Banking regulation and operations (BRO)

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  • FACULTY NAME: Mrs NALINI.N
    COLLEGENAME: MES INSTITUTE OF MANAGEMENT
    SUB:BANKING REGULATION AND OPERATION
    UNIT-1
    Meaning of Commercial Banks:
    A commercial bank is a financial institution which performs the functions of accepting
    deposits from the general public and giving loans for investment with the aim of earning
    profit. In fact, commercial banks, as their name suggests, axe profit-seeking institutions, i.e.,
    they do banking business to earn profit.
    They generally finance trade and commerce with short-term loans. They charge high rate of
    interest from the borrowers but pay much less rate of Interest to their depositors with the
    result that the difference between the two rates of interest becomes the main source of profit
    of the banks. Most of the Indian joint stock Banks are Commercial Banks such as Punjab
    National Bank, Allahabad Bank, Canara Bank, Andhra Bank, Bank of Baroda, etc.
    Functions of Commercial Banks
    The two most distinctive features of a commercial bank are borrowing and lending, i.e.,
    acceptance of deposits and lending of money to projects to earn Interest (profit). In short,
    banks borrow to lend. The rate of interest offered by the banks to depositors is called the
    borrowing rate while the rate at which banks lend out is called lending rate.
    The difference between the rates is called ‘spread’ which is appropriated by the banks.
    The functions of commercial bank is classified in to
    1. primary functions : which includes two important functions the are,
    (i) accepting deposits and
    (ii) giving loans are termed as commercial banks. For example post offices are not bank
    because they do not give loans.
    2. Secondary functions: it includes
    i, Agency functions
    ii. general utility functions
    Let us know about each of them:
    (A) Primary Functions:
    1. It accepts deposits: A commercial bank accepts deposits in the form of current, savings
    and fixed deposits. It collects the surplus balances of the Individuals, firms and finances the
    temporary needs of commercial transactions. The first task is, therefore, the collection of the
    savings of the public. The bank does this by accepting deposits from its customers. Deposits
    are the lifeline of banks.
    Deposits are of three types as under:
    (i) Current account deposits:
    Such deposits are payable on demand and are, therefore, called demand deposits. These can
    be withdrawn by the depositors any number of times depending upon the balance in the
    account. The bank does not pay any Interest on these deposits but provides cheque facilities.
    These accounts are generally maintained by businessmen and Industrialists who receive and
    make business payments of large amounts through cheques.
    (ii) Fixed deposits (Time deposits):

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  • Fixed deposits have a fixed period of maturity and are referred to as time deposits. These are
    deposits for a fixed term, i.e., period of time ranging from a few days to a few years. These
    are neither payable on demand nor they enjoy cheque facilities.
    They can be withdrawn only after the maturity of the specified fixed period. They carry
    higher rate of interest. They are not treated as a part of money supply Recurring deposit in
    which a regular deposit of an agreed sum is made is also a variant of fixed deposits.
    (iii) Savings account deposits:
    These are deposits whose main objective is to save. Savings account is most suitable for
    individual households. They combine the features of both current account and fixed deposits.
    They are payable on demand and also withdraw able by cheque. But bank gives this facility
    with some restrictions, e.g., a bank may allow four or five cheques in a month. Interest paid
    on savings account deposits in lesser than that of fixed deposit.
    Difference between demand deposits and time (term) deposits:
    DEMAND DEPOSITS
    TIME DEPOSITS
    (i) Deposits which can be withdrawn on
    demand by depositors are called demand
    deposits eg., current account and savings
    bank account
    Term deposits, also called time deposits, are
    deposits which are payable only after the
    expiry of the specified period.
    E.g., recurring deposit, fixed deposit.
    ii) Demand deposits do not carry interest
    whereas time deposits carry a fixed rate of
    interest.
    (iii) Demand deposits are highly liquid to
    customers
    whereas time deposits are less liquid,
    because it is not available to customers
    whenever they want
    (iv) Demand deposits are able to withdraw by
    cheque
    Time deposits are not.
    2. Lending loans and advances:
    The second major function of a commercial bank is to give loans and advances particularly to
    businessmen and entrepreneurs and thereby earn interest. This is, in fact, the main source of
    income of the bank. A bank keeps a certain portion of the deposits with itself as reserve and
    gives (lends) the balance to the borrowers as loans and advances in the form of cash credit,
    demand loans, short-run loans, overdraft as explained under.
    (i) Cash Credit:
    An eligible borrower is first sanctioned a credit limit and within that limit he is allowed to
    withdraw a certain amount on a given security. The withdrawing power depends upon the
    borrower’s current assets, the stock statement of which is submitted by him to the bank as the
    basis of security. Interest is charged by the bank on the drawn or utilised portion of credit
    (loan).
    (ii) Demand Loans:
    A loan which can be recalled on demand is called demand loan. There is no stated maturity.
    The entire loan amount is paid in lump sum by crediting it to the loan account of the

