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Commercial Bank

INTRODUCTION: -

1Commercial bank is the business organization which deals in money.

2 It borrows and lends money.
3 The banker is dealer in debts “ this own and other peoples and bankers
business is to take the debts of other people, to offer his own in exchange
and there by create money”.
Profitability and liquidity: -
1) The objective of a commercial bank is to maximize the profit.
2) A commercial bank has, like any other business organization, has
shareholders.
3) Besides the banker has to maintain the confidence of the depositors.
4) In short a banker has to satisfy two sets of people viz. depositors and
shareholders.
5) A banker has to earn profit for the shareholders and have to ensure the
security of the depositors.
6) A banker achieves these objectives i.e. income and security in the
following manner:
7) Suppose, banker receives deposits worth Rs. 1000/-
8) A deposits of Rs. 1000/- is a liability of a bank and at the same time it
is asset of commercial bank.
9) It is asset because deposit is used to earn profit.
10) If a banker lends the entire amount of money to the borrower then
these is a danger that banker will not be able to meet the claims of the
depositors.
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11) On the other hand, it the liquidity is maintained to satisfy its

depositors, a banker will not be able to satisfy its shareholders.
12) There is a conflict between liquidity and profitability i.e. if cent
percent liquidity is maintained, profit will not be maximized and if the
entire amount is given in form of loans and advance, a banker will
loose confidence of the depositors.
13) Therefore a banker has to keep two basic considerations:
14) Assts should be distributed in such a way that it will bring
maximum amount of profit for the shareholders.
15) These should always be an adequate amount of cash 9or non-
cash assets which can be easily convertible into cash) as to meet the
claim of the depositors.
16) A banker arranges his balance sheet in such a way so that he could
satisfy two sets of people.
Balance sheet of a commercial bank: -
Liabilities Assets

1] Paid up capital 1] a) Cash in hand

b) Cash with C/B
c) Cash with other banks
2] Reserve funds 2] Investments
3] Deposits 3] Bills of exchange
4] Fixed deposits 4] Money at call
5] Saving deposits 5] Loans and advance
6] Current 6] Other assets.
7] Other liability
Liabilities:
1) Paid up capital: Capital that is raised by the shareholders is called as
share capital.
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2) Reserve funds: The entire profit is not distributed to the

shareholders in the form of dividend. The part of the profit is retained
by the firm; it is called the reserve funds.
3) Deposits: Deposits are classified into current deposits fixed
deposits and saving account deposits. Current deposits are payable on
demand and can be withdrawn by the public through cheques. The
fixed deposits are payable the bank only after a certain fixed period of
time. In saving deposits money can be withdrawn through cheques but
there are limits t the amount, which can be withdrawn twice in a
week.
4) Borrowing: -Bank also borrows from the central bank. It constitutes
the liabilities.
Assets:
1) Cash in hand: The bank keeps the some percentage of its deposits in
the form of cash to meet the claims of the depositors. The assets in
the cash form do not give income to the banker but it gives guarantee
of liquidity to the banker.
2) Cash with Central Bank: Each commercial bank has to keep some
percent of their current and fixed deposits with the Central Bank.
3) Investment: Commercial bank makes investment in government
securities. Bank earns rate of interest on these securities.
4) Bills of exchange: A bank earns income by discounting bills of
exchange, which have maturity of three months.
5) Money at call: Commercial bank lends a part of their excess cash
balances in the money market for a very short period of time varying
from 1-7 days or at times up to 14 days and earns income.
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6) Loans and Advances: It is major component of the assets side on

which commercial bank maximizes their profit. The loans and
advances account for 25 % in the assets structure of the bank.

Conclusion: Thus, commercial bank arranges their balance sheet in

such a way so that they can resolve the conflict between profitability
and liquidity.

Credit Creation
Introduction:
1) The most important function of the commercial bank is a certain of credit.
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2) A commercial bank is described as a factory of credit or manufacturer of

credit
How is credit created?
1) It is open secret that banks do not keep 100 % reserves against
deposits to meet the demand of depositors.
2) Because all depositors do not approach simultaneously do withdraw
money.
3) This enables the bank to do with very small reserves.
4) On the basis of this, commercial banks are able to create super
structure of the credit.
Assumptions:
1) These are large number of commercial banks in the economy.
2) Each bank keeps 20% of the deposits in the form of cash.
Example:
1) Let us suppose that an individual deposits Rs.1000/- in a bank.
2) Ignoring all other entries in the balance sheet, the initial position of the
Bank A will be as follows: -
Initial position of Bank A

