Commercial Banks

Commercial Banks

"A bank is an institution which deals in money and credit"

Teaching Points
11.1   Introduction
11.2   Meaning and Definition
11.3   Functions of Commercial Banks
11.4   Credit Creation

Teaching Objectives
To make the students familiar with Commercial Banks and their functions.

There have been three great inventions since the beginning of time, fire, the wheel and banking.

11.1   Introduction
Banking System is important for the functioning of the economy. The entire structure of present day i.e. industry, trade and commerce rotates around banking sector. Commercial banks performs various functions in modern times. The growing needs of industry, trade and commerce are adequately met by the banking sector. Banks do play a pivotal role in nation's economic growth and development.
11.2   Meaning and Definition
         Meaning :
A bank is an institution in which, those people who have idle cash deposit in it and those who require funds borrow from it. Bank functions as reservoirs. Banks promote savings and channelise them into investments.
A commercial bank is a profit-seeking (making) business organisation, dealing in claims to money i.e. borrowing and lending of money. In this process, the banks make profit from the differences in its two activities. While lending, the interest charged is higher than, what is paid to the depositors.
         Definitions :
         Cairns Cross :
"A bank is an institution which deals in money and credit."
The banking regulation Act, 1949: defines a "banking company as a company which transacts the business of banking in India", and the word "banking" has been defined as the "acceptance for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise." [Section 5(1) (b)].
Sayers :
According to sayers "Banks are institutions whose debts are usually reffered to as `bank deposits' and commonly accepted in final settlement of other peoples debts".
From the above definitions, we can say that a bank is an institution which receives money as deposits and lends money as credit. Thus, a banker may be defined as `a dealer in money' or `dealer in credit'.
All the definitions given above focus on the various functions performed by a bank.
         1)       Accepting deposits from the public
         2)       Repaying money on demand
         3)       Lending money
         4)       Investing money
A.      Primary Functions
1)      Accepting deposits
Accepting deposits from the public is the primary or basic function of commercial bank. Banking business has its origin in this function. The bank acts as an intermediary by accepting deposits and paying interest on them and making loans and charging the borrowers interest at a higher rate. The difference between these two rates of interest minus the administrative charges, is the profit of the bank.
Commercial bank accepts following types of deposits.
a)       Demand deposits
b)       Time deposits
a)      Demand deposits: Deposits, which are withdrawable on demand, are known as demand deposits: They are in two forms : i) current account deposits ii) savings account deposits.
i)       Current account deposits
It is usually opened by businessmen, corporations, industrial enterprises, public bodies, trustees etc. The account facilitates them to carry out their transactions with minimum cash at hand, as the deposits are withdrawable any time by the depositor by means of cheques.
Usually, there are no restrictions on the amount of deposits. At the same time depositors can withdraw any number of times from this account. Overdraft facilities and agency services are provided by the bank to the current account holders. Very low interest or no interest is paid on the current account deposits. Banks may charge a nominal rate of interest for providing this facility.
ii)      Savings account deposits:
Savings bank deposits are opened by a large number of people who wish to save a small portion of their income and deposit the same with the bank. They are opened mainly by salaried class,, middle income group, small traders. Banks accept saving deposits with a view to encourage the saving habits among the people. Normally; a small rate of interest is paid on this account. Money can be withdrawn subject to some restrictions.
b)      Time Deposits:
Deposits, which are repayable after a certain period of time, are known as time deposits.
They are in two forms:
i)        Recurring Deposits
ii)       Fixed Deposits
i)       Recurring Deposits
In order to encourage customers to make regular savings, banks receive deposits in recurring accounts. A customer is required to deposit a fixed sum of money for a specified period of time.
ii)      Fixed Deposits
Deposits under this account are made for a fixed or a specified period. It is a time bound deposit. The money can be withdrawn only after the stipulated or specified time period. Rate of interest is relatively high on these deposits.
The rate of interest on fixed deposits varies with the period of time for which money is deposited. If the account holder wishes to withdraw, before the expiry of the specified time, he receives a lower rate of interest.
2)      Advancing of Loans:
The deposits accepted by the banks from the depositors are not kept `as idle' cash balance. After keeping certain cash reserves, the balance is used to lend to the needy borrowers in the form of loans and advances. Banks provide finance to institutions and individuals for various purposes.
The profit earning capacity of commercial banks depends upon this function. Commercial banks accept deposits at a lower rate of interest and give it as loans and advances at a higher rate of interest.
Generally, banks grant loans and advances to the borrowers in the following forms.
1)       Loans
         2)       Cash credit
         3)       Overdraft facility
         4)       Discounting of bills.
1)      Loans
Loans can be classified into call loans, short­term loans, medium term loans and long-term loans.
i)       Call Loans/Money at Call Notice:
Loans provided by commercial banks for a period of 7 to 15 days are known as call loans. These loans are taken by bill brokers or stock-brokers. The rate of interest is the lowest. These loans can be called back any time by the commercial banks from the borrowers.
ii)      Short term Loans:
Short-term loans are provided by commercial banks for the period of not more than two years. The rate of interest is higher than call loans and lower than medium term loans. It is required by manufacturers and producers in order to fulfil their requirements of working capital.
iii)     Medium term Loans:
Medium term loans are provided by commercial banks for the period from 2 years up to 5 years. The rate of interest charged by commercial banks is higher than the short term loans and lower than the long term loans. It is required by producers and manufactures for making changes in the methods of production, purchase of equipments, tools etc.
