Chapter-4

Commercial bank
What is bank?

An establishment authorized by a government to accept deposits, pay interest, clear checks, make
loans, act as an intermediary in financial transactions, and provide other financial services.

 A bank is a financial institution licensed to receive deposits and make loans.

 Banks may also provide financial services, such as wealth management, currency
exchange and safe deposit boxes.

Types of Banks

They are given below:

1. Commercial Banks:

These banks play the most important role in modern economic organisation. Their business
mainly consists of receiving deposits, giving loans and financing the trade of a country. They
provide short-term credit, i.e., lend money for short periods. This is their special feature.

2. Exchange Banks:

Exchange banks finance mostly the foreign trade of a country. Their main function is to discount,
accept and collect foreign bills of exchange. They also buy and sell foreign currencies and help
businessmen to convert their money into any foreign money they need. Their share in the internal
trade of a country is usually small. In addition, they carry on ordinary banking business too.

3. Industrial Banks:

There are a few industrial banks in India. But in some other countries, notably Germany and
Japan, these banks perform the function of advancing loans to industrial undertakings. Industries
require capital for a long period for buying machinery and equipment. Industrial banks provide
this type of Mock capital. Industrial banks have a large capital of their own. They also receive
deposits for longer periods. They are thus in a position to advance long-term loans.

In India, the Central Government set up an Industrial Finance Corporation of India (IFC1) in
1948. Its activities have since then been greatly enlarged. Further the States have also set up
State Financial Corporations. The Central Government has also established the Industrial Credit
and Investment Corporation of India (ICICI) and the National Industrial Development
Corporation for the financing and promotion of industrial enterprises. In 1964 the Industrial
Development Bank of India (1DBI) was established as the apex or top term-lending institution.
These new institutions fill important gaps in our system of industrial finance.
4. Agricultural or Co-operative Banks:

The main business of agricultural banks is to provide funds to farmers. They are worked on the
co-operative principle. Long-term capital is provided by land mortgage banks, nowadays called
land-development banks, while short-term loans are given by co-operative societies and co-
operative banks. Long-term loans are needed by the farmers for purchasing land or for
permanent improvements on land, while short-period loans help them in purchasing implements,
fertilizers and seeds. Such banks and societies are doing useful work in India.

5. Savings Banks:

These banks (perform the useful service of collecting small savings. Commercial banks too run
“savings departments” to mobilise the savings of men of small means. The idea is to encourage
thrift and discourage hoarding. Post Office Saving Banks in India are doing this useful work.

6. Central Banks:

Over and above the various types of banks mentioned above, there exists in almost all countries
today a Central Bank. It is usually controlled and quite often owned by the government of the
country.

7. Utility of Banks:

An efficient banking system is absolutely necessary for a country, if it is to progress

economically. The services that an efficient banking system can render a country are indeed very
valuable. Undeveloped banking system is not only an index of economic backwardness of a
country, it is also an important cause of it. The banking system can be useful in the following
ways, in addition to what has been mentioned in the functions of banks.

(i) The banks create instruments of credit which are very convenient substitutes for money. This
means a great saving Actual movement of money is avoided and expenses saved.

(ii) The banks increase the mobility of capital. They bring the borrowers and the lenders
together. They collect money from those who cannot use it, and give it to those who can. Thus,
they help the movement of funds from place to place, and from person to person, in a very
convenient and inexpensive manner.

(iii) They encourage the habit of habit by providing safe channels of investment. In the absence
of banking facilities, people would just squander their funds.

(iv) By encouraging savings, the banks bring about accumulation of large amount of capital in
the country from small individual savings. In this way, they make the resources of the country
more productive, and thus contribute to the general prosperity and welfare, of the country.
What is commercial bank?
A commercial bank is an institution that provides services such as accepting deposits, providing
business loans, and offering basic investment products.

Commercial bank can also refer to a bank, or a division of a large bank, which more specifically
deals with deposit and loan services provided to corporations.

A commercial bank is a financial institution which performs the functions of accepting deposits from the
general public and giving loans for investment with the aim of earning profit.

