Banking Theory Law and Practice

Banking Theory Law and Practice Evolution of Banks Functions of Commercial Banks Balance Sheet of Commercial Banks Credit Creation, Organisation and structure of Banks Unit Banking and Mixed Banking Public Sector and Private Sector Ban

Banking Theory Law and Practice

BBA 2.1 Banking Theory Law and Practice

Evolution of Banks Functions of Commercial Banks Balance Sheet of Commercial Banks Credit Creation,

Organization and structure of Banks Unit Banking and Mixed Banking Public Sector and Private Sector Banks Nationalization of Commercial Banks Objects Progress.

Central Bank Evolution Functions Credit Control Measures

Money market Indian money market Components Characteristics of developed and under developed money market.

Banker and Customer General and Special relationships Negotiable instruments Features Types of accounts Types of customers Pass Book Cheque Features Crossing Endorsements

Paying banker Duties Holder in due course Payment in the due course Protection Collecting banker Duties Protection

Text and Reference Books:

1. Basu:Theory and Practice of Development Banking2. Muranjan S.K. :Modern Banking in India3. Reddy & Appanniah:Banking Theory and Practice4. Natarajan & Gordon:Banking Theory and Practice

Lesson 1Evolution of BankingEvolution of Banking Institutions

Origin of the word Bank. Opinion is divided in regard to this. According to some authorities, the work Bank itself is derived from the words bancus or banqee, that is, a bench. The early bankers, the Jews in Lombardy, transacted their business on benches in the market place. When a banker failed his banco was broken up by the people, hence the word bankrupt. This etymology is however, ridiculed by Macleod on the ground Ages. There are others, who are of the opinion that the word bank is originally derived from the German word back meaning a joint stock fund, which was Italianised into banco when the Germans were masters of a great part of Italy. This appears to be more possible. But whatever be the origin of the word bank, as Professor Ramchandra Rao says (Present-Day Banking in India, 1st edition,p88) It would trace the history of banking in Europe from the Middle Ages. Early History of Banking As early as 2000 B.C., the Babylonians had developed a banking system. There is evidence to show that the temples of Babylon were used as banks, and such great temples as those of Ephesus and of Delbhi were the most powerful of the Greek banking institutions. But the spread of irreligion soon destroyed the public sense of security in depositing money and valuables in temples, and the priests were no longer acting as financial agents. The Romans did not organize State Banks as did the Greeks, but their minute regulations, as to the conduct of private banking, were calculated to create the utmost confidence in it. With the end of the covilisaiton of antiquity, and as a result of administrative decentralization and demoralization of the Government authority, with its inevitable counterpart of commercial insecurity, banking degenerated for a period of some centuries into a system of financial makeshifts. But that was not the only cause. Old prejudices die hard, and Aristotles dictum, that the charging of inerest was unnatural and consequently immoral was adhered to fanatically. Even now some Mohammedans, in obedience to the commands contained in that behalf in their religious books, refuse to accept interest on money loans. The followers of Aristotles dictum forgot that the ancient world, the Hebres included, although it had to system of banks that would be considered adequate from the modern point of view, and maintained moneylenders and made no sin of interest, but only of usury. However, upon the revival of civilization, growing necessity forced the issue in the middle of the 12th century, and banks were established at Venice and Genoa, though in fact they did not become banks as we understood them today, till long after. Again the origin of modern banking may be traced to the money dealers in Florence, who received money on deposit, and were lenders of money in the 14th century, and the names of the Bardi, Acciajuoli, Peruzzi, Pitti and Medici soon became famount throughout Europe, as bankers. At one time, Florence is said to have had eighty bankers, though it could boast of no public bank.

The Development of British BankingRoyal Exchanger in England, we find during the reign of Edward III, money changing-an important function of the bankers of those days-was taken up by a Royal Exchanger for the benefit of the Crown. He exchanged the various foreign coins, tendered to his my travelers and merchants entering the kingdom, into British money, and, on the other hand, supplied persons going out of the country with the foreign money they required.The Goldsmiths It is probably true to say that the ground was prepared for modern banking in England, by the influx of gold from America in the Elizabethan Age and the simultaneous growth of foreign trade. Land ceased to be the only form of wealth, and the country gentlemen and the town merchants, began to hold part of their capital in cash. Impetus was given to public banking by the seizure, by Charles I in 1640 of 130,000 bullion left for safe custody by the city merchants at the Royal Mint. As a result of this Royal repudiation, the merchants began to entrust their cashiers with large sums, but the later mis-appropriated their masters money for their own benefit. Finding that their employees had not treated them better than their king, the city merchants decided to keep their cash with goldsmiths,who in those days had strong rooms and employed watchmen.

Early Reginning of Issue and Deposit Banking - Thus, large sums of money were left with the goldsmiths for safe custody against their signed receipts, known as goldsmiths notes, embodying an undertaking to return the money to he depositor or to bearer on demand. Two developments quickly followed, which were the foundation of issue and deposit banking, respectively. The first was that the goldsmiths note bocmome payable to bearer, and so was transformed from a receipt to a bank note. It was payable on demand, and enjoyed considerable circulation. Secondly, the goldsmiths gradually discovered that large sums of money were left in their keeping for long periods and, following the example of Dutch bankers, they thought it safe and profitable to lend out a part of their customers money provided such loans were rapid within a fixed time. Further, realizing that the business of loaning of other peoples money at interest was profitable, and in order to attract larger amounts, the more enterprising of the goldsmiths began to offer interest on money deposited with them, instead of charging a fee for their services in guarding their clients gold. This marks an important step in the development of banking in England. Business grew to such an extent that it soon became clear that a goldsmith could always spare a certain proportion of his cash for loans, regardless of the date at which his notes fell due. It equally became safe for him to make his notes payable at any time, for so long as his credit remained good, he could calculate, on the law of average, the amount of gold he needed to meet the daily claims of his note holders and depositors.

Current Account. It was in 1672, that this development of English banking received a rude setback. Charles II borrowed heavily from the goldsmiths and promptly like his father repudiated his debts. A crisis ensued, and was followed by a general suspension of payments. Confidence, however, was restored in spite of the shock and the general belief, which it produced among people that the goldsmiths were guilty of imprudence and exorbitant practices. It was soon after this date that the goldsmiths found that they could receive money on what is now termed current account, i.e., money withdrawal without notice.

Early Growth of Joint-Stock banks in IndiaThe origin of modern banking in India dates back to 1770 when the first joint-stock bank, named the Hindustan Bank, was started by the English Agency house of Alexander & Co, in Calcutta. The bank was, however, would up in 1832.

Presidency BanksThe real growth of modern commercial banking began in the country when the government was awakened to the need for banks in 1806 with the establishment of the first Presidency Bank, called the Bank of Bengal, in Calcutta in that year. Then followed the establishment of two other Presidency Banks, namely, the Bank of Bombay in 1840 and the Bank of Madras in 1843. To each of these banks, the government had subscribed Rs. 3 lakhs to their share capital. However, a major part of their share capital was contributed by the European shareholders. These Presidency Banks, however, enjoyed the monopoly of government banking. They were also given the right of note-issue in 1823, which was however, withdrawn in 1862.These three Presidency Banks continued till 1920. In 1921 they were amalgamated into the Imperial Bank of India.

Indian Joint-Stock Banks

The year 1860 is a landmark in the history of public banks in India, since in that year the principle of limited liability was first applied to join-stock banks. Since 1860 till the end of the nineteenth century, a number of Indian joint stock banks come into existence. For instance, the Allahabad Bank was started at Allahabad in 1865. In 1875, the Alliance Bank of Simla was started. In 1889, another Indian bank called Oudh Commercial Bank was established. In 1895, the famous Punjab National Bank came into existence.Inspired by the Swadeshi Movement, several Indian entrepreneurs ventured into the modern banking business. During the boom period of 1906-13, thus, there was s mushroom growth of banks. Many prominent banks also came into existence during this period. These were the Bank of India (1906), the Canara Bank (1906), the Bank of Baroda (1908), and the Central Bank of India (1911).Foreign BanksIn addition to the Indian joint-stock banks, a number of multi-national foreign banks called exchange banks, with their head offices in their home countries, entered the banking system of India. Exchange banks were essentially meant for financing the foreign trade of the country, but they also conducted banking activity in competition with Indian banks. The exchange banks are termed foreign banks, because they were financed and managed by non-Indians.

