The balance sheet of a commercial bank is a statement of its assets and liabilities. Assets are what others owe the bank, and what the bank owes others constitutes its liabilities. The business of a bank is reflected in its balance sheet and hence its financial position as well.
The balance sheet is issued usually at the end of every financial year of the bank. The balance sheet of the bank comprises of two sides; the assets side and the liabilities side. It is customary to record liabilities on the left side and assets on the right side. The following is the proforma of a balance sheet of the bank.
|1. Capital||1. Cash|
|a. Authorised capital||a. Cash on hand|
|b. Issued capital||b. Cash with central bank and other banks|
|c. Subscribed capital|
|2. Reserve fund||2. Money at call and short notice|
|3. Deposits||3. Bills discounted|
|4. Borrowings from other banks||4. Bills for collection|
|5. Bills payable||5. Investments|
|6. Acceptances and endorsements||6. Loans and advances|
|7. Contingent liabilities||7. Acceptances and endorsement|
|8. Profit and loss account||8. Fixed assets|
|9. Bills for collection|
Liabilities are those items on account of which the bank is liable to pay others. They denote other’s claims on the bank. Now we have to analyse the various items on the liabilities side.
The bank has to raise capital before commencing its business. Authorised capital is the maximum capital upto which the bank is empowered to raise capital by the Memorandum of Association. Generally, the entire authorised capital is not raised from the public.
That part of authorised capital which is issued in the form of shares for public subscription is called the issued capital. Subscribed capital represents that part of issued capital which is actually subscribed by the public. Finally, paid-up capital is that part of the subscribed capital which the subscribers are actually called upon to pay.
Reserve fund is the accumulated undistributed profits of the bank. The bank maintains reserve fund to tide over any crisis. But, it belongs to the shareholders and hence a liability on the bank. In India, the commercial bank is required by law to transfer 20 per cent of its annual profits to the Reserve fund.
The deposits of the public like demand deposits, savings deposits and fixed deposits constitute an important item on the liabilities side of the balance sheet. The success of any banking business depends to a large extent upon the degree of confidence it can instill in the minds of the depositors.
The bank can never afford to forget the claims of the depositors. Hence, the bank should always have enough cash to honour the obligations of the depositors.
Under this head, the bank shows those loans it has taken from other banks. The bank takes loans from other banks, especially the central bank, in certain extraordinary circumstances.
These include the unpaid bank drafts and telegraphic transfers issued by the bank. These drafts and telegraphic transfers are paid to the holders thereof by the bank’s branches, agents and correspondents who are reimbursed by the bank.
This item appears as a contra item on both the sides of the balance sheet. It represents the liability of the bank in respect of bills accepted or endorsed on behalf of its customers and also letters of credit issued and guarantees given on their behalf.
For rendering this service, a commission is charged and the customers to whom this service is extended are liable to the bank for full payment of the bills. Hence, this item is shown on both sides of the balance sheet.
Contingent liabilities comprise of those liabilities which are not known in advance and are unforeseeable. Every bank makes some provision for contingent liabilities.
The profit earned by the bank in the course of the year is shown under this head. Since the profit is payable to the shareholders it represents a liability on the bank.
This item also appears on both the sides of the balance sheet. It consists of drafts and hundies drawn by sellers of goods on their customers and are sent to the bank for collection, against delivery documents like railway receipt, bill of lading, etc., attached thereto.
All such bills in hand at the date of the balance sheet are shown on both the sides of the balance sheet because they form an asset of the bank, since the bank will receive payment in due course, it is also a liability because the bank will have to account for them to its customers.
According to Crowther, the assets side of the balance sheet is more complicated and interesting. Assets are the claims of the bank on others. In the distribution of its assets, the bank is governed by certain well defined principles.
These principles constitute the principles of the investment policy of the bank or the principles underlying the distribution of the assets of the bank. The most important guiding principles of the distribution of assets of the bank are liquidity, profitability and safety or security.
In fact, the various items on the assets side are distributed according to the descending order of liquidity and the ascending order of profitability. Now, we have to analyse the various items on the assets side.
Here we can distinguish cash on hand from cash with central bank and other banks cash on hand refers to cash in the vaults of the bank. It constitutes the most liquid asset which can be immediately used to meet the obligations of the depositors. Cash on hand is called the first line of defence to the bank.
