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    Commercial Bank

    Uploaded by

    Abinash M

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Flag for inappropriate content
    Download as docx, pdf, or txt
    of 6

    Commercial Bank: Function # 1.

    Mobilization of Savings:
    Commercial banks accept deposits from the public who have surplus
    funds. Individuals and companies can deposit money with a bank by
    opening an account. Banks mobilize people’s savings by offering
    interest on the deposits. In this way, banks help depositors to come to
    banks and help in mobilizing savings and develop a habit of thrift
    among people.

    Bank deposits are usually of three types— demand deposits, time or


    fixed deposits and savings deposits. Demand deposits or current
    deposits are with drawable at any time on demand. No interest is paid
    on these deposits. However, banks, in return, provide some services

    The following points highlight the eleven major limitations


    of credit creation by commercial banks.
    Some of the limitations are: 1. Cash Reserve
    Ratio 2. Availability of Adequate and Proper
    Securities 3. Keeping of Reserve with the Central
    Bank 4. Banking Habits of the People 5. Volume of Currency
    in Circulation and Others.
    Limitation # 1. Cash Reserve Ratio:
    The credit creation power of banks depends upon the amount of cash
    they possess.

    Limitation # 2. Availability of Adequate and Proper


    Securities:
    If proper securities are not available with the public, a bank cannot
    create credit. As Crowther has written—”the bank does not create
    money out of thin air, it transmutes other forms of wealth into
    money.”

    Limitation # 3. Keeping of Reserve with the Central Bank:


    Every affiliated and attached bank has to keep certain reserves with
    the Central Bank of the country. The Central Bank keeps on changing
    the percentages of these reserves from time to time. When the Central
    Bank increases the percentages of these reserves, then the power of
    the commercial banks to create credit is reduced in the same
    proportion.

    Limitation # 4. Banking Habits of the People:


    The banking habits of the people are an important factor which
    governs the power of credit creation on the part of banks. If people are
    not in the habit of using cheques, the grant of loans will lead to the
    withdrawal of cash from the credit creation stream of the banking
    system. This reduces the power of banks to create credit to the desired
    level.

    Limitation # 5. Volume of Currency in Circulation:


    Volume of currency in circulation is an important factor of creation of
    credit. If the primary deposits are large, then the derivative deposits
    created on their basis will also be large. But the volume of primary
    deposits is closely connected with the actual volume of currency in
    circulation.

    If the volume of currency in circulation increases the volume of


    primary deposits will increase enabling the Commercial banks to
    create a large volume of derivative deposits. On the other-hand if the
    volume of currency in circulation decreases, the volume of primary
    deposits with the bank will also decrease leading to a decrease in the
    volume of derivative deposits created by the banks.

    Limitation # 6. If heavy with-drawl of Cash by the


    Borrowers:

    If the borrowers will withdraw money in cash, then the balance of


    deposits will be disturbed. With the withdrawal of cash, the excess
    reserves of the banks are automatically reduced. This reduces the
    power of credit creation.

    Limitation # 7. Existence of Cash Transactions in the


    Economy:
    This system of doing transaction sets another limitation on the power
    of the banks to create credit. In under-developed area most of the
    transactions have to be effected in cash. This puts a question as to
    what extent banks power to create credit is reduced.

    But as the economy develops, the ratio of currency to total money


    supply decreases and that of bank money increases. This increases
    correspondingly the banks power of credit creation in the economy.

    Limitation # 8. Economic Conditions of Trade and Business:


    Banks cannot continue to create credit limitlessly. Their power to
    create credit depends upon the economic climate present in the
    country. If there are boom times, there is a greater scope of profitable
    investment and thus greater demand for bank loans on the part of
    businessmen.

    The banks will, therefore, be able to create a greater volume of credit


    at such a time. Similarly, during the period of depression the scope of
    profitable investment is limited. Hence, the investors will be less
    inclined to borrow from the banks. Therefore, the banks power to
    create credit will be automatically reduced.

    Limitation # 9. If Good Collateral Securities are not


    Available:
    We are aware that every loan made by the bank must be backed by
    some valuable security like stocks, shares, bills and bonds etc. If these
    collateral securities are not available in sufficient number the banks
    cannot expand their lending activities and consequently cannot
    expand credit in the economy.

    Limitation # 10. It is Essential to Maintain Statutory


    Liquidity Ratio:
    The Commercial Banks under law are required to maintain a second
    line of defence in the form of the liquid assets. In India it has become
    essential to keep 34% of the assets in liquid forms. The liquid assets
    have been considered as government bonds and securities, treasury
    bills and other approved securities which can be en-cashed quite easily
    in emergency.

    Such restrictions reduce the lendable resources with the banks and
    curtail their power to create credit to that extent.

    Limitation # 11. If the Behaviour of Other Banks is Not Co-


    operative:
    If some of the banks do not advance loans to the extent required of the
    banking system, the chain of credit expansion will be broken. The
    effect will be that the banking system will not operate properly.

    Portfolio Management of a
    Commercial Bank: (Objectives
    and Theories)
    Thus “commercial bank investment policy emerges from a straight
    forward application of the theory of portfolio management to the
    particular circumstances of commercial bank.” Portfolio management
    refers to the prudent management of a bank’s assets and liabilities in
    order to seek some optimum combination of income or profit,
    liquidity, and safety.

    When a bank operates, it acquires and disposes of income-earning


    assets. These assets plus the bank’s cash make up what is known as its
    portfolio. A bank’s earning assets consist of (a) securities issued by the
    central and state governments, local bodies and government
    institutions, and (b) financial obligations, such as promissory notes,
    bills of exchange, etc. issues by firms. There earning assets constitute
    between one- fourth and one-third of a commercial bank’s total assets.
    Thus a bank’s earning assets are an important source of its income.

    The manner in which banks manage their portfolios, that is acquiring


    and disposing of their earning assets, can have important affects on
    the financial markets, on the borrowing and spending practices of
    households and businesses, and on the economy as a whole.

    Objectives of Portfolio Management:


    There are three main objectives of portfolio management which a wise
    bank follows: liquidity, safety and income. The three objectives are
    opposed to each other. To achieve on the bank will have to sacrifice the
    other objectives. For example, if the banks seek high profit, it may
    have to sacrifice some safety and liquidity. If it seeks more safety and
    liquidity it may have to give up some income. We analyse these
    objectives one by one in relation to the other objectives.

    1. Liquidity:
    A commercial bank needs a higher degree of liquidity in its assets. The
    liquidity of assets refers to the ease and certainty with which it can be
    turned into cash. The liabilities of a bank are large in relation to its
    assets because it holds a small proportion of its assets in cash. But its
    liabilities are payable on demand at a short notice.

    Therefore, the bank must hold a sufficiently large proportion of its


    assets in the form of cash and liquid assets for the purpose of
    profitability. If the bank keeps liquidity the uppermost, its profit will
    below. On the other hands, if it ignores liquidity and aims at earning
    more, It will be disastrous for it. Thus in managing its investment
    portfolio a bank must strike a balance between the objectives of
    liquidity and profitability. The balance must be achieved with a
    relatively high degree of safety. This is because banks are subject to a
    number of restrictions that limit the size of earning assets they can
    acquire

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