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  • borrower. Those like security brokers whose credit needs fluctuate generally, take such loans
    on personal security and financial assets.
    (iii) Short-term Loans:
    Short-term loans are given against some security as personal loans to finance working capital
    or as priority sector advances. The entire amount is repaid either in one instalment or in a
    number of instalments over the period of loan.
    (iv)Discounting bills of exchange or bundles:
    A bill of exchange represents a promise to pay a fixed amount of money at a specific point of
    time in future. It can also be encashed earlier through discounting process of a commercial
    bank. Alternatively, a bill of exchange is a document acknowledging an amount of money
    owed in consideration of goods received. It is a paper asset signed by the debtor and the
    creditor for a fixed amount payable on a fixed date. It works like this.
    Overdraft facility:
    An overdraft is an advance given by allowing a customer keeping current account to
    overdraw his current account up to an agreed limit. It is a facility to a depositor for
    overdrawing the amount than the balance amount in his account.
    In other words, depositors of current account make arrangement with the banks that in case a
    cheque has been drawn by them which are not covered by the deposit, then the bank should
    grant overdraft and honour the cheque.
    Difference between Overdraft facility and Loan:
    LOANS
    OVER DRAFT
    loans are given against security.
    Overdraft is made without security in current
    account
    the borrower has to pay interest on full
    amount sanctioned
    but in the case of overdraft, the borrower is
    given the facility of borrowing only as much
    as he requires.
    the borrower of loan pays Interest on amount
    outstanding against him
    Whereas but customer of overdraft pays
    interest on the daily balance.
    Loans is based on term period
    Whereas overdraft does not have fixed time
    peiod.
    Commercial banks invest their surplus fund in 3 types of securities:
    (i) Government securities,
    (ii) (ii) Other approved securities and
    (iii) (iii) Other securities. Banks earn interest on these securities.
    (B) Secondary Functions:
    Apart from the above-mentioned two primary (major) functions, commercial banks perform
    the following secondary functions also. It includes
    I. Agency functions of the bank
    II. General utility functions

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  • Agency functions of the bank: The bank acts as an agent of its customers and gets
    commission for performing agency functions as under:
    (i) Transfer of funds: It provides facility for cheap and easy remittance of funds from place-
    to-place through demand drafts, mail transfers, telegraphic transfers, etc.
    (ii) Collection of funds: It collects funds through cheques, bills, bundles and demand drafts
    on behalf of its customers.
    (iii) Payments of various items: It makes payment of taxes. Insurance premium, bills, etc. as
    per the directions of its customers.
    (iv) Purchase and sale of shares and securities: It buys sells and keeps in safe custody
    securities and shares on behalf of its customers.
    (v) Collection of dividends, interest on shares and debentures is made on behalf of its
    customers.
    (iv) Acts as Trustee and Executor of property of its customers on advice of its customers.
    (vii) Letters of References: It gives information about economic position of its customers to
    traders and provides similar information about other traders to its customers.
    General utility services
    The banks provide many general utility services, some of which are as under:
    Traveller’s cheques .The banks issue traveller’s cheques and gift cheques.
    Locker facility. The customers can keep their ornaments and important documents in
    lockers for safe custody.
    Underwriting securities issued by government, public or private bodies.
    Purchase and sale of foreign exchange (currency).
    Payment of bills like, electricity bill, water or phone bill etc., on behalf of its
    customers
    Providing modern functions is also one of the general utility function of the bank
    Credit (Money) Creation by Commercial Banks
    RBI produces money while commercial banks increase the supply of money by creating
    credit which is also treated as money creation. Commercial banks create credit in the form of
    secondary deposits.
    Significance of Commercial Banks in economic development:
    Commercial banks play such an important role in the economic development of a country that
    modern industrial economy cannot exist without them. They constitute nerve centre of
    production, trade and industry of a country. In the words of Wick-sell, Bank is the heart and
    central point of modern exchange economy.”
    The following points highlight the significance of commercial banks:
    (i) They promote savings and accelerate the rate of capital formation.
    (ii) They are source of finance and credit for trade and industry.
    (iii) They promote balanced regional development by opening branches in backward
    areas.
    (iv) Bank credit enables entrepreneurs to innovate and invest which accelerates the
    process of economic development.
    (v) They help in promoting large-scale production and growth of priority sectors such
    as agriculture, small-scale industry, retail trade and export.