Bank CrisisTill about the middle of the twentieth century, Indian joint-stock banks had a checkered career in the country. The banking sector experience severe set-backs during the priod-1913-17, as 108 banks failed and another 373 banks failed on 1922-36 which was again followed by the failure of 620 more banks in 1937-38.The Central Banking Enquiry Committee (1929) traced the following major causes of bank failure in India:(1) Insufficient paid-up capital and reserves;(2) Poor liquidity of assets;(3) Combination of non-banking activities with banking.(4) Irrational credit policy causing reckless and injudicious advances;(5) Favouritism by the directors the their vested interests;(6) Incompetent and inexperienced directors;(7) Mismanagement;(8) Dishonest management;(9) Creation of long-term loans on the basis of short-term deposits;(10) Indulgence in speculative investment;(11) Ignorgance of the people about banking business;(12) Lack of co-ordinate among joint-stock banks;(13) Absence of a central bank for overall supervision and control;(14) Lack of suitable banking legislation for regulation of banks.

And above all, the shattered public confidence in banks may be accounted for the failure of many Indian commercial banks over time.Another event of bank failure took place in 1946-47, with the crash of the A.B.C. Bank, the Exchange Bank of India and Africa and the Nath Banks.Eventually, at the time of Independence (in 1947), India inherited an extremely weak banking structure, with the urban-orientation, comprising 544 small non-scheduled banks and 96 scheduled banks, giving bulk finance to the trading sector. Moreover, only a few of them possessed on all-India character, while most of them had limited geographical coverage in their business.

Major banking developments/reforms during the planning eraAfter independence, the Government of India launched economic planning in the country since 1951. During the last 37 years of the planning era, commercial banking has undergone drastic transformation through several important developments/ reforms and policy measures introduced by the government.Some of the major changes introduced in the Indian banking system may be enlisted as follows:(1) Liquidation and amalgamation of banks;(2) Nationalization of the Reserve Bank of India;(3) Banking legislation;(4) Evolution of public sector banking through bank nationalization.(5) Declining significance of foreign banks;(6) Structural changes of commercial banking;(7) New strategies in banking business.

Banking : DefinitionA banking company is defined a company which transacts the business of banking in India. The Banking Regulation Act defines the business of banking by stating the essential functions of a banker. It also states the various other businesses a banking company may be engaged in and prohibits certain businesses to be preformed by it.The term Banking is defined as accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order of otherwise (Section 5(b)

The sailent features of this definition are as follows:(i) A banking company must perform both of the essential functions, viz., (a) accepting of deposits, and (b) lending or investing the same. If the purpose of accepting of deposits is not to lend or invest, the business will not be called banking business. The explanation to Section 5(c) makes it clear that any company which is engaged in the manufacture of goods or carries on any trade and which accepts deposits of money from the public merely for the purpose of financing its business, as such manufacturer or trader shall not be deemed to transact the business of banking.(ii) The phrase deposit of money from the public is significant. The banker accepts deposits of money and not a anything else. The word public implies that a banker accepts deposits from anyone who offers his/her money for such purpose. The banker however, can refuse to open an account in the name of the person who is considered as an undesirable person, e.g., a thief, robber, etc. Acceptance of deposits should be the known business of a banker. The money-lenders and indigenous bakers depend on their own resources and do not accept deposits from the public. If they ask for money from their friends or relatives in case of need, such money is not deemed as deposit accepted from the public.(iii) The definition also specifies the time and mode of withdrawal of the deposits. The deposited money should be repayable to the depositor on demand made by the latter or according to the agreement reached between the two parties. The essential feature of banking business is that the banker does nor refund the money on his own accord, even if the period for which it was deposited expires. The depositor must make a demand for the same. The Act also specified that the withdrawal should be effected through an order, cheque, draft or otherwise. It implies that the demand should be made in a proper manner and through an instrument in writing and not merely by verbal order or a telephonic message.

It is thus clear that the underlying principle of the business is that the resources mobilized through the acceptance of deposits must constitute the main stream of funds which are to be utilized for lending or investment purposes. The banker is, thus, an intermediary and deals with the money belonging to the public. A number of other institutions, which also deal with money, are not designated as banking institutions, because they do not fulfill all the above-mentioned pre-requisites. The specialized financial institutions, e.g., Industrial Finance Corporation of India and State Finance Corporation, are not banks because they do not accept the deposits in the prescribed manner. The essence of banking business lies in the two essential functions. This is also evident from the definition given by Sir John Paget, a noted authority on Banking.

Sir John Pagets Definition: According to Sir John Paget, No person or body corporate or otherwise, can be a banker who does not (i) take deposit, accounts, (ii) take current accounts, (iii) issue and pay cheques, and (iv) collect cheques, crossed and uncrossed, for his customers. This definitions points out the four essential functions of the banking business. Sir John Paget also lays emphasis on the performance of the above functions in a regular and recognized manner. According to his, one claiming to be a banker must profess himself to be one and the public must accept his as such, his main business must be that of banking from which, generally, he should be able to earn his living. The above-mentioned function are considered as the essential functions of a banker but this definition does not include the other functions which are now being performed by modern bankers.

Name must include the word Bank, Banker or Banking. Section 7 makes it essential for every company carrying on the business of baking in India to use as part of its name at least one of the words-bank, banker, banker, banking or banking company. Besides, it prohibits any other company of firm, individual or group of individuals, from using any of these words as parts of its/his name. Section 7 has been amended in 1983 with the effect that any of these words cannot be used by any such company event in connection with its business.

Lesson 2

Functions of commercial banks

A commercial bank is a financial institution whose main business is to accept deposits from the public and to give loans to those who require it for short periods. The general functions of a commercial bank may be summarized as follows:-

1. Receiving of DepositsThe most important functions of the commercial banks is to receive deposits form the public. The commercial banks not only protect them but also help transfer of funds through cheques and even undertake to repay the money in legal tender money.Deposits received by the commercial banks are of various types, - fixed deposits, savings deposits, current deposits and recurring deposits. Fixed deposits or Time deposits are with the bank for a specified period of time and they can be withdrawn only after the expiry of the said period. The interest rate depends on the time agreed upon. The longer the maturity period, the higher the interest rate and vice versa. Form the point of view of safety and interest, fixed deposits are preferable.Savings deposits are those deposits received subject to certain restrictions. For instance, the interest is normally lower on savings deposits; withdrawals may be made once or twice a week.Current deposit or demand deposits as they the often called, are those deposits withdrawable by the depositor at any time without any prior notice by means of cheques. The banks do not pay any interest on demand deposits, but in fact make a small charge on customers with current account.Recurring deposits are those deposits received by the banks in equal monthly premium for a certain number of years the total of which will be paid to the depositor with interest due thereon after the expiry of the date of maturity.Deposits at cal according to which deposits may be withdrawn when asked for by the depositor, deposits at short notice by which depositors are required to give notice before certain number of days (7,21,30,45 or 90) for withdrawal of deposits, short-time deposits for short period of a year or less for lower interest and retirement benefits deposits, are some of the important forms of deposits received by the commercial banks.

2. Making loans and AdvancesThe second principal functions of the commercial bank is to make loans and advances out of the public deposits. Direct loans and advances are given to all persons against personal security, gold and silver and other movable and immovable assets. This the banks do by overdraft facilities, that is, by allowing the borrower or overdraw his current account and also by discounting bills of exchange. The merchants and manufacturers enabled to obtain adequate funds for production of goods and services. They help in the development of those industries which perform the most useful service to the community.The loans and advances made by the commercial banks are of various forms, like cash credit, overdraft, demand loan, hire purchase loan, etc. Cash credit is that loan given by a commercial bank in installments against the security of raw materials, produced goods, etc. Overdraft is made on security against stock and shares, insurance policies, etc., under current account. Demand loan is paid in full to the debtor at a time. Hire purchase loans are made to all persons for the purchase of customer durable goods like radio, bicycle, tailoring machine, sites for buildings etc and these loans are repayable to the bank in easy installments with interest due thereon.

