Money and Financial Markets
PART-III (Banking)
Chapter 14
Commercial Banking
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Origin and Growth of Money
• Ancient Rome and Greece
• Acceptance of deposits from Merchants was prevalent in England
in 17th century.
• Banking made its first appearance in Italy when the Bank of
Venice was founded in 1157.
According to Crowther, modern banking has three ancestors.
1. The Merchant
2. The Goldsmith
3. Goldsmith Notes
4. The Money Lender
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Meaning and functions of bank
Definition
• According to Crowther, a bank “collects money from those who have it to
spare or who are saving it out of their incomes, and it lends this money to
those who require it.”
Bank has the following features:
– Accept deposits and advances loans.
– Create credit.
– Commercial institution aims at earning profit.
– Creates demand deposits serving the medium of exchange and thereby
manages payment system.
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Functions of Commercial Bank
(Basic Function)
1. Accepting Deposits (Basic function)
i. Fixed Deposit Account
ii. Current Deposit Account
iii. Saving Deposit Account
iv. Recurring Deposit Account
v. Home Safe Account
2. Advancing of Loans
i. Money at call
ii. Cash Credit
iii. Overdraft
iv. Discounting of Bills of Exchange
v. Term Loans
3. Credit Creation
4. Promoting Cheque System
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Functions of Commercial Bank
Agency Function
5. Agency Function
i. Remittance of funds
ii. Collection and payment of credit instruments
iii. Execution of standing orders
iv. Purchasing and Sale of securities
v. Collection of dividends on shares
vi. Income tax consultancy
vii. Acting as trustee and executor
viii. Acting as representative and correspondent
ix. Recurring Deposit Account
x. Home Safe Account
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Functions of Commercial Bank
General Utility Function
6. General Utility Services
i. Locker facility
ii. Traveler's cheques
iii. Letter of credit
iv. Collection of statistics
v. Underwriting securities
vi. Gift Cheques
vii. Acting as referee
viii. Foreign exchange business
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Role of Commercial banks in a
Developing Economy
1. Capital Formation
2. Promotion of Entrepreneurial innovation
3. Monetization of economy
4. Influencing Economic Activity
i. Variations in interest rates
ii. Availability of credit
5. Implementation of monetary policy
6. Promotion of Trade and Industry
7. Encouragement to right type of industries
8. Regional development
9. Development of agriculture and other neglected sectors
– Sound Banking system for UDCs.
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Types of Banks
1. Commercial Banks
2. Industrial Banks
3. Agricultural Banks
4. Exchange Banks
5. Saving Banks
6. Central Bank
7. Classification on the basis of Ownership
Public Sector Banks; Private Sector Banks; Co-operative banks
8. Classification on the Basis of domicile
Domestic Banks; Foreign Banks
9. Schedules and non-scheduled banks
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Banking System
a. Branch Banking: A big bank acts as a single institution and under
single ownership operates through a network of branches spread all
over the country.
b. Unit Banking System: An individual bank operates through a single
office.
c. Group Banking: Two or more banks are directly controlled by a
corporation, an association or a business trust. The holding company
may or may not be a banking company.
d. Chain Banking: Two or more banks are brought under common control
by a device other than a holding company.
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Balance Sheet of a commercial Bank
Liabilities Assets
1. Share Capital 1. Cash
a. Authorized capital a. Cash in hand
b. Issued capital b. Cash with Central Bank
c. Subscribed capital c. Cash with other banks
d. Paid up capital
2. Reserve Funds 2. Money at call and short notice
3. Deposits 3. Bills purchased or discounted
a. Demand deposits
b. Time deposits
c. Saving Deposits
4. Borrowings from other banks 4. Investments
5. Acceptance and endorsements 5. Loans purchased or discounted
6. Other Liabilities 6. Acceptance and endorsements
7. Building and other fixed assets
Total Total
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Portfolio Management
A. Liquidity
B. Solvency
C. Profitability
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Credit Creation
– Meaning:
Banks have the ability to expand their demand deposits as a multiple of their cash
reserves. This multiple expansion of deposits is called credit creation. Expansion of demand
deposits means expansion of money supply.
Basic Concepts:
1. Bank as a business institution
2. Bank Deposits (Primary, Secondary)
3. Cash Reserve Ratio
4. Excess Reserves
5. Credit Multiplier:
For example, the CBs get new deposit of Rs. 10 crores and the CRR is 20%, the additional
aggregate deposits would be. crores
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Derivation of the formula:
Multiplying equation-1 by ;
Subtracting equation (1) from (2),
Or,
When the value of would be 0.
Thus,
Assumptions:
– Constant CRR
– Bank adjusts their assets to maintain fixed relation between liabilities and cash reserves.
– No leakage in the system.
– Well developed banking system with normal situation
– No credit control policy by the central bank.
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Credit Creation by Single Bank
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Multiple Credit Creation by Banking
System
• Destruction of Credit
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Limitation of Credit Creation
1. Amount of cash
2. CRR
3. Leakages (Excess Reserves; Currency Drain
4. Availability of borrowers
5. Availability of Securities
6. Credit Policy of other banks
7. Banking habits
8. Business conditions
9. Monetary policy
• Leaf-Canon Criticism
• Crowther’s Answer
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