THE POLYTECHNIC IGBO-OWU
BUSINESS ADMINISTRATION
Course title:
INTRO TO ENTREPRENEURSHIP
Course code:
BAM 125
NAME:
ND/FT/SMS/BUS/18/137
Assignment
CHOOSE THE BUSINESS OF YOUR OWN, TELL US THE LOCATION, AND
FINANCE PROJECTION
SUMITTED TO:
MR. ORIMIDU EMMANUEL
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COMMERCIAL BANKS
Introduction To Banks
Banks have developed around 200 years ago. The natures of banks have changed as the time has
changed. The term bank is related to financial transactions. It is a financial establishment which uses,
money deposited by customers for investment, pays it out when required, makes loans at interest
exchanges currency etc. however to understand the concept in detail we need to see some of its
definitions. Many economists have tried to give different meanings of the term bank.
Nature of Commercial Banks
Commercial banks are an organisation which banks accept deposits its liabilities increase and it
becomes a debtor, but when it makes advances its assets increases and it becomes a creditor.
Banking transactions are socially and legally approved. It is responsible in maintaining the deposits of
its account holders.
Definitions of Commercial Banks
While defining the term banks it is taken into account that what type of task is performed by the banks.
Some of the famous definitions are given below:
According to Prof. Sayers , "A bank is an institution whose debts are widely accepted in settlement of
other people's debts to each other." In this definition Sayers has emphasized the transactions from
debts which are raised by a financial institution.
According to the Indian Banking Company Act 1949, "A banking company means any company which
transacts the business of banking. Banking means accepting for the purpose of lending of investment
of deposits of money from the public, payable on demand or other wise and withdraw able by cheque,
draft or otherwise."
Functions of Commercial Banks
Commercial bank being the financial institution performs diverse types of functions. It satisfies the
financial needs of the sectors such as agriculture, industry, trade, communication, etc. That means they
play very significant role in a process of economic social needs. The functions performed by banks are
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changing according to change in time and recently they are becoming customer centric and widening
their functions.
Generally the functions of commercial banks are divided into two categories is.
primary functions and the secondary functions. The following chart
simplifies the functions of banks.
Primary Functions of Commercial Banks
Commercial Banks performs various primary functions some of them are given below
1. Accepting Deposits : Commercial bank accepts various types of deposits from public
especially from its clients. It includes saving account deposits, recurring account deposits, fixed
deposits, etc. These deposits are payable after a certain time period.
2. Making Advances : The commercial banks provide loans and advances of various forms. It
includes an over draft facility, cash credit, bill discounting, etc. They also give demand and demand and
term loans to all types of clients against proper security.
3. Credit creation : It is most significant function of the commercial banks. While sanctioning a
loan to a customer, a bank does not provide cash to the borrower Instead it opens a deposit account
from where the borrower can withdraw. In other words while sanctioning a loan a bank automatically
creates deposits. This is known as a credit creation from commercial bank.
Secondary Functions of Commercial Banks
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Along with the primary functions each commercial bank has to perform several secondary functions too.
It includes many agency functions or general utility functions. The secondary functions of commercial
banks can be divided into agency functions and utility functions.
A. Agency Functions : Various agency functions of commercial banks are
1. To collect and clear cheque, dividends and interest warrant.
2. To make payment of rent, insurance premium, etc.
3. To deal in foreign exchange transactions.
4. To purchase and sell securities.
5. To act as trusty, attorney, correspondent and executor.
6. To accept tax proceeds and tax returns.
B. General Utility Functions : The general utility functions of the commercial banks include
1. To provide safety locker facility to customers.
2. To provide money transfer facility.
3. To issue traveller's cheque.
4. To act as referees.
5. To accept various bills for payment e.g phone bills, gas bills, water bills, etc.
6. To provide merchant banking facility.
7. To provide various cards such as credit cards, debit cards, Smart cards, etc.
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1. WITH THE AID OF CHART PROVIDED, PROVIDE THE DISCUSSION ON THE STRUCTURE OF
COMMERCIAL BANK
Upper Executive Management
Stockholders own commercial banks that elect a board of directors. The boards of directors are responsible for
making the commercial bank profitable and creating polices to facilitate that goal.
The board selects the bank's officers, who are responsible for creating a business strategy based on the boards
recommendations. The bank officers include the president, vice president, treasurer and secretary.
Executive Divisions
The bank officers appoint department managers, who head up each banking division. These divisions vary from
bank to bank, but most include some form of the following: loan, credit, auditing, trust, consumer banking and
business. Within each division, there are a president and various vice president.
