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A series on financial services
Types of banks[show]
A commercial bank is a type of bank that provides services, such as accepting deposits, giving business loans and basic investment products. Commercial bank can also refer to a bank or a division of a bank that mostly deals with deposits and loans from corporations or large businesses, as opposed to individual members of the public (retail banking). In the US the term commercial bank was often used to distinguish it from an investment bank due to differences in bank regulation. After the great depression, through the Glass–Steagall Act, the U.S. Congress
required that commercial banks only engage in banking activities, whereas investment banks were limited to capital markets activities. This separation was mostly repealed in the 1990s.
1 Origin of the word 2 The role of commercial banks 3 Types of loans granted by commercial banks
3.1 Secured loans 3.2 Unsecured loan
4 Functions 5 References 6 Further reading
Origin of the word
See also: History of banking The name bank derives from the Italian word banco "desk/bench", used during the Renaissance era by Florentine bankers, who used to make their transactions above a desk covered by a green tablecloth. However, traces of banking activity can be found even in ancient times. Some have suggested, the word traces its origins back to the Ancient Roman Empire, where moneylenders would set up their stalls in the middle of enclosed courtyards called macella on a long bench called a bancu, from which the words banco and bank are derived. As a moneychanger, the merchant at the bancu did not so much invest money as merely convert the foreign currency into the only legal tender in Rome – that of the Imperial Mint.
The role of commercial banks
Commercial banks engage in the following activities:
processing of payments by way of telegraphic transfer, EFTPOS, internet banking, or other means issuing bank drafts and bank cheques accepting money on term deposit lending money by overdraft, installment loan, or other means providing documentary and standby letter of credit, guarantees, performance bonds, securities underwriting commitments and other forms of off balance sheet exposures
safekeeping of documents & other items in safe deposit boxes sales, distribution or brokerage, with or without advice, of: insurance, unit trusts and similar financial products as a ―financial supermarket‖
cash management and treasury merchant banking and private equity financing traditionally, large commercial banks also underwrite bonds, and make markets in currency, interest rates, and credit-related securities, but today large commercial banks usually have aninvestment bank arm that is involved in the mentioned activities[clarify].
Types of loans granted by commercial banks
A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral — in the event that the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or all of the amount originally lent to the borrower, for example, foreclosnted a portion of the bundle of rights to specified property. If the sale of the collateral does not raise enough money to pay off the debt, the creditor can often obtain a deficiency judgment against the borrower for the remaining amount. The opposite of secured debt/loan is unsecured debt, which is not connected to any specific piece of property and instead the creditor may only satisfy the debt against the borrower rather than the borrower's collateral and the borrower. A mortgage loan is a very common type of debt instrument, used to purchase real estate. Under this arrangement, the money is used to purchase the property. Commercial banks, however, are given security a lien on the title to the house - until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it. In the past, commercial banks have not been greatly interested in real estate loans and have placed only a relatively small percentage of assets in mortgages. As their name implies, such financial institutions secured their earning primarily from commercial and consumer loans and left the major task of home financing to others. However, due to changes in banking laws and policies, commercial banks are increasingly active in home financing. Changes in banking laws now allow commercial banks to make home mortgage loans on a more liberal basis than ever before. In acquiring mortgages on real estate, these institutions follow two main practices. First, some of the banks maintain active and well-organized departments whose primary function is to compete actively for real estate loans. In areas lacking specialized real estate financial institutions, these banks become the source
for residential and farm mortgage loans. Second, the banks acquire mortgages by simply purchasing them from mortgage bankers or dealers. In addition, dealer service companies, which were originally used to obtain car loans for permanent lenders such as commercial banks, wanted to broaden their activity beyond their local area. In recent years, however, such companies have concentrated on acquiring mobile home loans in volume for both commercial banks and savings and loan associations. Service companies obtain these loans from retail dealers, usually on a nonrecourse basis. Almost all bank/service company agreements contain a credit insurance policy that protects the lender if the consumer defaults.
