CHAPTER THREE

COMMERCIAL BANKING

3.1. Introduction
The primary function of a commercial bank is to accept deposits from the general public.
public. People
prefer to keep their money in a bank because they consider bank as the safest place to do so.
so. This
confidence of the people is responsible for a bank to run its business. So accepting deposits and then
advancing loans with the help of these deposits are the main functions of a bank.
bank.
Every banker, by experience knows that only a few of them would come to the bank to withdraw
their deposits. If he can keep a small proportion of these deposits with him in the form of cash, that is
sufficient to meet the cash needs of those few depositors who come to a bank to withdraw their deposits.
The remaining part of the deposits will be made use of by the banker to advance loans to different sections
of the people. By this process, a banker will be in a position not only to help himself but also the economy
as a whole. This is how a banker creates credit and distributes among the borrower. Thus a bank is an
intermediary between depositors and borrowers.

3.2. Definitions of Commercial Banks

A commercial bank is a profit-seeking business firm, dealing in money and credit. It is a financial institution
dealing in money in the sense that it accepts deposits of money from the public to keep them in its custody
for safety. It also deals in credit, i.e., it creates credit by making advances out of the funds received as
deposits to needy people. Thus, it has a role as a mobilizer of saving in the economy. A bank is, therefore
like a reservoir into which flow the savings, the idle surplus money of households and from which loans are
given on interest to businessmen and others who need them for investment or productive uses.
Types of Banks
There are many types of commercial banks such as deposit banks, industrial banks, savings banks,
agricultural banks, exchange banks, and miscellaneous banks.
1. Deposit Banks: it is one of the most important commercial banks’ type.
They have connection with the commercial class of people. These banks accept deposits from the
public and lend them to needy parties . Since their deposits are for short period only, these banks extend
loans only for a short period. Ordinarily these banks lend money for a period between 3 to 6 months.
They do not like to lend money for long periods or to invest their funds in any way in long term
securities.

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 2. Industrial Banks
Industries require a huge capital for a long period to buy machinery and equipment. Industrial banks
help such industrialists. They provide long term loans to industries. Besides, they buy shares and
debentures of companies, and enable them to have fixed capital. Sometimes, they even underwrite the
debentures and shares of big industrial concerns. The important functions of industrial banks are:
1. Accepting long term deposits.
2. Meeting the credit requirements of industries by extending long term loans.
3. Advising the industrial firms regarding the sale and purchase of shares and debentures.
3. Savings Banks
These banks were specially established to encourage thrift among small savers and therefore, they were
willing to accept small sums as deposits. They encourage savings of the poor and middle class people.
4. Agricultural Banks
Agriculture has its own problems and hence there are separate banks to finance it. These banks are
organized on co-operative lines and therefore do not work on the principle of maximum profit for the
shareholders. These banks meet the credit requirements of the farmers through term loans, viz., short,
medium and long term loans. There are two types of agricultural banks,
(a) Agricultural Co-operative Banks:- are mainly for short periods
(b) Land Mortgage Banks:- are for long periods
5. Exchange Banks
These banks finance mostly for the foreign trade of a country. Their main function is to discount,
accept and collect foreign bills of exchange. They buy and sell foreign currency and thus help businessmen
in their transactions. They also carry on the ordinary banking business.
6. Miscellaneous Banks
There are certain kinds of banks which have arisen in due course to meet the specialized needs of the
people. In England and America, there are investment banks whose object is to control the distribution of
capital into several uses. There are numerous types of different banks in the world, carrying on one or the
other banking business.
3.3. Functions of Commercial Banks
We can broadly divide the functions of commercial banks into two categories:
1. Primary or fundamental functions: These functions are generally performed by all commercial banks.
banks.
It includes the receipt of deposits and lending of money.
2. Subsidiary functions: These functions vary from bank to bank depending upon the government
policy towards banking.
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Primary functions: All commercial banks perform the following functions.
1. Receipt of Deposits

A commercial bank accepts different kinds of deposits from the public. Deposits are of three types.

a) Fixed deposits:
deposits: These are deposits repayable after a certain period of time.
time. The rate of interest
depends upon the length of the period.
period. The longer the period of deposit, the higher is the rate of
interest on fixed deposits.
As banks are free to use these deposits during a special period, they grant attractive rates of
interest besides providing security of funds.
funds. Fixed deposits are also known as time liabilities of the
bank.
bank.
Generally, withdrawal of fixed deposit before the expiry of the specific period is not allowed.
allowed.
However, banks may permit the depositors to withdraw the amount in certain cases after making a
reduction in the rate of interest payable on the deposit.
deposit. Banks advance money on the security of
fixed deposits.
When bank receives fixed deposits, they issue fixed deposit receipts (FDR) to the depositors.
The amount deposited, the rate of interest allowed on the deposit, the date of maturity, withdrawal
etc., are mentioned in the receipts.
receipts.
These receipts are not negotiable instruments.
instruments. Hence, they cannot be used like cheques,
drafts, bills, etc. The holder of a fixed deposit is not regarded as a customer of a bank as he cannot
operate the account from time to time like current account or savings bank account.
account.