Types of commercial banks

Commercial banks are of three types, which are as follows:

(a) Public Sector Banks:

Refer to a type of commercial banks that are nationalized by the government of a country. In
public sector banks, the major stake is held by the government. In India, public sector banks
operate under the guidelines of Reserve Bank of India (RBI), which is the central bank. Some of
the Indian public sector banks are State Bank of India (SBI), Corporation Bank, Bank of Baroda,
Dena Bank, and Punjab National Bank.

(b) Private Sector Banks:

Refer to a kind of commercial banks in which major part of share capital is held by private
businesses and individuals. These banks are registered as companies with limited liability. Some
of the Indian private sector banks are Vysya Bank, Industrial Credit and Investment Corporation
of India (ICICI) Bank, and Housing Development Finance Corporation (HDFC) Bank.

(c) Foreign Banks:

Refer to commercial banks that are headquartered in a foreign country, but operate branches in
different countries. Some of the foreign banks operating in India are Hong Kong and Shanghai
Banking Corporation (HSBC), Citibank, American Express Bank, Standard & Chartered Bank,
and Grindlay’s Bank. In India, since financial reforms of 1991, there is a rapid increase in the
number of foreign banks. Commercial banks mark significant importance in the economic
development of a country as well as serving the financial requirements of the general public.

Other classification

1.scheduled banks

Banks implies the financial institution that takes public deposits and extends credit to those who
need it. They are a substantial part of the financial system, which assists in the overall economic
development.
 These are broadly classified as scheduled and non-scheduled banks in India regulated under the
Banking Regulation Act, 1949, wherein scheduled banks include all the commercial banks like
nationalised, foreign, development, cooperative and regional rural banks.

To qualify as a scheduled bank, the bank should conform to the following conditions:

1. The total minimum value of paid up capital and reserve must be of Rs. 25 lacs.
2. The bank requires to satisfy the central bank that its affairs are not carried out in a way
that causes harm to the interest of the depositors.
3. The bank needs to be a corporation rather than a sole-proprietorship or partnership firm.

2. non scheduled banks

On the other extreme, non-scheduled banks are the banks that do not adhere to the norms
prescribed by the Reserve Bank of India (RBI). In this article excerpt, you can find out all the
relevant differences between scheduled and non-scheduled banks in India.

The difference between scheduled and non-scheduled banks can be drawn clearly on the
following premises:

1. A banking corporation whose paid up capital is Rs. 25 lacs or more and does not harm the
interest of the depositors, is called as Scheduled bank. Unlike, non-scheduled banks are
the banks which are not capable of complying with the provision of RBI, for scheduled
banks.
2. Scheduled banks are the ones covered in the second schedule of the Reserve Bank,
whereas non-scheduled banks are the banks that are not covered in the second schedule of
the Reserve Bank.
3. Scheduled Banks need to maintain cash reserves with RBI, at the rates prescribed by it.
On the other hand, Non-Scheduled Bank also needs to keep cash reserves, but with
themselves only.
4. Scheduled banks are entitled to borrow money from the central bank for regular banking
purposes. Conversely, non-scheduled banks are not entitled to borrow money from the
central bank for regular banking purposes. Nevertheless, under abnormal conditions, they
can request the central bank for accommodation.
5. Scheduled banks must submit the periodic returns to the Reserve bank of India. As
against, there is no such requirement of submission of periodic returns to the central
bank, in case of non-scheduled banks.
6. Scheduled banks have the right to become the member in clearing house, while no such
facility is allowed to non-scheduled banks.
Explain briefly functions of commercial banks

(a) Primary Functions:

Refer to the basic functions of commercial banks that include the following:

(i) Accepting Deposits:

Implies that commercial banks are mainly dependent on public deposits.

There are two types of deposits, which are discussed as follows:

(1) Demand Deposits:

Refer to kind of deposits that can be easily withdrawn by individuals without any prior notice to
the bank. In other words, the owners of these deposits are allowed to withdraw money anytime
by simply writing a check. These deposits are the part of money supply as they are used as a
means for the payment of goods and services as well as debts. Receiving these deposits is the
main function of commercial banks.

(2) Time Deposits:

Refer to deposits that are for certain period of time. Banks pay higher interest on rime deposits.
These deposits can be withdrawn only after a specific time period is completed by providing a
written notice to the bank.