Unsecured loans are monetary loans that are not secured against the borrower's assets (no collateral is involved). There are small business unsecured loans such as credit cards and credit lines to large corporate credit lines. These may be available from financial institutions under many different guises or marketing packages:
bank overdrafts corporate bonds credit card debt credit facilities or lines of credit personal loans
A corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date. (The term "commercial paper" is sometimes used for instruments with a shorter maturity.) Sometimes, the term "corporate bonds" is used to include all bonds except those issued by governments in their own currencies. Strictly speaking, however, it applies only to bonds issued by corporations, not to bonds of local authorities and supranational organizations. Corporate bonds are often listed on major exchanges (bonds there are called "listed" bonds) and ECNs like Bonds.com and MarketAxess and the coupon (or interest payment) is usually taxable. Sometimes, this coupon can be zero, with a high redemption value. However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in most developed markets takes place in decentralized, dealer-based, overthe-counter markets. Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date. Other bonds, known as convertible bonds, allow investors to convert the bond into equity.
Corporate credit spreads may alternatively be earned in exchange for default risk through the mechanism of credit default swaps, which give an unfunded synthetic exposure to similar risks on the same 'Reference Entities'. However, quite volatile credit default swaps 'basis' make the spreads on credit default swaps and the credit spreads on corporate bonds be significantly different.
Assets and Liabilities of Commercial Banks in the United States Glass-Steagall Act Mortgage constant
Commercial banks perform many functions. They satisfy the financial needs of the sectors such as agriculture, industry, trade, communication, so they play very significant role in a process of economic social needs. The functions performed by banks, since recently, are becoming customer-centred and are widening their functions. Generally, the functions of commercial banks are divided into two categories: primary functions and the secondary functions. The following chart simplifies the functions of commercial banks. Commercial banks perform various primary functions, some of them are given below:
Commercial banks accept various types of deposits from public especially from its clients, including saving account deposits, recurring account deposits, and fixed deposits. These deposits are payable after a certain time period
Commercial banks provide loans and advances of various forms, including an overdraft facility, cash credit, bill discounting, money at call etc. They also give demand and demand and term loans to all types of clients against proper security.
Credit creation is most significant function of commercial banks. While sanctioning a loan to a customer, they do not provide cash to the borrower. Instead, they open a deposit account from which the borrower can withdraw. In other words, while sanctioning a loan, they automatically create deposits, known as a credit creation from commercial banks.
Along with primary functions, commercial banks perform several secondary functions, including many agency functions or general utility functions. The secondary functions of commercial banks can be divided into agency functions and utility functions. The agency functions are the following:
To collect and clear cheque, dividends and interest warrant. To make payments of rent, insurance premium, etc.
To deal in foreign exchange transactions. To purchase and sell securities. To act as trusty, attorney, correspondent and executor. To accept tax proceeds and tax returns.
The utility functions are the following:
To provide safety locker facility to customers. To provide money transfer facility. To issue traveller's cheque. To act as referees. To accept various bills for payment: phone bills, gas bills, water bills, etc. To provide merchant banking facility. To provide various cards: credit cards, debit cards, smart cards, etc.
1. 2. Jump up^ de Albuquerque, Martim (1855). Notes and Queries. London: George Bell. p. 431. Jump up^ Matyszak, Philip (2007). Ancient Rome on Five Denarii a Day. New York: Thames & Hudson. p. 144. ISBN 0-50005147-X.
CHAPTER - 1 : COMMERCIAL BANKING IN INDIA
CHAPTER - 1 : COMMERCIAL BANKING IN INDIA
Q.1: Define Bank / Commercial Bank and Discuss the functions of Commercial Banks.
A) MEANING AND DEFINATION OF COMMERCIAL BANK : In modern economy commercial Banks Play an important role in the financial sector. A Bank is an institution dealing in money and credit. Credit money is the major component of money supply in a modern economy. Commercial banks are the creators of credit. The strength of economy of any country basically depends on a sound and solvent banking system. A Commercial bank is a profit seeking business firms dealing in money or rather claims to money. It safeguards the savings of the public and give loans and advances. The Banking Companies Act of 1949, defines banking company as ―accepting for the purpose of lending or investment of deposit money from the public, repayable on demand or otherwise and withdrawable by cheque, drafts, order or otherwise‖.
