CHAPTER TWO: COMMERCIAL BANKS

CHAPTER TWO:

COMMERCIAL BANKS

L. ARAM SHABAN FATTAH [email protected]

LEARNING OUTCOMES

After studying this chapter , you will able to:

•Define Commercial Banks

•Getting Information About;

•The Role of Commercial Banks In The EconomicDevelopment,

•Types Of Commercial Banks,

•Functions of Commercial Banks,

•Investment Policy of Banks,

•Sources of Commercial Bank’s Income.

2L. ARAM SHABAN FATTAH [email protected]

WHAT ARE COMMERCIAL BANKS?

•Commercial banks are the most important components ofthe whole banking system.

•A commercial bank, (Deposit bank) is a profit-based/seeking financial institution that grants loans,accepts deposits, and offers other financial services, suchas overdraft facilities and electronic transfer of funds.

•In other words, commercial banks are financial institutionsthat accept deposits from the general public (surplusunits), transfer funds from the bank to another (deficitunits), and earn profit.


WHAT ARE COMMERCIAL BANKS?

•Commercial Banks mostly offer short-term and medium-term loansfrom a percentage of the cash deposits at a high interest rate.They do not provide long-term financing due to the need tomaintain liquidity of assets.

•The funds of commercial banks belong to the general public andare withdrawn at a short notice; therefore, commercial banksprefers to provide credit for a short period of time backed bytangible and easily marketable securities.

•Commercial banks, while providing loans to businesses, considervarious factors, such as nature and size of business, financialstatus and profitability of the business, and its ability to repayloans.


THE ROLE OF COMMERCIAL BANKS IN THE ECONOMIC DEVELOPMENT

•Banking industry is a very important tool in the constructionof economic structure of any country and it plays asignificant role in the economic development of a developingcountry. Economic development involves investment invarious sectors of economy.

•Banks play a vital role in the economic development of acountry. They accumulate the idle savings of the people andmake them available for investment.

•They facilitate trade both inside and outside the country byaccepting and discounting of bills of exchange.

•Commercial banks also increase the mobility of capital.



•Thus the banks collect savings from the people and mobilize

saving for investment in industrial projects. The investors borrow

from banks to finance the projects. Special funds are provided to

the investors for the completion of projects. The banks provide a

guarantee for industrial loan from international agencies. The

foreign capital flows to developing countries for investment in

projects.

•Besides normal banking, the banks perform agency services for

the client. The banks buy and sell securities, make rent

payments, receive subscription funds and collect utility bills for

the Government departments. Thus these banks save the time

and energy of busy people.



•Banks arrange foreign exchange for the business transactions

with other countries. The facility of foreign currency account has

resulted in an increase of foreign exchange reserves. By

opening a letter of credit the banks promote foreign trade.

•Banking sector plays a positive role in augmenting the progress

of a country as repositories of community’s savings and as

purveyors of credit. It is the heart of financial structure since it

has the ability to add to the money supply of the nation and thus

creates additional purchasing power. Lending, investing and

related activities of banks facilitate the economic processes of

production, distribution and consumption.


TYPES OF COMMERCIAL BANKS

There are three different types of commercial bank.

Private Bank – It is one type of commercial banks where private individualsand businesses own a majority of the share capital (the private individuals ownmore than 51% of the share capital). All private banks are recorded ascompanies with limited liability. Such as RT Bank , Babylon Bank, AshurInternational Bank, Morgan Stanley etc.

Public Bank – It is those type of bank that is nationalized, and thegovernment holds a significant stake (the Government holds more than 51%of the share capital). For example, Trade Bank of Iraq, Rafidain Bank,Rasheed Bank.

Foreign Bank – These banks are established in foreign countries and havebranches in other countries. For instance, American Express Bank, HongKong and Shanghai Banking Corporation (HSBC), Standard & CharteredBank, and Citibank etc.

L. ARAM SHABAN FATTAH [email protected] 8

FUNCTIONS OF COMMERCIAL BANKS


PRIMARY FUNCTIONS OF COMMERCIAL BANKS

1. Acceptance of Deposits

Current Deposits

Fixed Deposits

Savings Deposits

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The most important and

traditional place for a

commercial bank is to accept

deposits from the public.