3. Agency ServicesA commercial bank provides a range of investment services. Customers can arrange for dividends to be sent to their bank and directly remitted into their bank accounts, or for the bank to detach coupons from bearer bonds and present them for payments and to act upon announcements in the Press of drawn bonds, coupons payable, etc. Orders for the purchase or sale of stock exchange securities are executed through the banks brokers who will also their opinions on securities or lists of securities. Similarly, banks will make applications of behalf of their customers for allotments arising from new capital issues, pay calls as they fall due (that is, subscriptions to capital issues made over a period), and ultimately obtain the share certificate or other documents of title. On certain agreed terms the banks will allow their names to appear on approved prospectuses or other documents as bankers for the issue of new capital, they will receive applications and carry out other instructions.A commercial bank undertakes the payment of subscriptions, premia, rents and collection of cheques, bills, promissory notes etc., on behalf of its customers. It also acts as a correspondent or representative of its customers, other banks and financial corporations.Most of the commercial banks have an executor and trustee departments; some may have affiliated companies to deal with this branch of their business. They aim to provide, before, a complete range of trustee, executor, or advisory services for a small charge. The business of banks acting as trustees, executors, administrators, etc., has continuously expanded with considerable usefulness to their customers. By appointing a bank as an executor or trustee of his will the customer secures the advantage of continuity, and avoids having to make changes; impartiality in dealing with beneficiaries and in the exercise of discretions; and the legal and specialized knowledge pertaining to executor and trustee services. When a person dies without making a will the next-of-kin can employ the bank to act as administrator and to deal with the estate in accordance with the rules relating to intestacies. Alternatively, if a testator makes a will but fails to appoint an executor, or if an executor is unable of unwilling to act, the bank can usually undertake the administration with the consent of the persons who are immediately concerned. Banks will act solely or jointly with others in these maters, as also in the case of trustee for stocks, shares funds, properties or other investments. Under a declaration of trust, a bank undertakes the supervision of investments and distribution of income; a customers investments can be transferred into the banks name of control, this enabling it to act immediately upon a notice or rights issue, allotment letters, etc. Alternatively, where it is not desired to appoint the bank as nominee, these services may still be carried out by appointing the bank as attorney. Where business is included in an estate or trust, a bank will provide for its management for a limited period, pending its sale to the best advantage as a going concern or transfer to a beneficiary.Private companies wishing to set up pension funds may appoint a bank as a custodian, trustee and investment adviser, while retaining the administration of the scheme in the hands of the management of the fund.Most banks will undertake on behalf of their customers the preparation of income tax returns and claims for the recovery of overpaid tax; they also assist the customers in checking of assessments. In addition to the usual claims involving personal allowances and reliefs, claims are prepared on behalf of residents abroad, minors, charities, etc.

4. General Utility ServicesThese services are those in which the bankers position in not that of an agent for his customer. They include the issue of credit instruments like letters of credit and travellers cheques, the acceptance of bills of exchange, the safe custody of valuables and documents, the transaction of foreign exchange business, acting as a referee as to the respectability and financial standing of customers and providing specialized advisory service to customers.

By selling drafts or orders and by issuing letters of credit, circular notes, travellers cheques, etc., a commercial banker is discharging a very important function. A bankers draft is an order, addressed by one office of a bank to any other of its branches or by any one bank to another, to pay a specified sum to the person concerned. A letter of credit is a document issued by a banker, authorizing some other banker to whom it si addressed, to honour the cheques of a person named in the document, to the extent of a stated amount in the letter and to charge the same to the account ofhte grantor of the letter of credit A letter of credit includes a promise by the issuing banker to accept all bills to the limits of credit. When the promise to accept is conditional on the receipt of the documents of title to goods, it is called a documentary letter of credit. But the banker will still be liable for bills negotiated before the expiry of the period of its currency. Circular letter of Credit is generally intended for travelers who may require money in different countries. They may be divided into travelers letters of credit and guarantee letters of credit. A travelers letter of credit carries the instruction of the issuing bank to its foreign agents to honour the beneficiarys drafts, Cheques, etc., to a stated amount which it undertakes to meet on presentation. While issuing guarantee letters of credit, the banker secures a guarantee for reimbursement at an agree rate of interest or the may insist on sufficient security for the grant of the credit, the banker secures a guarantee for reimbursement at an agreed rate of interest or he may insist on sufficient security for the grant of the credit. There is yet another type which is knows as Revolving Credit. Here the letter is so worded that the amount of credit available automatically reverts to the original amount after the bills negotiated under them are duly honored.

Circular Notes are cheques on the issuing baker for certain round sums in his own currency. On the reverse side of the circular note is a letter addressed to the agents specifying the name of the holder and referring to a letter of indication in his hands, containing an specimen signature of the holder. The not will not be honource unless the letter of indication is presented. Travellers cheques are documents similar to circular notes with the exception that they are not accompanied by any letter of indication. Circular cheques are issued by banks in certain countries to their agents abroad. These agents sell them to intending visitors to the country of the issuing bank.Another important service rendered by a modern commercial bank is that of keeping in safe custody valuables such as negotiable securities, jewellery, documents of title, wills, deed-boxes, etc., Some branches are also equipped with specially constructed strong rooms, each containing a large number of private steel safes of various sizes. These may be used by non-customers for a small fee as well as by regular customers. Each licensee in provided with the key of an individual safe and thus not only obtains protection for his valuables, but also retains full personal control over them. The safes are accessible at any time during banking hours and often longer.For shopkeepers and other customers who handle large sums of money after banking hours. night safes are available at many banks. Night safe take the form of a small metal door in the outside wall of the bank, accessible from the street, behind which there is a chute connecting with the banks strong room. Customers who require this service are provided with a leather wallet, which they lock before placing in the chute. The wallet is opened by the customer when he calls at the bank the next day to pay the contents into his account.Another function of great value, both to bankers and to businessman, is that of a referee as to the respectability an financial status of the customer.

Among the services introduced by modern commercial banks during the last quarter of a century or so, the bank giro and credit cards deserve special mention. The bank giro is a system by which a bank customer with many payments to make, instead of drawing a cheque for each item, may simply instruct his bank to transfer to the bank accounts of his creditor the sum due from him, and he writes one cheque debiting his account with the total amount. Credit advices containing the name of each creditor with the name of his bank and the branch will be cleared through the credit clearing of the clearing-house, which operates in a similar way as for the clearing of cheques. Even non-customers of a bank for a small charge may make use of this facility. A direct debiting service is also operated by some banks, This service is designed to assist organizations which receive large number of payments on a regular basis. A creditor is thereby enabled with the prior approval of the debtor, to claim any money due to him direct from the debtors bank account. To some organizations, for example, insurance companies, which receive, say, six equal sums on six dated in a year, the scheme is only an extension of the standing order facility; but for the public utilities and traders which send out invoices for variable amounts at differing times, the scheme is an entirely new one.

Credit cards are introduced for the use of credit-worthy customers. Users are issued with a card on production of which their signature is accepted on bills in shops and establishments participating in the scheme. The banks thereby guarantee to meet the bill and recover from the cardholders through a single account presented periodically. In some cases uses are required to pay a regular subscription for the use of the service as well. An extension of the scheme allows the repayment of large sums (subject to a maximum) over a period at interest.

Some banks are opening budget accounts for credit-worthy customers. The bank guarantees to pay, for a specific charge, certain types of annual bills (for example, fuel bills, rates, etc.) promptly as they become due, whilst repayments are spread over a 12-monthly period from the customers current account.All these new money transmission services have particular regard to the developments in computerized book-keeping which the banks in some countries have already introduced. Some banks are reported to be experimenting with the use of electronic machines which will scan cheques and dispense notes or coins, thus saving time at the counter.

Overseas Treading ServicesRecognition of overseas trade has led modern commercial banks to set up branches specializing in the finance of foreign trade and some banks in some countries have taken interest in export houses and factoring organizations. Assisted by banks affiliated to them in overseas territories, they are able to provide a comprehensive network of services for foreign banking business, and may transactions can be carried through from start to finish by a home bank or its subsidiary. In places where banks are not directly represented by such affiliated undertakings, they have working arrangements with correspondents so that banks are in a position to undertake foreign banking business in any part of the world.The banks provide more than just a means for the settlements of debts between trades both at home and abroad for the goods they buy and sell; they are also providers of credit and enable the company to release the capital which would otherwise be tied up in the goods exported.