B) FUNCTIONS OF COMMERCIAL BANKS :Modern commercial banks perform a variety of functions. They keep the wheels of commerce, trade and industry always revolving. Major functions of a commercial bank are: Primary or Banking functions and Secondary or Non-Banking functions.
FUNCTIONS OF COMMERCIAL BANKS
Loans & Advances
Primary / Banking Functions :Commercial banks have two important banking functions. One is accepting deposits and other is advancing loans. 1) Deposits :One of the main function of a bank is to accept deposits from the public. Deposits are accepted by the banks in various forms. a) Current Account Deposits :Current Accounts are usually opened by businessmen who have a number of regular transactions with the bank, both deposits and withdrawls. There is no restriction on number and amount of deposits. There is also no restriction on withdrawls. No interest is paid on current deposits. Banks may even charge interest for providing this facility. These accounts are also known as demand deposits as amount can be withdrawn on demand. b) Saving Account Deposits :Saving Accounts are opened by salaried and other less income people. There is no restriction on number and amount of deposits. withdrawls are subject to certain restrictions. It earns Interest but less than fixed deposits. It encourages saving habit among salary earners and others. Saving deposits are an important source of funds for banks. c) Fixed Account Deposits :Deposits in fixed account are time deposits. Money under this account is deposited for a certain fixed period of time varying from 15 days to several years. A high rate of interest is paid. If money is withdrawn before expiry date, the depositor receives lower rate of interest. Deposits can be renewed for further period. Many banks sanction loans against security of fixed deposits. d) Recurring Account Deposits :In Recurring deposit, a specified amount is regularly deposited by account holder, at an internal of usually a month. This is to form the habit of small savings among the people. At the end of maturity period, the account holder gets a substantial amount. Interest on this type of deposit is almost equal to fixed deposits. Thus by creating variety of deposits, banks motivate people in a variety of ways and encourage savings in the economy. 2) Loans And Advances :Banks not only mobilize money but also lend to its credit worthy customers for maximizing profits. Loans and Advances are granted To :a) Business And Trade :Commercial banks grant short-term loans to business and trade activities in following forms:Overdraft :-
Commercial banks grant overdraft facility to current account holders Under this system a borrower is allowed to draw more than what is deposited in his account. The borrower is granted to a fixed additional amount against collateral security. Interest is charged for actual amount drawn. Cash Credit :Cash credit is given by the bank to any businessman to meet regular working capital needs, against the security of goods or personal security. Interest is charged on actual amount drawn by the customer. Discounting Of Bills :When the holder of the bill is not in a position to wait till the maturity of the bill and requires cash urgently, he sells the bill of exchange to bank. Bank advance credit by discounting bills of exchange, government securities or any other approved financial instruments. The bank purchases the instruments at a discount. Money At Call :Banks also grant loans for a very short period, generally not exceeding 7 days. Such advances are repayable immediately at a short notice hence they are called as Money at Call or Call money. These loans are given to dealers or brokers in stock market against Collateral Securities. Direct Loans :Loans are given to customers against the security of moveable properties. Their maturity varies from 1 to 10 years. Interest has to be paid on entire loan amount sanctioned. Loans are of many types like :- personal loans, term loans, call loans, participative loans, collateral loans etc. Loans to Agriculture :Banks grant short-term credit to agriculture at a lower rate of interest. Loans are granted for irrigation, purchase of equipments, inputs, cattle etc. Loans To Industries :Banks grant secured loans to small and medium scale industries to meet their working capital needs. The time period may be from one to five years. It may be in the form of Overdraft, cash credit or direct loan. Loans To Foreign Trade :Loans are granted to export and import in the form of direct loans, discounting of bills, guarantee for deferred payments etc. Here the rate of interest is low. Consumer Credit / Personal loans :Banks also grant credit to household in a limited amount to buy some durable consumer goods like television sets, refrigerators, washing machine etc. Such consumer credit is repayable in installments. Under 20-point programme, the scope of consumer credit has been extended to cover expenses on marriage, funeral etc., as well. Miscellaneous Advances :Banks also gives advances like packing credits to exporters, export bill purchased or discounted, import finance, finance to self-employed, credit to weaker sections of society at concessional rates etc. Secondary / Non-banking Functions :Banks gives various forms of services to public. Such services are termed as non- banking or secondary functions :1. Agency Services:-
