Support the Monkey! Tell All your Friends and Teachers

Help / FAQ


6.2 Banking

(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

Liabilities

Assets

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

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.

Index

6.1 Money
6.2 Banking

Chapter 7

All Contents Copyright © All rights reserved.
Further Distribution Is Strictly Prohibited.


Search:
Keywords:
In Association with Amazon.com