Commercial Banks and Central Bank: ISC Class 12 Economics Notes

What Commercial Banks and Central Bank is about

Weightage: Commercial Banks and Central Bank is part of the unit Money and Banking, which carries 8 of the 80 theory marks, shared with 1 other chapter. Questions on it can appear in any section of the paper.Source: CISCE ISC Economics syllabus, examination year 2027, distribution of marks

Key concepts

Functions of commercial banks

Primary functions

• Accepting deposits: current (demand) deposits, savings deposits, fixed (time) deposits, recurring deposits.
• Advancing loans: cash credit, overdraft, term loans, demand loans, discounting of bills of exchange.

Secondary functions

• Agency functions: collecting cheques, dividends and interest; making payments (insurance premiums, EMIs) on standing instructions; buying and selling securities; acting as trustee or executor.
• General utility functions: lockers, letters of credit, traveller's cheques, debit and credit cards, foreign exchange, online and mobile banking, ATMs.

Credit creation is a special function arising from deposits and loans together.

Worked example

Suppose a firm's bank allows it to draw up to ₹2 lakh more than its current account balance and charges interest only on the amount used. Name this facility and the type of bank function. [1 mark]

Try it first, then show the solutionSolution

1. Drawing beyond the balance up to a limit is an overdraft.

Answer: Overdraft: a lending (primary) function.

Credit creation by commercial banks

Credit creation is the process by which banks, as a system, create deposits many times larger than the initial cash deposit.

Process: a primary deposit (cash deposited) → the bank keeps the legal reserve (LRR) and lends the rest → the borrower spends it and the recipient deposits it in a bank → this derivative deposit again supports a loan, and so on. The deposits form a geometric series: D + D(1 − r) + D(1 − r)² + … = D ÷ r.

• Total deposits created = Initial deposit × credit multiplier = Initial deposit ÷ LRR.
• Credit multiplier = 1 ÷ LRR.
• Derivative deposits (credit created) = total deposits − initial deposit.

Assumptions: all loans are redeposited (no cash leakage), banks lend all excess reserves, there are enough borrowers.

Worked example

Suppose Ravi deposits ₹5,000 in a bank and the legal reserve ratio is 20%. Show the process of credit creation and find the total deposits and credit created. [4 marks]

Round	Deposit (₹)	Reserve 20% (₹)	Loan (₹)
Primary deposit (Bank A)	5,000	1,000	4,000
Round 2 (Bank B)	4,000	800	3,200
Round 3 (Bank C)	3,200	640	2,560
Round 4 (Bank D)	2,560	512	2,048
…	…	…	…
Total	25,000	5,000	20,000

Try it first, then show the solutionSolution

1. Each bank keeps 20% and lends 80%; each loan returns as a new deposit.
2. Total deposits = 5,000 ÷ 0.2 = ₹25,000 (credit multiplier 5).
3. Credit created (derivative deposits/loans) = 25,000 − 5,000 = ₹20,000.

Answer: Total deposits ₹25,000; credit created ₹20,000.

Limitations of credit creation; high powered money

Limitations

• Legal reserve ratio (CRR, SLR): a higher ratio means a smaller multiplier.
• Cash leakages: borrowers may hold part of the loan as cash instead of depositing it.
• Availability of creditworthy borrowers and security (collateral).
• Business conditions: in a depression, borrowing demand is low.
• Central bank policy: credit control measures.
• Banking habits of the people.

High powered money (H), also called reserve money: the money produced by the central bank and the government, held as currency by the public (C) and as reserves of commercial banks (R) with the central bank and in their vaults: H = C + R. A change in H changes total money supply by a multiple.

Worked example

Suppose currency held by the public is ₹400 crore and reserves of banks are ₹100 crore. Find high powered money. Why is it called "high powered"? [2 marks]

Try it first, then show the solutionSolution

1. H = C + R = 400 + 100 = ₹500 crore.
2. Bank reserves form the base for credit creation, so a rise in H raises total money supply by a multiple.

Answer: H = ₹500 crore; it is the base on which banks multiply credit.

Functions of the central bank

• Bank of issue: sole authority to issue currency notes (except one-rupee notes and coins issued by the Government of India).
• Banker, agent and adviser to the government: keeps government accounts, manages public debt, gives advice on economic policy.
• Bankers' bank and supervisor: commercial banks keep part of their reserves with it; it licenses, regulates and supervises banks.
• Lender of last resort: provides funds to banks in temporary difficulty, preventing panics.
• Custodian of foreign exchange reserves and manager of the exchange rate.
• Clearing house: settles inter-bank claims.
• Controller of credit: regulates the volume and direction of credit to keep prices stable and support growth (monetary policy, through the Monetary Policy Committee for the policy repo rate).