Banks perform certain functions on behalf of their customers. While performing these services, banks act as agents to their customers, hence these are called as agency services. Important agency functions are :Collection :Commercial banks collect cheques, drafts, bills, promissory notes, dividends, subscriptions, rents and any other receipts which are to be received by the customer. For these services banks charge a nominal amount. payment :Banks also makes payments on behalf of their customers like paying insurance premium, rent, taxes, electricity and telephone bills etc for such services commission is charged. Income – Tax Consultant :Commercial banks acts as income-tax consultants. They prepare and finalise the income tax returns of their clients. Sale And Purchase Of Financial Assets :As per the customers instruction banks undertake sale and purchase of securities, shares and any other financial assets. Nominal charges are charged by a bank. Trustee, Executor And Attorney :As a trustee, banks becomes the custodian and manager of customer funds. Bank also acts as executor of deceased customer’s will. As an Attorney the banks sign the documents on behalf of customer. E- Banking :Through Electronic Banking, a customer can operate his bank account through internet. He can make payments of various bills. He can even transfer money from one place to another. Utility Services :Modern Commercial banks also performs certain general utility services for the community, such as :a) Letter Of Credit :Banks also deal in foreign trade. They issue letter of credit and provide guarantee to foreign traders for the soundness of their customers. b) Transfer Of Funds :Banks arrange transfer of funds cheaply and safely from one place to another. Transfer can be in the form of Demand draft, Mail transfer Travellers cheques etc. c) Guarantor :Banks offer a guarantee of payment on behalf of importer to facilitate imports with deferred payments. d) Underwriting :This facility is provided to Joint Stock Companies and to government to enable them to raise funds. Banks guarantee the purchase of certain proportion of shares, if not sold in the market. e) Locker Facility :Safe Lockers are provided to the customers. So that they can deposit their valuables like Jewellary, Securities, Shares and otherdocuments. f) Referee :Banks may act as referee with respect to financial standing, business reputation and respectability of customers. g) Credit Cards :Credit card facility have been introduced by commercial banks. It enables the holder to minimize the use of hard cash. Credit card is a convenient medium of exchange which
enables its holder to buy goods and services from member – establishment without using money. Subsidiary Activities :Many commercial banks also undertakes subsidiary activities such as :1) Housing Finance :Housing finance is provided against the security of immoveable property of land and buildings. Many banks such as SBI, Bank of India etc. have set up housing finance subsidiaries. 2) Mutual Funds :A Mutual fund is a financial intermediary that pools the savings of investors for collective investment in diversified portfolio securities Many banks like SBI, Indian Bank etc. have set up mutual fund subsidiaries. 3) Merchant Banking :A variety of services are offered by merchant banking like :Management, Marketing and Underwriting of new issues, project promotion, corporate advisory services, investment advisory services etc. 4) Venture Capital Fund :Venture capital fund provides start-up share capital to new ventures of little known, unregistered, risky, young and small private business, especially in technology oriented and knowledge intensive business. Many commercial banks like SBI, Canara Bank etc. have set up venture Capital Fund Subsidiaries. 5) Factoring :Factoring is a continuing arrangement between a financial intermediary (factor) and a business concern (client) where by the factor purchases the clients accounts recieveable. Banks like SBI and Canara Bank have established subsidiaries to provide factoring services. Thus various services are provided by commercial Banks. Q.2: Explain the process of multiple credit creation of commercial banks. OR Write note on multiple credit creation by commercial banks. “Every loan creates a Deposit”. Discuss. Ans. A) MULTIPLE CREDIT CREATION BY COMMERCIAL BANKS:Creation of credit is an important function of a commercial bank. Prof. Sayers said ―Banks are not merely purveyors of money but, also in an important sense manufacturers of money‖. In a modern economy Bank’s deposits form a major proportion of total money supply. A bank’s demand deposits arise mainly from :- Cash deposits by customers and Bank Loans and Investments. 1. Cash Deposits By Customers :These are termed as primary deposits as they arise from the actual deposits of cash in a bank made by its customers. In receiving such deposits, the bank plays a passive role. The creation of primary deposits, however is nothing but transforming the currency money in to deposit money. 2. Bank Loans And Investments :These are termed as derivative or active deposits. The derivative deposits are lent in the form of loans or advances, discounting of bills or used for purchasing securities or other assets. Deposit account in the name of the customer or seller, credits him with the amount of loan granted or value of security purchased, subject to withdrawl by cheque, as required. Hence loans advanced or purchases of securities creates deposits.