(!!) Advancing Loans:

Refers to one of the important functions of commercial banks. The public deposits are used by
commercial banks for the purpose of granting loans to individuals and businesses. Commercial
banks grant loans in the form of overdraft, cash credit, and discounting bills of exchange.
(b) Secondary Functions:

Refer to crucial functions of commercial banks. The secondary functions can be classified under
three heads, namely, agency functions, general utility functions, and other functions.

These functions are explained as follows:

(1) Agency Functions:

Implies that commercial banks act as agents of customers by performing various functions,
which are as follows:

(i) Collecting Checks:

Refer to one of the important functions of commercial banks. The banks collect checks and bills
of exchange on the behalf of their customers through clearing house facilities provided by the
central bank.

(ii) Collecting Income:

Constitute another major function of commercial banks. Commercial banks collect dividends,
pension, salaries, rents, and interests on investments on behalf of their customers. A credit
voucher is sent to customers for information when any income is collected by the bank.

(iii) Paying Expenses:

Implies that commercial banks make the payments of various obligations of customers, such as
telephone bills, insurance premium, school fees, and rents. Similar to credit voucher, a debit
voucher is sent to customers for information when expenses are paid by the bank.

(2) General Utility Functions:

(i) Providing Locker Facilities:

Implies that commercial banks provide locker facilities to its customers for safe keeping of
jewellery, shares, debentures, and other valuable items. This minimizes the risk of loss due to
theft at homes.
(ii) Issuing Traveler’s Checks:

Implies that banks issue traveler’s checks to individuals for traveling outside the country.
Traveler’s checks are the safe and easy way to protect money while traveling.

(iii) Dealing in Foreign Exchange:

Implies that commercial banks help in providing foreign exchange to businessmen dealing in
exports and imports. However, commercial banks need to take the permission of the central bank
for dealing in foreign exchange.

(iv) Transferring Funds:

Refers to transferring of funds from one bank to another. Funds are transferred by means of draft,
telephonic transfer, and electronic transfer.

(3) Other Functions:

(i) Creating Money:

Refers to one of the important functions of commercial banks that help in increasing money
supply. For instance, a bank lends Rs. 5 lakh to an individual and opens a demand deposit in the
name of that individual.

Bank makes a credit entry of Rs. 5 lakh in that account. This leads to creation of demand
deposits in that account. The point to be noted here is that there is no payment in cash. Thus,
without printing additional money, the supply of money is increased.

(ii) Electronic Banking:

Include services, such as debit cards, credit cards, and Internet banking.

Credit creation process by the commercial banks

A central bank is the primary source of money supply in an economy through circulation of
currency.

It ensures the availability of currency for meeting the transaction needs of an economy and
facilitating various economic activities, such as production, distribution, and consumption.

However, for this purpose, the central bank needs to depend upon the reserves of commercial
banks. These reserves of commercial banks are the secondary source of money supply in an
economy. The most important function of a commercial bank is the creation of credit.

Therefore, money supplied by commercial banks is called credit money. Commercial banks
create credit by advancing loans and purchasing securities. They lend money to individuals and
businesses out of deposits accepted from the public. However, commercial banks cannot use the
entire amount of public deposits for lending purposes. They are required to keep a certain
amount as reserve with the central bank for serving the cash requirements of depositors. After
keeping the required amount of reserves, commercial banks can lend the remaining portion of
public deposits.

According to Benham’s, “a bank may receive interest simply by permitting customers to

overdraw their accounts or by purchasing securities and paying for them with its own cheques,
thus increasing the total bank deposits.”

Let us learn the process of credit creation by commercial banks with the help of an example.

Suppose you deposit Rs. 10,000 in a bank A, which is the primary deposit of the bank. The cash
reserve requirement of the central bank is 10%. In such a case, bank A would keep Rs. 1000 as
reserve with the central bank and would use remaining Rs. 9000 for lending purposes.

The bank lends Rs. 9000 to Mr. X by opening an account in his name, known as demand deposit
account. However, this is not actually paid out to Mr. X. The bank has issued a check-book to
Mr. X to withdraw money. Now, Mr. X writes a check of Rs. 9000 in favor of Mr. Y to settle his
earlier debts.