b) Current Account deposits: it is called as demand deposits. The depositors are free to operate the
account several times.
times. Hence, no interest is paid on this account by the banker.
banker. As these are
repayable on demand without any restrictions,
restrictions, these deposits are also called demand liabilities.
liabilities.
Cheques are generally used for withdrawing money from this account.
Mostly businessmen make use of this facility as they can avoid the risk of keeping or carrying
money with them and issue cheques instead of cash.
cash. Generally, banks charge some amount as
incidental charges for meeting the expenses of maintaining this account.
account.

c) Savings deposits:
deposits: are those on which banks place some restrictions on their withdrawal.
withdrawal. The interest
on these deposits is calculated on the minimum balance maintained during a specified period of
each month.
month. Generally, the interest rate is very low.
low. Savings deposits are of two types.
In the case of ordinary savings deposits,
deposits, the minimum balance to be maintained is fixed at a
low level.
level. For example it is fixed at Birr 25/50 by our commercial banks. The depositor does not

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 enjoy the use of cheque facility.
facility. He can withdraw money from his account by means of withdrawal
forms provided by the bank.
In the case of special savings account the banker insists/needs on a minimum amount of
balance, to be maintained in the account. The depositor is given the facility of withdrawing money
by means of cheques.

In addition to these types of deposits, some commercial banks may receive deposits under the name
of thrift deposits, recurring deposits, Kiddy bank deposits, etc. Some fixed amount is deposited at regular
periodical intervals in the case of recurring deposits.
deposits. The amount is accumulated at compound rate of
interest.
interest. After the expiry of a specified period of time the accumulated principal amount along with interest
is paid to the depositor.

2. Granting Loans and Advances

Banks use their surplus funds to grant loans and advances to businessmen and traders against the
personal security of the borrowers or against the documents of title to goods, collaterals and marketable
securities. Sometimes, loans are given against the personal security of the borrower with or without surety 1,
depending upon the credit worthiness of the borrower.
Mostly banks lend a major portion of their funds for short periods as they receive more deposits for
short periods. Commercial banks prefer to finance trade and commerce which require short term funds.
Moreover traders and business people may offer higher rates of interest on short term loans. Generally
banks lend in four ways, namely, direct loans, over-drafts, cash credits and by discounting bills.
bills. The
current account holders are given the facility of overdraft by which they are allowed to overdraw their
account up to a certain limits fixed by the bank. Interest is charged only on the amount withdrawn but not on
the entire amount of overdraft facility. The period of overdraft facility is decided by mutual agreement of
the customers and the banker. Bankers do not insist2 on any security against overdraft facility.
facility. Under the
facility of cash credit a customer is allowed to borrow money from the bank up to a certain limit against the
security of bonds, shares, promissory notes etc.

Discounting a bill of exchange is yet another important method of lending by commercial banks. Goods are
sold generally on basis of exchange. These are drawn by the seller of goods.
goods. The purchaser puts his
signature after accepting the conditions and terms of payment in due course (usually 90 days are fixed as the
maximum period with a grace period of 3 days). In the mean time if the seller wants to get money he can get
it discounted by his bank. The bill of exchange is a negotiable instrument and can be transferred from
person to person. It is a legal document of debt and the debtor cannot deny the debt. Not only the bank but

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/ Warranty
2
Needs/want
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also the buyer and seller of goods get the benefit by using bills of exchange. The banker gets profit by way
of discount. The purchasers of goods get the goods without making any payment. The seller gets the money
by getting the bill discounted by his bank.

In the process of lending, commercial banks create additional deposits called derived deposits.

Subsidiary Functions

Apart from the above main functions, banks perform a large number of other functions.

3. Agency Services
Banks act as agents of their customers. Banks collect and pay cheques, drafts, bills, etc. On behalf of their
customers they pay insurance premium, subscriptions, rents, income-tax, etc., by debiting the customers'
accounts as per specific instructions given. They also buy and sell shares and securities on behalf of the
customers. They provide information about different ways and means of productive and safe investment of
customer's funds. Sometimes bankers may also act as brokers for selling or purchasing securities on behalf
of their clients for which they get some commission. Banks transfer the funds of their customers from one
place to another by drafts or free mail or telegraphic transfers. In certain complicated matters, banks not
only advise the customers but also act as their trustees, executors and attorneys. On behalf of the customers,
banks may collect dividend and interest warrants and credit them to their account.