Deposits may be of three

types:

-Also known as demand deposits. These deposits can

be withdrawn at any time.

-No interest is allowed on it.

-The customer is required to leave a minimum

balance undrawn with the bank

-Cheques are used to withdraw

-Fixed deposits have a fixed period of maturity and

are referred to as time deposits.

-They can be withdrawn only after the maturity of the

specified fixed period.

-The interest rates are higher in case of such deposits.

-in practice banks allow the depositors to withdraw

funds. even before the maturity period but at a low

interest (or without paying interest rate).

-It is most suitable term of deposit for individual

households.

-They combine the features of both current account

and fixed. payable on demand and also by cheque.

-But bank gives this facility with some restrictions.

-Interest paid on savings account deposits in lesser

than that of fixed deposit.L. ARAM SHABAN FATTAH [email protected]

DIFFERENCE BETWEEN DEMAND DEPOSITS AND TIME (TERM) DEPOSITS

DEMAND DEPOSITS (ACCOUNTS) FIXED DEPOSITS (ACCOUNTS)

These deposits can be withdrawn at any time. They can be withdrawn only after the maturity of the

specified fixed period.

No interest is allowed on it. Specific interest rate allowed on it. (carry a fixed rate

of interest.)

Cheques are used to withdraw Cheques aren’t used to withdraw

Are highly liquid Are less liquid

L. ARAM SHABAN FATTAH [email protected] 11


-Advances to all types of persons, particularly to businessmen and

entrepreneurs.

-Loans are made against personal security.e.g; gold and silver, stocks and other assets.

2.Advancing Loans

A borrower is allowed to

withdraw more amount than what he has deposited.

(a) Overdraft

the bank advances a ‘cash loan’ up to a

specified limit to the customer

against an security/asset.

(b) Cash Credit

the bank pays the amount of bill

presented by the customer after

deducting the usual bank discount.

(c) Discounting Bills of Exchange

-Bank also grant loans for a very short

period, generally not exceeding 7 days to

the borrowers.

(d) Money at Call

Banks give term loans to traders,

industrialists and now to agriculturists also

against some collateral securities

(e) Term Loans

Consumer credit is personal debt taken on to purchase goods and services. A credit card is one form of

consumer credit.

(f) Consumer Credit



3. Creation of Credit:

A unique function of the bank is to create credit. Banks supply money to

traders and manufacturers. They also create or manufacture money. Bank

deposits are regarded as money. They are as good as cash. The reason is

they can be used for the purchase of goods and services and also in

payment of debts. When a bank grants a loan to its customer, it does not pay

cash. It simply credits the account of the borrower. He can withdraw the

amount whenever he wants by a cheque. In this case, bank has created a

deposit without receiving cash. That is, banks are said to have created

credit. Sayers says “banks are not merely purveyors of money, but also in an

important sense, manufacturers of money.”


3. CREATION OF CREDIT CONT.

(a) Let us assume that the entire commercial banking system is one unit. Let us callthis one unit simply “commercial banks’. Let us also assume that all receipts andpayments in the economy are routed through the commercial banks. One who makespayment does it by writing cheque. The one who receives payment deposits thesame in his deposit account.

(b) Suppose initially people deposit $1000. The commercial banks use this money forgiving loans. But the commercial banks cannot use the whole of deposit for thispurpose. It is legally compulsory for the banks to keep a certain minimum fraction ofthese deposits as cash. The fraction is called the Required Reserve Ratio (rr). The(rr) is fixed by the Central Bank.

(c) Let us now explain the process, suppose the initial deposits in banks is $1000and the (rr) is 10%. Further, suppose that commercial banks keep only the minimumrequired, i.e., $100 as cash reserve, commercial banks are now free to lend theremainder $900. Suppose they lend $900. What banks do to open deposit accountsin the names of the borrowers who are free to withdraw the amount whenever theylike.

• Suppose they withdraw the whole of amount for making payments.



