COMMERCIAL BANKING

DEFINITION

A commercial bank is a firm (a profit-making institution) with a charter from the

government to engage in the business of banking.

FUNCTIONS OF COMMECIAL BANK

1. Accepting Deposits from Customers

This function is important, because banks mainly depend on the funds

deposited with them by the public. There are basically three kinds of deposits:
current or demand deposits where cheques are drawn, savings deposits which
provides easy saving and withdrawing facilities and fixed or time deposits
which provides certain amount of interest at maturity.

2. Providing Loans and Advances

Commercial banks make profits by advancing loans to the public. There are
three ways in which banks can give loans: direct loans, overdraft / advance
account and discounting of bills.

Direct loans are where the clients would meet the loan officer and then
negotiate on matters pertaining to maturity period, interest rate and collateral
security.

For overdraft, a current account holder can withdraw in excess of his account
balance, for which he has to pay the bank interest.

Discounting of bills is when the bank advances payment to a client who has
allowed his debtor a period of credit, collecting the debt from the debtor when
it is due for repayment.

3. Providing Financial Services

This includes tax management, purchase of shares, night-safe facilities, and

automatic teller machine, keeping of valuables and documents and
consultation on financial matters.

CREDIT CREATION

This is a process where a small given deposit will lead to a greater increase in the
money supply of the economy.

Assumptions:

• Cash ratio is fixed by BNM and its value is constant.

• Leakage (e.g.: cash drawings from the bank) does not exist.
• Public keeps money in the bank.
• Bank does not keep excess reserves.
• There are only two types of assets: cash and loans.
• Bank has only one liability: deposits.
• Deposits are in the form of current deposits.
• Assume multiple banks (multi-banking system in the economy).

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Ways of creating credit:

• Giving loans through direct loans, overdraft or discounting of bills.

• Investing (buying of shares and government securities) and purchasing of T-
bills.

The process of credit creation:

Assume that bank’s legal cash requirement is 20% and the initial deposit is RM1000.

BANKS DEPOSITS RESERVES 20% LOANS @ EXCESS

RESERVE
A RM1000 RM200 RM800
B 800 160 640
C 640 128 512
D 512 102.4 409.6
. . . .
. . . .
TOTAL RM5000 RM1000 RM4000

TOTAL MONEY SUPPLY (TOTAL DEPOSITS) = 1 / Cash Ratio x Initial

Deposits
= 1 / 0.20 x 1000
= RM5000
TOTAL RESERVE = 1 / Cash Ratio x Initial Reserve
= 1 / 0.20 x 200
= RM1000
TOTAL LOANS (TOTAL CREDIT CREATED) = 1 / Cash Ratio x Initial Loans
= 1 / 0.20 x 800
= RM4000

___________________________________________________________________
COMMERCIAL BANK’S T-ACCOUNT
BANK A BANK B
Balance Sheet Balance Sheet

ASSETS LIABILITY ASSETS LIABILITY

Reserves 200 Deposits 1000 Loans 640 Deposits
800
Loans 800 Reserve 160
___

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 1000 1000 800
800

----------------------------------------------------------------------------------------------------

Note: The smaller the reserve ratio, the higher or better for banks to
increase credit.
Limits to credit creation:
• A change in cash ratio / legal reserve requirement (if ratio is increased, the credit
creation is reduced).
• Clearing house (cheque-sorting house / center). This slows down the process
because it involves a lot of physical movements among banks. Also, reserves
used to settle cheque in the clearinghouse need to be replaced.
• Replacing them means less loans to be given out.

• Availability to collateral security (mortgages, land titles, etc). Without it, lending
cannot take place.
• BNM”s monetary control (e.g. control on bank rates) will affect amount of loans.
• Leakages in the banking system (e.g. when idle money is held for precautionary
motive).
• When banks keep excess reserve, less credit can be created.

Example:
Given the balance sheet of Bank ABC
Balance Sheet (RM Million)
-------------------------------------------------------
ASSETS LIABILITY
Reserves 200 Deposits 1000
Loans 850
--------------------------------------------------------
Total 1000 1000

a) Calculate the percentage of cash ratio.