4. General Utility Services

Generally banks provide locker facilities for the safe keeping of valuables, Jewellery, documents, etc. at a
nominal charge. To ensure maximum security they provide double-key lockers. Thus, banks act as custodian
of valuables. They issue drafts, travelers’ cheques, etc., for the benefit of the people to enable them to
transfer their funds safely from place to place. Banks provide travelers' cheques free of charge. Sometimes
banks act as a referee to the financial standing and credit worthiness of customers. When people take loans
from any financial institution or other parties they are required to provide references to their bankers in
which they maintain their accounts so that their credit worthiness and financial stability can be verified by
the prospective creditors. When new companies are not able to mobilize capital for investment, banks may
provide underwriting facility by purchasing the new issue of shares and securities of the company. Banks
collect information relating to business, trade and general economic conditions in the country and publish
monthly or quarterly journals which are very useful and informative to the public. Banks may also deal in
foreign exchange. They collect foreign exchange and make payments in the local currency. They also
finance foreign trade of a country and discount the bills of exchange of the exporters. Bankers also help the
importers by accepting the bills drawn by foreign exporters. Banks issue letters of credit to help the traders

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and businessmen to obtain credit at distant places. Thus banks perform a large number of subsidiary services
which are very useful to the people in general and customers in particular.

5. International Services
Banks will also perform functions such as foreign exchange purchase and sell, issue of traveler’s cheques in
foreign currencies, money transfers to other countries and vice-versa. The banks play vital role in providing
guarantees in imports and exports of goods between countries.

3.4. Credit Creation

3.4.1. Meaning of Credit Creation

As already explained banks mobilize deposits and grant loans and advances. The amount of loans granted by banks
can be more than the amount of deposits they mobilize. The banks are not merely supplier of money but in an
important sense, manufacture money. The process of multiplying one deposit after keeping the minimum balance
required may be allowed as a loan to different persons; it is going to be a chain effect and entered as deposit and also
as loan disbursement in several banks in known as credit creation.
creation.

In a country, the total quantity of money in circulation includes not only the legal tender money issued by the banker.
Bank deposits are also known as bank money. While granting loans, instead of paying the amount in cash to the loan,
banks credit the amount to the accounts of the customers. Most of the customers use cheques and drafts for making
payments to different parties. Thus, additional deposits are also created on which banks get interest.

3.4.2. Process of Credit Creation

The term" Credit" is derived from the Latin word "Credo" which simply means belief or trust. In the modern
commercial world, credit refers to the faith or confidence of the creditor in the capacity of the debtor to fulfill his
promise to pay some amount in a certain period of time.

1. Primary and Secondary Deposits

One of the most important functions of a commercial bank is to create credit. Commercial banks create credit on the
basis of their deposits and loans. These deposits mainly depend upon the banking habits of the people. The initiative
for making deposits comes from the customers. In order to attract more deposits from the public, banks offer different
rates of interest on various types of deposits. By mobilizing more deposits the banker will be able to create more
credit. When an individual deposits money with a bank, the bank credits his account with the amount of his deposit.
Similarly when a customer deposits cheques, drafts or bills for collection, the banker, on realization of the amount,
credit the account of the customer. All these types of deposits are called primary deposits.
deposits. If people decide to keep
more money with the banks, the volume of primary deposits may be more. All these deposits are not kept idle with the
bank in the form of idle cash holdings. These primary deposits are used by commercial banks to create some
additional deposits. As these additional deposits are created from the primary deposits, they are called derived
deposits.
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 2. Process of Credit Creation
In the process of credit creation, there are different methods that to be adopted.
A. Granting Loans
“Loans create deposits" When a bank grants a loan to its customer it does not generally pay cash as the borrower may
not require it immediately. It credits the individual's account with the amount of the loan. Thus, without receiving any
cash or cheque or draft or any other credit instrument from the customer, the banker creates an additional deposit
simple by granting a loan to the customer. The banker supplies a pass book and a cheque book. The banker allows
him to withdraw the deposit from his account as and when the customer likes. Thus, by granting loans banks create
additional deposits. Hence, it is rightly said that “deposits are the children of loans".

