Professor Vipin 2014
Unit 3
Commercial Banks
Introduction
A Commercial Bank is a business organization which deals in money; it borrows and lends money. In this
borrowing and lending of money, it makes profit. The distinction between money lender and a
commercial bank may be noted. Whereas money lender only lends money to others and that too from
own sources; a commercial bank does both the lending and borrowing businesses.
Role of Commercial Banks
1. Accelerating the Rate of Capital Formation: Commercial banks encourage the habit of thrift and
mobilize the savings of people. These savings are effectively allocated among the ultimate users
of funds, i.e., investors for productive investment. So, savings of people result in capital
formation which forms the basis of economic development.
2. Provision of Finance and Credit: Commercial banks are a very important source of finance and
credit for trade and industry. The activities of commercial banks are not only confined to
domestic trade and commerce, but extend to foreign trade also.
3. Developing Entrepreneurship: Banks promote entrepreneurship by underwriting the shares of
new and existing companies and granting assistance in promoting new ventures or financing
promotional activities. Banks finance sick (loss-making) industries for making them viable units.
4. Promoting Balanced Regional Development: Commercial banks provide credit facilities to rural
people by opening branches in the backward areas. The funds collected in developed regions
may be channelized for investments in the under developed regions of the country. In this way,
they bring about more balanced regional development.
5. Help to Consumers: Commercial banks advance credit for purchase of durable consumer items
like Vehicles, T.V., refrigerator etc., which are out of reach for some consumers due to their
limited paying capacity. In this way, banks help in creating demand for such consumer goods.
Functions of Commercial Banks
The major functions of Commercial Banks are as follows:
1. Acceptance of Deposits: The main function of commercial banks is to accept deposits from the
public. Banks maintains demand deposits accounts for their customers and converts deposit
money into cash and vice versa, at the direction of the latter. Demand deposits are technically
accepted in current accounts, which are with draw able any time by the depositor by means of
cheques. Deposits are made in fixed deposit accounts which are with draw able only after a
specific period. Thus, fixed deposits are time liabilities of the banks. Deposits are also received in
saving bank accounts subject to certain restrictions on the amount receivable and with draw
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able. This is how banks pool the scattered savings of the community and serve as the reserves of
its savings.
2. Giving Loans and Advances: Another function of commercial banks is to extend loans and
advances out of the money which comes to them by way of deposits to businessmen and
entrepreneurs against approved securities such as gold or silver bullion, government securities,
easily saleable stocks and shares and marketable goods. Bank advances to customers may be
made in the following ways: (i) Overdrafts, (ii) discounting bills, (iii) money-at-call and short
notice, (iv) loans and advances (v) various forms of direct loans to traders and producers.
3. Using Cheque System: Banks also render important services by providing an expensive medium
of exchange, such as cheques. In modern business transactions, the use of cheques to settle
debts is found to be much more convenient than the use of cash. In fact, the cheque is also
known as the most developed credit instrument.
4. Other Functions: Commercial banks also perform a multitude of other non-banking functions
which may be classified as (a) agency services and (b) general utility services.
a) Agency services: The bankers perform certain functions for and on behalf of their
customers, such as:
i.
To act as executor, trustee and attorney for the customer’s will.
ii.
To collect or make payments for bills, cheques, promissory notes, interest,
dividends, rents, subscriptions, insurance premium, etc. For these services, some
charges are usually levied by the banks.
iii.
To remit funds on behalf of the clients by drafts or mail or telegraphic transfers.
iv.
To arrange income-tax experts to prepare income tax returns for their customers,
and help them to get refund of income tax in appropriate cases.
v.
To work as correspondents, agents or representatives of their clients.
b) General Utility Services: The modem Commercial banks usually perform certain general
utility services for society, such as:
i.
Bank drafts and traveler’s cheques are issued in order to provide facilities for
transfer of funds from one part of the country to another.
ii.
Letter of credit may be given by the banks to their customers to enable then to go
abroad.
iii.