Liabilities Amount Assets Amount

Deposit 1000 Cash 1000

1000 1000
1) Each bank keeps 20% amount in cash and remaining amount lends in
terms of loans and advances.
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2) When a bank lends to a person or a firm then a new deposit is created

that did not exist before.
3) Let us suppose that Bank A sanctions a loan of Rs. 800/- to Mr. Z.
4) Then before withdrawing this amount by Mr. Z , the balance sheet of
Bank A will be as follows: -
Bank A

Liabilities Amount Assets Amount

Deposits 800 Cash 800

New Deposits 640 Loan 640
Total 1440 1440

1) When Mr. Z issues a cheque of Rs. 800 to Mr. Y then Mr. Y deposits
this cheques in his bank, say B, then Bank A surrenders Rs. 800 to Bank
B and final position of Bank A will be as follows:
Final position of Bank A
Liabilities Amount Assets Amount
Original Deposit 1000 Cash 200
Deposits Loan 800
Total 1000 Total 1000

The initial position of Bank B will be as follows: -

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Initial position of Bank B

Liabilities Amount Assets Amount
Deposit 800 Cash 800
New deposit 640 Loan 640
Total 1440 Total 1440

1) Bank B maintains 20% amount in cash, 80% of in terms if loans.

2) When Bank B’ sanctions loan to Mr.X of Rs. 640 then the balance
sheet will be as follows: -

Bank B
Liabilities Amount Assets Amount
Deposit 800 Cash 800
New Deposit 640 Loan 640
Total 1440 Total 1440

When Mr. X receives loan of Rs. 640/- he issues a cheque to Mr. Y

whose account is in Bank C. The final position of ‘Bank B’ as follows: -

Final Position of Bank B

Liabilities Amount Assets Amount
Original deposits 800 Cash 160
Deposits Loan 640
Total 800 Total 800

1) This process of multiple credit creation will not stop here.

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2) It will continue still the total deposit worth of Rs 5000/- is created by

all the banks.
3) This process is shown in the following Table.

Bank Deposits Cash Loan

A 1000 200 800

B 800 160 640
C 640 128 512
D 512 102.40 409.60
409.60 81.92 327.68
Total 5000 1000 4000

1) It should be noted that total expansion of the bank credit depends

upon Cash Reserve Ratio [CRR]
2) Smaller the CRR, larger will be the credit expansion.
3) In the above example, the CRR is 20%. i.e. r = 20%.
4) Therefore 1 / 20%. which is 5 times of original deposits.
5) i.e. 1000 x 5 = 5000
6) If the value of r is 10% then commercial bank expand credit to the
extent of Rs.10, 000/- where as, it CRR is 50% then CRR = 2 times of
the original deposits.
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Limitations:
1) Cash Reserve Ratio [CRR]: -
CRR is determined by the central bank of the country. When CRR is raised
during the period of inflation, credit expansion will be less.
2) State of economy: -
Credit creation depends upon state of economy. During the period of
depression, firms are unwilling to borrow from the banks, as a result, credit
expansion will be less.
3) Cash Drain: -
If borrowers withdraw part of their loan in terms of cash then credit
expansion will be less.
4) Banking habits and Banking system: -
Development of the banking system and banking habits among the people
also decide credit expansion.
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Central Bank

Introduction:
1) The central bank is an apex institution of the monetary system.
2) The principle on which central bank is run differs from banking
principle.
3) The objective of commercial bank is to maximize profit on the other
hand the primary objective of the central bank is to promote the
financial and price stability of the country.
4) The guiding principle of the central bank is that should act only in
public interest and for the welfare of the country.
Functions of Central Bank:
1) It acts as sole note-issuing agency.
2) It acts as a banker to the State
3) It is a banker’s bank.
4) It controls the credit.
Methods of credit control:
1) The central bank of the country regulates the volume and direction of
the credit.
2) Bank credit is an important constituent of money supply.
3) Excessive credit will result in inflation; where as deficiency in credit
will result in recession.
4) Broadly speaking there are two types of credit control methods.
a) Quantitative Method
b) Selective method of Credit Control
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a) Quantitative Method: -
1) Quantitative method tries to change the quantity of credit.
2) Quantitative methods of credit control are-
 Bank Rate
 Open Market Operation (OMO)
 Cash Reserve Ratio (CRR)
 Statutory Liquidity Ratio (SLR)
 Bank Rate: -
 Bank rate is that rate of discount at which central bank discounts first class
bills of exchange of commercial banks.
 In other words, it is the rate at which central bank provides loans and
advances to commercial bank by discounting bills of exchange.
 Therefore, it is also known as Discount Rate.
 Through changes in the bank rate, central bank can influence credit
creation of commercial bank.
 Change in bank rate will be followed by changes in the market rate of
interest.
 When central bank wants to control the inflation, it raises bank rate.
 With the increase in bank rate, market rate of interest also rises.
 As a result, investment falls down.
 As a result, purchasing power decreases and aggregate demand can be
regulated.
 Open Market Operation (OMO)
 It refers to the purchase and the sale of government securities in the open
market by the central bank.
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 Sale of securities leads to contraction of credit and purchase of securities