5. Information and other ServicesAs part of their comprehensive banking services, many banks act as a major sources of information on overseas trade in all aspects. Some banks produce regular bulletins on trade and economic conditions at home and abroad, and special reports on commodities and markets. In some cases they invite enquiries for those wishing to extend their foreign trade, and are able through their correspondents to furnish the names of reputable and interested dealers of goods and commodities and to advise on the appointment of suitable agents. For businessmen traveling abroad letters of introduction, indicating the purpose of journey taken, can be issued addressed to banking correspondents in the various centers it is proposed to visit. In this way it is often possible to establish new avenues of business. On request, banks obtain for customers, for business houses, confidential opinions on the financial standing of companies, firms or individuals at home or overseas.Commercial banks furnish advice and information outside the scope merely of trade. If it is desired to set up a subsidiary or branch overseas (or for an overseas company to set up in the home country) they help to establish contracts with local banking organizations.To sum up, the service rendered by a modern commercial bank is of inestimable value. It mobilizes the scattered saving of the community and redistributes them into more useful channels. It enables large payments to be made over long distances with maximum expenses. It constitutes the very life blood of an advanced economic society. In the words of Walter Leaf: The banker is the universal arbiter of the worlds economy.Commercial Banks and Economic DevelopmentCommercial banks have come to play a significant role in the development of countries. In fact, without the evolution of commercial banking in the 18th and the 19th centuries, Industrial Revolution would not have taken place in England. It will be equally true to state that without the development of sound commercial banking, underdeveloped countries cannot hope to join the ranks of advanced countries. For, industrial development requires the use of capital which will not be possible without the existence of banks to provide the necessary finance to acquire capital. Besides, industrial development will be impossible without the existence of markets to dispose of the goods produced. But how can markets be extended without the services of commercial banks?In this section, we shall deal with the important services provided by commercial banks and show how banks play a significant role in the economic development of nations.(i) Banks are necessary for trade and industry: All economic progress in the last 200 years or so has been based on extensive trade and industrialization, which could not have taken place without the use of money. But money does not mean coins and currency notes, only since these form only a small proportion of the total volume of money supply. It is the bank deposits on which cheques can be issued that constitute the important sources of money. In all large transactions, payments are not made in terms of money but in terms of cheques and drafts. Between countries, trade is financed through bill so exchange which are discounted (i.e., bought) by banks. Without the use of the bank cheque, the bank draft and the bill of exchange, internal trade and international trade could not have developed, and without such trade, specialization and industrial development could not have taken place.(ii) Banks help in distribution of funds between regions: Another way by which commercial banks encourage production and enhance national income is by the transference of surplus capital from regions where it is not wanted so much, to those regions where it can be more usefully and efficiently employed. This distribution of funds between regions has the effect of opening up backward regions and paying the way for their economic development.

(iii) Banks create credit and help in business expansion: Fluctuations in bank credit have an important bearing on the level of economic activity. Expansion of bank credit will provide more funds to entrepreneurs and, hence, will lead to more investment. Under conditions of full employment, expansion of bank credit will have the effect of inflationary pressure. But under conditions of unemployment, it will push up production in the country. On the other hand, a decline in bank credit will result in decline in production, employment, sales and prices. From the view of an under-developed economy, the expansion of bank credit offering more financial resources to industries in one of the contributory causes for greater economic development.

(iv) Banks monetize debt: A very important service the banks render to he community is the creation of demand deposits in exchange of debts of other (viz., short and long-term securities). Commercial banks buy debts of others which are not generally acceptable as money, either because the debtors are not sufficiently known or because their debt is payable only after a period of time. In return for them, they issue demand deposits which are generally accepted as money. By these exchange operations, banks monetize debt. The significance of banks today flows from the fact that they are not merely traders in money but also, in an important sense, manufacturers of money. Bank money is used for the promotion of industry and trade. It is rightly said that they have not only the power to determine the aggregate volume of bank money in existence but to influence the uses to which that money should be put.

(v) Banks promote capital formation: Commercial banks afford facilities for saving and thus encourage habits of thrift and industry among people. The mobilize the idle and dormant capital of the community and make it available for productive purposes. Economic development depends upon the diversion of economic resources from consumption to capital formation. A higher rate of saving and investment is, therefore, what constitutes real capital formation. In this, the role of banks is invaluable. But then there can be other institutions also in a country such as insurance companies which may help in mobilizing the savings of the community for productive purposes.

(vi) Banks influence interest rates : Banks can influence economic activity in another way also. They can influence the rate of interest in the money market through its supply of funds. By offering more or less funds, it can exert a powerful influence upon interest rates. Besides, it can also influence the people to hold more less bank money or less or more other assets. In this way, too, it can influence the interest rates. A cheap money policy with low rate of interest will tend to stimulate economic activity, if other conditions are favourable.In a developing country like India, banking facilities are highly inadequate. The vast number of people living in villages and tows do not have any banking facilities and consequently all their savings are wasted. The opening of banks is these areas or extension of bank facilities will help mobilize savings in these areas and, when put in the hands of entrepreneurs, will become productive Besides in India commercial banks have started undertaking new functions to help the private sector industries. They help in concluding deferred payments agreements between Indian industrial units and foreign firms to enable the former to import machinery and other essential items.Thus, bans have come to occupy an important place in the industrial and commercial life of a nation. A developed banking organization is a necessary condition for the industrial development of a country./ Lesson 3 Balance sheet of commercial banks

The Liabilities and Assets of a Bank : A Balance SheetBanking is business much like nay other business. An indication of the financial position of a business concern may be obtained by examining its statement of liabilities and assets, called the Balance Sheet.A balance sheet is always prepared in two sections. In one section it is customary to record liabilities, normally on the left side, and assets in the other section on the right side. Liabilities are the debts or amounts of money owned to others. The liabilities of a bank consist mainly of the claims of its shareholders, creditors and the depositors. The assets, on the other hand, include such items as cash , accounts receivable, loans and investments, etc.A balance sheet always balances in total, but no individual items necessarily matches another. We can easily understand this if we have some elementary knowledge of double-entry accounting. Any change in the one side of the balance sheet must be precisely offset by an equal change in some other item on the other side. The equality of assets and liabilities is not peculiar to banking alone. Every balance-sheet balances. But a banks business is, in a very special sense, a balancing of assets and liabilities. A bank acquires assets by increasing its liabilities directly, unlike any other business where liabilities are acquired indirectly as a result of trading. Thus, the first thing we want to know about a bank and its operations is the amount of its debts and credits.

LiabilitiesThe liabilities of the balance sheet of a bank is comparatively simple. The liabilities represent others claims on the bank. The liabilities side of the balance sheet shows how the bank raises funds to function as a dealer in debts and credits. The liabilities of a bank usually consist of the following items:

(1) Capital: The bank capital from its shareholders by issuing various types of shares, such as ordinary, preference, deferred shares, etc. The balance sheet may show the amounts of authorized capital, issued capital, and subscribed capital. But the actual liability of a bank to its shareholders consists of the capital originally paid in and any accumulation of undistributed profits.

(2) Reserve Fund : It is the amount accumulated over the years out of undistributed profits. The bank may use this fund to offset its unexpected losses in certain years. Sometimes a bank is required by low to transfer a part of its annual profits to the reserve fund so long as amount in the fund does not become equal to its paid-up capital.

(3) Deposits: Deposits from the public constitute the biggest proportion of banks working funds. The deposits are categorized as the demand deposits and the time deposits. It is the former that represents the bulk of the money supply with public. It is on the basis of their deposit liabilities that the banks make loan and investments after keeping ascertain cash reserve ratio.Demand deposits are distinguished from time deposits. Time deposits are those against which cheques cannot be written. Demand deposits may arise out of the credits created by a bank as a claim against itself. But in simple terms, a customer is said to have made a deposit when he gives the bank cash or its equivalent and the bank gives him a deposit credit. A deposit, therefore, is the promise that the bank gives the depositor in exchange for the cash he deposits. The cash in an asset, the deposit is a liability. The depositor is a creditor of the bank having lent its cash, and he can claim repayment at any time.(4) Inter-bank borrowings : Liabilities are created when a bank borrows from another bank on a temporary basis. A large bank, in particular, may have deposit liabilities not only for the account of the general public but also for other banks in the country.The bank may also borrow form the central bank of the country on the basis of the eligible securities or get financial accommodation in times of need or stringency by rediscounting their bills of exchange.