Thus every loan creates a deposit. They increase the quantity of bank money. The size of derivative demand deposits is determined by the banks lending and investment activities. There will be a constant inflow and outflow of cash with the banks. For the sake of liquidity and safety some proportion of total deposit must be maintained in cash, for e.g. :- 10% to 20% to meet the demand for cash at the counter. This is known as Cash Reserve Ratio. Primary deposits serve as a basis for creating derivative deposits, that is credit creation, and for increasing money supply. Commercial banks are profit seeking institutions and when they find that large volume of cash received lies Idle, they use these resources for advancing loans or for making investment in securities, shares etc. there by earning high rate of interest. The creation of credit also depends on excess cash reserves or cash reserve ratio. The derivative deposits are used as working capital. When the borrower withdraws money from his loan account by cheque it is deposited by the payee in some other bank. Those banks again create deposit on the basis of fresh deposits received after keeping required reserves. Ultimately, the total volume of credit or derivative deposits or bank money created by all banks would be a multiple of the original amount of new cash reserves in the system. Thus multiple expansion of credit takes place. Example :Suppose the Cash Reserve Ratio is 20% and a person deposits Rs. 10,000/- with Bank of India. This is primary deposit. The bank keeps Rs. 2000 as CRR and balance of Rs. 8000 is used for granting credit. Now suppose Bank of India lends Rs. 8000 to Mr. A and Mr. A pays a cheque of Rs. 8000 to Mr. B, who has an account in Bank Of baroda. Then Bank Of Baroda receives Rs. 8000 as primary deposit. It keeps Rs. 1,600 (20%) as CRR and excess amount of Rs. 6,400 is used for giving credit. Now if, Mr. C is granted this loan and Mr.C gives a cheque of Rs. 6,400 to another person who may deposit it in Bank of Maharashtra. Bank of Maharashtra will keep Rs. 1,280 as CRR and issue a loan of Rs. 5,120. This process continues until the original excess reserves of Rs. 8000 with the first Bank of India, have been parceled out among various banks and have been required resources. As a result, the aggregate of derivative deposits in the entire banking system, approximates 5 times the initial derivative deposit over a period of time. Let us explain with the help of table:PROCESS OF MULTIPLE EXPANSION OF CREDIT BANKS PRIMARY DEPOSIT CRR 20% 2000 1,600 1,280 10,000 Credit Creation or Creation of Derivative Deposits 8000 6,400 5,120 40,000
Bank of India Bank of Baroda Bank of Maharashtra Total of all Banks
10,000 8,000 6,400 50,000
In the above Eg., the credit expansion is five times the initial excess reserve of Rs. 8,000 when CRR is 20%.
PD – PCR TC = CRR X 100
Where TC = Total Credit PD = Primary Deposit. PCR = Primary cash Reserve. CCR = Cash Reserve Ratio. Cash Creation =
10000 – 2000 X 100 20
8000 X 100 = ` 40,000
The Credit Multiplier depends on CRR.
r = CRR If CRR is 20 % then, credit multiplier will be The Multiple expansion of credit is the inverse of CRR maintained by banks. Higher the CRR, Lower the expansion of credit and vice versa.