In addition to cash on hand, the bank also keeps some money with the central bank or other commercial banks. This represents the second line of defence to the bank.
Money at call and short notice includes loans to the brokers in the stock market, dealers in the discount market and to other banks. These loans could be quickly converted into cash and without loss, as and when the bank requires. At the same time, this item yields income to the bank.
The significance of money at call and short notice is that it is used by th
e banks to effect desirable adjustments in the balance sheet. This process is called ‘Window Dressing’. This item constitutes the ‘third line of defence’ to the bank.
The commercial banks invest in short term bills consisting of bills of exchange and treasury bills which are self-liquidating in character. These short term bills are highly negotiable and they satisfy the twin objectives of liquidity and profitability.
If a commercial bank requires additional funds, it can easily rediscount the bills in the bill market and it can also rediscount the bills with the central bank. Bills for Collection: As mentioned earlier, this item appears on both sides of the balance sheet.
This item includes the total amount of the profit yielding assets of the bank. The bank invests a part of its funds in government and non-government securities.
Loans and advances constitute the most profitable asset to the bank. The very survival of the bank depends upon the extent of income it can earn by advancing loans. But, this item is the least liquid asset as well.
The bank earns quite a sizeable interest from the loans and advances it gives to the private individuals and commercial firms.
As discussed earlier, this item appears as a contra item on both sides of the balance sheet.
Fixed assets include building, furniture and other property owned by the bank. This item includes the total volume of the movable and immovable property of the bank.
Fixed assets are referred to as ‘dead stocks’. The bank generally undervalues this item deliberately in the balance sheet. The intention here is to build up secret reserves which can be used at times of crisis.
Balance sheet of a bank acts as a mirror of its policies, operations and achievements. The liabilities indicate the sources of its funds; the assets are the various kinds of debts incurred by a bank to its customers. Thus, the balance sheet is a complete picture of the size and nature of operations of a bank.
An important function performed by the commercial banks is the creation of credit. The process of banking must be considered in terms of monetary flows, that is, continuous depositing and withdrawal of cash from the bank. It is only this activity which has enabled the bank to manufacture money. Therefore the banks are not only the purveyors of money but manufacturers of money.
The basis of credit money is the bank deposits. The bank deposits are of two kinds viz.,
(1) Primary deposits
(2) Derivative deposits
Primary deposits arise or formed when cash or cheque is deposited by customers. When a person deposits money or cheque, the bank will credit his account.
The customer is free to withdraw the amount whenever he wants by cheques. These deposits are called “primary deposits” or “cash deposits.” It is out of these primary deposits that the bank makes loans and advances to its customers. The initiative is taken by the customers themselves. In this case, the role of the bank is passive.
So these deposits are also called “passive deposits.” These deposits merely convert currency money into deposit money. They do not create money. They do not make any net addition to the stock of money. In other words, there is no increase in the supply of money.
Bank deposits also arise when a loan is granted or when a bank discounts a bill or purchase government securities. Deposits which arise on account of granting loan or purchase of assets by a bank are called “derivative deposits.”
Since the bank play an active role in the creation of such deposits, they are also known as “active deposits.” When the banker sanctions a loan to a customer, a deposit account is opened in the name of the customer and the sum is credited to his account. The bank does not pay him cash.
The customer is free to withdraw the amount whenever he wants by cheques. Thus the banker lends money in the form of deposit credit.
The creation of a derivative deposit does result in a net increase in the total supply of money in the economy, Hartly Withers says “every loan creates a deposit.” It may also be said “loans make deposits” or “loans create deposits.” It is rightly said that “deposits are the children of loans, and credit is the creation of bank clerk’s pen.”
Granting a loan is not the only method of creating deposit or credit. Deposits also arise when a bank discounts a bill or purchase government securities. When the bank buys government securities, it does not pay the purchase price at once in cash.
It simply credits the account of the government with the purchase price. The government is free to withdraw the amount whenever it wants by cheque.
Similarly, when a bank purchase a bill of exchange or discounts a bill of exchange, the proceeds of the bill of exchange is credited to the account of the seller and promises to pay the amount whenever he wants. Thus asset acquired by a bank creates an equivalent bank deposit.