Cash Ratio = (Cash / Current Deposit) x 100%
= (200 / 1000) x 100% = 20%

b) Calculate the money multiplier.

Money Multiplier = 1 / Cash Ratio
= 1 / 0.2 = 5

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 c) Calculate the amount of credit created.
Money Supply = 5 x 1000 = 5000
Amount of Credit Created = 5000 – 1000
= 4000

CENTRAL BANK

The Central Bank of Malaysia was established on January 1959, under the Central
Bank of Malaya Ordinance and the Banking Ordinance 1958. It is owned and
controlled by government. The central bank is given the responsibility to manage the
country’s financial activities and financial bodies in order to maintain economic
stability and prosperity in the country.

FUNCTIONS
1. To issue currency and to safeguard the external value of the
currency.
The central bank has been issuing currency since 1967. It also helps to
safeguard the value of the currency. Malaysian Ringgit is being backed by
gold and foreign currency reserves to safeguard its value. One Malaysian
Ringgit is expressed as 0.290299 g of fine gold.

2. Banker to government
The central bank keeps the government’s principle bank accounts, receives
tax and other revenue and makes payments with respect to government
expenditure. It also manages the national debt on behalf of the government,
sells new issues and redeems maturity treasury bills. As banker to the
government, the central bank is a source of financing for the federal
government. The central bank provides temporary advances to the federal
government to meet shortfalls in the budget revenue to 12.5% of the
estimated receipts of the federal government. However, the government
needs to pay back no later than three months from the end of the financial
year in which the loan was made.

3. Banker to other banks

Banks will deposit any spare cash they posses into their balances at the
central bank. These working balance allow the banks to settle indebtedness
between them by shifting the ownership of a balance or deposits from one
bank to another. The central bank also provides lend-of-last-resort facility to
commercial banks, merchant banks, finance companies and discount houses.
The presence of a lender of last resort provides confidence in the financial
institution structure.

4. Holder of the country’s stock of gold and foreign currency reserves

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 The central bank manages the nation’s foreign exchange reserves,
implements the government’s exchange rate and balance of payment’s policy
and any exchange control regulations, which are in force.

5. Promotes monetary stability of the country

The central bank is responsible in achieving monetary stability, control of
credit and hence money supply as an essential condition for continued
growth. The central bank has been endowed with monetary instruments to
perform this function.

MONETARY POLICY
Definition:
Monetary Policy is government policy on money supply and credit creation aimed at
achieving higher economic growth, stability in prices, and full employment.
Types of Monetary Policy:
1. Contractionary or Restrictive or Tight Monetary Policy
Tool used will reduce money supply in the economy. This is aimed at reducing
the pressures of inflation in an economy.
2. Expansionary or Cheap Monetary Policy
Tool used will increase money supply and activities in an economy. This will
help increase employment and growth.
Instruments
1. Quantitative Instruments:
• Discount Rate
This refers to the rediscount rate of exchange and treasury bills. A
contractionary money policy will force BNM to increase its bank rate .
Higher rate will discourage borrowings and spending.
• Open Market Operations
BNM buys or sells securities and treasury bills in the open market to
influence the size of bank deposits. Money supply in the economy can be
reduced by selling more T-bills during inflation.
• Legal Reserve Requirements
BNM may increase cash, liquidity or reserve ratio requirements to
influence credit creation and money supply. Higher ratios will mean lesser
amount to be loaned out to public.
• Funding
This refers to the conversion of short-term loans. Short-term assets like
treasury-bills are reduced and more long-term loans and advances are
given. This will lengthen the payment of the principal sum so that the bank
cannot create multiple credits.
2. Qualitative Instruments:

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• Selective Credit Control
This is done by allowing loans for productive purposes only, by increasing
minimum margin requirement to open a letter of credit, or by imposing
tighter hire purchase regulations by fixing minimum down payment and
maximum repayment period.
• Moral Suasion
Commercial banks are sometimes required by BNM to reduce the volume
given to public.
• Interest Rate
Banks will be persuaded to increase their interest rate on deposits to
attract more savings from the public.