Banking System in India: Structure, Functions and Credit Creation

Structure of Banking System in India

The banking system in India is regulated by the Reserve Bank of India and consists of commercial banks, cooperative banks and regional rural banks.

Commercial banks include public sector banks, private sector banks, foreign banks and small finance banks.

Public sector banks are majority-owned by the Government of India.

Private sector banks are privately owned but regulated by RBI.

Regional Rural Banks focus on rural and agricultural credit.

Cooperative banks operate under dual regulation of RBI and state authorities.

The Reserve Bank of India acts as the central bank and regulator of the entire banking system.

Primary Functions of Commercial Banks

Banks perform three core functions.

Accepting deposits from the public.

Providing loans and advances.

Facilitating payment and settlement services.

Banks mobilise savings and channel them into productive investments.

They play a key role in financial intermediation.

Types of Deposits

Demand deposits can be withdrawn anytime. Savings and current accounts fall under this category.

Time deposits are fixed deposits for a specific duration and cannot be withdrawn without penalty before maturity.

Demand deposits are part of narrow money. Time deposits are part of broad money.

Credit Creation by Banks

Credit creation is the process by which banks create money through lending.

When a bank grants a loan, it does not hand out existing cash. Instead, it creates a deposit in the borrower’s account.

This deposit becomes part of money supply.

For example, if a bank gives a loan of 1 lakh rupees, it credits the borrower’s account. The borrower can spend this amount. The recipient deposits it into another bank. That bank can lend a portion again after keeping required reserves.

This process continues, leading to multiple expansion of deposits.

Money Multiplier

Money multiplier shows how initial increase in reserve money leads to larger increase in total money supply.

It depends on:

Cash Reserve Ratio.

Public’s preference for holding cash.

Banks’ willingness to lend.

Lower reserve requirement leads to higher money multiplier.

Higher CRR reduces money multiplier.

Limitations of Credit Creation

Credit creation is not unlimited.

It is constrained by:

Reserve requirements such as CRR and SLR.

Availability of reserves.

Demand for loans.

Economic conditions.

If borrowers are unwilling to borrow or banks are risk-averse, credit creation slows down.

Role of RBI in Banking Regulation

RBI regulates banks through:

CRR and SLR requirements.

Interest rate policies.

Licensing and supervision.

Prompt Corrective Action framework.

RBI acts as lender of last resort during financial stress.

Banking System and Inflation

Excessive credit growth can fuel demand-pull inflation.

Tight monetary policy reduces credit expansion.

Healthy banking transmission is essential for inflation targeting to work effectively.

Prelims Important Points

Public sector banks are majority government owned.

Demand deposits are part of M1.

Time deposits are part of M3.

CRR directly affects credit creation.

Money multiplier depends on reserve ratio.

Mains Analytical Angles

Banking sector health determines effectiveness of monetary policy.

High NPAs weaken credit transmission.

Financial inclusion improves monetary transmission.

Credit growth must align with economic fundamentals.