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Commercial Banking – Functions, Liabilities, Assets, Liquidity and Profitability

Definition – A Commercial 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 withdrawable by cheque, draft or otherwise.

Functions of Commercial Banks

The functions of Commercial Banks are divided into primary and secondary functions.

Primary Functions

  1. Accepting Deposits
  2. Making Advances
  3. Credit Creation

Secondary Functions

  1. Clearing Cheques
  2. Selling/Purchasing Shares & Bonds
  3. Transferring Money
  4. Serving as Trustee
  5. Serving as Representative
  6. Paying/Accepting Money
  7. Providing Letters of Credit

Primary Functions of Commercial Banks

1. Accepting Deposits

A commercial bank accepts various types of deposits from the public such as saving account deposits, recurring account deposits and fixed deposits.

2. Making Advances

Commercial banks provide loans and advances in various forms such as demand and term loans, overdraft facility, cash credit and bill discounting.

3. Credit Creation

While sanctioning a loan to a customer, a bank does not provide cash to the borrower; instead, it opens a deposit account from which the borrower can withdraw. This process is known as credit creation.

Secondary Functions of Commercial Banks

Secondary functions include several agencies and general utility functions such as:

1. Clearing Cheques

Commercial banks collect and clear cheques, dividends and interest warrants.

2. Selling/Purchasing of Securities

This includes the sale and purchase of shares and bonds.

3. Transfer of Money

Commercial banks provide money transfer facilities.

4. Serving as a Trustee and Representative

Banks act as trustees, attorneys, correspondents and executors.

5. Paying/Accepting Money

Banks allow making payment of rent, insurance premiums, various bills etc. and accept tax proceeds or tax returns.

6. Providing Letters of Credit

Banks provide letters of credit to importers to help them carry out trade activities.

Assets and Liabilities of Commercial Banks

The balance sheet of a commercial bank is a statement of its assets and liabilities at a particular time. Assets of a Bank refer to items from which the bank expects to earn an income or through which it tries to protect its interests. Liabilities of a Bank include payments to be made by the bank to shareholders, depositors or others.

Assets represent the use of funds to generate income, while liabilities represent sources of funds.

Liabilities

  1. Paid-up Capital
  2. Reserves and Surplus
  3. Deposits
  4. Borrowings
  5. Other Liabilities

Assets

  1. Cash Balances
  2. Money at call and short notice
  3. Investments
  4. Loans and Advances
  5. Other Assets

Liabilities of a Commercial Bank

1. Paid-up Capital

It refers to the contribution made by the shareholders of the bank; it indicates the bank’s liabilities to its shareholders.

2. Reserves and Surplus

The amount accumulated out of undistributed profits by the bank over the years to meet contingencies.

3. Deposits

Deposits are a primary source of funds for banks; deposits are classified as deposits payable on demand and deposits accepted for a term.

1. Current Deposits

These deposits are operated by businesspersons with no restrictions on the amount or number of withdrawals. Banks do not pay interest on such accounts.

2. Savings Deposits

These deposits are owned by individuals and trusts for non-commercial purposes; there are restrictions on the amount and number of withdrawals for such deposits. Banks pay some interest on these accounts.

3. Term or Time Deposits

These are deposits repayable after a specified term and have different maturity periods depending on the interest rate. They include fixed deposits, cumulative deposits and annuity deposits.

4. Borrowings

Borrowings consist of refinance obtained from the RBI, commercial banks and other financial institutions. They also include overseas borrowings made by Indian branches of the bank and the borrowings of foreign branches of the bank.

5. Other Liabilities

Other Liabilities are incurred by the bank in the course of its business. They include bills payable such as drafts, traveller’s cheques, payslips and banker’s cheques.

Interest accrued on deposits and borrowings but not due is also included in other liabilities along with the provision for income tax.

Assets of a Commercial Bank

1. Cash Balances

A part of the cash balance is held by the bank to meet customer requests for withdrawal. A certain proportion of cash is held in the form of deposits of other banks as well as with the central bank.