leads to expansion of credit.
 When the central bank wants to regulate the credit, it sells the securities in
the open market.
 These securities are purchased by commercial banks and general public.
 When commercial banks purchase securities, cash balances with
commercial banks fall down.
 As a result credit creation capacity of commercial banks decline and
market rate of interest increases.
 When central bank wants expansion of credit, it purchases securities.
 As a result, cash balances with commercial banks increase.
 As a result credit expansion capacity of commercial banks also increase
and market rate of interest falls down.
 Thus OMO becomes an important instrument of credit creation.
 Cash Reserve Ratio: -
 It is the direct instrument of credit control.
 Each commercial bank has to keep a certain percentage
of their time and demand deposits with the central bank.
 If the CRR is 20%, the commercial bank has to keep Rs
4000/- as reserve against the deposit of Rs. 20000/-.
 The central bank can vary CRR according to the
conditions in the economy.
 When central bank raises CRR from 20% to 25%,
commercial bank has to keep Rs. 4000/-against the deposits of Rs.
10000/-.
 That means the contraction of credit.
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 When central bank reduces CRR from 20% to 10%, then

the commercial bank has to keep Rs. 4000/-against the deposit of Rs.
40000/-.
 That means the expansion of credit.
 Selective methods of credit control:
Objectives:
1) To discriminate between essential and non-essential uses of credit and
to diversity credit towards more productive uses.
2) To deal only with the sensitive spots (areas) of the economy without
affecting the economy as a whole.
3) To discourage excessive use of consumer credit.
Margin Requirement:
1) It refers to the difference between market value of the security and to
amount lent against it.
2) A bank while advancing loans to the borrower does not lend according
to the full value of security but less than that.
3) During inflation, speculators borrow from commercial banks to create
shortage of essential commodities.
4) To discourage this activity, central bank raises the margin.
5) Bank does not advance loan according to the full value of the security
but less than that.
6) For example, commercial bank lends Rs. 800/- to the borrowers when
he provides the security worth of Rs.1000/-.
7) The margin in this case is 20%.
8) When the margin is raised to 50%, the borrower will now get Rs.500.
9) As a result the demand for credit contracts.
Consumer Credit:
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1) It is observed that demand for consumer durable goods is highly

unstable.
2) During the period of inflation, loan is taken to purchase durable
assets.
3) To maintain the price stability of durable articles minimum down
payment is raised.
4) The period of repayment is reduced and the interest rate is also raised
to discourage the credit.
Moral Persuasion: -
1) It is request made by the central to commercial bank to co-operate
with the general monetary policy.
2) The directives are issued by central bank to commercial bank not
to lend credit for speculative purposes.
3) It creates good psychological effects.
Direct Action:
1) Central Bank may refuse to discount bills of exchange for those
bank who do not follow the directives control bank.
2) It increases the discount rate for offending bank.
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Public finance & Private finance

1 Adjustment of income and expenditure
In case of private finance expenditure is adjusted to income
While in case of public finance, income is adjusted to expenditure.
2 Motive
The motive of the government is to maximize the welfare of the
community.
On the other hand, the motive of private finance is to maximize
individual benefits rather than social benefits.
3 Nature of Resources
The government has many resources to raise revenue. The government
can raise revenue through taxation.
While the individual has limited resources.
4 Foresightedness
The states, being a, permanent institution, has a long-term perspective
towards its expenditure.
5 Openness in financial operation
The private finance maintains secrecy with regard to sources of
income & spending.
On the other hand, the financial operations of government are open to
all.
6 Compulsory character
Government can raise revenue by using force. On the other hand,
individual cannot use force to government income.