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- FACULTY NAME: Mrs NALINI.NCOLLEGENAME: MES INSTITUTE OF MANAGEMENTSUB:BANKING REGULATION AND OPERATIONUNIT-1Meaning of Commercial Banks:A commercial bank is a financial institution which performs the functions of acceptingdeposits from the general public and giving loans for investment with the aim of earningprofit. 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 ofinterest from the borrowers but pay much less rate of Interest to their depositors with theresult that the difference between the two rates of interest becomes the main source of profitof the banks. Most of the Indian joint stock Banks are Commercial Banks such as PunjabNational Bank, Allahabad Bank, Canara Bank, Andhra Bank, Bank of Baroda, etc.Functions of Commercial BanksThe 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 theborrowing 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 to1. 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 bankbecause they do not give loans.2. Secondary functions: it includesi, Agency functionsii. general utility functionsLet us know about each of them:(A) Primary Functions:1. It accepts deposits: A commercial bank accepts deposits in the form of current, savingsand fixed deposits. It collects the surplus balances of the Individuals, firms and finances thetemporary needs of commercial transactions. The first task is, therefore, the collection of thesavings of the public. The bank does this by accepting deposits from its customers. Depositsare 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 These canbe withdrawn by the depositors any number of times depending upon the balance in theaccount. 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 andmake 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 aredeposits for a fixed term, i.e., period of time ranging from a few days to a few years. Theseare neither payable on demand nor they enjoy cheque facilities.They can be withdrawn only after the maturity of the specified fixed period. They carryhigher rate of interest. They are not treated as a part of money supply Recurring deposit inwhich 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 forindividual 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 facilitywith some restrictions, e.g., a bank may allow four or five cheques in a month. Interest paidon savings account deposits in lesser than that of fixed deposit.Difference between demand deposits and time (term) deposits:DEMAND DEPOSITSTIME DEPOSITS(i) Deposits which can be withdrawn ondemand by depositors are called demanddeposits eg., current account and savingsbank accountTerm deposits, also called time deposits, aredeposits which are payable only after theexpiry of the specified period.E.g., recurring deposit, fixed deposit.ii) Demand deposits do not carry interestwhereas time deposits carry a fixed rate ofinterest.(iii) Demand deposits are highly liquid tocustomerswhereas time deposits are less liquid,because it is not available to customerswhenever they want(iv) Demand deposits are able to withdraw bychequeTime deposits are not.2. Lending loans and advances:The second major function of a commercial bank is to give loans and advances particularly tobusinessmen and entrepreneurs and thereby earn interest. This is, in fact, the main source ofincome of the bank. A bank keeps a certain portion of the deposits with itself as reserve andgives (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 towithdraw a certain amount on a given security. The withdrawing power depends upon theborrower’s current assets, the stock statement of which is submitted by him to the bank as thebasis 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 loanson personal security and financial assets.(iii) Short-term Loans:Short-term loans are given against some security as personal loans to finance working capitalor as priority sector advances. The entire amount is repaid either in one instalment or in anumber 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 oftime in future. It can also be encashed earlier through discounting process of a commercialbank. Alternatively, a bill of exchange is a document acknowledging an amount of moneyowed in consideration of goods received. It is a paper asset signed by the debtor and thecreditor 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 tooverdraw his current account up to an agreed limit. It is a facility to a depositor foroverdrawing the amount than the balance amount in his account.In other words, depositors of current account make arrangement with the banks that in case acheque has been drawn by them which are not covered by the deposit, then the bank shouldgrant overdraft and honour the cheque.Difference between Overdraft facility and Loan:LOANSOVER DRAFTloans are given against security.Overdraft is made without security in currentaccountthe borrower has to pay interest on fullamount sanctionedbut in the case of overdraft, the borrower isgiven the facility of borrowing only as muchas he requires.the borrower of loan pays Interest on amountoutstanding against himWhereas but customer of overdraft paysinterest on the daily balance.Loans is based on term periodWhereas overdraft does not have fixed timepeiod.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 performthe following secondary functions also. It includesI. Agency functions of the bankII. General utility functions
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- Agency functions of the bank: The bank acts as an agent of its customers and getscommission 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 draftson behalf of its customers.(iii) Payments of various items: It makes payment of taxes. Insurance premium, bills, etc. asper the directions of its customers.(iv) Purchase and sale of shares and securities: It buys sells and keeps in safe custodysecurities and shares on behalf of its customers.(v) Collection of dividends, interest on shares and debentures is made on behalf of itscustomers.(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 totraders and provides similar information about other traders to its customers.General utility servicesThe 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 inlockers 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 itscustomers Providing modern functions is also one of the general utility function of the bankCredit (Money) Creation by Commercial BanksRBI produces money while commercial banks increase the supply of money by creatingcredit which is also treated as money creation. Commercial banks create credit in the form ofsecondary deposits.Significance of Commercial Banks in economic development:Commercial banks play such an important role in the economic development of a country thatmodern industrial economy cannot exist without them. They constitute nerve centre ofproduction, trade and industry of a country. In the words of Wick-sell, “Bank is the heart andcentral 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 backwardareas.