B. Discounting Bills of Exchange

Derived deposits are created when a bank discounts a bill of exchange. The bank does not pay cash. It credits the
account of the customer with the amount equal to the value of the discounted bill. Accordingly, the bank's deposits
increase equal to the value of the discounted bill. In this case also the bank creates deposits to increase equal to the
value of the discounted bill. In this case also the bank creates a deposit without receiving any cash.
C. Purchasing Securities
When a banker purchases Government bonds and securities from a customer it will credit the customer's accounts
with the value of the security. In this instance also, the banker creates a deposit without receiving cash.

It is clear from the above description that the commercial banks create additional or derived deposits which will add
to the total supply of money or the purchasing power of the community.
3. Multiple Expansion of Credit or Extent of Credit Creation
The bank receives deposits from the public. The banker pays interest on these deposits. He cannot afford to keep the
deposits idle. Therefore he lends them to the needy people and institutions at higher rates of interest to make some
profit. But how much can be he lend is an important aspect of credit creation. Generally the bankers know by
experience that a part of the deposits can lent as all customers do not withdraw all their deposits at the same time.
Some people may withdraw money from the bank, while others may deposit new money. The new deposits and
withdrawals of every day may tend to be equal in such a way that the money held by a bank may not change
substantially over a short period.

It is generally believed that banks cannot lend more than their deposits. But in reality banks can lend much more than
what they receive as deposits. According to R.S. Sayers, an authority on modern banking, banks are not only
purveyors/supplier of money but also manufacturers of money. Let us try to understand the significance of this
statement. In all the countries where the banking habit is developed, people feel it secure to keep their money with the
banks. They prefer to make payments by cheques as they find it more convenient and methodical. Moreover a cheque
is a proof of payment. Every day the banker receives cash and pays cash across the counter. The receipts may balance
the payments in day-to day transactions. The total deposits of the bank may not decrease. The banker knows by
experience that he need not keep the entire money that he received. All customers do not withdraw cash from the

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bank. Some customers may draw cheques in favor of their creditors. Those creditors may deposit these cheques with
the same bank or with some other bank. They may not withdraw cash. Even if they withdraw cash from one bank they
may deposit the same with another bank. Thus people in general may not wish to keep a large part of their money
with them as it involves risk. When people receive cheques form their debtors they may deposit the cheques into their
account. The banker simply debts one account and credits another account when debtor and creditor maintain their
accounts in the same bank. Even if they have accounts in two different banks through the clearing house the claims
can be realized by debiting the account of the debtor's bank and crediting the account of creditor's bank. Thus money
may not actually flow out of the bank, but transactions may take place by book adjustments. Hence the banker
maintains only a fraction of his total deposits in the form of cash to meet the claims if customers and inter-bank
claims. The remaining balance is used for the purpose of credit creation. He need not restrict the total volume of credit
up to the amount of this balance. He can lend much more than that.

4. Deposit Multiplier
The amount of credit created by the banking system as a whole depends upon the liquidity ratio or
percentage of cash to be kept by the banks against their deposits. This percentage will determine the deposit
multiplier. With the following formula the deposit multiplier can be calculated.

r¿
1¿ ¿
K= ¿
In which K = deposit multiplier, r =percentage of cash reserves to deposits. If the percentage cash reserve ratio is 20%

20/100¿ 1/5 ¿ 20/100¿

1¿ ¿ 1¿ ¿ 1¿ ¿
then the deposit multiplier will be ¿ or ¿ or 5 times. If it is 25% deposit multiplier will be equal ¿
1/4¿ 10/100¿ 1/10¿
1¿ ¿ 1¿ ¿ 1¿ ¿
or ¿ or 4 times. If the percentage cash reserve is lowered to 10% the deposit multiplier is ¿ or ¿ or 10
times. Thus it is evident that the lower the rate of cash reserve, the higher will be the deposit multiplier. By
multiplying the additional deposits with the deposit multiplier one will be able to calculate the amount of additional or
derived deposits that would be created by the entire banking system as a whole with a given amount of increased
deposits. Just as there is multiple expansion of credit there would be multiple contraction of credit when cash is
withdrawn from the banks. Hence Crow there rightly said: "the bank's cash is the levy with which the whole gigantic
system is manipulated"

3.4.3. Limitations of Credit Creation

Though the deposit multiplier indicates the maximum extent of credit that can be created by the banking system as a
whole, banks face certain limitations to credit expansion. Credit creation depends upon the cash to be held by the

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commercial banks. The percentage of cash reserves of commercial banks is determined by the central bank. For
example, in Ethiopia the National Bank of Ethiopia determines the statutory liquidity ratio and net liquidity ratio
(NLR) of the commercial banks. If the reserve ration is increased by the central bank, the capacity of commercial
banks to create credit will decrease.