(d) Now, since all the transactions are routed through the commercial banks, the moneyspent by the borrowers comes back into the banks into the deposit accounts of those whohave received this payment. This increases demand deposit in banks by $900. It is 90% ofthe initial deposit. These deposits of $900 have resulted on account of loans given by thebanks. In this sense the banks are responsible for money creation. With this round,increased in total deposits are now $1900 (=$1000 + $900).

(e) When banks receive new deposit of $900, they keep 10% of it as required reserves anduse the remaining $810 for giving loans. The borrowers use these loans for makingpayments. The money comes back into the accounts of those who have received thepayments. Bank deposits again rise, but by a smaller amount of $810. It is 90% of the lastdeposit creation. The total deposits now increase to $2710 (=$1000 + $900 + $810). Theprocess does not end here.

(f) The deposit creation continues in the above manner. The deposits go on increasinground after round but Deposit Creation By Commercial Banks each time only 90% of thelast round deposits. At the same time cash reserves go on increasing, each time 90% of thelast required reserve.

*The deposit creation comes to end when the total require reserves become equal to theinitial deposit. The total deposit creation comes to $10,000 (ten times the initial deposit) asshown in the table.

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Rounds Deposits $ Loans $

Required

Reserves

(rr= 0.1) $

Initial 1,000 900 100

Round 1 900 810 90

Round 2 810 729 81

- - - -

- - - -

- - - -

Total 10,000 9,000 1,000


Money (Credit) Creation By Commercial Banks

•It can also be explained with the help of the following formula:

•Money Multiplier= 1/rr = 1 / 0.1= 10

•Thus, the total money creation is;

•Money Creation= Initial Deposit * 1/rr = $10,000



•Banks are required to keep only a fraction of deposits as cash

reserves because of the following two reasons:

•(a) First, the banking experience has revealed that not all depositors

approach the banks for withdrawal of money at the same time and

also that normally they withdraw a fraction of deposits.

•(b) Secondly, there is a constant flow of new deposits into the

banks. Therefore to meet the daily demand for withdrawal of cash, it

is sufficient for banks to keep only a fraction of deposits as a cash

reserve.

•When the primary cash deposit in the banking system leads to

multiple expansion in the total deposits, it is known as money

multiplier or credit multiplier.


4. Promote the Use of Cheques:

The commercial banks render an important

service by providing to their customers a

cheap medium of exchange like cheques. It is

found much more convenient to settle debts

through cheques rather than through the use

of cash. The cheque is the most developed

type of credit instrument in the money market.



5. Financing Internal and Foreign Trade:

The bank finances internal and foreign

trade through discounting of exchange bills.

Sometimes, the bank gives short-term

loans to traders on the security of

commercial papers. This discounting

business greatly facilitates the movement of

internal and external trade.



•6. Transfer of Funds:

•Commercial banks, on account of their network of

branches throughout the country, also provide

facilities to remit funds from one place to another

for their customers by issuing bank drafts, mail

transfers or telegraphic transfers on nominal

commission charges. As compared to the postal

money orders or other instruments, bank drafts

have proved to be a much cheaper mode of

transferring money and has helped the business

community considerably.


SECONDARY FUNCTIONS OF COMMERCIAL BANKS

SECONDARY FUNCTIONS

AGENCY SERVICES

GENERAL UTILITY

SERVICES




•1. Agency Services: Banks also perform certain agency functions forand on behalf of their customers. The agency services are of immensevalue to the people at large. The various agency services rendered bybanks are as follows:

•(a) Collection and Payment of Credit Instruments: Banks collect andpay various credit instruments like cheques, bills of exchange,promissory notes etc., on behalf of their customers.

•(b) Purchase and Sale of Securities: Banks purchase and sell varioussecurities like shares, stocks, bonds, debentures on behalf of theircustomers.

•(c) Collection of Dividends on Shares: Banks collect dividends andinterest on shares and debentures of their customers and credit them totheir accounts.



•1. Agency Services

•(d) Acts as Correspondent: Sometimes banks act as representative andcorrespondents of their customers. They get passports, travelers' ticketsand even secure air and sea passages for their customers.

•(e) Income-tax Consultancy: Banks may also employ income taxexperts to prepare income tax returns for their customers and to helpthem to get refund of income tax.