The check is now deposited by Mr. Y in bank B. Suppose the cash reserve requirement of the
central bank for bank B is 5%. Thus, Rs. 450 (5% of 9000) will be kept as reserve and the
remaining balance, which is Rs. 8550, would be used for lending purposes by bank B.

Thus, this process of deposits and credit creation continues till the reserves with commercial
banks reduce to zero.

This process is shown in the Table-1:

From Table-1, it can be seen that deposit of Rs. 10,000 leads to a creation of total deposit of Rs.
50,000 without the involvement of cash.

The process of credit creation can also be learned with the help of following formulae:

Total Credit Creation = Original Deposit * Credit Multiplier Coefficient

Credit multiplier coefficient= 1 / r where r = cash reserve requirement also called as Cash
Reserve Ratio (CRR)

Credit multiplier co-efficient = 1/10% = 1/ (10/100) = 10

Total credit created = 10,000 *10 = 100000

If CRR changes to 5%,

Credit multiplier co-efficient = 1/5% = 1/ (5/100) = 20

Total credit creation = 10000 * 20 = 200000

Thus, it can be inferred that lower the CRR, the higher will be the credit creation, whereas higher
the CRR, lesser will be the credit creation. With the help of credit creation process, money
multiplies in an economy. However, the credit creation process of commercial banks is not free
from limitations.

Some of the limitations of credit creation by commercial banks are

The limitations of credit creation process (as shown in Figure-3) are explained as follows:

(a) Amount of Cash:

Affects the creation of credit by commercial banks. Higher the cash of commercial banks in the
form of public deposits, more will be the credit creation. However, the amount of cash to be held
by commercial banks is controlled by the central bank.

The central bank may expand or contract cash in commercial banks by purchasing or selling
government securities. Moreover, the credit creation capacity depends on the rate of increase or
decrease in CRR by the central bank.

(b) CRR:

Refers to reserve ratio of cash that need to be kept with the central bank by commercial banks.
The main purpose of keeping this reserve is to fulfill the transactions needs of depositors and to
ensure safety and liquidity of commercial banks. In case the ratio falls, the credit creation would
be more and vice versa.

(c) Leakages:

Imply the outflow of cash. The credit creation process may suffer from leakages of cash.

The different types of leakages are discussed as follows:

(i) Excess Reserves:

Takes place generally when the economy is moving towards recession. In such a case, banks
may decide to maintain reserves instead of utilizing funds for lending. Therefore, in such
situations, credit created by commercial banks would be small as a large amount of cash is
resented.

(ii) Currency Drains:

Imply that the public does not deposit all the cash with it. The customers may hold the cash with
them which affects the credit creation by banks. Thus, the capacity of banks to create credit
reduces.

(d) Availability of Borrowers:

Affects the credit creation by banks. The credit is created by lending money in form of loans to
the borrowers. There will be no credit creation if there are no borrowers.

(e) Availability of Securities:

Refers to securities against which banks grant loan. Thus, availability of securities is necessary
for granting loan otherwise credit creation will not occur. According to Crowther, “the bank does
not create money out of thin air; it transmutes other forms of wealth into money.”

(f) Business Conditions:

Imply that credit creation is influenced by cyclical nature of an economy. For example, credit
creation would be small when the economy enters into the depression phase. This is because in
depression phase, businessmen do not prefer to invest in new projects. In the other hand, in
prosperity phase, businessmen approach banks for loans, which lead to credit creation.

In spite of its limitations, we can conclude that credit creation by commercial banks is a
significant source for generating income.
Role of bank in development

1. Capital Formation
Banks play an important role in capital formation, which is essential for the economic
development of a country. They mobilize the small savings of the people scattered over a wide
area through their network of branches all over the country and make it available for productive
purposes.

2. Creation of Credit
Banks create credit for the purpose of providing more funds for development projects. Credit
creation leads to increased production, employment, sales and prices and thereby they cause
faster economic development.