It is perfectly correct to state that “bank loans create deposits.” The derivate deposits are regarded as bank money or credit. Thus the power of commercial banks to expand deposits through loans, advances and investments is known as “credit creation.”
Thus, credit creation implies multiplication of bank deposits. Credit creation may be defined as “the expansion of bank deposits through the process of more loans and advances and investments.”
The commercial banks do not have unlimited power of credit creation. Their power to create credit is limited by the following factors:
The power to create credit depends on the cash received by banks. If banks receive more cash, they can create more credit. If they receive less cash they can create less credit. Cash supply is controlled by the central bank of the country.
All deposits cannot be used for credit creation. Banks must keep certain percentage of deposits in cash as reserve. The volume of bank credit depends also on the cash reserve ratio the banks have to keep. If the cash reserve ratio is increased, the volume of credit that the banks can create will fall. If the cash reserve ratio is lowered, the bank credit will increase. The Central Bank has the power to prescribe and change the cash reserve ratio to be kept by the commercial banks. Thus the central bank can change the volume of credit by changing the cash reserve ratio.
The loan advanced to a customer should again come back into banks as primary deposit. Then only there can be multiple expansion. This will happen only when the banking habit among the people is well developed. They should keep their money in the banks as deposits and use cheques for the settlement of transactions.
Credit creation will depend upon the nature of business conditions. Credit creation will be large during a period of prosperity, while it will be smaller during a depression. During periods of prosperity, there will be more demand for loans and advances for investment purposes. Many people approach banks for loans and advances. Hence, the volume of bank credit will be high. During periods of business depression, the amount of loans and advances will be small because businessmen and industrialists may not come to borrow. Hence the volume of bank credit will be low.
There may be some leakages in the process of credit creation. The funds may not flow smoothly from one bank to another. Some people may keep a portion of their amount as idle cash.
A bank creates credit in the process of acquiring sound and profitable assets, like bills, and government securities. If people cannot offer sound securities, a bank cannot create credit. Crowther says “a bank cannot create money out of thin air. It transmutes other forms of wealth into money.”
If people desire to hold more cash, the power of banks to create credit is reduced.
The extent of credit creation will largely depend upon the monetary policy of the Central Bank of the country. The Central Bank has the power to influence the volume of money in circulation and through this it can influence the volume of credit created by the banks. The Central Bank has also certain powerful weapons, like the bank rate, open market operations with the help of which it can exercise control on the expansion and contraction of credit by the commercial bank.
Thus, the ability of the bank to create credit is subject to various limitations. Still, one should not undermine the importance of the function of credit creation of the banks. This function has far-reaching effect on the working of the economy, especially on the business activity. Bank credit is the oil which lubricates the wheels of the business machine.
Unit banking means a system of banking under which banking services are provided by a single banking organisation. Such a bank has a single office or place of work. It has its own governing body or board of directors.
It functions independently and is not controlled by any other individual, firm or body corporate. It also does not control any other bank.
Such banks can become member of the clearing house and also of the Banker’s Association. Unit banking system originated and grew in the U.S.A. Different unit banks in the U.S.A. are linked with each other and with other financial centres in the country through “correspondent banks.”
Following are the main advantages of unit banking:
One of the most important advantages of unit banking system is that it can be managed efficiently because of its size and work. Co-ordination and control becomes effective. There is no communication gap between the persons making decisions and those executing such decisions.
Unit banks can render efficient service to their customers. Their area of operation being limited, they can concentrate well on that limited area and provide best possible service. Moreover, they can take care of all banking requirements of a particular area.
Since the area of operation is limited the customers can have direct contact. Their grievances can be redressed then and there.
In case there is a strike or closure of a unit, it does not have much impact on the trade and industry because of its small size. It does not affect the entire banking system.
Since the size of the bank and area of its operation are limited, it is difficult for the bank to adopt monopolistic practices. Moreover, there is free competition. It will not be possible for the bank to indulge in monopolistic practices.
No Risks of Fraud
Due to small size of the bank, there is stricter and closer control of management. Therefore, the employees will not be able to commit fraud.
Closure of Inefficient Banks: Inefficient banks will be automatically closed as they would not be able to satisfy their customers by providing efficient service.
