UNIT 3

COMMERCIAL BANKS
INTRODUCTION
In modern economy commercial Banks play an important role in the financial
sector. Commercial banks are those banks which perform all kinds of banking
functions such as accepting deposits, advancing loans, credit creation, and agency
functions. They are also called joint stock banks because they are organized in the
same manner as joint stock companies.
They usually advance short-term loans to customers. Of late, they have started
giving medium term and long-term loans also. In India 20 major commercial banks
have been nationalized, whereas in developed countries they are run like joint
stock companies in the private sector. Some of the commercial banks in India are
Andhra Bank, Canara Bank, Indian Bank, Punjab National Bank, etc.

MEANING
A commercial bank is a financial institution that is authorized by law to receive
money from businesses and individuals and lend money to them. Commercial
banks are open to the public and serve individuals, institutions, and businesses. A
commercial bank is almost certainly the type of bank you think of when you think
about a bank because it is the type of bank that most people regularly use.
Banks are regulated by federal and state laws depending on how they are organized
and the services they provide. Commercial banks are also monitored through the
Federal Reserve System.

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St. Josephs Evening College (Autonomous)

DEFINITION
While defining the term banks it is taken into account that what type of task is
performed by the banks. Some of the famous definitions are given below:
According to Prof. Sayers, "A bank is an institution whose debts are widely
accepted in settlement of other people's debts to each other." In this definition
Sayers has emphasized the transactions from debts which are raised by a
financial institution.
According to the Indian Banking Company Act 1949, "A banking company
means any company which transacts the business of banking. Banking means
accepting for the purpose of lending of investment of deposits of money from the
public, payable on demand or other wise and withdraw able by Cheques, draft or
otherwise."

TYPES OF COMMERCIAL BANKS

(a)

Public Sector Banks: Refer to a type of commercial banks that are

nationalized by the government of a country. In public sector banks, the
major stake is held by the government. In India, public sector banks operate
under the guidelines of Reserve Bank of India (RBI), which is the central
bank. Some of the Indian public sector banks are State Bank of India (SBI),
Corporation Bank, Bank of Baroda, Dena Bank, and Punjab National Bank.

(b)

Private Sector Banks: Refer to a kind of commercial banks in which major

part of share capital is held by private businesses and individuals. These
banks are registered as companies with limited liability. Some of the Indian
private sector banks are Vysya Bank, Industrial Credit and Investment
Corporation of India (ICICI) Bank, and Housing Development Finance
Corporation (HDFC) Bank.
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St. Josephs Evening College (Autonomous)

(c)

Foreign Banks: Refer to commercial banks that are headquartered in a

foreign country, but operate branches in different countries. Some of the
foreign banks operating in India are Hong Kong and Shanghai Banking
Corporation (HSBC), Citibank, American Express Bank, Standard &
Chartered Bank, and Grindlays Bank. In India, since financial reforms of
1991, there is a rapid increase in the number of foreign banks. Commercial
banks mark significant importance in the economic development of a
country as well as serving the financial requirements of the general public.

ROLE OF COMMERCIAL BANKS

Besides performing the usual commercial banking functions, banks in developing
countries play an effective role in their economic development. The majority of
people in such countries are poor, unemployed and engaged in traditional
agriculture. There is acute shortage of capital. People lack initiative and enterprise.
Means of transport are undeveloped. Industry is depressed. The commercial banks
help in overcoming these obstacles and promoting economic development. The
role of a commercial bank in a developing country is discussed as under.

1. Mobilizing Saving for Capital Formation:

The commercial banks help in mobilising savings through network of branch
banking. People in developing countries have low incomes but the banks induce
them to save by introducing variety of deposit schemes to suit the needs of
individual depositors. They also mobilise idle savings of the few rich. By
mobilising savings, the banks channelise them into productive investments. Thus
they help in the capital formation of a developing country.
2. Financing Industry:

Asst. Prof. Prashanth Kumar (M.A Economics)

St. Josephs Evening College (Autonomous)