The banking habits of the people will also affect the total volume of credit. If people develop banking habits and
deposits more money with the banks and carry on their day to day transaction with cheques, drafts and other credit
instruments, banks would be in a position to create more credit. But if people do not have much faith in the banking
system and prefer to keep cash with them and withdraw their deposits from the banks, the volume of credit would be
reduced. The commercial banks are also required to keep a certain prescribed percentage of total deposits with the
central bank under the cash reserve ratio. For example, the National Bank of Ethiopia can increase this ratio from the
minimum of 3% to 15% on which the central bank does not pay any interest to the commercial banks. By increasing
this ratio, the credit creating capacity of the commercial banks can be reduced.

The power of the commercial banks to create credit depends upon the availability of good securities and bills of
exchange in the market. If good securities are not available or if genuine bills of exchange are not presented, banks
may not be able to expand credit. If the economic conditions are good and prosperous, the business people and traders
come forward to make more investment with a view to making more profits. In such prosperous boom periods, banks
may held more. But during periods of depression when the economic activity is at a low level, banks may not come
forward to expand credit.

If the monetary policy of the central bank is anti-inflationary, the commercial banks' credit creating capacity will
decrease. Quantitative and qualitative credit control weapons are used by the central bank to control the total volume
of credit in the economy.

Criticism
Edwin cannan, an economist, and Walter leaf, a practical banker, are of the opinion that banks do not have much
power to create credit as people withdraw cash from the banks. They may not keep their cash with the bank for a long
time. Dr. Cannan compares the bank with that of a cloak room in which 100 umbrellas are deposited every day when
the members visit a night club. The-in charge of the cloak room knows by experience that not more than 20 umbrellas
are demanded during club hours. Hence he can give 80 umbrellas to the needy persons and collect some rent during
the night and get some income. By any stretch of imagination can we say that the cloak room in charge created 80
umbrellas? Certainly not. Just as he cannot rent out more than 80 umbrellas, banks also cannot lend more than what
they receive as deposits. This argument may be true only when it is applied to a single bank. But in respect of the
entire banking system banks can create much more credit than the deposits they receive.

3.4.4. Significance of Bank Credit

Bank credit refers to the loans and advances granted by the banks. It is an important source of investment to exploit
the available resources in a country. When credit is productively invested, the total employment and incomes of the
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people will also increase. During periods of depression more credit is created to stimulate the economic activity so
that the economy may move into the phase of recovery and prosperity. Thus the total production and consumption of
goods and services in a country can increase with the additional investment made available by bank credit,
industrialists, traders and businessmen generally rely on bank credit, to promote and expand their enterprises. As
credit increases consumption of goods and services, there will be encouragement for the development of large scale
enterprises in a modern capitalists economy. Credit plays a pivotal role in the corporate form of businesses
organization which issues shares, bonds, securities, etc. Institutions like commercial banks, insurance companies and
other financial institutions deal with these issues in creating credit. Credit enable the state to meet its expenditure over
and above its revenue. Above all, credit is very important in an economy as it provides a convenient and economical
medium of exchange in addition to other types of money. As changes in the quantity of credit lead to changes in the
total money supply, it renders the monetary system of the country elastic.

3.5. Principles of Banking

Share capital and customers’ deposits constitute a major portion of the total capital of a commercial bank.
The bank has to use this capital, by properly and productively investing it. This is called the investment
policy of commercial banks. A prudent banker invests his funds so as to maximize profits to shareholders,
while providing adequate liquidity and security to depositors at the same time. There are no hard and fast
rules for investment of funds. As economic conditions differ from country to country, the investment policy
is not uniform in all countries. Moreover the nature of funds also may differ from locality to locality. If
long-term deposits are received, funds may be invested by granting long-term loans. Hence local conditions
also influence investment policy. But generally the investment policy of a Commercial Bank is influenced
by three important principles. They are: liquidity, profitability and security.

1. The Principle of Security

The most important principle is the safety or security of funds. As the banks deal with others’ money, they
must be very careful while granting loans and advances or else they may not be able to recover them. The
funds of the bank should not be locked up for a long time. Hence, Commercial Banks tend to invest in short
term securities. If the banks are influenced only by large security considerations they may not advance a
large portion of their funds and may not earn much profit. On the other hand, if the Commercial Banks are
very greedy and lend more funds without looking into the security aspect, they may have to face several
risks of loss. If the bank lends heavily to one individual or group of individuals, it may or may not be able to
recover the money safely unless the enterprise is in a position to repay the loan. Hence it must lend to as
large a number of persons as possible so that loss of income by bad debts may be compensated by proper
recoveries from safe investments. Similarly, banks should not invest all the funds in one place as there is a
danger of natural calamities like floods, famines, etc., causing untold damage and misery to the people of
that area. If the people of that area have taken a high portion of the funds of a bank, the bank’s financial
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position would be endangered. When the funds are diversified and invested in different places, losses at one
place may be compensated by gains in other places.