Dealing with foreign exchange or finance foreign trade by accepting or collecting
foreign bills of exchange.
iv.
Shares floated by Government, Public bodies and corporations may be underwritten
by banks.
v.
Banks arrange the safe deposit vaults, to the customers, for their valuables.
vi.
Banks also compile statistics and business information relating to trade, commerce
and industry. Some banks may publish valuable journals or bulletins containing
research on financial economic and commercial matters.
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Investment Policy of Commercial Banks
A bank makes investments for the purpose of earning profits. First it keeps primary and secondary
reserves to meet its liquidity requirements.
This is essential to satisfy the credit needs of the society by granting short-term loans to its customers.
Whatever is left with the bank after making advances is invested for long period to improve its earning
capacity.
Before discussing the investment policy of a commercial bank, it is instructive to distinguish between a
loan and an investment because the usual practice is to regard the two as synonymous. The bank gives a
loan to a customer for a short period on condition of repayment.
It is the customer who asks for the loan. By advancing a loan, the bank creates credit which is a
temporary source of fund for the bank. An investment by the bank, on the other hand, is the outlay of
its funds for a long period without creating any credit. A bank makes investments in government
securities and in the stocks of large reputed industrial concerns, while in the case of a loan the bank
advances money against recognized securities and bills. However, the goal of both is to increase its
earnings.
The investment policy of a bank consists of earning high returns on its un-loaned resources. But it has to
keep in view the safety and liquidity of its resources so as to meet the potential demand of its
customers.
Since the objective of profitability conflicts with those of safety and liquidity, the wise investment policy
is to strike a judicious balance among them. Therefore, a bank should lay down its investment policy in
such a manner so as to ensure the safety and liquidity of its funds and at the same time maximize its
profits. This requires adherence to certain principles.
The Narasimham Committee
Problems Identified
1.
2.
Directed Investment Programme : The committee objected to the system of maintaining
high liquid assets by commercial banks in the form of cash, gold and unencumbered
government securities. It is also known as the statutory liquidity Ratio (SLR). In those days, in
India, the SLR was as high as 38.5 percent. According to the M. Narasimham's Committee it
was one of the reasons for the poor profitability of banks. Similarly, the Cash Reserve Ratio(CRR) was as high as 15 percent. Taken together, banks needed to maintain 53.5 percent of
their resources idle with the RBI.
Directed Credit Programme : Since nationalization the government has encouraged the
lending to agriculture and small-scale industries at a confessional rate of interest. It is known
as the directed credit programme. The committee opined that these sectors have matured
and thus do not need such financial support. This directed credit programme was successful
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3.
4.
from the government's point of view but it affected commercial banks in a bad manner.
Basically it deteriorated the quality of loan, resulted in a shift from the security oriented
loan to purpose oriented. Banks were given a huge target of priority sector lending, etc.
ultimately leading to profit erosion of banks.
Interest Rate Structure : The committee found that the interest rate structure and rate of
interest in India are highly regulated and controlled by the government. They also found
that government used bank funds at a cheap rate under the SLR. At the same time the
government advocated the philosophy of subsidized lending to certain sectors. The
committee felt that there was no need for interest subsidy. It made banks handicapped in
terms of building main strength and expanding credit supply.
Additional Suggestions : Committee also suggested that the determination of interest rate
should be on grounds of market forces. It further suggested minimizing the slabs of interest.
Narasimham Committee Report I - 1991
The Narsimham Committee was set up in order to study the problems of the Indian financial system and
to suggest some recommendations for improvement in the efficiency and productivity of the financial
institution.
The committee has given the following major recommendations:1. Reduction in the SLR and CRR: The committee recommended the reduction of the higher
proportion of the Statutory Liquidity Ratio 'SLR' and the Cash Reserve Ratio 'CRR'. Both of these
ratios were very high at that time. The SLR then was 38.5% and CRR was 15%. This high amount
of SLR and CRR meant locking the bank resources for government uses. It was hindrance in the
productivity of the bank thus the committee recommended their gradual reduction. SLR was
recommended to reduce from 38.5% to 25% and CRR from 15% to 3 to 5%.