iv)     Long term Loans:
When commercial banks give loans for a period of more than 5 years they are referred as long term loans. The rate of interest charged by the commercial banks is highest as compared to other types of loans. It is required by producers for making permanent changes in the methods of production, technique of production etc.
2)      Cash Credit
Cash credit facilities are allowed to any customer / borrower. The borrower is allowed to draw from that account upto a certain limit against eligible securities. Interest is charged on the amount actually drawn.
3)      Over Draft Facility:
Over draft facility is generally given to current account holders. Commercial banks allow their
customers to withdraw the amount from bank in excess of their balance. This arrangement is known as overdraft facility. The bank specifies the maximum limit of overdraft. Rate of interest charged by commercial banks is generally low.
4)      Discounting of Bills
Discounting bill of exchange means advancing a loan against a promise of repayment in future. The commercial bank charge a commission for discounting bills. When the bill mature, the bank can get direct payment from the banker of the debtor who originally accepted the bill.
B)      Secondary Functions :
Secondary functions are called as non-banking functions. In addition to the above mentioned banking functions, the commercial banks perform a number of non-banking functions. Broadly, these functions are of two types A) Agency functions/Agency services B) General functions / General utility services.
(a)     Agency Functions /Agency Services :
Banks perform certain functions on behalf of their customers. The bank acts as agents while performing these functions for their account holders. Some of these functions are:
1)      Collection of money:
The commercial banks accept standing instructions from customers regarding collection of money such as cheques, drafts, interest, dividend, bills, promissory notes, rents, demand drafts, etc. The bank charges a small commission for rendering such services.
2)      Payments/Periodical payments:
The banks can also make payments on behalf of their customers, such as payment of insurance premium, rent, electricity bill, telephone bill, taxes etc. A commission is normally charged for such services.
3)      Purchase and sale of securities:
The commercial banks can undertake buying and selling of securities, debentures, shares as per the instructions and authority given by the customer. Commercial banks on the basis of its expert knowledge can help its customers in this regard.
4)      Acting as Trustee, Executor, Administrator or Attorney:
As a trustee, the bank is the custodian of the customer's fund. The bank also act as the executor of the customers will, in case of death. As an attorney, the banks signs the documents on behalf of the customer's. Commission is normally charged for such services.
5)      E-Banking (Electronic Banking):
Through electronic banking, a customer can operate his bank account through internet. He can transfer money from one place to another. He can also make payments of various bills like telephone bills, E-banking helps businessmen, traders, merchants. Banking transactions can be carried out safely and with total confidentiality with the help of E-banking.
6)      Dematerialization Account: (D-mat) account Some commercial banks provide D-mat facility to their customers. D-mat account is useful to investors who deal in shares. Each investor has to open a separate de-mat account. The transactions relating to buying and selling of shares are recorded. Periodically statements about buying and selling of shares are given by commercial banks to each investor.
7)      Other functions:
Commercial banks can work as an agent for any government or local authority or any other persons i.e. clearing and forwarding of goods.
(b)     General Functions/General Utility Services: The commercial banks also provide following general utility services to the general public.
1)      Safe Deposit Vault:
Safe deposit vault facility is available to the general public to enable them to keep there valuables, such as shares, gold, silver ornaments etc. There is a separate section in the bank, where lockers are provided in various sizes at payment of a fixed rent.
2)      Remittance of funds/Transfer of money:
An important function performed by commercial bank is remittance of funds, banks remit money from one place to another or even from one country to another. This facility is more useful to traders. Remittance of funds is done by telegraphic transfer, mail transfer, demand draft etc.
3)      Letters of credit:
The commercial banks issue letters of credit to enable the traders to buy goods on credit. A letter of credit is a document or order by a banker in one place, authorizing some other banker in some other place, to honour the drafts or cheques of the person whose name appears in the document. The amount is chargeable to the issues of the letter of credit.
A bank's letter of credit helps a businessman, because of the better credit standing of a bank compared with his personal credit.
4)      Reference/Status Report:
The commercial bank also gives confidential reports on third party about its financial standing, mode and frequency of payments etc.
5)      Underwriter/Underwriting
The commercial bank also acts as an underwriter for issue of shares and debentures of any public and private limited company.
The banks guarantee the purchase of certain proportion of shares, if not sold in the market.
6)      Dealings in foreign exchange:
By keeping separate foreign exchange department, bank deals in foreign exchange. Commercial bank offer services for converting one currency into another. Banks make profit in foreign exchange transactions. In India, Reserve Bank of India has a, strict control on this function.
7)      ATM facility, credit card, debit card:
It is an electronic delivery system. It is a convenient method of withdrawing money from bank without going to the bank through automated/ automatic teller machines. It enables people to do their banking transactions at any hour of the day.
Credit card is a plastic card issued by bank to its customers. It facilitates the card holders to use it for purchase on credit or draw cash.
Debit card can be used for the purchase of goods and services. The amount gets debited from the debit card holders account automatically.
8)      Compilation of statistics/Publishing information:
Some banks, publish business and financial information relating to trade, commerce and industry. Some bank also publish bulletins or journals on research, on economic and commercial matters.