Unlike commercial banks, the central bank does not aim at profit and does not deal with the public directly.

Worked example

Suppose a commercial bank faces a sudden rush of withdrawals and turns to the RBI for funds. Which function of the central bank is used? [1 mark]

Try it first, then show the solutionSolution

1. The RBI supplies funds when no other source is available.

Answer: Lender of last resort.

Quantitative methods of credit control

These affect the overall volume of credit:

• Repo rate: the rate at which the RBI lends short-term funds to banks against securities. A higher repo rate makes borrowing costlier for banks and customers: credit contracts.
• Reverse repo rate: the rate at which the RBI borrows (absorbs funds) from banks. A higher reverse repo rate makes it attractive for banks to park surplus funds with the RBI and earn income, reducing funds available for lending.
• Bank rate: the rate at which the RBI rediscounts bills or lends long-term to banks.
• Cash Reserve Ratio (CRR): the share of deposits banks must keep with the RBI. Higher CRR → smaller multiplier → less credit.
• Statutory Liquidity Ratio (SLR): the share of deposits banks must keep in liquid assets (cash, gold, approved securities). Higher SLR → less credit.
• Open market operations (OMO): sale of government securities absorbs liquidity (credit contracts); purchase injects liquidity.

To fight inflation: raise repo, reverse repo, CRR, SLR; sell securities. To fight deflation: the reverse.

Worked example

Suppose the RBI raises the repo rate from 6.25% to 6.50% and announces continued withdrawal of liquidity. In which situation would it do this, and name two other measures with the same aim. [3 marks]

Try it first, then show the solutionSolution

1. Raising the repo rate and withdrawing liquidity reduce credit and spending: used to control inflation (excess demand).
2. Other measures: raise CRR (banks keep more with RBI, less to lend); sell government securities through OMO (absorbs money from banks).

Answer: Inflation; raise CRR and sell securities (or raise SLR).

Qualitative (selective) methods of credit control

These direct credit towards or away from particular uses:

• Margin requirements: the margin is the part of a loan's security value that the bank will not lend. Raising margins on loans against, say, commodities being hoarded reduces credit for speculation; lowering margins on a priority sector increases credit for it.
• Regulation of consumer credit: changing the down payment and the number of instalments for loans to buy durable goods (cars, appliances). A lower down payment and more instalments let a borrower get a larger loan.
• Rationing of credit: fixing ceilings on loans to certain sectors.
• Moral suasion: persuading banks through advice and meetings to follow the RBI's wishes.
• Direct action: penalties on banks that do not comply.
• Publicity.

Selective controls are useful when only some sectors overheat.

Worked example

Suppose the RBI wants households to borrow more for two-wheelers without touching the repo rate. Which selective credit control measure can it relax so that each buyer can borrow a larger share of the price? Explain. [1 mark]

Try it first, then show the solutionSolution

1. Regulation of consumer credit sets the minimum down payment and maximum number of instalments for consumer loans.

Answer: Regulation of consumer credit: a lower required down payment (and more instalments) lets each buyer borrow more.

Commercial Banks and Central Bank in real life

Each concept, met in an everyday situation. Read the situation, answer the question in your own words, then compare with the model answer. The one-line hook is what to remember.

Topics in this chapter

• Central Bank: Functions and Methods of Credit Control
• Credit Creation by Commercial Banks: Credit Multiplier and Limitations

Commercial Banks and Central Bank: key facts

Credit multiplier

1 ÷ LRR

Total deposits

Initial deposit ÷ LRR

Credit created

Total deposits − initial deposit

High powered money

H = C + R (currency with public + bank reserves)

How the board asks Commercial Banks and Central Bank

The question patterns to expect, and the method that works for each.

Tricks to remember Commercial Banks and Central Bank

Short memory aids. Say each one aloud once, then use it on a question the same day.

• Anti-inflation toolkit: "Raise the rates, sell the paper"

  Raise repo, reverse repo, CRR, SLR; sell securities in OMO.

  Use it when: Credit control direction.

• Multiplier = 1 ÷ reserve

  Reserve 20% → 5 times; 10% → 10 times; 25% → 4 times.

  Use it when: Credit creation numericals.

Commercial Banks and Central Bank: board-level solved questions

Ordered from board level to HOTS. Cover the solution, write your own, then compare step by step.

Case-study practice (Section C style)

Read the situation, then answer every part. In the board paper this is a 8-mark question split into 2 + 2 + 2 + 2 marks.

Where the marks are

How a typical answer is split into step marks. Show every step: a right final answer alone rarely earns full marks.

Where students lose marks in Commercial Banks and Central Bank

The slips examiners see most often, and what to write instead.