(5) Liabilities relating to bills : The bank may have some bills which are payable by it out of its resources. It may also accept some bills from its customers for collection. The amount when collected is credited to the accounts of the customers. Hence the amount under this head is shown on both the sides of the balance sheet. They become the liabilities of the bank after collection, but they are to be treated as assets before collection. The banks also accept of endorse the bills of exchange on behalf of their customers, which simply means that the bank guarantees the payment of bills at maturity. Thus, when the bank has accepted bills for its customers it is technically liable to meet them on maturity, but since the customers are expected to meet them and have presumably given due security, this liability of the customers to the bank is an offsetting asset against the acceptance. In addition to the above, the banks make some provision for the contingent or unforeseeable liabilities. The profit earner by the bank is also shown as the liability because it is payable to the shareholders.It may be emphasized, however, that the assets of a bank are based on its liabilities. Banks, unlike other business organization, acquire only a very small part of their total assets by issuing capital-account claims. An even more important point is that the volume of capital-account claims or share capital changes only slowly and within narrow limits relative to bank assets. Bank reserves, borrowings from other banks and the central bank are also very small relative to total assets. Most of the assets of banks are acquired by creating and issuing bank credits in the form of deposit claims. The volume of deposits that the banking system can issue depends on its reserve requirements enforced by the central bank and the currency volume of reserves available to banks.

AssetsWe shall now briefly describe the main items of a banks assets in descending order or liquidity and ascending order of profitability, and show how they reflect these two considerations.

1. Cash Balances The first asset in the portfolio of a commercial banks assets is cash-with itself and with the central bank of the country. In certain countries, as in India, every commercial bank is required by law to keep some cash reserves against its deposits. Cash is called the primary reserve of a bank. By experience a bank knows how much cash reserves will have to be kept to meet the demands of depositors. Part of this cash is kept in the banks premises, a certain portion with other commercial banks for purposes of inter-bank adjustments and a certain portion is kept as deposit with the central bank of the country. A deposit with other commercial banks or with the central bank is regarded as cash by a commercial bank. In India, commercial bank are obliged, by law, to keep a certain proportion of total deposits in the form of cash reserves with the Reserve Bank of India.The success of a bank depends upon the maintenance of sufficient cash reserves to honor the cheques presented by the clients. But only a small percentage of depositors may be withdrawing their deposits through cheques and other methods at any particular time. At the same time, if some are withdrawing, others may be depositing. A commercial bank has therefore, to adjust its business in such a way that the amount of cash flowing in and the amount of cash flowing out should be equal, keeping of course a margin of extra cash for the sake of safety. Too much of cash will reduce the profit-earning capacity of a bank, at the same time, it should not keep too low cash reserves below the minimum considered necessary or prudent.

2. Money at call and Short NoticeCash, being a barren asset, should not be kept beyond the minimum necessary for safety. But a bank may feel that there may be a heavy pressure on its cash reserves due to seasonal changes in depositors and borrowers requirements. To meet this pressure, it may be borced to carry large cash reserves even in times when they are not required at all. The other and better alternative for the bank is to keep some highly liquid but earning assets which can be converted into cash quickly and without loss. There are two tyupes of such assets, viz., (a) call and short notice loans to the brokers in the stock market., dealers in the discount market and to other banks, (b) short-term treasury bills (borrowings of the government for short periods). These assets can be quickly converted into cash and without loss, as a and when the bank wants. Hence banks regard such assets as secondary reserves as different from cash which is their primary reserve. At the same time, these assets bring in some revenue income to the bank.

3. Short-term BillsA commercial bank like to acquire assets which are for short period (generally for 90 days) and which are easily marketable and hence sufficiently liquid and at the same time bring in some interest income to the bank. Such assets are sometimes called self-liquidating because there is evidence of genuine commercial transactions, at the end of which the necessary finance will be realized to repay the original loan. These self-liquidating bills consist mainly of bills of exchange. A bill of exchange is written promises by a merchant, who has ordered certain goods, to pay a specified sum of money on a specified sum of money on a specified date. This bill may be guaranteed by a bank or a well-known merchant house-known in London as the Acceptance Houses. Besides commercial bills, there are short-dated treasury bill through which the government borrows funds for short periods.

Commercial banks like short-dated paper or bill for a number of reasons : First of all, these assets are highly negotiable and can be easily bought and sold. In countries like England, there is a special bill market in which these bills are bought and sold (or discounted). Therefore, if a commercial bank requires additional funds, it can easily rediscount the bills in the bill market or the discount market. Secondly, these bills are eligible for rediscounting with the central bank of the country. That is, if a commercial bank wants cash, it can rediscount (or sell) the short-term bills with the central bank. Thirdly, these bill bring in handsome interest for the commercial banks. Thus, commercial banks prefers these short-dated bills because of their high marketability as well as their interest income; they are regarded as ideal bank assets because they satisfy the twin considerations of liquidity and profit.

4. Loans and Advances

The most profitable of all assets is bank loans and advances. This asset is universally sought after by banks. Bank loans and advances may be made to businessmen either by the system of overdrafts of an agreed amount or by discounting bills of exchange. Loans and advances carry a high rate of interest because of the risk involved, low liquidity and the difficulty of shifting them. They involve great risk to the bank because of the possible failure of the borrowers and in extreme cases because of their insolvency and liquidation. Again, these loans and advances have a low liquidity and low shiftability in the sense that they cannot be converted into cash easily as and when the bank requires additional cash to meet withdrawals, nor is there any possibility of shifting them to other banks or institution. As a matter of fact, all bank failure may be ascribed to faulty policies regarding loans and advances. From the point of view of safety of the bank and its liquidity, loans and advances are poor assets. But the high yield of these assets compensates for the difficulties associated with them. These assets, thus, have low liquidity but high yield.

5. Investments

Banks make investments in the profit-yielding securities. Investments in government securities represent the book value of central and state government securities, including treasury bills and treasury deposit receipts etc. Banks may make investments in other approved securities as well. The different types of investments are shown separately in the balance sheet. Banks regard their short-term investments as their secondary reserves as different from cash which is their primary reserve.

6. Properties

Building, furniture and fixtures etc. are the other assets of the banks. These fixed assets are often referred to as Dead Stock. They are generally shown at their depreciated value. These are, in a way, the secret reserves of the banks which can be availed of in case of crises or collapse.

The amount of assets that a bank can command depends upon the amount of its liabilities. Many types of assets are available to a bank, profitless and profitable, liquid and non-liquid. A bank must therefore formulate a portfolio policy determining what types and proportions of assets it will acquire and hold.

Lesson 4

Commercial Banks : Credit creation

Control of Banks over Deposits

Bank deposits are of two types. There are current deposits which are used by businessmen, industrialists and others to settle debts. These current deposits, in which cheques are issued, are also known as cash deposits or demand deposits. The second type of bank deposits, which are not meant for current transactions, are known as savings deposits. They are kept in bans as a form of savings or investments so as to earn interest from the banks. The savings deposits are not held to meet the needs of the presents or the near future, but are kept by individuals as part of their total stock of wealth, Savings deposits may also be known as time deposits. On type of savings deposits is known as fixed deposits, i.e., deposits of money which can be withdrawn only after a given period of time.

The distinction between current deposits and savings deposits a matter of degree only. Money is kept in a bank for the sake of convenience. It is used to meet excess of payments over receipts. Current deposits are useful to meet payments immediately but savings deposits are kept to settle debts in future. In the case of current deposits the depositor expects only convenience of payment of debts. In the case of savings deposits, however, the depositor expects an interest income also.

Who decides the distribution of deposits into current deposits and savings deposits? It is the customer who decides whether he would prefer current deposits or savings deposits. Besides, if a depositor feels that he has too large a volume of current deposits from which he is getting nothing, he may convert part of it into savings deposit. Likewise, a customer with savings deposit may turn part of it into current deposit. The bank has nothing to do with this.

Primary and Derivative Deposits

Deposits may be created in two ways:

(a) People may deposit their cash with the banking system. i.e., they convert their cash into demand deposits. One form of money (cash with the public) has been changed into another form of money (bank money). The initiative for creating deposits is taken by he customers themselves. Such deposits are known as primary deposits. Apparently the total volume of money remains the same through, in fact, it is not so.

(b) Primary deposits bring cash to the banking system. Using this cash, the banking system buys assets from the market (bills, bonds, debentures, etc.) or it lends to businessmen and industrialists. Now, whenever a bank buys assets from the market or ends to certain parties, it does not give to them but creates demand deposits to their name. These deposits are secondary or derived from the primary deposit-hence they are known as derivative deposits. The initiative for creating deposits comes from the banking system. In a modern money economy, the second from the deposits has become quite significant. When we say banks have control over deposits has become quite significant. When we say banks have control over deposits, we mean that they have control over the total volume of deposits. Let us see how the banking system is able to create the derivative deposits through acquiring assets.