11.4   Credit Creation :
The main source of funds, which is available to commercial banks, is in the form of deposits from the public.

Primary Deposits :
Primary deposits are also known as cash deposits. Such deposits refer to money deposited by the people in the form of cash with the banks. These deposits are withdrawable by the depositors.
A part of these deposits are kept by the bank, to meet the demand for cash of the depositor. This is termed as minimum cash reserves. The banks are able to do with a very small reserve because all depositors do not withdraw money at the same time.

Secondary/Derivative Deposits :
The balance over the minimum cash reserves, which is used by the banks to create credit by way of providing loans is known as derivative deposit. or Derivative deposit is a deposit which is left over after deducting cash reserve from primary deposits. When a bank grants loan to a borrower, bank opens a deposit account in the name of the borrower. Borrower can withdraw money from this account by means of cheque.
If a bank purchases securities from a seller, it opens an account in the name of the seller who can withdraw from it.
When the borrower withdraws money from his loan account by a cheque, it is deposited by the payee in some other bank. These banks again create credit on the basis of fresh deposits received after keeping the required reserves. In this way, commercial banks create credit money, which is the part of total money supply.
For example, let us suppose that every bank has to keep 20%, of its deposits as cash reserve and advances loans from 80% of its deposits. Bank 'A' receives a primary deposit of `10,000/- retains, 20% as cash reserve and lends ` 8,000/- to a businessman who deposits it in bank `B'. The bank 'B' would lend ` 6,400/- after retaining ` 1,600/- The amount of ` 6400/- is deposited in bank 'C', which retains Rs. 1,280/- and lends ` 5,120/-. The amount ` 5120/- is deposited in bank 'D'. The bank D would lend ` 4096/- after retaining ` 1024/-. This process ends at the stage where the subsequent banks receive too small amount as primary deposit to advance any loans from it. The following table summaries this process.
Primary Deposit
Secondary Deposits

Total credit created can be arrived at with the help of the following simple formula.
Total Credit Created = A X 1/R
'A' is the original primary deposit and
'R' is the Reserve Ratio.
1 is ratio of primary deposits.
Cash reserve ratio is 20%. For example
` 10000 X 1/20% = ` 10,000 X 1
= ` 10,000 X 1 X 100 / 20
= ` 10,000 X 10 /2
= ` 100,000/2
= ` 50,000/-

Q.1A) Fill in the blanks with appropriate alternatives given in the brackets.
         1.       Deposit from ................... account can be withdrawn without any notice.
         2.       .......... is a primary function of commercial banks.
                  (Purchasing and selling securities/ Accepting deposits/Safe deposit vault / Letter of credit)
         3.       Every loan creates a .............................. (credit/deposit/profit/loss)
         4.       Facility of E-banking is provided through ............................ (telephone/debit cards/ internet/credit cards)
B)      Match the following groups:
         "A" Group                                "B" Group
         1.    D-mat account                    a.     current account
         2.    over draft facility                 b.    agency function
         3.    ATM facility                        c.     share brokers
         4.    commercial bank                 d.    general function
         5.    credit creation                    e.     recurring account
                                                         f.     profit making
                                                         g.    central bank
                                                         h.    commercial bank
C)      State whether the following statements are True or False.
         1.       Commercial banks are the backbone of modern economy.
         2.       The saving bank deposit can be opened with a small amount.
         3.       Credit money is created by the central bank of a country.
         4.       There is no difference between primary deposit and secondary deposit of a commercial bank.

Q.2 A) Define or explain the following concepts.
         1.       Fixed deposits
         2.       Cash credit
         3.       Safe deposit vault
         4.       Discounting of bills
B)      Give reasons or explain the following statements:
         1.       Commercial banks provide agency functions to earn profits.
         2.       Overdraft facility is provided to current accountholders.
         3.       Saving account deposits are usually opened by salaried class.
         4.       Rate of interest on fixed deposit is high.

Q.3 A) Distinguish between
         1.       Call loans and long term loans.
         2.       Current account and saving account.
         3.       Cash credit and overdraft facility.
B)      Write short notes on
         1.       Derivative deposit
         2.       E-banking facility
         3.       D-mat account
         4.       Long term loans

Q. 4)  Answer the following questions:
         1.       Explain various types of deposits.
         2.       What are the different types of loans provided by commercial banks?
Q. 5)  State with reasons whether you agree or disagree with the following statements.
         1.       A commercial bank can create credit on the basis of primary deposit.
         2.       Commercial banks perform many general utility services.

Q. 6)  Answer in detail:
         1.       What are the primary functions of commercial banks?
         2.       Explain the process of credit creation.
         3.       What are the secondary functions of commercial banks?

Write the features of the following.








State Whether The Following Statement Are True Or False (Give Reason)