The commercial banks finance the industrial sector in a number of ways. They
provide short-term, medium-term and long-term loans to industry. In India they
provide short-term loans. Income of the Latin American countries like Guatemala,
they advance medium-term loans for one to three years. But in Korea, the
commercial banks also advance long-term loans to industry.
In India, the commercial banks undertake short-term and medium-term financing
of small scale industries, and also provide hire- purchase finance. Besides, they
underwrite the shares and debentures of large scale industries. Thus they not only
provide finance for industry but also help in developing the capital market which is
undeveloped in such countries.
3. Financing Trade:
The commercial banks help in financing both internal and external trade. The
banks provide loans to retailers and wholesalers to stock goods in which they deal.
They also help in the movement of goods from one place to another by providing
all types of facilities such as discounting and accepting bills of exchange,
providing overdraft facilities, issuing drafts, etc. Moreover, they finance both
exports and imports of developing countries by providing foreign exchange
facilities to importers and exporters of goods.
4. Financing Agriculture:
The commercial banks help the large agricultural sector in developing countries in
a number of ways. They provide loans to traders in agricultural commodities. They
open a network of branches in rural areas to provide agricultural credit. They
provide finance directly to agriculturists for the marketing of their produce, for the
modernization and mechanization of their farms, for providing irrigation facilities,
for developing land, etc.
They also provide financial assistance for animal husbandry, dairy farming, sheep
breeding, poultry farming, seri-culture and horticulture. The small and marginal
farmers and landless agricultural workers, artisans and petty shopkeepers in rural
areas are provided financial assistance through the regional rural banks in India.
These regional rural banks operate under a commercial bank. Thus the commercial
banks meet the credit requirements of all types of rural people.
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St. Josephs Evening College (Autonomous)

5. Financing Consumer Activities:

People in underdeveloped countries being poor and having low incomes do not
possess sufficient financial resources to buy durable consumer goods. The
commercial banks advance loans to consumers for the purchase of such items as
houses, scooters, fans, refrigerators, etc. In this way, they also help in raising the
standard of living of the people in developing countries by providing loans for
consumptive activities.
6. Financing Employment Generating Activities:
The commercial banks finance employment generating activities in developing
countries. They provide loans for the education of young persons studying in
engineering, medical and other vocational institutes of higher learning. They
advance loans to young entrepreneurs, medical and engineering graduates, and
other technically trained persons in establishing their own business. Such loan
facilities are being provided by a number of commercial banks in India. Thus the
banks not only help inhuman capital formation but also in increasing
entrepreneurial activities in developing countries.
7. Help in Monetary Policy:
The commercial banks help the economic development of a country by faithfully
following the monetary policy of the central bank. In fact, the central bank depends
upon the commercial banks for the success of its policy of monetary management
in keeping with requirements of a developing economy.
Thus the commercial banks contribute much to the growth of a developing
economy by granting loans to agriculture, trade and industry, by helping in
physical and human capital formation and by following the monetary policy of the
country

Asst. Prof. Prashanth Kumar (M.A Economics)

St. Josephs Evening College (Autonomous)

FUNCTIONS OF COMMERCIAL BANKS

Commercial banks are institutions that conduct business for profit motive by
accepting public deposits for various investment purposes.
The functions of commercial banks are broadly classified into primary
functions and secondary functions as shown in the below figure:

PRIMARY FUNCTIONS:
1. ACCEPTING DEPOSITS: This functions of Commercial banks indicates that
commercial banks are mainly dependent on public deposits. The different types
of deposits are discussed as follows:
a. Current Account Deposits: Current Accounts are usually opened by
businessmen who have a number of regular transactions with the bank, both
deposits and withdrawals. There is no restriction on number and amount of
deposits. There is also no restriction on withdrawals. No interest is paid on
current deposits. Banks may even charge interest for providing this facility.
These accounts are also known as demand deposits as amount can be
withdrawn on demand.

Asst. Prof. Prashanth Kumar (M.A Economics)

St. Josephs Evening College (Autonomous)

b. Saving Account Deposits: Saving Accounts are opened by salaried and

other less income people. There is no restriction on number and amount of
deposits. Withdrawals are subject to certain restrictions. It earns Interest but
less than fixed deposits. It encourages saving habit among salary earners and
others. Saving deposits are an important source of funds for banks.
c. Fixed Account Deposits: Deposits in fixed account are time deposits.
Money under this account is deposited for a certain fixed period of time
varying from 15 days to several years. A high rate of interest is paid. If
money is withdrawn before expiry date, the depositor receives lower rate of
interest. Deposits can be renewed for further period. Many banks sanction
loans against security of fixed deposits.
d. Recurring Account Deposits: In Recurring deposit, a specified amount is
regularly deposited by account holder, at an internal of usually a month. This
is to form the habit of small savings among the people. At the end of
maturity period, the account holder gets a substantial amount. Interest on
this type of deposit is almost equal to fixed deposits.
Thus by creating variety of deposits, banks motivate people in a variety of ways
and encourage savings in the economy.