Local Development: Unit banking is localised banking. The unit bank has the specialised knowledge of the local problems and serves the requirement of the local people in a better manner than branch banking. The funds of the locality are utilised for the local development and are not transferred to other areas.
Promotes Regional Balance: Under unit banking system, there is no transfer of resources from rural and backward areas to the big industrial and commercial centres. This tends to reduce regional imbalance.
Since the size of a unit bank is small, it cannot reap the advantages of large scale viz., division of labour and specialisation.
In unit banking system there will be large number of banks in operation. There will be lack of control and therefore their rates of interest would differ widely from place to place. Moreover, transfer of funds will be difficult and costly.
Since the number of unit banks is very large, their co-ordination and control would become very difficult.
Unit banks are more exposed to closure risks. Bigger unit can compensate their losses at some branches against profits at the others. This is not possible in case of smaller banks. Hence, they have to face closure sooner or later.
Under unit banking system the size of bank is small. Consequently its resources are also limited. Hence, they cannot meet the requirements of large scale industries.
A number of unit banks come into existence at an important business centre. In order to attract customers they indulge in unhealthy competition.
Unit banks concentrate in big metropolitan cities whereas they do not have their places of work in rural areas. Consequently there is uneven and unbalanced growth of banking facilities.
Unit banks, because of their limited resources, cannot afford to open uneconomic branches in smaller towns and rural areas. As such, these areas remain unbanked.
Since unit banks are highly localised in their business, local pressures and interferences generally disrupt their normal functioning.
It means a system of banking in which a banking organisation works at more than one place. The main place of business is called head office and the other places of business are called branches.
The head office controls and co-ordinates the work at branches. The day-to-day operations are performed by the branch manager as per the policies and directions issued from time to time by the head office.
This system of banking is prevalent throughout the world. In India also, all the major banks have been operating under branch banking system.
Such banks, because of their large size can enjoy the economies of large scale viz., division of work and specialisation. These banks can also afford to have the specialised services of bank personnel which the unit banks can hardly afford.
Branch banking can provide extensive service to cover large area. They can open their branches throughout the country and even in foreign countries.
In branch banking system branches are not concentrated at one place or in one industry. These are decentralised at different places and in different industries. Hence the risks are also distributed.
In branch banking, there is better control and coordination of the central bank. Consequently interest rates can be uniform.
In branch banking there can be better cash management as cash easily be transferred from one branch to another. Therefore, there will be lesser need to keep the cash idle for meeting contingencies.
Under branch banking the size of the bank is quite large. Therefore, such banks can afford to provide better training facilities to their employees. Almost every nationalised bank in India has its separate training college.
Under branch banking, a bank has a widespread of branches. Therefore, it is easier and economical to transfer funds from one branch to the other.
Such bank can afford the services of specialised and expert staff. Therefore they invest their funds in such industries where they get the highest return and appreciation without sacrificing the safety and liquidity of funds.
Under branch banking, the central bank has to deal only with a few big banks controlling a large number of branches. It is always easier and more convenient to the central bank to regulate and control the credit policies of a few big banks, than to regulate and control the activities of a large number of small unit banks. This ensures better implementation of monetary policy.
Under branch banking, the bank maintains continual contacts with all parts of the country. This helps it to acquire correct and reliable knowledge about economic conditions in various parts of the country. This knowledge enables the bank to make a proper and profitable investment of its surplus funds.
A bank, with huge financial resources and number of branches spread throughout the country, can command greater public confidence than a small unit bank with limited resources and one or a few branches.
Following are the disadvantages of branch banking:
Since there are hundreds of branches of a bank under this system, management, supervision and control became more inconvenient and difficult. There are possibilities of mismanagement in branches. Branch managers may misuse their position and misappropriate funds. There is great scope for fraud. Thus there are possibilities of fraud and irregularities in the financial management of the bank.
The branches of the bank under this system suffer from a complete lack of initiative on important banking problems confronting them. No branch of the bank can take decision on important problems without consulting the head office. Consequently, the branches of the bank find themselves unable to carry on banking activities in accordance with the requirements of the local situation. This makes the banking system rigid and inelastic in its functioning. This also leads to “red-tapism” which means “official delay.”
Branch banking encourages monopolistic tendencies in the banking system. A few big banks dominate and control the whole banking system of the country through their branches. This can lead to the concentration of resources in the hands of a small number of men. Such a monopoly power is a source of danger to the community, whose goal is a socialistic pattern of society.