2. The Principle of Liquidity

Liquidity is another important guiding principle of investment. Liquidity refers to the ability of banks to pay
cash against deposit. A bank receives deposits from the public in different forms. A portion of these deposits
may be withdrawn by the depositors with or without any notice. The banker can enjoy the confidence of the
public only when he pays the depositors on demand. Hence a wise banker must keep adequate cash or liquid
assets to meet this demand. The liquid assets-deposit ratio is called liquidity ratio. The banks must keep a
certain percentage of their total deposits in liquid or in near liquid form, to meet the claims of customers and
inter-bank claims. Liquid assets refer to those assets that can be converted into cash easily. The liquidity of
any asset depends upon the ease with which it can be shifted on to other banks or the Central Bank before
maturity in case of need. This is referred to as shiftability of an asset. If the assets of a bank are mostly
shiftable, they increase the liquidity of the bank. The Central Bank prescribes certain rules and regulations
when Commercial Banks want to shift their assets to the Central Bank. Generally Commercial Banks tend to
invest their funds in Government securities so that as and when they are hard pressed for liquid cash they
can easily sell the government securities in the market. The investment of bank funds in easily saleable
securities or debentures will increase the liquidity of commercial banks. In case of any need, the bank can
sell the security and realize the money without any loss. When commercial banks maintain a high
percentage of liquidity, the funds of the bank are immobilized without contributing any income to bank.
[

3. The Principle of Profitability

Banks are influenced by the principle of profitably. The aim of investment is to make profit. As the very
name implies, Commercial Banks are mainly commercial in their banking activities. They cannot afford to
keep funds idle. After mobilizing the deposits, banks have to invest them in profitable ventures with
adequate security. The banks lend some portion of their funds to get constant and regular return. All the
investments of the banker may not be profitable. A profitable investment is one which yields some income
to the bank. Loans and advances, investment in securities, money at call and short notice shown on the
assets side of a balance sheet represent profitable investments. Cash reserves held by a bank and the dead
stocks represent non-profitable investments. Land, Building, Furniture, Stationary etc., represent the dead
stocks. They may not directly yield any income. But they are essential for the functioning of the banking
system.

Conflicting Nature of these Principles

Even though the rate of return is high, loans may not be granted unless the bank is satisfied with the
security. Thus safety and profitability may not go together in all types of investment. Hence the banker

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should strike a balance between the two. Similarly when banks maintain high liquidity, their profitability
may fall. If the banker prefers to lend more, the liquidity ratio of the bank may fall bellow the required level.
The bank may have to face shortage of funds and may have to face a run on the bank. Thus it looks as
though the principle of liquidity and profitability. Similarly security principle cannot be set aside on the
ground of profitability. Hence a prudent banker has to take wise decisions relating to the diversion of
investment into various productive channels keeping in view the three important guiding principles of
liquidity, security and profitability. In view of the conflicting nature of these principles a wise banker must
frame this investment policy by striking a balance between profitability on the one hand the liquidity and
solvency on the other.

3.6. Factors Influencing Liquidity of Banks

Every bank maintains cash balances and other liquid assets to meet the claims of customers. The ratio
between the liquid assets and the total deposits of bank is called liquidity ratio. This is determined by
several factors.
i. Legal Requirements
The Central Bank of the country may prescribe a certain minimum liquidity ratio applicable to all
Commercial Banks. This is called statutory liquidity ratio.
ratio. At present in India Commercial Banks are
required to maintain 35% of total deposits in the form of cash and other liquid assets. This ratio is prescribed
by the Central Bank from time to time in accordance with the change in economic conditions of the country.
All countries do not maintain any uniform ratio. For example in England it is 8% while in U.S.A. it is 10%.

ii. Banking Habits and Condition

The liquidity ratio of a bank is mostly influenced by the banking habits of the people. If the people are in the
habit of keeping money in the banks in the form of deposits and make payments by way of cheques, less
cash may be withdrawn from the banks. Hence the liquidity ratio may be less. On the other hand, if people
withdraw cash from the bank and do not use the cheques in the course of their day-to-day transactions,
banks may have to maintain a higher liquidity ratio. In developed countries like U.K. and U.S.A. people
make use of credit instruments like cheques, drafts, etc., in most of their transactions. Hence the liquidity
ratio in those countries may be much less compared to underdeveloped countries. Similarly even within a
country, in rural areas where the banking habit is not much developed, banks may have to maintain a higher
liquidity ratio compared to the developed urban areas.

