May 31, 2023
Banking System

Banking System

When we think about money, we often focus on our personal sources of income, such as our salary or rent. These are all examples of income measured per unit of time. But there’s more to the concept of money than just our personal finances.

Money, as understood in economics, is a standard unit of measurement for economic magnitudes. It’s a medium of exchange that allows us to trade goods and services with one another. The demand for cash balances, or the amount of money we hold on hand, is referred to as the “transactions demand” for money. Some cash balances are held for precautionary purposes, such as an emergency fund, while others are held for speculative reasons, such as investments.

The world over, the currency with the public (that is, cash balances on hand) and the demand deposits with banks are considered money. This is known as the narrow definition of money, denoted as M1. However, there is also a broader definition of money, known as M3, which includes time deposits as well.

But what about the banking system? How does it fit into our financial lives?

When we deposit money into a bank, we generally don’t withdraw it immediately. Even if we do withdraw cash, we typically don’t withdraw it all at once. This allows banks to lend out the remaining amount of our deposit to other individuals or firms. This creates an additional deposit, known as a secondary deposit, with the bank.

This process continues, and as a result, banks are able to create chequable deposits that are much larger than the initial cash deposit made by an individual. This multiple creation of credit and deposit allows banks to charge interest on loans and make a profit.

Of course, a bank is a profit-making entity, and it must earn income through some activities. To ensure that banks maintain sufficient reserves against their deposit liabilities, the Reserve Bank of India (RBI) sets minimum limits on the cash reserve to be maintained by banks. This minimum limit, enforced by RBI, is called the Cash Reserve Ratio (CRR), which varies from 20 percent to 3 percent of the deposit liabilities of the banks.

RBI also mandates that banks maintain a certain proportion of their deposit liabilities in the form of secure investments, such as government securities, gold, and/or cash. This requirement is called the Statutory Liquidity Ratio (SLR), which was as high as 39 percent a few decades ago and is currently at 21 percent.

It’s important to note that runs on banks can arise due to deposit holders’ loss of faith and confidence in the banks. To counter such panic situations, governments generally support a deposit insurance mechanism for the banks. In India, deposit holders’ bank accounts are insured up to a maximum of Rs.1 lakh each, per insured bank by the Deposit Insurance and Credit Guarantee Corporation (DICGC).

Fortunately, statutory requirements of CRR, SLR, and deposit insurance have instilled sufficient confidence in the minds of the public, and bank runs are a rarity in India. Today, all the scheduled banks in India, including private sector banks such as ICICI Bank, YES Bank, and IndusInd Bank, as well as public sector banks such as State Bank of India, Punjab National Bank, and Bank of Baroda, and all the cooperative banks, are regulated by the RBI.

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