The loan division oversees a variety of commercial loans including home mortgages and auto and personal
loans.
The credit division is responsible for unsecured debt, such as credit cards.
The audit division makes sure that all government regulations and bank procedures are followed. They also
oversee the internal security of the bank.
The trust division monitors legal trusts to make sure they follow government and legal guidelines. Trusts are
overseen by a trustee who manages property, assets and the trust holder’s requirements for the beneficiaries.
Consumer banking supports the retail division of the bank. This includes working with other executive divisions to
solve banking issues and to execute policy.
The business department handles everything to do with business accounts. This includes loans, checking,
savings and other business-related banking.
Retail Division
The retail division of a commercial bank interfaces with the public the most. The corner bank is a part of a retail
division in a commercial bank. Retail banks are run by a bank manager, who oversees the various departments
within the bank, such as business, loans and consumer banking. Each department is supported by a
corresponding executive division.
The retail division helps consumers open and manage accounts, apply for loans and provide other banking
services. Bank tellers are normally the first person a consumer meets when doing business with a bank.
Commercial Banking Services
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Commercial banks engage in a number of banking services. They process payments, oversee instalment loans,
provide notary services, safe-keep items in safe deposit boxes and issue bank drafts and checks. The larger
commercial banks also underwrite products such as bonds and direct investors to their partner investment bank.
2. BALANCE SHEET OF A COMMERCIAL BANK
The balance sheet of a commercial bank provides a picture of its functioning. It is a statement which
shows its assets and liabilities on a particular date at the end of one year.
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The assets are shown on the right- hand side and the liabilities on the left-hand side of the balance
sheet. As in the case of a company, the assets and liabilities of a bank must balance. The balance sheet which
every commercial bank in India is required to publish once in a year is shown as under:
We analyse the distribution of assets and liabilities of a commercial bank on the basis of the division
given in the above Table.
The Distribution of Assets: The assets of a bank are those items from which it receives income and profit. The
first item on the assets side is the cash in liquid form consisting of coins and currency notes lying in reserve with
it and in its branches. This is a certain percentage of its total liabilities which it is required to keep by law. Cash
reserves do not yield income to the bank but are essential to satisfy the claims of its depositors.
The second item is in the form of balances with the central bank and other banks. The commercial banks are
required to keep a certain percentage of their time and demand deposits with the central bank. They are the
assets of the bank because it can withdraw from them in cash in case of emergency or when the seasonal
demand for cash is high.
The third item, money at call and short notice, relates to very short-term loans advanced to bill brokers, discount
houses and acceptance houses. They are repayable on demand within fifteen days. The banks charge low rate
of interest on these loans. The fourth item of assets relates to bills discounted and purchased.
The bank earns profit by discounting bills of exchange and treasury bills of 90 days duration. Some bills
of exchange are accepted by a commercial bank on behalf of its customers which i ultimately purchases. They
are a liability but they are included under assets because the bank can get them rediscounted from the central
bank in case of need.
The fifth item, investments by the bank in government securities, state bonds and industrial shares,
yields a fixed income to the banks. The bank can sell its securities when there is need for more cash. The sixth
item relating to loans and advances is the most profitable source of bank assets as the bank changes interest at
a rate higher than the bank rate.
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The Distribution of Liabilities: The liabilities of commercial banks are claims on it. These are the items which form
the sources of its funds. Of the liabilities, the share capital of the bank is the first item which is contributed by its
shareholders and is a liability to them. The second item is the reserve fund. It consists of accumulated resources
which are meant to meet contingencies such as losses in any year.
They are the main source from which the bank gets funds for investment and are indirectly the source of
its income. By keeping a certain percentage of its time and demand deposits in cash the bank lends the
remaining amount on interest. Borrowings from other banks are the fourth item.
These are the bills of exchange which the bank collects on behalf of its customers and credits the
amount to their accounts. Hence it is a liability to the bank. The seventh item is the acceptance and endorsement
of bills of exchange by the bank on behalf of its customers. These are the claims on the bank which it has to
meet when the bills mature.
Table 1. Form of Balance Sheet:
Liabilities Assets
1. Share Capital 1. Cash
2. Reserve Fund 2. Balances with the Central Bank and other banks.
3. Deposits 3. Money at call and Short-Notice
4. Borrowings from other banks 4. Bills Discounted and Purchased.
5. Bills Payable 5. Investments
6. Bills for collection 6. Loans, Advances, Cash Credits and Overdrafts.
7. Acceptances. Endorsements and other 7. Liabilities of Customer for Acceptances. Endorsements and
obligations other Obligations.