iii. Structure of the Banking System

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The structure of the banking system also influences liquidity. If a large number of branches are functioning
under each head office of a bank, each bank may function with less cash reserves as they can borrow from
its main office in case of any need.
iv. Nature of Money Market
If the money market is well developed in a country with a large number of banking and other financial
institutions, the liquidity ratio may be kept at a low level. Possibilities to borrow from others will be more
when the money market is well developed. Banks may borrow not only from other banks but also from the
central bank.
v. Size of Deposits
If the number of deposits is large, banks may function with small cash reserves. The withdrawals of some
depositors may be made good by receipts form other customers. When there are a small number of
depositors each having a huge amount of deposit, banks may have to keep more cash reserves to meet their
claims.

vi. Nature of Deposits

The nature of the account also determines the liquidity. If the bank maintains more current accounts, the
funds may be withdrawn by the depositors at any time without notice. Hence banks have to maintain more
cash reserves. On the other hand if banks have huge funds in fixed deposit account liquidity may be less.

vii. Busy periods

During a certain busy season like the harvesting period there may be more withdrawals from the banks.
Hence the liquidity ratio may be high during such periods.

viii. Economic Conditions

The general economic conditions in the country also influence the cash reserves of commercial banks. In a
period of rising prices and inflation, business conditions may be prosperous. A small cash reserve may be
sufficient to meet the withdrawals.

ix. Nature of Advance and Investments

If the banks have invested a major portion of their funds in short period loans and in other liquid assets
which can be converted into cash easily, the liquidity ratio may be less.
3.7. Balance Sheet of a Commercial Bank

The balance sheet of a commercial bank is a statement showing its financial position on a particular date. It
consists of assets and liabilities. Generally assets are shown on the left side and liabilities are shown on the
right side of the balance sheet. Usually this statement is prepared at the end of every financial year. There is

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no uniformity in presenting the balance sheet among the various countries. But all balance sheets reflect
their business transactions. Let us examine the structure of assets and liabilities of a commercial bank.

Liabilities
The liabilities represent others' claims on bank. Let us discuss these claims in detail.
Capital
It is the paid-up capital that actually brings funds to the bank. Paid-up capital represents the amount of
capital already paid by the shareholders. Authorized capital represents the maximum amount of capital
which a company can raise by way of shares. Issued capital is that part of the authorized capital which is
issued to the public for subscription. The subscribed capital is the actual capital subscribed by the public.
 Balance Sheet of a Commercial Bank

Assets Liabilities
1. Cash in hand 1. Share Capital
Authorized Capital
Issued Capital
Subscribed Capital
Paid-up capital
2. Cash with other Banks 2. Reserve Fund and other reserves
3. Money at call and short notice receivable 3. Deposits and other accounts
4. Investments 4. Borrowings from other banks or Agents
5. Advances 5. Bills payable
6. Bills receivable being bills for 6. Bills for collection being bills receivable
collection as per contra. as per contra
7. Constituents; Liabilities for 7. Other Liabilities
acceptances, endorsements and
other obligations per contra.
8. Premises less depreciation. 8. Acceptances, Endorsements and other
obligations as per contra.
9. Furniture and fixtures less depreciation. 9. Profit & Loss Account
10. Other assets including silver. 10. Contingent Liabilities described in the B/S
11. Non-Banking assets acquired in satisfaction.
of claims
12. Profit and Loss Account

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Reserve Fund: This fund is created by transferring a portion of the accumulated profits of the bank.
Normally 20% of a bank's profits must be transferred to the reserve fund so long as it is not equal to the
paid-up capital. In the event of any unexpected losses, the bank is permitted to draw upon these reserves.
These reserves belong to the shareholders. Only in the event of liquidation of the bank, the capital and
reserves will be repaid to the shareholders. Generally a bank with a high reserve fund enjoys more
confidence. It acts as an additional security to the customers. The reserve fund is invested in the first class
government securities which yield regular income to the bank.

Deposits: Deposits are of various types like fixed, demand and savings deposits which we have discussed
earlier. Generally deposits form the largest item on the liabilities side. Increased deposits not only provide
more liquidity but also reflect the increased confidence of the public in the working of the bank. Both the
primary and secondary deposits form a major portion of the total liabilities of a bank.