Loans Create Deposits

Money at call and short notice are extremely short-period loans made by a bank to speculators and brokers in the money market and the capital market (i.e., stock exchange). The bank credits the deposit accounts of these speculators and dealers for their promises to repay at call or short notice. The speculators and dealers would use these deposits to pay off their creditors. The creditors who receive cheques or drafts credit them to their accounts. Thus as a result of loan made by bank, deposits equal to the value of the loans have been created.

Bills discounted refer to the commercial bills and financial bills which are short-dated paper (generally for 90 days) which a bank acquires from the bill market. When a bank buys (or discount) a bill of exchange from a party, it will credit the account of the latter (if the party keeps an account with bank) or it will pay the party through a cheque on itself. The party selling the bills will deposit the cheque in its bank account. In both cases, bank deposits will increase.

Bank advances, commonly known as loans, are made by the bank to industrialists, businessmen, traders and others. When a loan is sanctioned, the bank creates a deposit in the name of the borrower. It allows the borrower to draw on this deposit to pay off his creditors. In this case also, every loan a bank makes is creating a deposit. Naturally, the banks create more deposits simply by making more and more advances.

Finally, investments are made by a bank when it purchases and holds Governments bonds and other securities which have a longer life than three months. When a bank buys a bond from the Government, it places at he disposal of the Government a bank deposit which the Government can use in any way it likes. If a bank buys an old Government bond from the stock exchange, it will create a deposit in the name of the seller who is free to use the money in any way he likes.

From what we have described above, it should be clear that every time a bank acquires an earning asset, it creates a deposit in the name of the person or institution from whom the asset is purchased. The asset may be promise to pay within a day or two or it may be a promise to pay within three months or it may be a Governments I.O.U. to be redeemed over a long period of time. Against the promises of individuals, institutions and the Government, which do not constitute money the bank gives it own promise (viz, the bank deposit) which is money, i.e., it is creating money. Two points should be mentioned here. First, every asset acquired by bank an equivalent bank deposit. It is perfectly correct to state that bank loans create deposits. Bank take the initiative to give loans and advances and acquire other earning assets: by doing go, they control the total volume of deposits in the banking system.

Secondly, commercial banks monetize the debt of others. Against the promises of other to pay, the banks give their own promises to pay. The former is not money but the latter is money. In this sense, banks create money.

Limitations to Creation of Deposits

An important question arises here. If a bank can buy assets just by giving its own promise to pay (i.e., bank deposits), is there any limit to its buying of assets? Is there any limit to its creation of deposits? We are anwering this question rather elaborately in the next section. One point, however, may be emphasized here. Against its deposits, a commercial bank has to keep cash reserves. The proportion of cash to deposits may be fixed by law or its may be determined according to convention and general usage. As the volume of earning assets increases, the volume of bank deposits also increases but the ratio of cash deposits rises, business transactions will increase, giving rise to an increase in price levels. People, therefore, will demand more currency notes for purposes of trade and exchange. When the public draw out cash from banks, the ratio of cash to bank deposits will decline still further. The cash ratio is thus, subject to decline on two rounds : (a) increase in deposits, and (b) drain of cash into circulation.

If the absolute size of the cash reserves with commercial banks in the country is given, the maximum amount of deposits which banks can create will depend upon the cash reserve ratio to deposits. Suppose that commercial banks have cash reserves of Rs. 100 crores and further the legal cash reserves ratio to deposits is 10 per cent. Then the commercial banks can create and maintain deposits worth Rs. 1,000 crores. If the volume of bank deposits is less, banks can acquire some more earning assets and increase the bank deposits also. Of course, it is assumed that there are people willing to borrow from commercial banks. Suppose that the volume of deposits Rs. 1,200 crores while the size of cash reserves in Rs. 100 crores. With legal cash reserve ratio at 10 per cent, commercial banks will have to reduce their deposits by disposing of some of their earning assets. There will, thus, be a simultaneous decline of bank assets and bank deposits, till the ratio of cash reserves to bank deposits becomes 10 per cent.

Thus the commercial banks have absolute control over the volume of bank deposits, subject or course to : (a) the supply of cash, (b) the public demand for cash, and (c) the cash reserve ratio to be maintained. The central bank enters the picture through its control of cash. By supplying more cash, the central bank can expect commercial bank to increase their earning assets and increase their bank deposits. By reducing cash, the central bank can attempt to achieve the opposite result.

The technique of Credit Creation

Demand deposits or cash deposits are money are used as such, for every depositor having a current account in a commercial bank can meet his obligations through cheques drawn on his account. Expansion or contraction of deposits, therefore, means expansion and contraction of money in the country. Now, as indicated already, banks have the power to expand or contract demand deposits and they exercise this power through granting more or less loans and advances. Now, this power of commercial banks to expand deposits through expanding loans and advances is known as credit creation.

Bank credit really refers to bank loans and advances and creation refers to the multiplication of loans and advances. As every bank loan creates an equivalent deposit, credit creation by the banks implies also multiplication of bank deposits. The word creation is used to imply that bank are unique institutions and that they can create assets (or give loans and purchase bills and bonds) out of nothing. Or with a small amount of cash, they are in a position to acquire a large amount of assets.

At one time, there was needless controversy regarding the ability of commercial banks to create credit. Some writers meant by bank credit bank loans and investments and, therefore, maintained that bank could never and more than the amount which it had been entrusted with by the depositors. Suppose that a person deposited Rs. 1,000 which a bank, the latter could lend up to Rs. 1,000 and not more. In fact, it should lend for less, since it had to maintain a small margin of cash reserve against the withdrawal of money by the depositors. In any case the bank could not lend more than Rs. 1,000 and, therefore, it was concluded that bank could not create credit.

It is true that a bank cannot lend more than what it has got. But it is equally true that what is lent out by a bank comes back to the bank by way of new deposits, which may again be lent out, and so on-deposit becoming the basis for a loan or investment, which again returning to the bank as fresh deposit becomes the basis for a loan or investment, which again returning to the bank as fresh deposit becomes the basis for a new loan, and so on. Commercial banks, therefore, are able to multiply loans and investments and thus multiply deposits. A small volume of cash is the basis for multiplication of deposits through multiplication of loans and advances (loan create deposits). It is in this sense that banks create credit. Credit creation can be defined as the expansion of bank deposits through the process of more loans and advances and investments.

Technique of Credit Creation

Let us explain, in highly simplified manner, the technique or the process of credit creation by assuming:

(a) the existence of a number of banks, A,B,C,D, etc., each with different sets of depositors:

(b) Every bank has to keep 20 per cent of cash reserves, according to law; and

(c) A new deposit of Rs. 1,000 has been made with bank A to start with

After the new deposit of Rs. 1,000 has been made in Bank A, the balance sheet of the bank (taking only the new transaction) is as follows:Balance Sheet of Bank A

Liabilities Amount (Rs.)Assets Amount (Rs.)

New Deposit 1,000 New Cash 1,000

Total 1,0001,000

Under the double-entry system the amount of Rs. 1,000 is shown on both sides. The deposit of Rs. 1,000 is a liability for the bank since it is obliged to return the amount to the depositor whenever he demands. At the same time, the amount is an asset to the bank which it may use to earn an interest income. Bank A has to keep only 20 per cent reserve, i.e., Rs. 200 against its new deposit; it has a surplus of Rs. 800 which it can profitably employ. Suppose that Bank A gives a loan to Mr. X who uses the amount to pay off his creditors. After the loan has been made and the amount so withdrawn by Mr. X to pay ff his creditors, the balance sheet of Bank. A will be as follows :

Balance Sheet of Bank A


Deposit 1,000 Cash 200

Loan to Mr. X800

Total 1,0001,000

Now, the creditors of Mr. X, who got Rs. 800 from the latter, may be assumed to deposit the amount with their bank, viz., Bank B. (This assumption is unnecessary, for the creditors of Mr. X may be banking with Bank A depositing Rs. 800 with Bank A itself). The balance sheet of Bank B will be as follows:

Balance Sheet of Bank B


New Deposit 800 New Cash 800

Total 800800

After keeping a cash reserve of Rs. 160, (viz., 20 percent of Rs. 800), Bank B is free to lend the balance of Rs. 640 to any one. Suppose that the bank buys bills worth Rs. 640.