• ✗Mistake: Credit creation without the process

  CISCE examiners' comments, 2025: "Wrote only the meaning of credit creation without explaining the process"; "Did not use a numerical example, GP series or table to derive the increase in money supply"; "Did not mention or apply the credit multiplier formula".

  ✓Do this: Show primary and derivative deposits in a table and apply 1/LRR.

  Usually costs: 2-3 marks.

• ✗Mistake: Confusing credit creation with credit control

  CISCE examiners' comments, 2024: "Wrote credit creation or change in repo rate instead of credit control function"; "Wrote recession or deflation instead of inflation".

  ✓Do this: Commercial banks create credit; the RBI controls it. A repo rate rise targets inflation.

  Usually costs: 1-2 marks.

• ✗Mistake: Measures named but not explained

  CISCE examiners' comments, 2024: "Wrote only captions of monetary measures without explaining them; explained qualitative measures but not the process".

  ✓Do this: For each measure, say what changes and how credit responds.

  Usually costs: 1-2 marks.

• ✗Mistake: Wrong selective tool

  CISCE examiners' comments, 2025: "Did not specify a selective credit control measure and described general ways banks give loans"; "Described quantitative credit control measures instead".

  ✓Do this: Selective tools: margin requirements, consumer credit regulation, rationing, moral suasion, direct action.

  Usually costs: 1 mark.

• ✗Mistake: Credit multiplier confused with investment multiplier

  CISCE examiners' comments, 2025: "Wrote about components of M1, M2, M3 because the question mentioned money supply"; "Confused with the investment multiplier".

  ✓Do this: Credit multiplier = 1/LRR (banking); investment multiplier = 1/MPS (income).

  Usually costs: 1 mark.

Practice questions on Commercial Banks and Central Bank

Write each answer on paper first. Open the hint only if you are stuck, and the answer only when you have finished.

1. Q1 · 1 mark · MCQBoard level

   If the LRR is 25%, the credit multiplier is:
   (a) 2.5
   (b) 4
   (c) 25
   (d) 0.25

   Hint

   1/LRR.

   Answer

   (b) 4

2. Q2 · 1 mark · Very short answerBoard level

   What is high powered money?

   Hint

   C + R.

   Answer

   Currency held by the public plus reserves of commercial banks (with the central bank and in vaults): H = C + R.

3. Q3 · 1 mark · Very short answerHarder board level

   State the meaning of SLR.

   Hint

   Liquid assets.

   Answer

   The share of deposits a bank must keep in liquid assets such as cash, gold and approved government securities.

4. Q4 · 2 marks · Short answerHarder board level

   Explain two limitations of credit creation.

   Hint

   Leakages.

   Answer

   Cash leakages (borrowers hold cash, so less is redeposited); lack of creditworthy borrowers or collateral (also reserve ratios, central bank policy).

5. Q5 · 2 marks · Short answerHarder board level

   How do open market operations help control deflation?

   Hint

   Buy.

   Answer

   The RBI buys government securities, paying banks; their reserves rise, they lend more and credit expands.

6. Q6 · 1 mark · Very short answerBoard level

   Give two agency functions of commercial banks.

   Hint

   On behalf of customers.

   Answer

   Collecting cheques and dividends; paying insurance premiums or EMIs on standing instructions.

7. Q7 · 2 marks · Short answerHarder board level

   Why is the RBI called the lender of last resort?

   Hint

   Last source.

   Answer

   When a bank cannot get funds from any other source, the RBI lends to it, protecting depositors and preventing a banking crisis.

8. Q8 · 2 marks · Short answerHOTS / competency

   A deposit of ₹1,000 creates total deposits of ₹5,000. What happens to total deposits if the LRR is halved?

   Hint

   New multiplier.

   Answer

   LRR was 20%; halved to 10%, the multiplier becomes 10, so total deposits become ₹10,000.

Test your recall

Answer in your head or on paper first, then open the card. Pulling an answer out of memory makes it stick far better than re-reading.

1. 1.Credit multiplier?Show answer

   1 ÷ legal reserve ratio.

2. 2.Rate at which RBI lends short-term to banks?Show answer

   Repo rate.

3. 3.Effect of selling securities in OMO?Show answer

   Credit contracts.

4. 4.Who is the lender of last resort?Show answer

   The central bank (RBI).

Quick revision checklist

The night before the exam: can you do each of these without looking?

• ☐Total deposits = initial deposit ÷ LRR.
• ☐H = currency with public + bank reserves.
• ☐RBI: issue, government's bank, bankers' bank, lender of last resort, credit control.
• ☐Inflation: raise repo/CRR/SLR, sell securities.
• ☐Selective: margins, consumer credit, rationing, moral suasion, direct action.

Commercial Banks and Central Bank: frequently asked questions