2. ADVANCING LOANS: It refers to one of the important functions of

commercial banks. The public deposits are used by commercial banks for the
purpose of granting loans to individuals and businesses. Commercial banks
grant loans in the form of overdraft, cash credit, and discounting bills of
exchange.

SECONDARY FUNCTIONS:
It refers to crucial functions of commercial banks. The secondary functions
can
be classified under three heads, namely, agency functions, general utility functions,
and other functions. These functions are explained as follows:
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St. Josephs Evening College (Autonomous)

1. AGENCY FUNCTIONS: It implies that commercial banks act as agents of

customers by performing various functions, which are as follows:
a. Collecting Cheques: It refers to one of the important functions of
commercial banks. The banks collect checks and bills of exchange on the
behalf of their customers through clearing house facilities provided by the
central bank.
b. Collecting Income: Commercial banks collect dividends, pension, salaries,
rents, and interests on investments on behalf of their customers. A credit
voucher is sent to customers for information when any income is collected
by the bank.
c. Paying Expenses: It implies that commercial banks make the payments of
various obligations of customers, such as telephone bills, insurance
premium, school fees, and rents. Similar to credit voucher, a debit voucher is
sent to customers for information when expenses are paid by the bank.

2. GENERAL UTILITY FUNCTIONS: This include the following functions:

a. Providing Locker Facilities: Commercial banks provide locker facilities to
its customers for safe keeping of jewellery, shares, debentures, and other
valuable items. This minimizes the risk of loss due to theft at homes.
b. Issuing Travelers Checks: Commercial banks issue travelers cheques to
individuals for traveling outside the country. Travelers cheques are the safe
and easy way to protect money while traveling.
c. Dealing in Foreign Exchange: Commercial banks help in providing foreign
exchange to businessmen dealing in exports and imports. However,
commercial banks need to take the permission of the central bank for dealing
in foreign exchange.

Asst. Prof. Prashanth Kumar (M.A Economics)

St. Josephs Evening College (Autonomous)

d. Transferring Funds: It refers to transferring of funds from one bank to

another. Funds are transferred by means of draft, telephonic transfer, and
electronic transfer.

3. OTHER FUNCTIONS: This include the following functions:

a. Electronic Banking: Include services, such as debit cards, credit cards, and
Internet banking.
b. Housing Finance: Housing finance is provided against the security of
immoveable property of land and buildings. Many banks such as SBI, Bank
of India etc. have set up housing finance subsidiaries.
c. Mutual Funds: A Mutual fund is a financial intermediary that pools the
savings of investors for collective investment in diversified portfolio
securities many banks like SBI, Indian Bank etc. have set up mutual fund
subsidiaries.
d. Venture Capital Fund: Venture capital fund provides start-up share capital
to new ventures of little known, unregistered, risky, young and small private
business, especially in technology oriented and knowledge intensive
business. Many commercial banks like SBI, Canara Bank etc. have set up
venture Capital Fund Subsidiaries.

INVESTMENT POLICY OF COMMERCIAL BANKS

The financial position of a commercial bank is reflected in its balance sheet. The
balance sheet is a statement of the assets and liabilities of the bank. The assets of
the bank are distributed in accordance with certain guiding principles. These
principles underline the investment policy of the bank. They are discussed below:

Asst. Prof. Prashanth Kumar (M.A Economics)

St. Josephs Evening College (Autonomous)

1. LIQUIDITY: In the context of the balance sheet of a bank the term liquidity
has two interpretations. First, it refers to the ability of the bank to honor the
claims of the depositors. Second, it connotes the ability of the bank to
convert its non-cash assets into cash easily and without loss. It is a wellknown fact that a bank deals in funds belonging to the public. Hence, the
bank should always be on its guard in handling these funds. The bank should
always have enough cash to meet the demands of the depositors. In fact, the
success of a bank depends to a considerable extent upon the degree of
confidence it can instill in the minds of its depositors. If the depositors lose
confidence in the integrity of their bank, the very existence of the bank will
be at stake. So, the bank should always be prepared to meet the claims of the
depositors by having enough cash. Among the various items on the assets
side of the balance sheet, cash on hand represents the most liquid asset. Next
comes cash with other banks and the central bank. The order of liquidity
goes on descending.
Liquidity also means the ability of the bank to convert its non-cash assets
into cash easily and without loss. The bank cannot have all its assets in the
form of cash because each is an idle asset which does not fetch any return to
the bank.
So some of the assets of the bank, money at call and short notice, bills
discounted, etc. could be made liquid easily and without loss.
2. PROFITABILITY: A commercial bank by definition, is a profit hunting
institution. The bank has to earn profit to earn income to pay salaries to the
staff, interest to the depositors, dividend to the shareholders and to meet the
day-to-day expenditure.
Since cash is the least profitable asset to the bank, there is no point in
keeping all the assets in the form of cash on hand. The bank has got to earn
income. Hence, some of the items on the assets side are profit yielding
assets.