2. Phasing out Directed Credit Programme: In India, since nationalization, directed credit
programmes were adopted by the government. The committee recommended phasing out of
this programme. This programme compelled banks to earmark then financial resources for the
needy and poor sectors at confessional rates of interest. It was reducing the profitability of
banks and thus the committee recommended the stopping of this programme.
3. Interest Rate Determination: The committee felt that the interest rates in India are regulated
and controlled by the authorities. The determination of the interest rate should be on the
grounds of market forces such as the demand for and the supply of fund. Hence the committee
recommended eliminating government controls on interest rate and phasing out the
concessional interest rates for the priority sector.
4. Structural Reorganizations of the Banking sector: The committee recommended that the actual
numbers of public sector banks need to be reduced. Three to four big banks including SBI should
be developed as international banks. Eight to Ten Banks having nationwide presence should
concentrate on the national and universal banking services. Local banks should concentrate on
region specific banking. Regarding the RRBs (Regional Rural Banks), it recommended that they
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should focus on agriculture and rural financing. They recommended that the government should
assure that henceforth there won't be any nationalization and private and foreign banks should
be allowed liberal entry in India.
5. Establishment of the ARF Tribunal: The proportion of bad debts and Non-performing asset (NPA)
of the public sector Banks and Development Financial Institute was very alarming in those days.
The committee recommended the establishment of an Asset Reconstruction Fund (ARF). This
fund will take over the proportion of the bad and doubtful debts from the banks and financial
institutes. It would help banks to get rid of bad debts.
6. Removal of Dual control: Those days’ banks were under the dual control of the Reserve Bank of
India (RBI) and the Banking Division of the Ministry of Finance (Government of India). The
committee recommended the stepping of this system. It considered and recommended that the
RBI should be the only main agency to regulate banking in India.
7. Banking Autonomy: The committee recommended that the public sector banks should be free
and autonomous. In order to pursue competitiveness and efficiency, banks must enjoy
autonomy so that they can reform the work culture and banking technology up gradation will
thus be easy.
Narasimham Committee Report II - 1998
In 1998 the government appointed yet another committee under the chairmanship of Mr. Narsimham. It
is better known as the Banking Sector Committee. It was told to review the banking reform progress and
design a programme for further strengthening the financial system of India. The committee focused on
various areas such as capital adequacy, bank mergers, bank legislation, etc.
It submitted its report to the Government in April 1998 with the following recommendations.
1. Strengthening Banks in India: The committee considered the stronger banking system in the
context of the Current Account Convertibility 'CAC'. It thought that Indian banks must be
capable of handling problems regarding domestic liquidity and exchange rate management in
the light of CAC. Thus, it recommended the merger of strong banks which will have 'multiplier
effect' on the industry.
2. Narrow Banking: Those days many public sector banks were facing a problem of the Nonperforming assets (NPAs). Some of them had NPAs were as high as 20 percent of their assets.
Thus for successful rehabilitation of these banks it recommended 'Narrow Banking Concept'
where weak banks will be allowed to place their funds only in short term and risk free assets.
3. Capital Adequacy Ratio: In order to improve the inherent strength of the Indian banking system
the committee recommended that the Government should raise the prescribed capital
adequacy norms. This will further improve their absorption capacity also. Currently the capital
adequacy ratio for Indian banks is at 9 percent.
4. Bank ownership: As it had earlier mentioned the freedom for banks in its working and bank
autonomy, it felt that the government control over the banks in the form of management and
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ownership and bank autonomy does not go hand in hand and thus it recommended a review of
functions of boards and enabled them to adopt professional corporate strategy.
5. Review of banking laws: The committee considered that there was an urgent need for reviewing
and amending main laws governing Indian Banking Industry like RBI Act, Banking Regulation Act,
State Bank of India Act, Bank Nationalization Act, etc. This up gradation will bring them in line
with the present needs of the banking sector in India.
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