Meaning of Commercial Banks

Commercial Banks are one of the most important financial institution of a financial system. In our country it
has responsibility of implementing the monetary policy that framed by the Reserve Bank of India. These banks
are concerned with accepting of money from public at large, repayable on demand or otherwise and
withdrawals by cheque, draft, withdrawal slip, order or otherwise and employing those deposits so pooled in
the form of loans and investments to meet the financial needs of the business and other class of economy. It
acts as the mobilisers of the public savings for their productive utilisations. However the mechanism that is
provided by the commercial banks for the moblisation of the savings of public is different from other financial
institutions as deposits with other financial institutions does not circulate as money but the deposits in the
commercial banks circulate as money in the form of advances provided to the public. In our country
commercial banks are functioning in the form of public limited company.
General functions of Commercial Banks
❖ Acceptance of deposits from the public
❖ Provide demand withdrawal facility
❖ Lending facility
❖ Transfer of funds
❖ Issue of drafts
❖ Provide customers with locker facilities
❖ Dealing with foreign exchange
Repository functions of Commercial Banks
Commercial Banks acts as the repository of savings of public. It provides their customer a range of financial
investments to choose from the current deposits repayable on demand and saving which are also payable on
demand but some interest is paid by the commercial banks to its customers in saving bank account deposits.
Fixed deposit in which the amount is fixed for a particular period and customers are paid these fixed amount
with interest. Recurring deposits in which a particular sum of money is regularly in the recurring deposit
account of the customer and this sum is also paid to the customer on demand with interest after the expiry of
particular period.
Deployment function of Commercial Banks
Under this function of commercial banks, it utilizes the funds by way of granting loans and advances, investing
them in industrial securities by underwriting industrial issues. A major portion funds deposited in the
commercial banks are employed as loans. Loans are provided in varieties of ways, according to their form,
security, maturity, method of repayment, origin and purpose.
Types of Loans and Advances
❖ Call or Notice Loans
❖ Cash Credit
❖ Overdrafts
❖ Purchasing and Discounting of Bills
❖ Loans
Call or notice loans
These types of loans are granted to a customer for a period from an overnight to a maximum of 14 days. It is
used for temporary purposes and are granted without securities. These credit facilities are provided by one
commercial bank to other commercial banks also.
Cash Credit
It is an arrangement under which a borrower is allowed to borrow up to a certain limit against the security of
tangible assets or guarantees. Thus, cash credit may be regrouped as a secured cash credit and a clean cash
credit. Under secured cash credit, the customer is required to provide tangible assets as security to cover the
amount borrowed from the bank. In case of clean cash credit, the customer provides the bank with a promissory
note, which is signed by one or more sureties or guarantors.
Cash credit account is a running account in which withdrawals and deposits can be made frequently. The
customer has to pay the interest only on the amount actually utilized by him and not on the limit granted.
Overdrafts
Under this arrangement, the bank allows its customer to overdraw his current account. Any business person
can enter into this arrangement in the situation of a temporary shortage of funds. The bank may or may not
take some tangible security of the borrower. The customer can draw his fund as and when he requires and
repay it when it is convenient for him. The operation of overdraft is same as that of cash credit with the main
difference that cash credit is a little long-period accommodation. The customer is charged interest on the
amount actually overdrawn by him and not on the limit sanctioned.
Purchasing and Discounting of Bills
The bank provides its customers with the facility of purchasing and discounting of their bills receivable. This
is a method of financial accommodation offered by the banker to their customers. The bank permits the
customer to discount his bills receivable and have the value of the bills credited to his account. The bank
charges on the face value of the bills. It waits till the maturity of the bill and presents it on the due date to the
drawee for payment. After collection, the proceeds of the bill are appropriated towards the loan and interest
due by the customer. If the bill is dishonored, the amount will be recovered from the customer.
Loans
A loan is different from a cash credit. Cash credit is of a continuing nature, i.e., money can be withdrawn or
paid into the cash credit account and interest will be charged only on the actual credit. But in case of a loan,
the interest is charged on the entire amount and a loan once repaid in full or in part cannot be drawn again. A
borrower has to apply for a fresh loan if he needs funds. The second transaction will be totally distinct from
the first one. Commercial Banks generally advance loans for short-terms, medium terms and long term. Since
the banks charge interest on the entire amount of loans, this way of raising funds is costlier to the customer as
compared to cash credits and overdrafts but huge amounts can be withdrawn through loan only.
Types of Loans
❖ On the basis of purpose
➢ Commercial Loans: to meet the requirement of working capital of business organisation.
➢ Industrial Loans: for the construction of a manufacturing unit or plant.
➢ Agricultural Loans: to meet the expenses of cultivation of crops.
➢ Educational Loans: to meet the expenses of education.
➢ Housing Loans: for the construction or purchase of house.
➢ Medical Loans: to meet the medical expenses.
 ➢ Personal Loans: no purpose specified
❖ On the basis of period
➢ Short- term loans (less than one year)
➢ Medium term loans (one to three years)
➢ Long term loans (more than three years)
❖ On the basis of security
➢ Secured Loans (Charges against the tangible assets of the borrower)
➢ Unsecured Loans (No charges against the tangible assets of the borrowers but sureties or
guarantors are required)
Credit Creation By Commercial Banks
Concept of Credit Creation
Credit creation is one of the most important function of commercial banks and for this function, commercial
banks are also called as manufacturer of money and through this function the commercial really multiplies
money. In the process of credit creation the deposits in the commercial banks plays a vital role. Banks offers
two kinds of deposits to its customers such as the primary deposits and secondary deposits which is also called
as derivative deposits. Primary deposits refers to those deposit which the banks receives in the form of deposits
by its saving bank account and current account holder. Secondary or Derivative deposits are those deposits
which the bank creates for its customers who have taken loans and advances.
The commercial banks cannot advance all the deposits of its customers. Some percentage of deposits must be
held by the bank in the forms of reserves which are known as the Cash Reserve Ratio (CRR) and Statutory
Liquidity Ratio (SLR). CRR must be only in the form of Cash and SLR must be in the form of Cash, Gold
and Govt. Securities.
The current rate (26.05.2021) of CRR and SLR are 3 % and 18 % respectively. The rate of CRR and SLR is
not fixed and it changes according to the situation in the economic system as both of them are one the important
tools of monetary policy that is framed by the Reserve Bank of India.
Assumptions
• Banks do not accept time deposits.
• All the deposits of the banks will not be withdrawn at the same time.
• All banks have to keep the same reserve requirement that is 20 % (take it as an example)
• Banks have no desire to hold excess reserves with them.
• There is no cash drain by the public.
Process of Credit Creation
• Mr. A has a saving bank account in the SBI and he deposited Rs 10,000 in that.
• From the Rs 10,000 that is deposited by Mr. A, the bank kept Rs 2,000 (20% of 10,000) as reserve and
advanced Rs 8,000 to Mr. B as loan.
 • Now the balance sheet of Bank will be like this
Liabilities Amount Assets Amount
Rs Rs

