2. COMMERCIAL BANK
A commercial bank is a financial institution which
performs the functions of accepting deposits from
the general public and giving loans for investment
with the aim of earning profit.
They generally finance trade and commerce with
short-term loans. They charge high rate of interest
from the borrowers but pay much less rate of
Interest to their depositors with the result that the
difference between the two rates of interest
becomes the main source of profit of the banks.
3. CLASSIFICATION OF
COMMERCIAL BANKS-
CLASSIFICATION OF COMMERCIAL BANKS- Commercial banks are classified
into two categories i.e. scheduled commercial banks and non-scheduled commercial
banks.
Scheduled commercial banks refer to the banks which are covered in the Reserve
Bank of India’s second schedule. Further, scheduled commercial banks are further
classified into three types:
1) Private Bank: When the private individuals own more than 51% of the share
capital, then that banking company is a private one. However, these banks are publicly
listed companies in a recognized exchange.
2)Public Bank: When the Government holds more than 51% of the share capital of a
publicly listed banking company, then that bank is called as Public sector bank.
3)Foreign Bank: Banks set up in foreign countries, and operate their branches in the
home country are called as foreign banks.
Non-scheduled commercial banks refer to the banks which are not covered in the
Reserve Bank of India’s second schedule. The paid-up capital of such banks is not
more than Rs. 5 lakhs.
4. Features of commercial bank
1. It accepts deposits from the public. These deposits can
be withdrawn by cheque and are repayable on demand.
2. A commercial bank uses the deposited money for
lending and for investment in securities.
3. It is a commercial institution, whose aim is to earn profit
4. It is a unique financial institution that creates demand
deposits which serves as the medium of exchange.
5. Money created by commercial banks is known as
deposit money.
5. Functions of Commercial
Banks:
The fundamental functions of commercial banks are as follows-
1) Acceptance of deposits – The primary function of banks is to accept
deposits. Banks accepts three types of deposits from the public under the
following accounts:—
(i) Fixed deposit account - Money in this account is accepted for a fixed
period and cannot be withdrawn before the expiry of that period. The
longer the period, the higher is the rate of interest.
(ii) Current account - The depositor can withdraw money from the
account whenever he requires it. Generally, the bank grants no interest on
this account. On the contrary, it levies certain incidental charge on
customer for the services rendered by it.
(iii) Saving bank account - Some restrictions are imposed on the
depositor under the account. For example, the customer can withdraw
only a specified sum of money in a week. The rate of interest allowed on
this account is rather low.
6. (2) Advancing of loans - The deposits received are given as loans and
advances by banks to the needy borrowers after keeping certain cash
reserves. The various types of loans and advances are as follows:—
(i) Ordinary loans - The bank gives a specified sum of money to a
person or a firm against some security. The loan money is credited to the
account of the borrower and he can withdraw the money according to his
requirements.
(ii) Cash credit - The bank gives loans to the borrowers against certain
securities. The entire loan is not given at one particular time. The bank
charges interest only on the amount withdrawn from the account. For
example, the bank allows the debtor to withdraw the money from time to
time up to a certain limit determined by the value of the stock kept in the
debtor’s safe.
(iii) Overdraft - The bank allows its respectable & reliable customers to
overdraw their accounts through cheques. The customer pay interest to
the bank on the amount overdrawn by them.
(iv) Discounting to the bills of exchange – the holder of an exchange
bill submits it to the bank and gets it immediately discounted by the bank.
The bank pays the present price of the bill to the holder after deducting its
commission. When the bill matures, the bank can secure its payment from
the party which had accepted the bill.
7. (3) Agency functions of the bank - The banks Perform the
following agency services:—
(i) Transfer of funds - The bank helps its customers in
transferring funds from one place to another through an
instrument known as 'bank draft'.
(ii) Collecting customer's funds - The bank collect the funds of
its customers from other banks and credit them to their accounts.
(iii) Purchase and sale of shares and securities for the
customers - The bank buys and sells stocks and shares of
private companies as well as government securities on behalf of
its customers.