8. Contingent Liabilities 8. Property, Furniture, Fixtures less Depreciation
9. Profit and Loss 9. Profit and Loss.
Bank's Liabilities
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Bank's liabilities constitute five major items. The share capital, the contribution which shareholders have
contributed for starting the bank. Reserve funds are the money, which the bank has accumulated over the years
from its undistributed profits. Deposits are the money owned by customers and therefore it is a liability of a bank.
There can be various kinds of deposits and recurring deposits. Apart from these items a bank can borrow from
central and other commercial banks. These borrowings are also treated as bank's liabilities.
Bank's Assets
Bank's assets comprises cash, money at short notice, bills and securities discounted, bank's investments, loans
sanctioned by the bank, etc. Bank's cash in hand, cash with other banks and cash with central bank (RBI) are its
assets. When a bank makes money available at short notice to other banks and financial institutions for a very
short period of 1-14 days it is also treated as bank's asset. Apart from these items bank always make money
available to people on the form of loans and advances. They are also become bank's assets.
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3. EXPLAIN CLEARLY PROFITABILITY AND LIQUIDITY IN BANK MANAGEMENT
Liquidity is the ability of a company to meet its short term obligations. It is the ability of the company to
convert its assets into cash. Short term, generally, signifies obligations which mature within one accounting year.
Short term also reflects the operating cycle: buying, manufacturing, selling, and collecting. A company that
cannot pay its creditors on time and continue to fail its obligations to the suppliers of credit, services, and goods
can be declared a sick company or bankrupt company. Inability to meet the short term liabilities may affect the
company’s operations and in many cases it may affect its reputation too. Lack of cash or liquid assets on hand
may force a company to miss the incentives given by the suppliers of credit, services, and goods. Loss of such
incentives may result in higher cost of goods which in turn affect the profitability of the business. So there is
always a need for the company to maintain certain degree of liquidity. However, there is no standard norm for
liquidity. It depends on the nature of the business, scale of operations, location of the business and many other
factors.
The Concept of Liquidity
The concept of Liquidity has been a source of worry to the management of firms of the uncertainty of
the future. Liquidity is a financial term that means the amount of capital that is available for investment. Today,
most of this capital is credit, not cash. That's because the large financial institutions that do most investments
prefer using borrowed money.
High liquidity means there is a lot of capital because interest rates are low, and so capital is easily
available. Why are interest rates so important in controlling liquidity? Because these rates really dictate how
expensive it is to borrow. Low interest rates mean credit is cheap, so businesses and investors are more likely to
borrow. The return on investment only has to be higher than the interest rate, so more investments look good. In
this way, high liquidity spurs economic growth.
Liquidity can be defined as the state or condition of a business organization which determines its ability
to honour or discharge its maturing obligations. These maturing obligations are composed of current liabilities
and long-term debts. Liquidity can also be defined as a measure of the relative amount of asset in cash or which
can be quickly converted into cash without any loss in value available to meet short term liabilities.
Liquidity Components
1. Vault Cash
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2. Balances Held With CBN
3. Balances Held With Other Banks In Nigeria
4. Balances Held With Offices & Branches Outside Nigeria
5. Money At Call In Nigeria
6. Inter-bank Placement
7. Placement with Discount Houses
8. Treasury Bills
9. Treasury Certificates
10. Investment in Stabilization Securities
11. Bills Discounted Payable In Nigeria
12. Negotiable Certificates of Deposits
Elements of Liquidity
Liquidity is a complex concept as the rate of liquidity among different liquid assets differs. For instance, a savings
or time deposit is more liquid than common stock and common stocks in turn are more liquid than real estate.
Liquidity is a relative concept because there is no specific level of any balance sheet ratio that indicates that the
firm is no longer liquid.
Liquidity involves three elements or characteristics namely Marketability, Stability and Conservatism. Liquid
assets should be more marketable or transferable. That means, they are expected to be converted to cash easily
and promptly, and are redeemed prior to maturity. All assets that cannot be redeemed at maturity are said to be
illiquid.
The Management of Liquidity in Commercial Banks
Bank liquidity refers to the ability of the bank to ensure the availability of finds to meet financial commitments or
maturing obligations at a reasonable price at all times. Put tersely, bank liquidity means a bank having money
where they need it particularly to satisfy the withdrawal needs of the customers.