The balance sheet of Bank will be: Balance Sheet of Bank B


Deposit 800 New Cash 160

Bills640

Total 8001,000

We can assume that the sellers of bills who received Rs. 640 from Bank B would be depositing the amount in their bank, viz, Bank C. Bank Cs balance sheet will as follows: Balance Sheet of Bank CLiabilities Amount (Rs.)Assets Amount (Rs.)


Total 640640

Bank C finds that it has excess cash reserves to the extent or Rs. 512 (since under 20 per cent cash reserve, it will have to keep a cash reserve of Rs. 128 only against a deposit of Rs. 640). Suppose that Bank C invests Rs. 512. Its Balance Sheet will be as follows Balance Sheet of Bank CLiabilities Amount (Rs.)Assets Amount (Rs.)


Investment512

Total 640640

Now, Mr. Y who sold the long-term securities to Bank C for Rs. 512 may be expected to deposit the amount with his bank, viz., Bank D, which in turn may keep 20 per cent as cash reserve and lend the rest. And this process of a deposit becoming a loan or an investment which, in turn, becoming a new deposit goes on and on till the original deposit of Rs. 1,000 is completely exhausted. The original deposit of Rs. 1,000 becomes additional deposits of Rs. 800, 640, 512, 410, 328, etc. If we add up all these deposits, the total will be Rs. 4,999.99 or Rs. 5000. This is the process of deposit multiplication through the process of credit creation.

The formula of Credit Creation

As credit creation depends upon the ratio of cash reserves to deposits, the deposit multiplier is

If cash reserve ratio is 10 per cent or 0.1 the deposit multiplier is 10, and so on. The higher the cash reserve ration, the lower will be the deposit multiplier. The total deposit creation will be additional cash (M) multiplied by the deposit multiplier. That is

Additional Aggregate Deposit (D) = M X K

If the commercial banks get fresh cash of Rs. 10 crores, as a result of Governemnt spending, they would be able to multiply deposits through loans and investments to the extent or Rs. 50 crores (assuming a cash reserve of Rs. 20 per cent). That is

D =M X K=Rs. 10 crores X 5=Rs. 50 crores

So far, we have assumed that credit creation will take place when there are many banks. However, it is not really necessary that there should be many banks, it is just sufficient that there is only one bank. Even then, the process of credit creation will be the same. That is, whenever the bank ahs excess cash reserves, it will lend or invest the same; this amount will come back to the bank in the form of a new deposit which will become the basis for yet another loan, and so on. The money which goes out from the bank by way of loans etc., and the money concerned as to how a depositor gets the cash which was with the bank a whole ago. Thus credit creation will take place, whether we consider only one bank in an isolated town or we consider the banking system as a whole.

Credit Contractions

Just as there is multiple expansion of deposits there is multiple contraction of bank deposits too, when cash is removed from the banking system. Suppose there are a number of banks in the banking system. And each bank has to keep a cash reserve ratio of 20 per cent against deposits. Let us further assume for the sake of simplicity that every bank ahs a cash reserve of Rs. 10,000, total deposits of Rs. 50,000 and loans and investments worth Rs. 40,000. Suppose that a depositor withdraws Rs. 1,000 from Bank A. The balance sheet of Bank A will be as follows: Bank A


Deposit 49,000 Cash 9,000

Loans & Investments40,000

Total 49,00049,000

Against deposit liabilities of Rs. 49,000 Bank A requires Rs. 9,800 as cash reserve, (This is 20 per cent of deposits). But the Bank has only Rs. 9,000, leaving it with a deficiency of Rs. 800. The bank will make up the deficiency by disposing of Rs. 800 worth of investments to someone who may be assumed to the banking with Bank B and who, therefore, draws a cheque against Bank B in payment. After Bank A has collected the amount from Bank B, the balance sheet of Banks A and B will be as follows:

Bank ALiabilities Amount (Rs.)Assets Amount (Rs.)



Total 49,00049,000

Bank BLiabilities Amount (Rs.)Assets Amount (Rs.)



Total 49,20049,200

From the balance sheet of Bank A, it will be clear that by disposing of some investments it has been able to restore itself to a satisfactory position. However, the balance sheep of Bank B shows a reduction of Rs. 800 from its deposits and of the same amount from it cash. This account has been paid to Bank A against the sale of investments of Rs. 800. Bank B is now deficient of cash to the extent of Rs. 640. (It requires Rs. 9.840 against total deposits of Rs. 49,200; but it actually has Rs. 9,200 only) To make up the deficiency, Bank B will sell some of the investments to some one who may be banking with Bank C, and who issue cheque against Bank C in payment. After Bank B has received the payment from Bank C, the balances sheets of the two banks will be:

Bank B




Total 49,20049,200

Bank C




Total 49,36049,360

Bank B has adjusted itself, but bank C has deficiency of cash which it will make up by deposing of its investments or by contracting loans. This process goes on till al the effects are fully exhausted. Thus the original reduction deposits by Rs. 1,000 from Bank A is followed by reduction of deposits by Rs. 800 from Bank B, of Rs. 640 form Bank C, and so on. The process of contraction of Bank deposits in the same as that of expansion-only in the reserve direction.

Limitations on Credit Creation

Theoretically, the banking system can create an unlimited amount of money by way of expansion of deposits. However, there are creation factors on which the volume of credit creation depends. It is not possible, rather it is dangerous, to attempt credit expansion beyond a creation limit.

(i) Amount of cash held : The firs important factor on which the extent of credit creation depends is the amount of cash which commercial banks posses. We have shown that banks have to redeem their demand deposits in coins and currency notes at the request of their depositors. Fialure to do so will mean instantaneous failure of the bank. The larger the amount of cash with the banking system, the larger will be the credit creation. As Crowther puts it, The banks cash in the lever with which the whole gigantic system is manipulated.

(ii) Ratio of cash reserves : The required ratio of cash reserves to deposits is another important factor on which the volume of credit creation will depend. We have shown that credit creation will be the reserve of the cash reserve ratio. If a bank considers or the law requires that cash reserve equivalent to 10 per cent of deposits should be kept as cash, the bank may expand the amount of its deposits to 10 times the volume of its cash resources, if a bank is required to keep 20 per cent cash reserve against its deposits, credit creation will be to the extent of 5 times only. Thus, he higher the percentage of cash reserve ratio to be kept, the smaller will be the volume of credit creation.

(iii) Publics desire to hold cash : Credit creation depends upon the amount of cash with the banking system which will in turn depends upon the desire of the general public to hold cash. If for any reason they decide to have more cash (assuming the total amount of currency notes and coins to be constant), the banks will be left with a smaller amount of cash and thus credit creation will be smaller. In fact, large expansion of deposits will add to the total amount of money supply in the country and this will be accompanied by an increased volume of business, rising prices, wages, retain trade, and so on. The depositors will like to keep more cash in the form of coins and currency notes. This will mean reduction in the volume of cash reserves with the banks.

(iv) Nature of business conditions in the country : Credit creation will depend upon ht nature of business conditions. Credit creation will be large during a perious of business prosperity while it will be smaller during a depression. In periods of business prosperity, there will be more demand for loans and advances for investment purposes. And as we have seen, expansion of deposit depends upon the volume of bank loans and advances. Therefore, during periods of business prosperity, many people approach banks for loans and advances and hence the volume of bank credit will be high. Besides, the banks are willing to lend freely during such periods because of the general optimism and the high percentage of returns.

During periods of business depression, however, the amount of loans and advances will be small businessmen and industrialists may not come forward to borrow in this period. Besides, banks may prefer to keep excess reserves and sacrifice earnings. There can be many reasons for this.

(a) Banks may anticipate a possible loss of depositors confidence in them and therefore, of possible run on them.

(b) They may not be sure about the ability of borrowers to repay, In depression, the credit is contracted, partly because of deficiency of sound investments of borrowers and partly because proper securities are not available.

(c) They may be afraid of falling prices of securities. Hence they may not like to invest in them. Thus, they may elect to hold more cash reserves with themselves and may not expand credit to the maximum extent, but in normal times we can expect them to lend and invest up to the maximum extent permitted by their cash reserves.