Under the branch banking system, the financial resources collected in the smaller and backward regions are transferred to the bigger industrial centres. This encourages regional imbalances in the country.
Under branch banking, the weak and unprofitable branches continue to operate under the protection cover of the stronger and profitable branches.
Branch banking is delocalised banking, under branch banking system, the branches of different banks get concentrated at certain places, particularly in big towns and cities. This gives rise to unnecessary and unhealthy competition among them. The branches of the competing banks try to tempt customers by offering extra inducements and facilities to them. This naturally increases the banking expenditure.
Branch banking system is much more expensive than the unit banking system. When a bank opens a number of branches at different places, then there arises the problem of co-ordinating their activities with others. This necessitates the employment of expensive staff by the bank.
When some branches suffer losses due to certain reasons, this has its repercussions on other branches of the bank. Thus branch banking system as well as unit banking system suffer from defects and drawbacks. But the branch banking system is, on the whole, better than the unit banking system. In fact, the branch banking system has proved more suitable for backward and developing countries like India. Branch banking is very popular and successful in India. A comparison between unit banking and branch banking is essentially a comparison between small-scale and large-scale operations.
Commercial banks are considered not merely as dealers in money but also the leaders in economic development. They are not only the store houses of the country’s wealth but also the reservoirs of resources necessary for economic development.
They play an important role in the economic development of a country. A well-developed banking system is essential for the economic development of a country. The “Industrial Revolution” in Europe in the 19th century would not have been possible without a sound system of commercial banking.
In case of developing countries like India, the commercial banks are considered to be the backbone of the economy. Commercial banks can contribute to a country’s economic development in the following ways :
Capital formation is the most important determinant of economic development. The basic problem of a developing economy is slow rate of capital formation. Banks promote capital formation. They encourage the habit of saving among people.
They mobilise idle resources for production purposes. Economic development depends upon the diversion of economic resources from consumption to capital formation. Banks help in this direction by encouraging saving and mobilising them for productive uses.
Commercial banks are a very important source of finance and credit for industry and trade. Credit is a pillar of development. Credit lubricates all commerce and trade.
Banks become the nerve centre of all commerce and trade. Banks are instruments for developing internal as well as external trade.
An underdeveloped economy is characterised by the existence of a large non-monetised sector. The existence of this non-monetised sector is a hindrance in the economic development of the country.
The banks, by opening branches in rural and backward areas can promote the process of monetisation (conversion of debt into money) in the economy.
Innovations are an essential prerequisite for economic development. These innovations are mostly financed by bank credit in the developed countries.
But in underdeveloped countries, entrepreneurs hesitate to invest in new ventures and undertake innovations largely due to lack of funds.
Facilities of bank loans enable the entrepreneurs to step up their investment on innovational activities, adopt new methods of production and increase productive capacity of the economy.
Economic development need an appropriate monetary policy. But a well-developed banking is a necessary pre-condition for the effective implementation of the monetary policy.
Control and regulation of credit by the monetary authority is not possible without the active co-operation of the banking system in the country.
Banks generally provide financial resources to the right type of industries to secure the necessary material, machines and other inputs. In this way they influence the nature and volume of industrial production.
Underdeveloped economies are primarily agricultural economies. Majority of the population in these economies live in rural areas.
Therefore, economic development in these economies requires the development of agriculture and small scale industries in rural areas.
So far banks in underdeveloped countries have been paying more attention to trade and commerce and have almost neglected agriculture and industry. Banks must provide loans to agriculture for development and modernisation of agriculture.
In recent years, the State Bank of India and other commercial banks are granting short term, medium-term and long term loans to agriculture and small-scale industries.
Banks can also play an important role in achieving balanced development in different regions of the country. They transfer surplus capital from the developed regions to the less developed regions, where it is scarce and most needed.
This reallocation of funds between regions will promote economic development in underdeveloped areas of the country.
Industrial development needs finance. In some countries, commercial banks encouraged industrial development by granting long-term loans also. Loan or credit is a pillar to development.
In underdeveloped countries like India, commercial banks are granting short-term and medium-term loans to industries. They are also underwriting the issue of shares and debentures by industrial concerns. This helps industrial concerns to secure adequate capital for their establishment, expansion and modernisation.