Borrowings from others: In addition to these deposits, the banks may also borrow funds from other banks or
financial institutions in times of need. The commercial banks may also borrow from the central Bank by
rediscounting its bills of exchange. All the borrowings form a part of the total liabilities of the bank.

Bills Payable: The bills payable will be shown on the liabilities side. These bills are payable to the
customers to facilitate remittance of funds. Bills of exchange accepted or endorsed by the bank on behalf of
the customers will appear on the liabilities side as the banks have to make payments. They also appear on
the assets side as the bank has to get these payments from the customers.

Bills for Collection: On behalf of customers banks collect bills, cheques, drafts, etc. After collection, they
become the liabilities of the bank. They are treated as liabilities as the bank has to pay the proceeds to the
customers.

Other Liabilities: Under this item, other liabilities like gratuity or pension to the employees, un expired
discounts, insurance fund, unclaimed dividends, branch adjustments, etc. are shown separately.

Acceptances, Endorsements and other obligations: The banks accept or endorse the bills of exchange on
behalf of their customers. It means they guarantee the payment of bills at maturity. These obligations fall on
the liabilities side because banks have to make the payment of maturity.

Profit and loss Account: The profit earned by the bank is payable to the shareholders. Hence it is also
shown on the liabilities side.

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Contingent Liabilities: Every bank makes some provision for these liabilities in its balance sheet. These
are unforeseeable as they are not known in advance. For example, liabilities may occur when banks have to
meet the guarantees given on behalf of customers.

Having discussed briefly the liabilities side of the balance sheet let us turn to assets side of the banks.

Cash: Cash is the most liquid form of an asset. Hence it appears first in the list of assets. A bank has to
maintain sufficient liquidity to meet the claims of customers. Cash is the first life of defense against
depositors. Though cash is not an earning asset, to avoid any risky situation it maintains sufficient cash
balance to meet the customers' demands. Further, a commercial bank has to maintain a minimum percentage
of cash against the total deposits to satisfy the requirements of law.

Cash with other banks: Banks also keep a certain percentage of their total deposits with the central bank
and with other commercial banks for the purpose of inter-bank clearance adjustments. small banks may keep
their funds with bigger banks for the purpose of safety as well as clearance. Commercial banks maintaining
cash reserves with the central bank have more prestige in the eyes of the customers.

Money at Call and Notice:

Notice: Short period loans which are repayable to the bank on demand or at short notice
are included under this category. These are regarded as a second like of defense against depositors. These
loans are highly liquid as they can be converted into cash in a short period of time. These loans are given for
a maximum period of fifteen days and the bank can recall them at short notice. These loans carry a nominal
rate of interest.

Investments: Banks invest their funds to maximize their profits. The different types of investments are
shown separately on the assets side of the balance sheet. Banks mostly invest in government securities. The
fixed interest yielding securities are called gilt edged securities. As there are no risks of loss, banks prefer
investment in government bond and securities. The investment made by banks in nongovernmental
securities is also shown separately in the balance sheet. These short-term investments of banks are regarded
as secondary reserves.

Loans and Advances: Banks generally give short term loans and advances which yield high income loans
and advances, cash credits, overdraft ,etc., are the forms in which banks create additional purchasing power
in the economy. These loans and advances are given against tangible securities offered by the customers. A
bank also lend on the personal security of the borrowers to fulfill its social obligations in helping the
economically poor people.

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Bills Receivable: Bills of exchange will appear on both sides of the balance sheet. Banks discount the bills
of exchange on behalf of the customers. As these bills receive payments they are shown on the assets side.
As commercial banks sell these assets easily they are regarded as liquid assets. These bill of exchange
maybe rediscounted by the central bank. If the bills can be shifted to the central bank they become more
liquid.

Acceptances and Endorsements: These items refer to the obligations which the banker has accepted on
behalf of the customers. They represent the total dues of a bank's customers which it has accepted. They
appear on both sides of the balance sheet.

Premises and Furniture: Land, building, furniture, fixtures and other properties form a part of the total
assets of a bank. These are called " Dead stock" and are shown at their depreciated value in the balance
sheet. Usually these assets are undervalued. This under valuation is the secret reserves of the bank. In the
event of failure of the bank, these assets may come to the rescues of the bank to keep up its public
confidence and solvency.

Other Assets: The interest accrued on investments, silver, income-tax paid in advance, rent recoverable,
etc., are included under this item. These items are shown separately under different headings.

Non-Banking Assets: In the course of their business, banks may acquire certain assets in settlement of
claims. Under the banking regulation Act of banks must dispose of such assets within a period of seven
years from the date of their acquisition.

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