C) ASSUMPTIONS :-
The bank deposit multipler, discussed above, is based on the following assumptions:1) There is no leakage from the banking system. All the money should remain with banking system. 2) The banks must receive new deposits. 3) They must be willing to make loans or buy securities. 4) The CRR remains constant through all the stages. 5) People must be willing to borrow. 6) The business conditions are normal. 7) There is no credit control policy of central bank. 8) There should be popular banking habit in the country and a well developed banking system. Q.3: What are the limits to the power of banks to create credit ? OR Write notes on limitations of credit creation. Ans. A) LIMITATIONS OF CREDIT CREATION :Commercial banks do not have unlimited powers of deposit or credit creation, because their activities in this direction are subject to a number of restrictions, such as :Amount Of Cash :The larger the amount of cash with banking system, the greater will be the excess funds, and that larger will be the credit creation power of the bank. The banks power of creating money or credit is thus limited by cash it can get in its hands on, primarily through primary deposits. Cash Reserve Ratio :Higher the cash reserve ratio, smaller the volume of credit creation and vice versa. If CRR falls to a certain minimum, then power of the banks to create credit is limited. External Drain:External drain refers to the withdrawl of cash from the banking system by public. Every rupee in cash that is withdrawn from the banking system, lowers the reserves of the banks and thus checks further deposit expansion. Willingness To Borrow:-
Credit creation will be larger during a period of business prosperity and smaller during a depression. Bankers cannot create credit at will.The amount of credit is conditioned by the needs and will of the borrowers. 5) Supply Of Collateral Securities:The availability of good securities places one more limitation on the power of banks to create money. If approved securities are not available, the bank cannot create credit without inviting trouble. ―The bank does not create money out of thin air, it transmutes other forms of wealth in to money. 6) Banking Habits And Banking System:In the absence of banking habits and banking system, credit creation will be impossible. The banking habit will become popular only if there is a sound, developed banking system. 7) Monetary Policy Of Control Bank:The Central bank has the power to influence the volume of money in the country and from time to time, use various methods of credit control and thus its influences the banks to expand or contract credit. Q.4: Explain in details the Items included in Asset Side of Commercial Bank Balance Sheet. OR Explain the Assets and Liabilities of Commercial Banks. OR Write notes on: - Assets and Liabilities of Commercial Banks. OR Explain the Balance Sheet of Commercial Banks. Ans. A) BALANCE SHEET OF COMMERCIAL BANKS :Banks are the most important financial intermediary in an economy. Banks performance can be analysed by its balance sheet and profit and loss account. Bank publish balance sheet in their annual accounts. The balance sheet of a commercial Bank is a statement of its liabilities and Assets at a particular time. Liabilities show the sources of funds through which bank raises funds for its business. Assets represents uses of funds to generate income for bank. Thus, the balance sheet indicates the manner in which bank has raised funds and invested them in various types of assets. It is customary to state liabilities on left and assets on right side. A model of balance sheet of a bank is given below:BALANCE SHEET OF A COMMERCIAL BANK LIABILITIES 1) Share Capital (paid up) ASSETS 1) Cash Balances a) With Central Bank b) With other Banks 2) Money at call and short notice. 3) Bills discounted, including treasury bills.
2) Reserves and surplus 3) Deposits :a) Time deposits. b) Demand Deposits c) Saving Deposits 4) Borrowings 5) Other Liabilities
4) Investments 5) Loans and Advances 6) Other Assets.
B. LIABILITIES OF A COMMERCIAL BANK (LIABILITIES PORTFOLIO) :The liabilities of a commercial bank shos how the bank raises funds for its business.