Commercial banks are also helping manufacturers to secure machinery and equipment from foreign countries under instalment system by guaranteeing deferred payments. Thus, banks promote or encourage industrial development.
The businessmen are more afraid of a banker than a preacher. The businessmen should have certain business qualities like industry, forethought, honesty and punctuality.
These qualities are called “commercial virtues” which are essential for rapid economic progress. The banker is in a better position to promote commercial virtues. Banks are called “public conservators of commercial virtues.”
In recent years, commercial banks, particularly in developing countries, have been called upon to help achieve certain
socio-economic objectives laid down by the state.
For example, nationalised bank in India have framed special innovative schemes of credit to help small agriculturists, self-employed persons and retailers through loans and advances at concessional rates of interest.
Banking is thus used to achieve the national policy objectives of reducing inequalities of income and wealth, removal of poverty and elimination of unemployment in the country.
Thus, banks in a developing country have to play a dynamic role. Economic development places heavy demand on the resources and ingenuity of the banking system. It has to respond to the multifarious economic needs of a developing country. Traditional views and methods may have to be discarded.
“An Institution, such as the banking system, which touches and should touch the lives of millions, has necessarily to be inspired by a larger social purpose and has to sub serve national priorities and objectives.” A well-developed banking system provides a firm and durable foundation for the economic development of the country.
A central bank is an ‘apex institution’ in the banking structure of a country. It supervises, controls and regulates the activities of commercial banks and acts as a banker to them. It also acts as a banker, agent and adviser to the government in all financial and monetary matters.
A central bank is also the custodian of the foreign balances of the country and is responsible to maintain the rate of exchange fixed by the government and manages exchange control. The most important function of a central bank is to regulate the volume of currency and credit in a country.
It will be no exaggeration to say that a modern central bank is the central arch to the monetary and fiscal framework in almost all the countries developed or developing in the world.
In developing economies, the central bank has also to perform certain promotional and developmental functions to accelerate the pace of economic growth.
In every country there is one bank which acts as the leader of the money market, supervising, controlling and regulating the activities of commercial banks and other financial institutions. It acts as a bank of issue and is in close touch with the government, as banker, agent and adviser to the latter. Such a bank is known as the central bank of the country.
A banking institution can more easily be identified by the functions that it performs. According to Vera Smith, “the primary definition of central banking is a banking system in which a single bank has either a complete or residuary monopoly in the note issue.”
Kisch and Elkin believe that “the essential function of a central bank is the maintenance of the stability of the monetary standard.” In the statutes of the Bank for International Settlements a central bank is defined as “the bank of the country to which has been entrusted the duty of regulating the volume of currency and credit in that country.”
De Kock gives a very comprehensive definition of central bank. According to De Kock, a central bank is a bank which constitutes the apex of the monetary and banking structure of its country and which performs, best it can in the national economic interest, the following functions:
The nature of function of a central bank differs in a developed economy as compared to those in a developing economy.
Reserve Bank of India was established in 1935. It is the central bank of India. The following are the main objectives of RBI :
RBI is the sole authority for the issue of currency notes in India except one rupee coin, one rupee note and subsidiary coins. These notes are printed and issued by the issue department.
RBI acts as the banker and agent of the government. It gives the following services:
a) It maintains and operates the government cash balances.
b) It receives and makes payments on behalf of the government.
c) It buys and sells government securities in the market.
d) It sells treasury bills on behalf of the government.
e) It advises the government on all banking and financial matters such as financing of five year plans, balance of payments etc.,
f) It acts as the agent of the government in dealings with International Monetary Fund, World Bank International finance Corporations, EXIM Banks etc.,
As per the Banking Regulation Act 1949,every bank has to keep certain minimum cash balance with RBI. This is called as Cash Reserve ratio. The scheduled banks can borrow money from the reserve bank of India on eligible securities and by rediscounting bills of exchange. Thus it acts as bankers’ bank.
RBI controls money supply and credit to maintain price stability in the country. It controls credit by using the following methods:
If you want to know more about credit control methods, we may recommend a further reading on Credit control methods by the Reserve Bank of India
RBI controls the foreign exchange reserves and exchange value of the rupee in relation to other country’s currencies. Currencies should be exchanged only with RBI or its authorized banks.