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  • (vi) They create credit in the sense that they are able to give more loans and advances
    than the cash position of the depositor’s permits.
    (i) They help commerce and industry to expand their field of operation.
    (vii) Thus, they make optimum utilisation of resources possible.
    INVESTMENT POLICY OF COMMERCIAL BANK
    Investments form a significant portion of a bank's assets, next only to loans and advances and
    are an important source of overall income. Commercial banks' investments are of three broad
    types:(a) Government securities, (b) other approved securities and (c) other securities. These
    three are also categorized into SLR (Statutory Liquidity Ratio) investment and non-SLR
    investments. SLR investments comprise Government and other approved securities, while
    non-SLR investments of the consist of 'other securities' which comprise commercial papers,
    shares, bonds and debentures policies issued by the corporate sector.
    Under the SLR requirement, banks are required to invest a prescribed minimum of their net
    demand and time liabilities (NDTL) in Government- and other approved securities under the
    BR act, 1949. This provision amounts to 'directed investment', as the law directs banks to
    invest a certain minimum part of their NDTL in specific securities. While the SLR provision
    reduces a bank's flexibility to determine its asset mix, it helps the Government finance its
    fiscal deficit. It is the RBI that lays down guidelines regarding investments in SLR and non-
    SLR securities. Bank investments are handled by banks create through their respective
    Treasury Department.
    FACTORS DETERMINING THE LIQUIDITY OF COMMERCIAL BANKS
    Statutory requirements: The extent of liquid reserves held by banks depends on the
    statutory requirements of the Central Bank. According to RBI, commercial banks have to
    maintain a certain CRR (cash Reserve Ratio) and SLR (statutory liquid ratio), Higher CRR
    and SLR result in lower liquidity.
    Banking habits of the people: The nature of the economy has an impact on the banking
    habits of the people. In developing countries, cheque transactions are confined to business.
    Individuals depend more on cash transactions. Hence, the need for liquidity is comparatively
    higher.
    Monetary transactions: The number and magnitude of monetary transactions determine the
    liquidity of banks. Higher monetary transaction leads to higher liquidity.
    Nature of money market: In case of fully developed money markets, banks buy and sell
    securities easily. Therefore, liquidity requirement is lower.
    Structure of banking system: Branch banking system requires lower liquidity since cash
    reserves can be centralized in the head office. Unit Banking System requires higher degree of
    liquidity.
    Nature of money market: In case of fully developed money markets, banks buy and se
    securities easily. Therefore, liquidity requirement is lower.
    Structure of banking system: Branch banking system requires lower liquidity since ca
    reserves can be centralized in the head office. Unit Banking System requires higher degree
    liquidity.
    Number and size of deposits: The number and sized of deposits influence the liquidity
    banks. Increase in the number and size of deposits will require higher liquidity.
    Nature of deposits: Deposit trade with the banks are of various types like time deposits