Liquidity
The concept of “liquidity” is use to address financial condition of the bank. Another author defined
liquidity as “the ability to settle obligations with immediacy”. The management of liquidity is essential for financial
and non-financial firms. This is a responsibility of the bank to pay the financial obligations, the financial
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obligations contain long and short-term debts and other financial expenses. Liquidity is a way which is used by
the bank or banking sector to transform assets into the shape of cash to made payment in cash. This is a
responsibility of all banks to encounter their fiscal duties, banks convert their current assets into the shape of
cash to pay the due obligations. The banks having less amount in current assets will face difficulties in on-going
its processes and if the amount of currents assets is too high, this displays that the return on investment for the
bank is not in the unspoiled state.
The liquidity ratio is important in mostly organizations like banks because banks typically work through
the huge number of funds deposited by savers. Liquidity ratios calculate a bank capacity to see the payment
responsibilities by relating the cash with the payment responsibilities. Liquid assets mostly comprise of cash,
marketable securities, sovereign debt central bank reserves. This is good if the liquid assets of the banks must
be marketable securities because marketable securities are easy to convert into the form of cash without.
The Liquidity risk management is a crucial factor for risk management framework of the banking sector
and other financial institutions because it affects the profitability. A well-managed liquidity monitoring regulates
more or less managing decisions on the basis of on bank liquidity situations to avoid losses.
Profitability
The matter of bank profitability is a central forecaster of financial crises. The profitability of banking sector is
important with the aim to estimate the constancy and reliability of the financial and banking sector.
Another author described profitability as the variation between expenses and revenues through a fixed period of
time, generally fixed period is consisting of one financial year. This is essential of banks for to generate sufficient
amount of income endure that will lead on the way additional growth and expansion.
Author claimed that preparation for bank profitability is furthermost major and challenging part made by
the administration of the bank because numerous factors are tangled in the decision. The profit planning and
management is more complex in the highly challenging economic environment. The profitability is represented by
three alternative variables. First, most important profitability ratio is the return on asset (ROA), ROA shows the
ability of bank asset to produce the profit. Another ratio is the return on equity (ROE), this ratio mentions the
returns to shareholders on their equity. The next one is the return on Investment (ROI), it measures the bank's
efficiency by using invested capital. Scholar stated that Earnings per share (EPS) serve as a pointer of a bank’s
profitability. Another scholar stated that Net profit margin (NPM) and Tobin Q as bank’s profitability factor.
Association among Liquidity and Profitability
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There are many theories demonstrate the link between liquidity and profitability of the banks. Researchers
conducted research in on banking sector of United States and proposed that more liquidity is typically costly for
banks, signifying that more liquidity cuts profitability of the banks. Another researcher argues that liquidity level
vary time to time, holding larger capital would risk their profitability lead towards less lending. Liquidity problems
can interrupt a bank’s incomes in risky circumstances may result in the downfall or bankrupt.
In earlier research stated that the banks with high liquidity have a lower rate of net interest margins. In the time of
liquidity crisis, the bank may borrow from the market remarkably high rate and this is eventually reasons decline
in the profitability of the bank. Another scholar makes clear the connection among liquidity and profitability in
short [25]. They stated that banks preserve the high quantity of cash funds compared to the deposits held by the
bank. The reserve will not earn a profit for the bank but if they approve the plan financing reserved money for
raising the profit of bank they might face the serious issue like liquidity crisis. Banking sector of Pakistan faced a
hard time in loaning to the private sector in 2008 because of the liquidity crisis.
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4. PRINCIPLE GOVERNING BORROWING AND LENDING IN BANKS
Principles of lending
The business of lending, which is main business of the banks, carry certain inherent risks and bank cannot take
more than calculated risk whenever it wants to lend. Hence, lending activity has to necessarily adhere to certain
principles. Lending principles can be conveniently divided into two areas:
i. Activity
ii. Individual.
i. Activity:
a. Principle of Safety of Funds
b. Principle of Profitability
c. Principle of Liquidity
d. Principle of Purpose
e. Principle of Risk Spread
f. Principle of Security
ii. Individual:
a. Process of Lending
b. 5 ‘C’s of the borrower = Character, Capacity, Capital, Collateral, Conditions Sources of information
available to assess the borrower
– Loan application
– Market reports
– Operation in the account
– Report from other Bankers
– Financial statements, IT returns etc.
– Personal interview
– Unit inspection prior to sanction
c. Security Appraisal
Primary & collateral security should be ‘MASTDAY’
M – Marketability
A – Easy to ascertain its title, value, quantity and quality
S – Stability of value
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T – Transferability of title
D – Durability – not perishable
A – Absence of contingent liability. I.e. the bank may not have to spend more money on the security to make it
marketable or even to maintain it.