(iv) Bank credit enables entrepreneurs to innovate and invest which accelerates theprocess of economic development.(v) They help in promoting large-scale production and growth of priority sectors suchas 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 advancesthan 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 BANKInvestments form a significant portion of a bank's assets, next only to loans and advances andare an important source of overall income. Commercial banks' investments are of three broadtypes:(a) Government securities, (b) other approved securities and (c) other securities. Thesethree are also categorized into SLR (Statutory Liquidity Ratio) investment and non-SLRinvestments. SLR investments comprise Government and other approved securities, whilenon-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 netdemand and time liabilities (NDTL) in Government- and other approved securities under theBR act, 1949. This provision amounts to 'directed investment', as the law directs banks toinvest a certain minimum part of their NDTL in specific securities. While the SLR provisionreduces a bank's flexibility to determine its asset mix, it helps the Government finance itsfiscal 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 respectiveTreasury Department.FACTORS DETERMINING THE LIQUIDITY OF COMMERCIAL BANKSStatutory requirements: The extent of liquid reserves held by banks depends on thestatutory requirements of the Central Bank. According to RBI, commercial banks have tomaintain a certain CRR (cash Reserve Ratio) and SLR (statutory liquid ratio), Higher CRRand SLR result in lower liquidity.Banking habits of the people: The nature of the economy has an impact on the bankinghabits of the people. In developing countries, cheque transactions are confined to business.Individuals depend more on cash transactions. Hence, the need for liquidity is comparativelyhigher.Monetary transactions: The number and magnitude of monetary transactions determine theliquidity of banks. Higher monetary transaction leads to higher liquidity.Nature of money market: In case of fully developed money markets, banks buy and sellsecurities easily. Therefore, liquidity requirement is lower.Structure of banking system: Branch banking system requires lower liquidity since cashreserves can be centralized in the head office. Unit Banking System requires higher degree ofliquidity.Nature of money market: In case of fully developed money markets, banks buy and sesecurities easily. Therefore, liquidity requirement is lower.Structure of banking system: Branch banking system requires lower liquidity since careserves can be centralized in the head office. Unit Banking System requires higher degreeliquidity.Number and size of deposits: The number and sized of deposits influence the liquiditybanks. 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 nehigher 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 buildgoodwill among depositors.PROFITABILITY OF COMMERCIAL BANKEqually important is the principle of 'profitability in bank advance like other commercialinstitutions, banks must make profits. Firstly, they have to pay interest on the depositsreceived by them. They have to incur expenses on establishment rent stationery, etc. Theyhave to make provision for depreciation of their fixed assets and also for any possible bad ordoubtful debts. After meeting all these items of expenditure which enter the running cost ofbanks, a reasonable profits must be made; otherwise, it will not be possible to carry anythingto the reserve or pay dividend to the shareholders. It is after considering all these factors thata bank decides upon its lending rate. It is sometimes possible that a particular transaction maynot appear profitable in itself but there may be some ancillary business available, such asdeposits from the borrower's other concerns or his foreign exchange business, which may behighly 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-bankcompetition 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-shipmentfinance or a consumer loan, etc.FACTORS AFFECTING THE PROFITABILITY OF COMMERCIAL BANKSAmount of working funds: Fund deployed by a bank in profitable assets are the workingfunds of the bank. Profitability of a business is directly proportionate to the amount workingfunds deployed by the bank.Cost of funds: Cost of funds are the expenses incurred on obtaining funds from varioussources in the form of share capital, reserves, deposits and borrowings. Thus, it generallyrefers 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 invarious assets. These assets yield income in the form of interest. Higher the interest leads togreater the profitability.Spread: Spread is defined as the difference between the interest received (interestincome)and the interest paid (interest expense). Higher spread indicates more efficientfinancial intermediation and higher net income. Thus, higher spread leads to higherprofitability.Operating costs: Operating costs are the expenses incurred in the functioning of the bankexcluding cost of funds, all other expenses are operating costs. Lower operating costs giverise to greater profitability of the banks.Risk cost: This cost is associated to the probable annual loss on assets. They includeprovisions made towards bad debts and doubtful debts. Lower risk costs increase theprofitability of banks.
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- Non-interest income: It is the income derived from non-financial assets and services. Itincludes commission & brokerage on remittance facility, rent of locker facility, fees forunderwriting 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 operatingcosts of banks. This improves the profitability of banks.Level of Non-performing assets (NPAS): The profitability of a bank is inversely related tothe level of NPAS. Hence, over the years, the NPAS of commercial banks have greatlydeclined.Level of competition: Increase in competition generally leads to higher operating costs. Thisleads to lower profitability.POSSIBLE QUESTIONSSECTION-A Conceptual Types1. 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 Types1. 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 creation9, What are the factors determining liquidity of banks?10. What are the factors considered by a banker while sanctioning loan?SECTION-C Descriptive Types1. 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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