•(f) Execution of Standing Orders: Banks execute the standinginstructions of their customers for making various periodic payments. Theypay subscriptions, rents, insurance premia etc., on behalf of theircustomers.

•(g) Acts as Trustee and Executor: Banks preserve the ‘Wills’ of theircustomers and execute them after their death.



•2. General Utility Services: In addition to agency services, the modern banks provide

many general utility services for the community as given.

•(a) Locker Facility: Bank provide locker facility to their customers. The customers can keep

their valuables, such as gold and silver ornaments, important documents; shares and

debentures in these lockers for safe custody.

•(b) Travelers' Cheques and Credit Cards: Banks issue travelers' cheques to help their

customers to travel without the fear of theft or loss of money. With this facility, the customers

need not take the risk of carrying cash with them during their travels.

•(c) Letter of Credit: Letters of credit are issued by the banks to their customers certifying

their credit worthiness. Letters of credit are very useful in foreign trade.

• (d) Collection of Statistics: Banks collect statistics giving important information relating to

trade, commerce, industries, money and banking. They also publish valuable journals and

bulletins containing articles on economic and financial matters.

SOURCES OF BANK’S INCOME


•Traditionally, banks have generated most of their income by issuing loans

and collecting the interest payments. However, a large fraction of bank

revenue also comes from so-called “noninterest income,” which includes

items such as overdraft fees and ATM charges. In the wake of very low

interest rates since the financial crisis, it might seem natural that banks

would make greater use of noninterest income to make up for any declines

they might be experiencing in interest income.

•Traditional banking focus on the interest spread earned as a difference of

interest received on advances and interest expanded on deposits. Modern

banking focuses not only on interest spreads but also on non-interest

income streams.



•What Is Noninterest Income?

•Noninterest income is defined as income generated by banks from

sources unrelated to the collection of interest payments. e.g.; ATM fees,

Overdraft fees, Check/Cheque Payment fees, Remittance of Funds,

Letter of Credit fees and fees on other banking services .

•Another type of noninterest income related to modern bank activities,

such as brokering securities, arranging mergers and acquisitions for

firms, trading stocks and bonds and selling insurance.



•The followings are the various sources of a bank’s profit:

•1. Interest on Loans: The main function of a commercial bank is to accept deposit

in order to lending at a higher interest rate. Bank grants different types of loans to

the individuals, companies and governments etc. . The returns from loans

constitute the major part of the income of a bank. The banks provide loans

generally for short periods. But now the banks also grant call loans which can be

called at a very short notice. Such loans are granted to share brokers and other

banks. These assets are highly liquid because they can be called at any time.

Moreover, they are source of income to the bank.

•2. Interest on Investments: Banks also invest an important part of their resources

in government and other first class industrial securities. The interest and dividend

received from time to time on these investments is a source of income for the

banks. Bank also earn some income when the market prices of these securities

rise.



•3. Discounts: Commercial banks invest a part of their funds in bills of exchange by

discounting them. Banks discount both foreign and inland bills of exchange, or in

other words, they purchase the bills at discount and receive the full amount at the

date of maturity.

•4. Commission, Brokerage, etc.: Banks perform numerous services to their

customers and charge commission, etc., for such services. Banks collect cheques,

rents, dividends, etc., accepts bills of exchange, issue drafts and letters of credit and

collect pensions and salaries on behalf of their customers. They pay insurance

premiums, rents, taxes etc., on behalf of their customers. For all these services

banks charge their commission. They also earn locker rents for providing safety

vaults to their customers. Recently the banks have also started underwriting the

shares and debentures issued by the joint stock companies for which they receive

underwriting commission.

• Commercial banks also deal in foreign exchange. They sell demand drafts, issue

letters of credit and help transfer of funds in foreign countries. They also act as

brokers in foreign exchange. Banks earn income out of these operations.

INVESTMENT POLICY OF BANKS


•A bank makes investments for the purpose of earning profits. First it

keeps primary and secondary reserves to meet its liquidity requirements.

This is essential to satisfy the credit needs of the society by granting

short-term loans to its customers. Whatever is left with the bank after

making advances is invested for long period to improve its earning

capacity.