It collects data related to all economic matters such as finance, production, balance of payments, prices etc. and are published in the form of reports, bulletins etc.
The central bank of India acts as a bank of central clearance in settling the mutual accounts of commercial banks. If there is no RBI branch to do this service, the State Bank of India discharges these functions.
It provides finance for the development of Agriculture, industry and export. RBI also gives credit to weaker sections and priority sectors at concessional rate of interest. It takes an active part in developing organized bill market to provide rediscounting facilities to commercial banks and other financial institutions. It helps for the development and regulation of banking system in the country. The RBI has increased the banking facilities to the remote corners of the country through lead bank scheme. It has helped in promoting the financial institutions such as IDBI, IFCI, ICICI, and SIDBI etc.
In this method the central bank controls the quantity of credit given by commercial banks by using the following weapons.
It is the rate at which bills are discounted and rediscounted by the banks with the central bank. During inflation, the bank rate is increased and during deflation, bank rate is decreased.
Direct buying and selling of government securities by the central bank in the open market is called as open market operations. During inflation the securities are sold in the market by the Central Bank. During the deflation period, the central bank buys the bills from the market and pays cash to commercial banks.
Every commercial bank has to keep a minimum cash reserve with the Reserve Bank of India depending on the deposits of the commercial bank. During inflation this ratio is increased and during deflation the ratio is decreased.
This is also called as selective credit control methods. The following weapons are used under this method:
Banker lends money against price of securities. The amount of loan depends upon the margin requirements of the banker. The word margin here it means the difference between the loan value and market value of securities.
The central bank has the power to change the margins, which limits the amount of loan to be sanctioned by the commercial banks. During inflation higher margin would be fixed and during deflation lower margin would be fixed.
Customer gets this type of foreign exchange reserves and exchange value of the rupee in relation to other country’s currencies. Currencies should be exchanged only with RBI or its authorized banks.
To regulate the volume of bank loans the central bank may issue directives to the commercial banks from time to time. The directives may be in the form of oral or written statements or appeals or warnings. By means of these directives the RBI may decrease or increase the volume of credit.
It is a method of regulating and controlling purpose for which credit is guaranteed by the commercial bank. It may be of two types.
In this method the central bank fixes a maximum amount of loans and advances for every commercial bank.
In this method the central bank fixes a ratio, which the capital of the commercial bank must bear to the total assets of the bank. By changing these ratio the credit can be regulated.
This is a gracious method followed by RBI. In this method the RBI gives advices and suggestions to the bankers to follow the instructions given by it, by sending letters and conducting meeting of the Board of Directors.
Bank Rate Policy or the Discount Rate Policy has been the earliest instrument of quantitative credit control. It was the Bank of England which experimented with the bank rate policy for the first time as a technique of monetary management. Now every central bank has been endowed with this instrument of credit control.
Bank rate refers to the official minimum lending rate of interest of the central bank. It is the rate at which the central bank advances loans to the commercial banks by rediscounting the approved first class bills of exchange of the banks. Hence, bank rate is also called as the discount rate.
The theory underlying the operation of bank rate is that by manipulating the bank rate, the central bank is in a position to exercise influence upon the supply of credit in the economy.
According to the theory of bank rate an increase or a decrease in the bank rate leads to a reduction or an increase in the supply of credit in the economy. This is possible because changes in the bank rate bring about changes in the other rates of interest in the economy.
As mentioned above, by manipulating the bank rate it is possible to effect changes in the supply of credit in the economy. During a period of inflation, to arrest the rise in the price level, the central bank raises the bank rate. When the bank rate is raised, all other interest rates in the economy also go up.
As a result, the commercial bank also raise their lending rates. The consequence is an increase in the cost of credit. This discourages borrowing and hence investment activity is curbed in the economy. This will bring about a reduction in the supply of credit and money in the economy and therefore in the level of prices.
On the other hand, during a period of deflation, the central bank will lower the bank rate n order to encourage business activity in the economy. When the bank rate is lowered, all other interest rates in the economy also come down. The banks increase the supply of credit by reducing their lending rates. A reduction in the bank rate stimulates investment and the fall in the price level is arrested.
