Commercial banks accept deposits and provide loans to earn a profit from the interest rate spread. They create credit in the economy through the process of lending out deposits while maintaining required reserve ratios. The Reserve Bank of India uses various monetary policy tools like repo rates, cash reserve ratios, and statutory liquidity ratios to regulate money supply and credit creation in order to achieve economic objectives. It has established a monetary policy committee to decide interest rates, replacing the previous system of the RBI governor making decisions with input from the monetary policy department.

3.  A commercial bank is a financial institution
which performs the functions of accepting
deposits from the public and giving loans for
investment with the aim of earning profit.
 They charge high rate of interest from the
borrowers but pay much less rate of Interest
to their depositors with the result that the
difference between the two rates of interest
becomes the main source of profit of the
banks

7.  Bank credit is the aggregate amount
of credit available to a person or business from
a banking institution.
 The power of commercial banks to expand
deposits through loans, advances and
investments is called “credit creation.”
 Through the process of credit creation,
commercial banks provide finance to all sectors of
the economy thus making them more developed

8.  Suppose a man, say X, deposits Rs 2,000 with a
bank and the Reserve Ratio(RR) is 10%, which
means the bank keeps only the minimum
required Rs 200 as cash reserve. The bank can
use the remaining amount Rs 1800 (2000 – 200)
for giving loan to someone. (loan is never given in
cash but it is redeposited in the bank as demand
deposit in favour of borrower). The bank lends Rs
1800 to, say, Y who is actually not given loan but
only demand deposit account is opened in his
name and the amount is credited to his account.
This is the first round of credit creation in the form
of secondary deposit (Rs 1800), which equals

9. Contd..
 Again 10% of Y’s deposit (i.e.Rs 180) is kept
by the bank as cash reserve (RR) and the
balance Rs 1620 (1800 – 180) is advanced to,
say, Z. The bank gets new demand deposit of
Rs 1620. This is second round of credit
creation which is 90% of first round of
increase of Rs 1800. The third round of credit
creation will be 90% of second round of 1620.
The process of credit creation goes on
continuously till derivative deposit (secondary
deposit) becomes zero.

10. Contd..
 In the end, volume of total credit created in this way
becomes multiple of initial (primary) deposit. The
quantitative outcome is called Money multiplier. The
bank succeeds in creating total credit of, Rs 20000.
This is what is meant by credit creation.
 Money (or credit) creation by commercial banks is
determined by
1. Amount of initial (primary) deposits
2. Reserve Ratio(RR). The multiple is called credit
creation or money multiplier.
Symbolically:
 Total Credit creation = Initial deposits x 1/RR

11.  Amount of Cash: The power to create credit depends
on the cash received by banks. If banks receive more
cash, they can create more credit.
 Cash Reserve Ratio: All deposits cannot be used for
credit creation. Banks must keep certain percentage of
deposits in cash as reserve.
 The Banking Habits of the People: The loan
advanced to a customer should again come back into
banks as secondary deposit.
 Nature of Business Conditions in the Economy:
Credit creation will be large during a period of
prosperity, while it will be smaller during a depression.

12.  Leakages in Credit-Creation: Some people may
keep a portion of their amount as idle cash.
 Liquidity Preference: If people desire to hold more
cash, the power of banks to create credit is reduced.
 Monetary Policy of the Central Bank: The extent
of credit creation will largely depend upon the
monetary policy of the Central Bank of the country.
The Central Bank has the power to influence the
volume of money in circulation and through this it
can influence the volume of credit created by the
banks.

15. Monetary policy refers to the use of instruments
under the control of the central bank to regulate
the availability, cost and use of money and credit.

16. 1. Bank Rate - 6.75 %
2. Cash Reserve Ratio (CRR) - 4 %
3. Statutory Liquidity Ratio (SLR) - 20.75 %
4. Repo Rate (RR) - 6.25 %
5. Reverse Repo Rate (RRR) - 5.75 %
6. Marginal Standing Facility (MSF) - 6.75 %
7. Base rate: 9.7%
8. Savings Deposit rate: 4%
9. Term deposit rate>1 year: 7.5 %

17.  Reserve Bank of India has progressively reduced
the repo rate by 150 basis points. As against this,
commercial banks have reduced their base rates
only by 50–60 basis points till March this year.
 To make sure that the reduced policy rates are
passed on to borrowers by banks, RBI introduced
the Marginal Cost of Funds based Lending Rate
(MCLR) methodology as an alternative to the
earlier base rate system has been made
applicable w.e.f 1st April 2016.

18.  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
 MCLR actually describes the method by which the
minimum interest rate for loans is determined by a
bank
 Introduced by Dr. Raghuram Rajan
MCLR is calculated on the basis of four major
components –
1. Marginal cost of funds
2. Operating cost
3. Tenor premium

19.  As mentioned above, 4 factors have to be properly
understood
1. Marginal Cost of Funds: It comprises 3 parts:
 The interest rates on deposits given by the banks to its
customers
 The Rate charged by RBI for amount borrowed from it.
(REPO) . Any changes in deposit rate or repo rate impacts
the lending rates of the bank and MCLR’s monthly reporting
would mean banks would now be compelled to pass on
benefits of rate cuts to borrowers
 The rate of return on Net Worth (in accordance with capital
adequacy norms)

20. Contd..
3. Negative carry in maintaining CRR with
RBI: CRR is the amount kept as reserve by the
banks in accordance with the guidelines and
monetory policy of RBI.
4. Tenor Premium: Tenor premium means, longer
the loan, higher can be the premium for the
same. This, in other words, is the profit margin of
the bank.

21. Suppose SBI's marginal cost of funds
comes out to 6%, operating costs 1% ,
CRR maintenance: 1% and tenor
premium 1% for one year. Therefore if
you take a loan for one year then the
MCLR comes out to 9% . Now suppose
if any cut in the REPO rate happens,
then this would cut the rate of marginal
cost of funds

23.  A new monetary policy committee has been
established that will decide on the interest rates.
 Earlier the Reserve Bank’s Monetary Policy
Department (MPD) used to assist the Governor in
formulating the monetary policy.

25. Contd..
 It is a six-member panel, which will include three
nominees of the government and three members
of the Reserve Bank including the Governor
 Members of the MPC is appointed for a period of
four years and shall not be eligible for
reappointment
 With the introduction of the monetary policy
committee, the RBI will follow a system similar to
the one followed by most global central banks.

26. Members from RBI:
Governor-Urjit Patel
Deputy Governor-Rama Subramaniam Gandhi
Executive Director-Michael Patra
Members nominated by Government:
Chetan Ghate-Professor at Indian Statistical
Institute
Pami Dua-Director at Delhi School of
Economics
Ravindra Dholakia-Professor at IIM-

27. Withdrawal of Legal Tender Character
of existing Rs.500/- and 1000/- Bank
Notes
 A new series of Bank Notes called Mahatma
Gandhi (New) Series having different size and
design, highlighting the cultural heritage and
scientific achievements of the country, is issued.