Asst. Prof. Prashanth Kumar (M.A Economics)

St. Josephs Evening College (Autonomous)

They include money at call and short notice, bills discounted, investments,
loans and advances, etc. Loans and advances, though the least liquid asset,
constitute the most profitable asset to the bank.
Much of the income of the bank accrues by way of interest charged on loans
and advances. But, the bank has to be highly discreet while advancing loans.
3. SAFETY OR SECURITY: Apart from liquidity and profitability, the bank
should look to the principle of safety of its funds also for its smooth
working. While advancing loans, it is necessary that the bank should
consider the three Cs of credit character, capacity and the collateral of the
borrower.
The bank cannot afford to invest its funds recklessly without considering the
principle of safety. The loans and investments made by the bank should be
adequately secured. For this purpose, the bank should always insist on
security of the borrower. Of late, somehow or other the banks have not been
paying adequate importance to safety, particularly in India.
4. DIVERSITY: The bank should invest its funds in such a way as to secure
for itself an adequate and permanent return. And while investing its funds,
the bank should not keep all its eggs in the same basket. Diversification of
investment is necessary to avoid the dangerous consequences of investing in
one or two channels. If the bank invest its funds in different types of
securities or makes loans and advances to different objectives and
enterprises, it shall ensure for itself a regular flow of income.
5. SALEABILITY OF SECURITIES: Further, the bank should invest its
funds in such types of securities as can be easily marketed at a time of
emergency. The bank cannot afford to invest its funds in very long term
securities or those securities which are unsaleable.
It is necessary for the bank to invest its funds in government or in first class
securities or in debentures of reputed firms. It should also advance loans
against stocks which can be easily sold.
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St. Josephs Evening College (Autonomous)

6. STABILITY IN THE VALUE OF INVESTMENTS: The bank should

invest its funds in those stocks and securities the prices of which are more or
less stable. The bank cannot afford to invest its funds in securities, the prices
of which are subject to frequent fluctuations.
7. PRINCIPLES OF TAX-EXEMPTION OF INVESTMENTS: Finally, the
investment policy of a bank should be based on the principle of tax
exemption of investments. The bank should invest in those government
securities which are exempted from income and other taxes. This will help
the bank to increase its profits.
PROFITABILITY V/S LIQUIDITY
Of late, there has been a controversy regarding the relative importance of the
various principles influencing the investment policy of a bank particularly between
liquidity and profitability.
It is interesting to examine this controversy.
Let us examine what happens if the bank sticks to the principle of liquidity only. It
is true that if the bank pays importance to liquidity, it can easily meet the demands
of the depositors. The bank should have adequate cash to meet the claims of the
depositors. It is true that a successful banking business calls for installing
confidence in the minds of the depositors. But, it should be noted that accepting
deposits is not the only function of a bank.
Moreover, the bank cannot afford to forget the fact that it has to earn income to pay
salaries to the staff, interest to the depositors, dividend to the shareholders and
meet the day-to-day expenditure. If the bank keeps all its resources in liquid form,
it will not be able to earn even a rupee.
But profitability is a must for the bank. Though cash on hand is the most liquid
asset, it is the least profitable asset as well. Cash is an idle asset. Hence, the banker
cannot concentrate on liquidity only. If the bank attaches importance to
profitability only, it would be equally disastrous to the very survival of a bank. It is
true that a bank needs income to meet its expenditure and pay returns to the
Asst. Prof. Prashanth Kumar (M.A Economics)
St. Josephs Evening College (Autonomous)

