(A) Commercial Banks
i. Nature and Functions: Modern commercial banks
have been functioning for over two centuries. They perform a variety of
functions. They accept money deposits, lend money, transfer money,
issue checks and drafts, provide safe deposit vault facilities, act as
trustees, act as financial agents, finance agriculture, industry and
foreign trade etc. Modern bankers mainly act as middlemen between
lenders and borrowers. Their deposits are collected out by the small
savings of households and firms. Their borrowers are usually investors
and businessmen or needy households asking for consumption loans. The
loans are normally made by discounting bills. Money that banks receive
creates liabilities on their part for future repayment. Money
that they lend is their asset which they will get back sometime in the
future. Tabular arrangement of the accounts of a banker is called a Balance Sheet. The loans issued by banks are also known as advances.
Balance sheet
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Liabilities
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Assets
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1) | Share Capital |
500
|
1) | Reserves with Central Bank and Cash in hand |
1200
|
2) | Reserve Fund |
1000
|
2) | Call Money |
1500
|
3) | Saving (Demand) Deposits |
3500
|
3) | Bills Discounted |
4300
|
4) | Fixed (Time) Deposits |
4000
|
4) | Investments, Loans, Advances |
2200
|
5) | Borrowing from other banks |
1000
|
5) | Premises, Property etc. |
800
|
Total |
10,000
|
Total |
10,000
|
The Balance sheet of a banker always balances. This is because it is only a technical device of equating assets with liabilities.
ii. Creation and supply of credit: Modern commercial banking is a profit making activity. It appears that their profits arise out of the difference in the rate of interest
that they pay to the depositors and the rate of interest that they
charge on their loans or advances. But a major source of their profit is
creation and supply of credit money. Such
transactions in credit money are much in excess of the original cash
deposits that the bankers receive. The ability of a banker to satisfy
all its depositors by paying them cash is called 'liquidity' of a
banker. But because bankers create credit and liabilities much in excess
of their cash holding, no banker is ever fully liquid. The banking
business is therefore an activity colored with risk. Hence commercial
banks have to operate under some control of the central banking agency
in the interest of the public. The central banks have legal authority to
require commercial banks to maintain certain reserves with it. Such reserve funds maintained by the central bank can be useful in the event of an emergency.
In their credit creation activity commercial
banks go by the saving habits of their depositors. If the depositors are
known to demand about 10 percent of their total amount deposited then
the remaining 90 percent of the amount is available for credit creation
and the issue of loans. For example, if the total deposit amount
received by the banker is $10,000 then 10 percent of this is set aside.
This is also the proportion of the reserve fund that is required
to be maintained with the central bank. After maintaining a reserve of
$1000 the remaining amount of $9000 can be issued as credit or advance. But the borrower of a banker is also its own depositor since bankers issue advances in the form of a fresh bank account in the name of the borrower. This explains the chief principle on which the banking activity is based. It can be stated as:
'Every advance creates a deposit'.
Therefore in the example above $9,000 becomes a fresh
deposit of which 10 percent or $900 is set aside and the remaining
amount of $8,100 is lent in the same manner to yet another borrower.
Again this becomes a deposit of which 10 percent or $810 is set aside and the remaining $7,290 is available to be loaned to the third borrower. The chain of
borrowing and depositing continues until finally all resources are
exhausted. But by that time the total transactions of a banker add up to
$100,000 i.e. the amount exactly ten times as large as
the original cash deposits of $10,000. The final tally is made up of
$10,000 total reserves plus $90,000 total credit and advances. This has
been summarized in the table below:
Credit creation by banks
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Serial No.
1
2
3
4
|
Deposits
10,000
9,000
8,100
7,290
|
Reserves
1000
900
810
729
|
Advances
9,000
8,100
7,290
6,561
|
Final Total
|
100,000 | 100,000 | 100,000 |
In the example above with the depositors are in the
habit of demanding 10 percent and the same requirement of the central
banks to maintain reserves, the net creation of credit money is $90,000
against original deposits of $10,000. This is 9 times larger the amount.
However, this is the potential capacity of a banker to multiply his
credit supply activity. In reality no individual banker will ever
indulge in such a large proportion of the supply of credit. In reality
bankers normally create credit to the extent of 5 to 6 times of their
original deposits (500 to 600 percent). This is determined by a variety
of factors such as convention, permission of the central bank, general
market conditions and demand for loans, alternative sources of issuing
financial resources etc.
There is also leakage in the credit creation activity, for example if the borrower of the loan
immediately demands payment of it in cash, or if depositors change
their habits during festive seasons etc. or if the central bank reserve requirement
is altered or if bankers themselves want to play safe and maintain cash
reserves in larger proportions, then to that extent the capacity of the
bankers to create and supply credit reduces.
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