1) Share Capital (Paid-up) :It is the contribution made by the shareholders of the bank. This indicates the bank’s liabilities to its shareholders. 2) Reserves And Surplus :It is the amount accumulated over the years out of undistributed profits to meet contingencies. Reserves and surplus are liabilities of the bank, as they belong to its shareholders. 3) Deposits :Deposits from the public constitute the biggest proportion of banks working funds. The deposits accepted by bank in current, fixed and savings account are liabilities of bank to t5heir customers. They are categorized as demand, time and saving deposits. These funds are liabilities of bank to their customers, which have to be returned to them. But at the same time, these funds are also assets to bank since the banker can make use of them to get certain interest yielding assets. 4) Borrowings :When a bank borrows from other banks liability is created. It consist of borrowing / refinance obtained from RBI, commercial banks and other financial institutions. It also includes overseas borrowings. 5) Other Liabilities :In course of its business, miscellaneous liabilities are incurred by bank. They include bills payable like drafts, travelers cheques, pay slips etc. It also includes income tax provision. C. ASSETS OF A COMMERCIAL BANK (ASSETS PORTFOLIO):The assets portfolio shows how the bank uses the funds entrusted to it:1) Cash Balances :A bank holds cash to meet the day-today withdrawls of deposits by its customer. This is known as cash reserve. Bank hold cash balances with itself, with other banks and with RBI. In India, Commercial Banks are obliged to keep a certain proportion of total deposits in the form of cash reserve requirement with RBI. Cash has perfect liquidity, but yields no profit. 2) MONEY AT CALL AND SHORT NOTICE :It refers to short term loans made in money market. Such loans are borrowed by speculators in stock exchange market. Their maturity vary between one day to 15 days. These loans are repayable on demand and at the option of either lender or borrower. Thus, these forms of assets are highly liquid and are interest earning too, though at a comparatively low rate. 3) Bills Discounted :Banks funds are invested in commercial bills which are short-dated, usually three months. Banks also invest in treasury bills. These assets are self-liquidating in nature. 4) Investments :Investment in various kinds of securities is a major part of assets of a bank. Mainly commercial banks invest in government securities, shares etc. Securities and bonds are known as banks secondary reserves because they are shiftable and Interest yielding. Usually banks prefer medium and short term securities. This secondary reserve fails to convert securities in to cash at the same time. 5) Loans And Advances :The most important asset item in the Balance sheet of a bank is loans advances. The profitability of a bank depends upon the extent to which it grants loans advances to customers. The various types of loans advances provided by banks are :- Cash Credit, Overdraft, Loans, Installments, purchase and discounting of Bills. Banks mostly grant short term working capital loans only so that they can have fair liquidity with high profitability. 6) Other Assets :-
It includes fixed assets, furniture and fixtures etc. It will also include the net position of inter-office account. From above assets and liabilities, banks will have to balance their revenues against expenses in such a way to generate income to sustain profitability from business. Q.5:Explain the trade – off between bank’s objectives of liquidity and profitability. OR Write note on trade – off between liquidity and profitability objectives of bank. OR Explain commercial bank’s objectives of liquidity and profitability. How do the banks reconcile these two conflicting objectives? Ans. A) OBJECTIVES OF PORTFOLIO MANAGEMENT (TRADE-OFF BETWEEN LIQUIDITY AND PROFITABILITY) :A commercial bank has to manage its assets and liabilities with three objectives in mind, namely :- Liquidity, profitability and solvency. Liquidity means the capacity of the bank to give cash on demand in exchange for deposits. But a commercial bank is a profit – seeking institution. It has to arrange its assets in such a way that it makes maximum profits. The bank should also maintain the confidence of public by making cash available on demand. Liquidity and profitability are, therefore, conflicting considerations for bankers. Cash has perfect liquidity but yields no return at all, while other income-yielding assets such as loans are profitable but have no liquidity. The bank should strike a balance between liquidity and profitability. Another consideration of the bank is its own solvency and security. This refers to liquidity and shiftability. Liquidity is the capacity to produce cash on demand. Shiftability means the assets acquired by bank should be easily shiftable to other banks or central bank. Those securities would be preferred by a bank which can be shifted easily without any loss to the bank than the risky and more profitable ones. A bank which is solvent may not be liquid. Its assets may exceed its liabilities, but the assets may not be in such a form that they are readily convertible in to cash. Thus, the two motives of a bank’s liquidity and profitability are contradictory, but have to be reconciled. A good banker is one who follows a wise investment policy and distributes the assets in such a way that both the requirements of liquidity and profitability are satisfied. The assets should bring in maximum profits and should provide maximum security to the depositors. The secret of success of a bank lies in striking a sound balance between liquidity and profitability. The liquidity – profitability trade – off is shown in following figure:-