depositors and shareholders. The bank cannot undermine the interests of the
depositors.
If the bank lends out all its funds, it will be left with no cash at all to meet the
claims of the depositors. It should be noted that the bank should have cash to
honour the obligations of the depositors. Otherwise, there will be a run on the
bank.
A run on the bank would be suicidal to the very existence of the bank. Loans and
advances, though the most profitable asset, constitute the least liquid asset. It
follows from the above that the choice is between liquidity and profitability. The
constant tug of war between liquidity and profitability is the feature of the assets
side.
According to Crowther, liquidity and profitability are opposing or conflicting
considerations. The secret of successful banking lies in striking a balance between
the two.
NARASIMHAM COMMITTEE ON BANKING SECTOR REFORMS (1998)
From the 1991 India economic crisis to its status of third largest economy in the
world by 2011, India has grown significantly in terms of economic development.
So has its banking sector. During this period, recognizing the evolving needs of the
sector, the Finance Ministry of Government of India (GOI) set up various
committees with the task of analyzing India's banking sector and recommending
legislation and regulations to make it more effective, competitive and efficient.
[1]
Two such expert Committees were set up under the chairmanship of M.
Narasimham. They submitted their recommendations in the 1990s in reports
widely known as the Narasimham Committee-I (1991) report and the
Narasimham Committee-II (1998) Report. These recommendations not only
helped unleash the potential of banking in India, they are also recognized as a
factor towards minimizing the impact of global financial crisis starting in 2007.
Unlike the socialist-democratic era of the 1960s to 1980s, India is no longer
insulated from the global economy and yet its banks survived the 2008 financial
crisis relatively unscathed, a feat due in part to these Narasimham Committees.

Asst. Prof. Prashanth Kumar (M.A Economics)

St. Josephs Evening College (Autonomous)

RECOMMENDATIONS OF NARASIMHAM COMMITTEE - (1998)

M. Narasimham headed the committee on review of financial sector reforms. It
submitted its report in April, 1998.

The main recommendations of the committee are as follows:

1. Autonomy in Banking: Greater autonomy was proposed for the public
sector banks in order for them to function with equivalent professionalism as
their international counterparts. For this the panel recommended that
recruitment procedures, training and remuneration policies of public sector
banks be brought in line with the best-market-practices of professional bank
management. Secondly, the committee recommended GOI equity in
nationalized banks be reduced to 33% for increased autonomy. It also
recommended the RBI resign its seats on the board of directors of these
banks. The committee further added that given that the government
nominees to the board of banks are often members of parliament, politicians,
bureaucrats, etc., they often interfere in the day-to-day operations of the
bank in the form of the behest-lending. As such the committee
recommended a review of functions of banks boards with a view to make
them responsible for enhancing shareholder value through formulation of
corporate strategy and reduction of government equity.

Asst. Prof. Prashanth Kumar (M.A Economics)

St. Josephs Evening College (Autonomous)

2. Reform in the role of RBI: First, the committee recommended that the RBI
withdraw from the 91-day treasury bills market and that interbank call
money and term money markets be restricted to banks and primary dealers.
Second, the Committee proposed a segregation of the roles of RBI as
a regulator of banks and owner of bank. It observed that "The Reserve Bank
as a regulator of the monetary system should not be the owner of a bank in
view of a possible conflict of interest". As such, it highlighted that RBI's role
of effective supervision was not adequate and wanted it to divest its holdings
in banks and financial institutions.
3. Stronger banking system: The Committee recommended for merger of
large Indian banks to make them strong enough for supporting international
trade. It recommended a three tier banking structure in India through
establishment of three large banks with international presence, eight to ten
national banks and a large number of regional and local banks. The
Committee recommended the use of mergers to build the size and strength of
operations for each bank.
4. Non-performing assets: Non-performing assets had been the single largest
cause of irritation of the banking sector of India. Earlier the Narasimham
Committee-I had broadly concluded that the main reason for the reduced
profitability of the commercial banks in India was the priority sector
lending. The committee had highlighted that 'priority sector lending' was
leading to the buildup of non-performing assets of the banks and thus it
recommended it to be phased out. Subsequently, the Narasimham
Committee-II also highlighted the need for 'zero' non-performing assets for
all Indian banks with International presence.
5. Capital adequacy and tightening of provisioning norms: To improve the
inherent strength of the Indian banking system the committee recommended
that
the
Government
should
raise
the
prescribed capital
adequacy norms. This would also improve their risk taking ability. The
committee targeted raising the capital adequacy ratio to 9% by 2000 and
10% by 2002 and have penal provisions for banks that fail to meet these
requirements.

Asst. Prof. Prashanth Kumar (M.A Economics)

St. Josephs Evening College (Autonomous)

6. Entry of foreign banks: The committee suggested that the foreign banks
seeking to set up business in India should have a minimum start-up capital
of $25 million as against the existing requirement of $10 million. It said that
foreign banks can be allowed to set up subsidiaries and joint ventures that
should be treated on a par with private banks.

Asst. Prof. Prashanth Kumar (M.A Economics)

St. Josephs Evening College (Autonomous)