Demand Deposits (Primary) 10,000 Cash 10,000

Demand Deposits (Derivative) 8,000 Loan to Mr. B 8,000

• Mr. B has a saving bank account in the PNB and he deposited Rs 8,000 in that.
• From the Rs 8,000 that is deposited by Mr. B, the bank kept Rs 1,600 (20% of 10,000) as reserve and
advanced Rs 6,400 to Mr. C as loan.
• Now the balance sheet of Bank will be like this

Liabilities Amount Assets Amount

Rs Rs

Demand Deposits (Primary) 8,000 Cash 8,000

Demand Deposits (Derivative) 6,400 Loan to Mr. C 6,400

• Mr. C has a saving bank account in the IOB and he deposited Rs 6,400 in that.
• From the Rs 6,400 that is deposited by Mr. B, the bank kept Rs 1,280 (20% of 6,400) as reserve and
advanced Rs 5, 120 to Mr. D as loan.
• Now the balance sheet of Bank will be like this

Liabilities Amount Assets Amount

Rs Rs

Demand Deposits (Primary) 6,400 Cash 6,400

Demand Deposits (Derivative) 5,120 Loan to Mr. D 5,120

Credit creation by Commercial Banks

Banks Deposits Reserves Loans

SBI 10,000 2,000 8,000

PNB 8,000 1,600 6,400

IOB 6,400 1,280 5,120

Total 24,400 4,880 19,520

48,800

Investment Policy of Commercial Banks

In our country, commercial banks are incorporated as companies whose aim is also to earn profit. There some
routine work of commercial banks such as accepting of deposits and advancing those of deposits as loans to
its customers. Through advancing of loans, the commercial banks generate income as they charge interest on
the advances provided by them. Apart from these routine works the commercial banks has to do some financial
investing activities to earn more profit. And for the earning of more profit, commercial banks employ their
surplus funds in the investment of financial instruments. Because of the prudent nature of the Indian
Commercial Banks, the banks keeps some primary reserves such as CRR and SLR and secondary reserve such
as general reserve and other similar reserves to maintain its liquidity.
For the investment policy of Commercial Banks, they have to cope up with three factor such as liquidity,
safety and profitability and all these three factors are not available in any one investment. If the banks opts for
liquidity and safety and it has to sacrifice the high profitability and if it opts profitability than it has to sacrifice
the safety. One of the limitation of banking investment policy is that it can only invest in financial instruments
for the earning of profit because financial investment are more liquid and convenient in comparison to other
investments. And to earn more profit it cannot employ its funds into risky ventures as we know that liquidity
and safety of fund is most important for the banks because the banks have funds in the forms deposits which
are deposited by its account holders. For the investment of banking funds has to cope with the liquidity, safety
and profitability which is not an easy task.
Principles of Banking Investment Policy
 Principle of Liquidity: liquidity is an important principle of banking investment policy because the
banks employ the money of its depositors in the investment which can be demanded by them at any
time. Therefore, the commercial banks should invest in that securities and bonds that are issued by
the central, state and local government which can be liquidated easily without affecting the market
 prices. Share and debentures of large industrial concerns also falls in this category. Therefore the
commercial banks should invest in the government securities and shares and debentures of well
established and reputed companies.
 Principle of Safety: Safety is also one of the important principle of banking investment policy.
Investment involve risk but the degree of risk varies with the type of investment. The securities of
central government are safer than that of state government and local bodies and the securities of state
government and local bodies are safer than that of industrial concerns. Therefore while making
investment the banks should opt for that class of securities that satisfy the principle of safety of banking
investment.
 Principle of Diversity: In opting the investment the bank should follow the principle of diversity and
it should not invest its maximum funds in one type of securities. Therefore it should invest in the shares
and debenture of that well established and reputed companies that are running different kind of
business and this principle must also be followed in investing in the securities of the central, state
government and local bodies. This principle of diversity is based on the principle “Do not keep all eggs
in one basket”