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  • demand deposits, short-term deposits, etc. larger demand deposits/short-term deposits ne
    higher liquidity.
    Liquidity policies of other banks: Various banks may function in the same area. So,
    liquidity policies of other banks also have an impact on the liquidity of a bank to build
    goodwill among depositors.
    PROFITABILITY OF COMMERCIAL BANK
    Equally important is the principle of 'profitability in bank advance like other commercial
    institutions, banks must make profits. Firstly, they have to pay interest on the deposits
    received by them. They have to incur expenses on establishment rent stationery, etc. They
    have to make provision for depreciation of their fixed assets and also for any possible bad or
    doubtful debts. After meeting all these items of expenditure which enter the running cost of
    banks, a reasonable profits must be made; otherwise, it will not be possible to carry anything
    to the reserve or pay dividend to the shareholders. It is after considering all these factors that
    a bank decides upon its lending rate. It is sometimes possible that a particular transaction may
    not appear profitable in itself but there may be some ancillary business available, such as
    deposits from the borrower's other concerns or his foreign exchange business, which may be
    highly remunerative. In this way, the transaction may on the whole be profitable for the bank.
    It should, however, be noted that lending rates are affected by the Bank Rate, inter-bank
    competition and the Central Bank's directives (e.g. Directives of Reserve Bank of India,
    RBI), if any. The rates may also differ depending on the borrower's credit, nature of security,
    mode of charge and form and type of advance, whether it is a cash credit. loan pre-shipment
    finance or a consumer loan, etc.
    FACTORS AFFECTING THE PROFITABILITY OF COMMERCIAL BANKS
    Amount of working funds: Fund deployed by a bank in profitable assets are the working
    funds of the bank. Profitability of a business is directly proportionate to the amount working
    funds deployed by the bank.
    Cost of funds: Cost of funds are the expenses incurred on obtaining funds from various
    sources in the form of share capital, reserves, deposits and borrowings. Thus, it generally
    refers to interest expenses. Lower the cost of funds, higher the profitability.
    Yield on funds: The funds raised by the bank through various sources are deployed in
    various assets. These assets yield income in the form of interest. Higher the interest leads to
    greater the profitability.
    Spread: Spread is defined as the difference between the interest received (interest
    income)and the interest paid (interest expense). Higher spread indicates more efficient
    financial intermediation and higher net income. Thus, higher spread leads to higher
    profitability.
    Operating costs: Operating costs are the expenses incurred in the functioning of the bank
    excluding cost of funds, all other expenses are operating costs. Lower operating costs give
    rise to greater profitability of the banks.
    Risk cost: This cost is associated to the probable annual loss on assets. They include
    provisions made towards bad debts and doubtful debts. Lower risk costs increase the
    profitability of banks.

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  • Non-interest income: It is the income derived from non-financial assets and services. It
    includes commission & brokerage on remittance facility, rent of locker facility, fees for
    underwriting and financial guarantees, etc. This income adds to the profitability of banks.
    Level of technology: Use of upgraded technology normally leads to decline in the operating
    costs of banks. This improves the profitability of banks.
    Level of Non-performing assets (NPAS): The profitability of a bank is inversely related to
    the level of NPAS. Hence, over the years, the NPAS of commercial banks have greatly
    declined.
    Level of competition: Increase in competition generally leads to higher operating costs. This
    leads to lower profitability.
    POSSIBLE QUESTIONS
    SECTION-A Conceptual Types
    1. What are commercial banks?
    2. What is the statutory definition of the term "banking"?
    3. Give the meaning of schedule bank.
    4. What are the primary functions of commercial banks?
    5. What are the sources of funds of commercial banks?
    6. Mention any three ageney functions of commercial banks?
    7. What is bank rate?
    8. State any four public utility functions of banks.
    9. What are financial assets?
    10. What is a fixed deposit account?
    11. What is a recurring deposit?
    12. What is bank overdraft?
    13. Expand ATM and CRR.
    14. What is CRR?
    15. What is cash credit?
    16. What is factoring?
    17. What is letter of credit?
    18. What is creation of credit.
    19. What are term loans?
    20. What are secured loans or advances?
    21. What are unsecured loans or advances?
    22. What are travellers cheques? State two features.
    23. What is meant by liquidity?
    24. State any four factors which determine liquidity of banks.
    SECTION-B Analytical Types
    1. Explain the role of commercial banks in the economic development of India.
    2. Write a note on financial assets.
    3. Explain the different deposits provided by commercial banks.
    4. State the important merchant banking functions.
    5. Give the structure of commercial banks.
    6. What are the forms of advances given by commercial banks?
    7. Distinguish between loans and overdraft.

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  • 8. What is credit creation? Explain with examples technique of credit creation
    9, What are the factors determining liquidity of banks?
    10. What are the factors considered by a banker while sanctioning loan?
    SECTION-C Descriptive Types
    1. Define commercial bank. Explain the main sources for commercial bank.
    2. What are the primary and secondary functions of commercial banks?
    3. Explain the sound investment policy of a commercial bank.
    4. Discuss narasimaham committee report on banking sector reforms.

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