(v) Leakages in credit creation : There may be a difference between the maximum potential credit expansion and the actual expansion because of certain leakages in credit creation. These leakage have been actually omitted in our simple example of credit creation given above. The important leakages are:

(a) The banks may not be able to make loans and investments exactly according to the surplus funds they may have. For example, if a bank has a surplus fund of Rs.800, it is not necessary that the exact amount of Rs. 800 may be lent out. To the extent that the actual loan is short of Rs. 800, credit creation will be smaller.

(b) The amounts of advances made by the banks have been assumed to return to them by way of new deposits. But they may not, as the public may wish to hold some cash with themselves. Again, therefore, the new deposits every may not be by full amount of the loans made earlier. Credit creation, therefore, will be limited again.

(iv) Monetary policy of the central bank. The extent of credit creation will largely depend upon the monetary policy of the central bank of the country. For one thing, the central bank has the influence the volume of money in the country and for another, it can directly or indirectly influence the banks power to expand or contract credit.

Significance of Credit Creation and Contraction

Bank deposits in modern communities form the predominant type of money and hence expansion of bank deposits means expansion of money supply, and contraction means contraction of money supply. But fluctuations in the volume of money supply have a direct effect on the level of business activity, prices and wages. An increase in the volume of credit, by leading to an increase in the money supply, will lead to a rise in prices and profit margins and consequently increase in business and economic activity. On the other hand, contractions, of bank credit will result in contraction of business activity. At one time, the expansion and contraction of credit were given the pride of place in the explanation of business cycles and also in any policy designed to control them. But, these days, they are given a secondary importance only. That is, very may not be responsible for prosperity or depression but when once prosperity or depression starts, credit expansion contraction accelerates the tempo of cyclical fluctuations. The expansion of bank credit to the maximum extent may boom the boom, while the failure to create as much credit as their reserves permit may depress the depression.

Whether credit expansion (and contraction) plays are primary role or only a secondary role in the causation of cyclical fluctuations, it is but obvious that any policy designed to bring about business stability should include measures to bring about stability in credit expansion and contraction.

Lesson 5

Organisation and Structure of Banks

Banking Organisations

1. Private Individuals

Law does not prohibit a private individual from carrying on banking business. His main difficulty would be to attract depositors in the present days when there are reputed big banking companies and corporations in the private and public sectors. The maximum number of depositors have also been restricted under the Reserve Bank of India Act.

Prohibition of acceptance of deposits by unincorporated Bodies Chapter IIIC has been INSERTED IN THE Reserve Bank of India Act, 1934 by the Banking Laws (Amendment) Act, 1983 with effect from 15.2.1984 containing sections 45R, 45S and 45T. Section 45S provides that no person, being an individual or a firm or an unincorporated associations of individuals shall have deposits from more than following number of depositors:

(i) IndividualNot more than 25 depositors excluding relatives.

(ii) FirmNot more than 25 depositors per partner and not more than 250 in all, excluding relatives of any of the partner.

(iii) Unincorporated association of individualsNot more than 25 depositors per individual and not more than 250 in all, excluding relatives of any of the individuals.

Sub-sections 2 provides that where at the commencement of the Act number of depositors, exceed the above limit, the person shall repay within 2 years such number of depositors to bring them within the limits specified.

(a) a person shall be deemed to be a relative of another if, and if, - (i) they are members of a Hindu undivided family, or (ii) they are husband and wife, of (iii) the one is related to the other in the manner indicated in the list of relatives:

(b) a person in whose favor a credit balance is outstanding for a period not exceeding 6 months in any account relating to mutual dealings in the ordinary course of trade or business shall not, on account of such balance alone, be deemed to be a depositor.

In Kanta Mehta V. Union of India and others, (1987), the Delhi High Court has held that section 45-S (read with section 48B(5A) of Chapter III-C of the Reserve Bank of India Act, 1934, as introduced by section 10 of the Banking Laws (amendment) Act, 1983, which imposes a ceiling on depositors in the case of Individuals, Firm and Association is not discriminatory and does not affect he fundamental right to carry on business or to form association or unions. It is not violative of Articles 14 and 19 of the Constitution, There is nothing demonstrably irrelevant or perverse in limiting the number of depositors that an individual, form or association could accept. Nor is there any element of compulsion on individuals and firms or associations which are not incorporated to incorporate themselves as a company. Chapter III-C imposes reasonable restrictions on the right of individuals firms and unincorporated association to carry on the business of acceptance of deposits and advancing or giving loans to the public. There is a further safeguard that Chapter III-C is being operated under the supervision and control of the Reserve Bank of India.Section 45T further provides that an officer of the Reserve Bank or the State Government, authorized in this behalf, may obtain a search warrant from courts so as to enable them to enter into and search any premises suspected to be used for the purpose connected with the receipt of the deposits in contravention of sections 45S. Such warrant shall be executed in the same way and shall have the same effect as a search warrant issued under the Code of Criminal Procedure, 1973.

II. Partnership FirmsA firm with more than ten partners cannot carry on banking business : it has to be registered as a company (Section 11(1) of the Companies Act, 1956). A banking firm of ten partners or less faces the same difficulties as an individual would face.The law relating to Partnership Firms is laid down in the Indian Partnership Act, 1932.

III. Hindu Joint Family System

A many places in India other than cities banking business was carried on by private banks owned by joint Hindu Families. The most prominent among these are the VAishya, the Jain and the Marathi families scattered all over India, the Nattukottai Chettys in the State of Madras; the Khatries and the Auroras in Punjab, and the Multanies in Gujarat and the Uttar Pradesh. This system bears striking resemblance to our modern joint stock banks in more than one respect. Its lie is institutional, and not personal, and as such, it enjoys unbroken continuity, it has a distinct existence in law and the going out or the coming in of persons makes not the slightest difference to the continuity of that body. The concept of Joint Hindu family is recognized by law. A business, according to that law, is a distinct heritable asset. Where a Hindu dies leaving a business it asses like other heritable properties to his heirs. If he dies leaving male issues it descends to them. In the hands of the male issues it becomes Joint Family business and the firm which consists of the male issued becomes a joint family firm (Mullas Hindu Law). The joint ownership is not an ordinary partnership arising out of contract but a family Partnership created by the operation of Law. The rights and liabilities of the co-partners constituting the family firm as also of the persons dealing with the firm are not to be determined by exlusive reference to the Indian Partnership Act but are to be considered with regard to certain rules of the Hindu Law.

IV Banking Companies and Corporations

The bulk of banking business now in India is carried on by scheduled banks which are the Banking Companies and the nationalized Banks. Bulk of the banking business in the country is in the public sector. There are altogether 27 banks in the public sector, comprising the State Bank of India and its 7 associate banks, 19 commercial banks nationalized in July 1969, and in April 1980. The public sector banks account for about 90% of the total banking business in India.

The provisions regulating the formation, management and administration of the banking companies in the Private sector are laid down in the Banking Regulation Act (previously known as the Banking Companies Act, 1949).

The Board of Directors of banking company in the private sector is to be constituted under section 10A of the Banking Ac.

The Chief Executive of such a banking company is the private sector is to be constituted under section 10A of the Banking Regulation Act.

The 19 banks in the public sector have their own directors appointed by the Central Government under the provisions of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 and 1980.

Unit Versus Branch BankingThe structure of banking differs from country to country depending upon the socio, economic and political conditions. Broadly speaking, there are two types of banking systems-branch banking and unit banking. There was a growing controversy among economist and bankers as to the relative superiority of the two banking systems. Even now the echo of the controversy has not altogether passed away. The controversy has, however, no practical significance.

Branch Banking

The branch banking system is a system in which every commercial bank has a network of branches operating throughout the country. Every bank is a separate legal entity and ahs one board of directors and one group of shareholders.

Merit of Branch Banking

Branch banking has certain definite advantage over unit banking. The following are some of them.

1. Advantage of the large scale - operations

Firstly, the branch banking system has the advantages of large scale operations. R.S. Sayers is also of the same view. Efficiency in administration, economy in working, effective central banking control, etc., are some of the important advantages of having branch banking system. The banking functions can be divided into a number of departments and placed under different individuals or groups of individuals. Bank officers can be given management and supervisory training at the training centres established for that specific purpose. Expert advice from the head office is always available to all the branches.

2. Economy of reserves

Every bank is supposed to keep a certain of its total deposits as cash reserves in order to gain and retain the public confidence at large. But profitability is an opposing cons

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Banking Theory Law and Practice