In India, commercial banks are obliged to keep a certain proportion of their total deposits in the form of cash reserve requirement (CRR) with the RBI. Cash does not earn any income for a bank; however, it is the most liquid asset.

2. Money at Call and Short Notice

This refers to the short-term loans made by the bank in the money market; these loans have maturity varying from one to 15 days. Banks borrow from other banks to meet a sudden demand for funds, large payments, large remittances, and to maintain cash or liquidity with the RBI.

These assets are highly liquid because they can be quickly converted to cash. They generate some interest income for the banks.

3. Investments

Investments by commercial banks are of the following three types

  • Government of India securities (SLR securities)
  • Other approved securities (SLR securities)
  • Non-approved securities (Non-SLR securities)

They earn income for banks; however, they are less liquid.

1. Investment in SLR securities

Government securities include securities issued by both, the central and state government agencies and public sector undertakings (PSUs) of the state and central government.

Quasi-government securities or approved securities are given the status of SLR securities on a case-to-case basis.

2. Investment in Non-SLR securities

Non-SLR Securities include commercial papers, units of mutual funds and shares, bonds and debentures of PSUs and the private corporate sector.

4. Loans and Advances

The following are the types of loans and advances offered by commercial banks:

1. Cash Credit and Overdraft

They are the running accounts from which the borrower can withdraw funds as and when needed up to the credit limit sanctioned. Cash credit is sanctioned against the security of commodity stock, while overdrafts are allowed on current accounts.

Interest is charged on the outstanding amount borrowed and not on the credit limit sanctioned.

2. Purchase and discounting bills

Bills are purchased and discounted to finance trade transactions and the movement of goods. Bill finance is either repayable on demand or after a period not exceeding 90 days.

3. Loans

Loans can be of two types: demand loans and term loans.

Demand Loans: These are loans repayable when demanded by the creditor. They are mainly short-term loans.

Term Loans: These are loans sanctioned for a period exceeding one year; they have a specific schedule of repayment.

4. Other Assets

Other Assets include fixed assets such as premises which are wholly or partly owned by the bank for business/residential purpose and furniture and fixtures.

The trade-off between Liquidity and Profitability of Banks

Motives of Investment Policy are:

The investment policy, also known as portfolio management of a bank, is guided by two important motives: profitability and liquidity.

A commercial bank must earn profits for its shareholders and at the same time, have sufficient liquidity to satisfy the withdrawal needs of its customers.

Profitability

Profitability is an important objective of a bank is to earn profit for its shareholders. Hence, banks tend to be influenced by the consideration of profits while acquiring assets.

In case of Safety and Security (or Liquidity)

In the case of Safety and Security (or Liquidity) Because the business of a bank depends on the confidence of the depositors, every bank must have sufficient liquidity, that is, the ability to produce cash on demand. Apart from maintaining enough cash balance, a bank should acquire assets that can be easily converted or shifted to cash.

The trade-off between Liquidity and Profitability

The objectives of profitability and liquidity are contradictory in nature. Maximum liquidity can be achieved by maintaining a high proportion of cash against deposits, which will not generate any income or profitability for the bank.

However, if the bank uses all its funds for lending to earn a large interest income, it will not be able to maintain liquidity and expose itself to higher liquidity risk.

Reconciling Twin Objectives

  1. The asset portfolio of a bank tries to achieve sound balance between liquidity and profitability.
  2. A commercial bank arranges its assets in an ascending order of profitability and descending order of liquidity.
  3. As we move down the balance sheet, the assets start becoming less liquid and more profitable.

Factors Affecting Liquidity

  1. Statutory requirements
  2. Banking habits of people
  3. Monetary transactions
  4. Nature of money market
  5. Structure of the banking system
  6. Number and size of deposits
  7. Nature of deposits

Factors affecting Profitability

  1. Amount of working funds deployed
  2. Cost of funds
  3. Yield on funds
  4. Spread (which is the difference between interest income and expenses)
  5. Operating costs
  6. Risk costs
  7. Non-interest income
  8. Level of Non-performing assets (NPAs)