(iv) Collecting dividends on the shares of the customers -
The bank collects dividends as well as interest on the shares and
debentures of the customers and credits them to their account.
(v) Payment of insurance premium - The bank pays premium
to the insurance companies on behalf of its customers.
(vi) Trustee and executor - The bank preserves the `wills' of the
customers and executes them after their death.
8. (4) Purchase and sale of foreign exchange - The bank also carries on the business of buying
and selling foreign currencies by the department of foreign exchange of the bank.
(5) Financing internal and foreign trade - The bank gives short-term loans to traders on the
security of commercial papers such as exchange bills. This provision greatly facilitates the
movement of internal and external trades.
(6) Miscellaneous functions of the bank - The bank will also attend the following functions:—
(i) Safe custody of valuable goods - The modern bank provides locker facilities to its
customers for which it charges them an annual rental.
(ii) Issuing of traveller's cheques - The bank also issues traveller's cheques or circular letters
of credit for the benefit of its customers.
(iii) Giving information about its customers - Since the bank is closely familiar with its
customers, it can pass on reliable information about their credit-worthiness to other parties of
other places.
(iv) Collection of statistics - The modern bank collects statistics about money, banking, trade
and commerce and publishes them in the form of pamphlets and handbills.
(v) Underwriting of company debentures - Private companies issue debentures for public
sale. But the public may hesitate in buying these debentures unless they have underwriting by
the banks. For underwriting these debentures, the banks charge small commission.
(vi) Accepting bills of exchange on behalf of customers - The banks accept exchange bills
on behalf of their trusted customers.
(vii) Financial advice - It gives useful advice to its customers on financial matters.
9. (7) Creation of credit - When the bank grants loan to its
customers, it generally does not lend out cash to the
customers concerned but opens an account in the
borrower's name and credits the amount of the loan to
his account. Thus, whenever a bank grants a loan, it
creates a deposit or liability against itself. As the deposits
of the bank circulate as money, the creation of such
deposits leads to a net increase in the money stock. This
is known as ‘creation of credit by the bank.'
10. Credit Creation by Commercial
Banks
Introduction: The creation of credit or deposits is
one of the most vital operations of the commercial
banks. Similar to other corporations, banks aim at
earnings profits. For this intention, they accept cash
in demand deposits and advance loans on credit to
customers. When a bank advances funds, it does not
pay the amount in currency notes. However, it
introduces a current account in the name of the
investor and lets him to withdraw the necessary
amount by cheques. By this way, banks create
deposits or credit.
11. Commercial bank Credit Creation
Meaning: The power of commercial banks to expand deposits
through loans, advances and investments is known as “credit
creation”.
Demand deposits mount in two ways:
When the customer deposits currency with commercial banks,
and
When banks advance loans, discount bills, provide overdraft
facilities and make deposit investments through bonds and
securities.
The first type of demand deposits is termed “primary deposits”.
Banks play a passive play in introducing them.
The second type of demand deposits is termed as “derivative
deposits”. Banks actively create deposits
12. Assumptions of credit creation
process
Assumptions: The credit creation process is based on the
following assumptions:
1 There is no leakage from the banking system. All the money
should remain with banking system.
2. The banks must receive new deposits.
3. They must be willing to make loans or buy securities.
4. The LRR (legal reserve ratio) remains constant through all the
stages.
5. People must be willing to borrow.
6. The business conditions are normal.
7. There is no credit control policy of central bank.
8. There should be popular banking habit in the country and a
well-developed banking system.
13. Limitation of credit creation
Limitation on Credit Creation
• Amount of Cash: The power to create credit depends
on the cash received by banks. If banks receive more
cash, they can create more credit.
• Legal Reserve Ratio: All deposits cannot be used for
credit creation. Banks must keep certain percentage of
deposits in cash as reserve.
• The Banking Habits of the People: The loan advanced
to a customer should again come back into banks as
primary deposit.
• Nature of Business Conditions in the Economy:
Credit creation will be large during a period of prosperity,
while it will be smaller during a depression.