•Before discussing the investment policy of a commercial bank, it is

instructive to distinguish between a loan and an investment because the

usual practice is to regard the two as synonymous. The bank gives a

loan to a customer for a short period on condition of repayment.

•By advancing a loan, the bank creates credit which is a temporary source

of fund for the bank.



•An investment by the bank, on the other hand, is the outlay of its funds for

a long period without creating any credit. A bank makes investments in

government securities and in the stocks of large reputed industrial

concerns, while in the case of a loan the bank advances money against

recognised securities and bills. However, the goal of both is to increase its

earnings.

•The investment policy of a bank consists of earning high returns on its

nonleaded resources. But it has to keep in view the safety and liquidity of

its resources so as to meet the potential demand of its customers.

•Since the objective of profitability conflicts with those of safety and liquidity,

the wise investment policy is to strike a judicious balance among them.

Therefore, a bank should lay down its investment policy in such a manner

so as to ensure the safety and liquidity of its funds and at the same time

maximize its profits. This requires adherence to certain principles.


•The financial position of a commercial bank is reflected in its balance sheet. The balance

sheet is a statement of the assets and liabilities of the bank. The assets of the bank are

distributed in accordance with certain guiding principles. These principles underline the

investment policy of the bank.

•BALANCE SHEET OF A COMMERCIAL BANK


Assets = Liabilities + Capital

Reserves Deposits

Cash in bank Current deposits

Deposits at central bank Fixed deposits

Deposits at commercial bank Savings deposits

Loan Borrowings

Securities Others

Others Capital


•1- Liquidity: In the context of the balance sheet of a bank the term liquidity has two

interpretations. First, it refers to the ability of the bank to honor the claims of the

depositors. Second, it connotes the ability of the bank to convert its non-cash

assets into cash easily and without loss.

•It is a well known fact that a bank deals in funds belonging to the public. Hence, the

bank should always be on its guard in handling these funds. The bank should

always have enough cash to meet the demands of the depositors. In fact, the

success of a bank depends to a considerable extent upon the degree of confidence

it can instill in the minds of its depositors.

•The bank should always be prepared to meet the claims of the depositors by having

enough cash.



•2. Profitability: Profitability is the primary goal of all business ventures. Without

profitability the business will not survive in the long run. So measuring current and

past profitability and projecting future profitability is very important. Profitability is

measured with income and expenses.

• The bank has to earn profit to earn income to pay salaries to the staff, interest to the

depositors, dividend to the shareholders and to meet the day-to-day expenditure.

Since cash is the least profitable asset to the bank, there is no point in keeping all the

assets in the form of cash on hand. The bank has got to earn income.

•Hence, some of the items on the assets side are profit yielding assets. They include

money at call and short notice, bills discounted, investments, loans and advances,

etc.



•3. Safety or Security: Apart from liquidity and profitability, the bank should look to

the principle of safety of its funds also for its smooth working.

•While advancing loans, it is necessary that the bank should consider the ‘5C’ s of

credit character, capacity, condition, capital and the collateral of the borrower.

•The bank cannot afford to invest its funds recklessly without considering the principle

of safety. The loans and investments made by the bank should be adequately

secured.

•Thus, banks should always insist on security of the borrower.



•4. Diversity: The bank should invest its funds in such a way as to secure for itself

an adequate and permanent return. And while investing its funds, the bank should

not put all its eggs in the same basket.

•Diversification of investment is necessary to avoid the dangerous consequences

of investing in one or two channels. If the bank invest its funds in different types of

securities or makes loans and advances to different objectives and enterprises, it

shall ensure for itself a regular flow of income.



•5. liquid Securities: Further, the bank should invest its funds in such types of

securities as can be easily marketed at a time of emergency. The bank cannot afford to

invest its funds in very long term securities or those securities which are unsaleable. It

is necessary for the bank to invest its funds in government or in first class securities or

in debentures of reputed firms. It should also advance loans against stocks which can

be easily sold.

• 6. Stability in the Value of Investments: The bank should invest its funds in those

stocks and securities the prices of which are more or less stable. The bank cannot

afford to invest its funds in securities, the prices of which are subject to frequent

fluctuations.


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Documents

CHAPTER TWO: COMMERCIAL BANKS