Y – Yield. The security should provide some on-going income to the borrower/ bank to cover interest & or partial
repayment.
The traditional principles of bank lending have been followed with certain modifications. The concept of security
has undergone a radical change and profitability has been subordinated to social purpose in respect of certain
types of lending. Let us now discuss the principles of lending in details:
Safety
As the bank lends the funds entrusted to it by the depositors, the first and foremost principle of lending is to
ensure the safety of the funds lent. By safety is meant that the borrower is in a position to repay the loan, along
with interest, according to the terms of the loan contract. The repayment of the loan depends upon the
borrower’s:
a. Capacity to pay, and
2. Willingness to pay. The former depends upon his tangible assets and the success of his business; if he
is successful in his efforts, he earns profits and can repay the loan promptly. Otherwise, the loan is recovered out
of the sale proceeds of his tangible assets.
The willingness to pay depends upon the honesty and character of the borrower. The banker should, therefore,
taken utmost care in ensuring that the enterprise or business for which a loan is sought is a sound one and the
borrower is capable of carrying it out successfully. He should be a person of integrity, good character and
reputation. In addition to the above, the banker generally relies on the security of tangible assets owned by the
borrower to ensure the safety of his funds.
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Liquidity
Banks are essentially intermediaries for short term funds. Therefore, they lend funds for short periods and mainly
for working capital purposes. The loans are, therefore, largely payable on demand. The banker must ensure that
the borrower is able to repay the loan on demand or within a short period. This depends upon the nature of
assets owned by the borrower and pledged to the banker. For example, goods and commodities are easily
marketable
while fixed assets like land and buildings and specialized types of plant and equipment can be liquidated after a
time interval. Thus, the banker regards liquidity as important as safety of the funds and grants loans on the
security of assets which are easily marketable without much loss.
Profitability
Commercial banks are profit-earning institutions; the nationalized banks are no exception to this. They must
employ their funds profitably so as to earn sufficient income out of which to pay interest to the depositors,
salaries to the staff and to meet various other establishment expenses and distribute dividends to the
shareholders (the Government in case of nationalized banks). The rates of interest charged by banks were in the
past primarily dependent on the directives issued by the Reserve Bank.
Now banks are free to determine their own rates of interest on advances. The variations in the rates of interest
charged from different customers depend upon the degree of risk involved in lending to them. A customer with
high reputation is charged the lower rate of interest as compared to an ordinary customer. The sound principle of
lending is not to sacrifice safety or liquidity for the sake of higher profitability. That is to say that the banks should
not grant advances to unsound parties with doubtful repaying capacity, even if they are ready to pay a very high
rate of interest. Such advances ultimately prove to be irrecoverable to the detriment of the interests of the bank
and its depositors.
Purpose of the Loan
While lending his funds, the banker enquires from the borrower the purpose for which he seeks the loan. Banks
do not grant loans for each and every purpose they ensure the safety and liquidity of their funds by granting
loans for productive purposes only, viz., for meeting working capital needs of a business enterprise. Loans are
not advanced for speculative and unproductive purposes like social functions and ceremonies or for pleasure
trips or for the repayment of a prior loan. Loans for capital expenditure for establishing business are of long-term
nature and the banks grant such term loans also. After the nationalization of major banks loans for initial
expenditure to start small trades, businesses, industries, etc., are also given by the banks.
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Principle of Diversification of Risks
This is also a cardinal principle of sound lending. A prudent banker always tries to select the borrower very
carefully and takes tangible assets as securities to safeguard his interests. Tangible assets are no doubt valuable
and the banker feels safe while granting advances on the security of such assets, yet some risk is always
involved therein. An industry or trade may face recessionary conditions and the price of the goods and
commodities may sharply fall. Natural calamities like floods and earthquakes, and political disturbances in certain
parts of the country may ruin even a prosperous business.
To safeguard his interest against such unforeseen contingencies, the banker follows the principle of
diversification of risks based on the famous maxim “do not keep all the eggs in one basket.” It means that the
banker should not grant advances to a few big firms only or to concentrate them in a few industries or in a few
cities or regions of the country only.
The advances, on the other hand, should be over a reasonably wide area, distributed amongst a good number of
customers belonging to different trades and industries. The banker, thus, diversifies the risk involved in lending. If
a big customer meets misfortune, or certain trades or industries are affected adversely, the overall position of the
bank will not be in jeopardy
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