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Commercial Bank

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Commercial Bank: Function # 1.

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

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


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

The following points highlight the eleven major limitations


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

Limitation # 2. Availability of Adequate and Proper


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

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


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

Limitation # 4. Banking Habits of the People:


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

Limitation # 5. Volume of Currency in Circulation:


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

If the volume of currency in circulation increases the volume of


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

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


Borrowers:

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


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

Limitation # 7. Existence of Cash Transactions in the


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

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


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

Limitation # 8. Economic Conditions of Trade and Business:


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

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


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

Limitation # 9. If Good Collateral Securities are not


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

Limitation # 10. It is Essential to Maintain Statutory


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

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

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


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

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

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


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

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


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

Objectives of Portfolio Management:


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

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

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


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

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