3. Channelizing the Funds to Productive Investment

Banks invest the savings mobilized by them for productive purposes. Capital formation is not the
only function of commercial banks. Pooled savings should be distributed to various sectors of the
economy with a view to increase the productivity of the nation. Then only it can be said to have
performed an important role in the economic development of the nation..

4. Fuller Utilization of Resources

Savings pooled by banks are utilized to a greater extent for development purposes of various
regions in the country. It ensures fuller utilization of resources.

5. Encouraging Right Type of Industries

The banks help in the development of the right type of industries by extending loan to right type
of persons. In this way, they help not only for industrialization of the country but also for the
economic development of the country. They grant loans and advances to manufacturers whose
products are in great demand. The manufacturers in turn increase their products by introducing
new methods of production and assist in raising the national income of the country.

6. Bank Rate Policy

Economists are of the view that by changing the bank rates, changes can be made in the money
supply of a country. In our country, the RBI regulates the rate of interest to be paid by banks for
the deposits accepted by them and also the rate of interest to be charged by them on the loans
granted by them.

7. Bank Monetize Debt

Commercial banks transform the loan to be repaid after a certain period into cash, which can be
immediately used for business activities. Manufacturers and wholesale traders cannot increase
their sales without selling goods on credit basis. But credit sales may lead to locking up of
capital. As a result, production may also be reduced. As banks are lending money by
discounting bills of exchange, business concerns are able to carry out the economic activities
without any interruption.
8. Finance to Government
Government is acting as the promoter of industries in underdeveloped countries for which
finance is needed for it. Banks provide long-term credit to Government by investing their funds
in Government securities and short-term finance by purchasing Treasury Bills.
9. Bankers as Employers
After the nationalization of big banks, banking industry has grown to a great extent. Bank’s
branches are opened in almost all the villages, which leads to the creation of new employment
opportunities. Banks are also improving people for occupying various posts in their office.

10. Banks are Entrepreneurs

In recent days, banks have assumed the role of developing entrepreneurship particularly in
developing countries like India. Developing of entrepreneurship is a complex process. It includes
the formation of project ideas, identification of specific projects suitable to local conditions,
inducing new entrepreneurs to take up these well-formulated projects and provision of
counseling services like technical and managerial guidance.

Investment policy of the commercial banks

The main function of a commercial bank is to accept deposits. It is a institution which do

business with the money provided by the depositors. The bank makes investment of such funds
in different sectors of the economy and thus a bank should take into consideration the main
factors while investing its funds. The following principles followed as regard the investment
policy of a commercial bank :

1. Profitability – Bank is a profit earning institution. Thus, it makes investment of its funds in
the securities which are profitable to the bank. Thus, the principle of profitability is an important
consideration for investment of a bank.

2. Safety – The bank funds are generally the amount of savings done by general public which are
deposited in the different accounts. In this way bank are trustee of a public money. So, it is
necessary the bank should be in position to repay deposit whenever demanded by the depositors.
It is the responsibility of the bank to provide safety of the fund generated from public money.
The bank thus makes investment of funds in those securities which are safe and secured. In this
connection the banks make investment in the securities. Thus, the principle of safety is a
important consideration while making investment of funds by commercial bank.

3. Diversification – This is an important principle of investment policy of commercial bank.

According to this principle, the bank should diversify the risks involved in investment of fund by
making investment in different types of securities of different companies. This principle is based
on the logic that “All eggs should not be kept in the same basket.” If the bank invests its fund in
different securities of different companies the risks of loss involved in one security may be
covered up by the profits earn from investment in other securities. When investment is made
according to this policy there will be low risk in investment of fund by the bank.

4. Liquidity – Another important consideration in investment of funds by the bank is that

investment should be made in such securities which can be easily converted into cash. So that
depositors easily withdraw their money whenever need of money arise. Thus, liquidity is an
important consideration by banks while investing its funds.

5. Stability  – A commercial bank make investment in share, debenture and other securities

issued by companies, financial institutions and government. The prices of these securities
fluctuate. When there is a greater fluctuation of prices of securities in the market there will be
greater risk involved in such investment. Thus the bank considers the stability in the prices of
securities as important factors while making investment of its funds.

6. Productivity of investment – Bank should invest its funds in such a company which is
engaged in manufacturing business. It is necessary from safety point of view.