of a bank is accepting demand deposits (which are chequable and act as money), so the answer is (c).
Many financial institutions accept deposits and lend money, but what makes an institution a bank is that it accepts demand deposits — deposits that are withdrawable on demand and transferable by cheque. Such demand deposits function as money (they are part of the money supply), and the ability to create them throu …
- CBSE 2026Set ANNUAL1 markQ.Identify the main consideration that weigh with the commercial bank in deciding about the composition of their assets.
›Reveal solutionSolution
A commercial bank's asset-composition decision is driven mainly by the need to balance profitability against liquidity.
A commercial bank holds its assets in various forms -- cash reserves, short-term loans, investments in government securities, and long-term loans/advances to businesses. In deciding how to split its funds among these assets, the bank has to weigh two competing considerations:
- Profitability -- the bank is a profit-seeking institution, so it wants to lend/invest funds in avenues (loans, advances, securities) that earn the highest possible return.
- Liquidity -- since deposits are repayable to customers on demand or after a short notice, the bank must also keep a sufficient portion of its assets in cash or near-cash (easily convertible) form to be able to meet depositors' withdrawal demands at any time and maintain public confidence. …
- CBSE 2025Set MARCH1 markMCQQ.Easy availability of credit encourages,(a) a) Savings(b) b) Investment(c) c) Rate of interest(d) d) Disinvestment
›Reveal solutionSolution
Easy availability of credit encourages investment — option (b).
Commercial banks create credit and make loans available to households and firms. When credit is easily available (and interest rates are low), borrowing becomes cheaper, so businesses take loans to buy machinery, build factories and expand production. This increase in spending on capital goods is exactly what economists call investment.
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- CBSE 2025Set ANNUAL1 markMCQQ.Which of the following is the secondary function of commercial banks? (A) Agency function (B) General utility function (C) Social function (D) All of these
›Reveal solutionSolution
The secondary functions of banks include agency and general utility functions (and modern social functions), so the answer is (D) All of these.
Commercial banks' functions are grouped as primary (accepting deposits and advancing loans) and secondary. The two classic secondary functions are: (A) agency functions — collecting cheques, paying bills, transferring funds, acting as agent for customers; and (B) general utility functions — issuing drafts, lockers, letters of credit, foreign exchange dealings. In addition, present-day banks carry out (C) social/developmental functions s …
- CBSE 2025Set ANNUAL1 markMCQQ.Commercial banks (A) issue currency notes (B) accept deposits from customers (C) provide loan to customers (D) both (B) and (C)
›Reveal solutionSolution
Commercial banks accept deposits and provide loans, so the answer is (D) both (B) and (C).
The primary functions of a commercial bank are (B) accepting deposits from the public (savings, current, fixed, recurring) and (C) providing loans and advances to customers. Issuing currency notes (A) is the sole function of the central bank (in India, the Reserve Bank), not of commercial banks …
- CBSE 2025Set ANNUAL1 markMCQQ.14 big scheduled commercial banks in India were nationalised in (A) 1949 (B) 1955 (C) 1969 (D) 2000
›Reveal solutionSolution
The 14 big scheduled commercial banks were nationalised in 1969, so the answer is (C).
To widen the reach of banking, direct credit to priority sectors (agriculture, small industry, exports) and reduce concentration of economic power, the Government of India nationalised 14 major scheduled commercial banks (each with deposits above a specified limit) on 19 July 1969. 1949 (A) is the year the Banking …
- CBSE 2025Set ANNUAL1 markMCQQ.Narasimham Committee Report is related to reform of which of the following? (A) Taxation reform (B) Administrative reform (C) Banking reform (D) Trade reform
›Reveal solutionSolution
The Narasimham Committee dealt with reform of the banking sector, so the answer is (C).
The Narasimham Committee, under M. Narasimham, submitted two major reports (1991 and 1998) on the financial and banking system of India as part of the post-1991 economic reforms. Its recommendations covered reducing the statutory liquidity ratio and cash reserve ratio, deregulating interest rates, improving capital adequacy and asset quality (prudenti …
- CBSE 2025Set ANNUAL1 markMCQQ.How many banks were nationalised on April 15, 1980? (A) 20 (B) 6 (C) 8 (D) 10
›Reveal solutionSolution
On 15 April 1980, 6 banks were nationalised, so the answer is (B).
India nationalised banks in two major rounds. The first was in July 1969, covering 14 large scheduled commercial banks. The second round, on 15 April 1980, nationalised 6 more private-sector banks (those with deposits above a specified limit), t …
- CBSE 2025Set ANNUAL1 markQ.Write any one mode of digital transactions.
›Reveal solutionSolution
Any one electronic mode of payment is acceptable — for example, UPI (Unified Payments Interface).
In the RBSE/CBSE Class-12 money-and-banking chapter, digital (cashless) transactions are payments made electronically through the banking system rather than in physical currency. A widely used mode in India is UPI (Unified Payments Interface), which lets a person transfer money instantly from one bank account to another using a smartphone app.
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- CBSE 2025Set ANNUAL1 markQ.What is a commercial bank?
›Reveal solutionSolution
A commercial bank accepts public deposits and lends/invests those funds for profit, performing both primary and secondary banking functions.
A commercial bank is a profit-oriented financial institution that acts as an intermediary between savers and borrowers. Its main functions are:
- Primary functions: accepting deposits (savings, current, fixed/term deposits) from the public, and granting loans and advances (cash credit, overdraft, term loans, discounting bills) to individuals, businesses and government using those deposited funds.
- Secondary functions: agency services (collecting cheques/bills, paying insurance premiums, transferring funds on a customer's behalf) and general utility services (issuing drafts, lockers/safe custody, foreign exchange dealing). …
- CBSE 2024Set ANNUAL1 markMCQQ.Which is associated with the reform in Banking sector? (A) Year 1991 (B) Narasimham Committee (C) Y. V. Reddy Committee (D) Both (A) and (B)
›Reveal solutionSolution
India's banking reforms are linked to the year 1991 and the Narasimham Committee, so the answer is (D) Both (A) and (B).
In the BSEB Inter / Class-12 Economics course, the reform of India's banking sector is part of the wider economic reforms (LPG — liberalisation, privatisation, globalisation) launched in 1991. The Narasimham Committee (first set up in 1991, with a second report in 1998) made the central recommendations — on capital adequacy, reducing SLR/CRR, prudential norms, and strengthening the banking system.
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- CBSE 2024Set ANNUAL1 markMCQQ.Which is the primary function of commercial bank? (A) Accepting deposits (B) Advancing loans (C) Credit creation (D) All of these
›Reveal solutionSolution
Accepting deposits, advancing loans and credit creation are all treated as primary functions of a commercial bank, so the answer is (D).
In the BSEB Inter / Class-12 Economics money-and-banking unit, the functions of a commercial bank are divided into primary and secondary (agency and general utility) functions. The PRIMARY functions are: (A) accepting deposits (current, savings, fixed, recurring), (B) advancing loans and advances (cash credit, overdraft, loans), and (C) credit creation — banks create credit/money by lending a multiple of their deposits (money multiplier), which arises directly from the deposit-and-loan f …
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