Regarding the process through which changes in the bank rate influence the supply of credit, the level of business activity and the price level, we can distinguish two approaches. One put forth by R.G. Hawtrey and the other one associated with J.M. Keynes.
In the opinion of Hawtrey, changes in the bank rate operate through changes in the short term rates of interest. These changes in the short term interest rates, in their turn, influence the cost of borrowing by businessmen and industrialists.
But, according to Lord Keynes, changes in bank rate become effective through changes in the long term interest rates as reflected by changes in the capital value of long term securities.
But, it should be noted that there is not much difference between the two approaches and hence they are complementary to each other.
Under the gold standard, bank rate was used primarily to set right the disequilibrium in the balance of payments of the country. When there was a deficit in the balance of payments and hence an outflow of gold, bank rate was raised to check the outflow of gold. This was done by attracting the inflow of short term capital into the country.
The efficacy of bank rate as an instrument of monetary management calls for the fulfillment of the following conditions:
(a) Close relationship between bank rate and other interest rates
It is necessary that the relationship between bank rate and the other interest in the economy should be close and direct. Changes in the rate should bring about similar and appropriate changes in the other interest rates in the economy. Otherwise the efficacy of bank rate will be limited. There is, therefore, the need for the existence of an integrated interest rate structure.
(b) Existence of an elastic economic system
The success of bank rate requires the existence of an elastic economic structure. That is, the entire economic system should be perfectly flexible to accommodate itself to changes in the bank rate. Changes in the bank rate should bring about similar and desirable changes in prices, costs, wages, output, profits, etc. The existence of a rigid economic structure will reduce the efficacy of bank rate.
(c) Existence of short term funds market
Another condition required for the success of bank rate policy is the existence of market for short term funds in the country. This will help to handle foreign as well as domestic funds that come up on account of changes in the interest rates, following changes in the bank rate.
Before the First World War, bank rate policy was very effective as an instrument of quantitative credit control because, the conditions necessary for the success of bank rate were there. But, after the war, the significance of bank rate began to wane because the post-war atmosphere was not conducive for the smooth and effective operation of the bank rate policy.
The Bank Rate Policy suffers from the following limitations:
(a) It has been argued that bank rate proves ineffective to combat boom and depression. During a period of boom, investment is interest inelastic.
Even if the bank rate is raised to any extent, investment activity will not be curbed, because during a period of boom, the marginal efficiency of capital will be very high and the entire business community will be caught in a sweep of optimism.
During depression, bank rate becomes ineffective following the general psychology of diffidence and pessimism among the business circles.
(b) The growth of non-banking financial intermediaries has proved an effective threat to the effectiveness of bank rate policy. It has been adequately established by the study of the Redcliffe Report and Gurley-Shaw, that the mushroom growth of non-banking financial intermediaries has belittled the significance of bank rate.
This is because changes in the bank rate immediately affect the rates of interest of the commercial banks only and the non-banking financial institutions are not subject to the direct control of the central bank. Hence, it is said that “the good boy is punished for
the actions of a bad boy.”
(c) The decline in the use of bills of exchange as credit instruments also has been responsible for the decline in the importance of bank rate.
(d) Further, of late, businessmen have found out alternative methods of business financing, self-financing, ploughing back the profits, public deposits, etc. Indeed, the role of commercial banks as suppliers of loanable funds has been decreasing in importance.
(e) Moreover, the economic structure has not been adequately responding itself to changes in the bank rate. After the war, all kinds of rigidities have crept into the economic system.
(f) The invention of alternative instruments of credit control also has accounted for the decline in the popularity of bank rate.
(g) Further, the dependence of the commercial bank on the central bank for loans also has decreased leading to the decline in getting the bills of exchange rediscounted by the central bank. In addition, there has been an increased liquidity in the assets of banks.
(h) Finally, the increase in the importance of fiscal policy following the Great Depression of 1930’s has also reduced the importance of bank take policy as a technique of credit control.
However, in spite of the above limitations that the bank rate policy is subject to, it would be wrong to undermine the significance of bank rate as a tool monetary management. Though, by itself, it may not yield the desirable results, but
will certainly prove effective when used with other instruments of credit control.
The scope for the use of bank rate by the central bank, therefore, cannot be completely ruled out. The bank rate has undergone a significant revival. Its significance in controlling inflation cannot be undermined.