CHAPTER THREE

COMMERCIAL BANK

3.1. Introduction

A commercial bank is a profit-seeking business firm, dealing in money and credit. It is a

financial institution dealing in money in the sense that it accepts deposits of money from the
public to keep them in its custody for safety. So also, it deals in credit, i.e., it creates credit by
making advances out of the funds received as deposits to needy people. It thus, functions as a
mobiliser of saving in the economy. A bank is, therefore like a reservoir into which flow the
savings, the idle surplus money of households and from which loans are given on interest to
businessmen and others who need them for investment or productive uses.

The term „Bank‟ has been defined in different ways by different economists. A few definitions
are: According to Walter Leaf “A bank is a person or corporation which holds itself out to
receive from the public, deposits payable on demand by cheque.” Horace White has defined a
bank, “as a manufacture of credit and a machine for facilitating exchange.” According to Prof.
Kinley “A bank is an establishment which makes to individuals such advances of money as may
be required and safely made, and to which individuals entrust money when not required by them
for use.”

Thus, we can say that a bank is a financial institution which deals in debts and credits. It accepts
deposits, lends money and also creates money. It bridges the gap between the savers and
borrowers. Banks are not merely traders in money but also in an important sense manufacturers
of money.

Recall our discussion in chapter one that banks, broadly, can be categorized into two broad
categories: Central bank and Commercial Banks. In addition, we have seen some six
classifications of commercial banks. These are: Deposit banks, Industrial Banks, Saving Banks,
Agricultural Banks, Exchange Banks and Miscellaneous Banks.

Compiled by: Getachew Yitbarek (MSc) - Lecturer at Accounting and Finance Department, DTU 1
3.2. Functions of Commercial Banks

Commercial banks have to perform a variety of functions which are common to both developed
and developing countries. These are known as „General Banking‟ functions of the commercial
banks. The modern banks perform a variety of functions. These can be broadly divided into two
categories: (a) Primary functions and (b) Secondary functions.

A. Primary Functions
Primary banking functions of the commercial banks include:

1. Acceptance of deposits
2. Advancing loans
3. Creation of credit
4. Clearing of cheques
5. Financing foreign trade
6. Remittance of funds

1. Acceptance of Deposits: Accepting deposits is the primary function of a commercial bank.

Mobilize savings of the household sector. Banks generally accept three types of deposits viz.,
(a) Current Deposits (b) Savings Deposits, and (c) Fixed Deposits.

(a) Current Deposits: These deposits are also known as demand deposits. These deposits can
be withdrawn at any time. Generally, no interest is allowed on current deposits, and in case,
the customer is required to leave a minimum balance undrawn with the bank. Cheques are
used to withdraw the amount. These deposits are kept by businessmen and industrialists who
receive and make large payments through banks. The bank levies certain incidental charges
on the customer for the services rendered by it.
(b) Savings Deposits: This is meant mainly for professional men and middle class people to help
them deposit their small savings. It can be opened without any introduction. Money can be
deposited at any time but the maximum cannot go beyond a certain limit. There is a
restriction on the amount that can be withdrawn at a particular time or during a week. If the
customer wishes to withdraw more than the specified amount at any one time, he has to give
prior notice. Interest is allowed on the credit balance of this account. The rate of interest is

Compiled by: Getachew Yitbarek (MSc) - Lecturer at Accounting and Finance Department, DTU 2
 greater than the rate of interest on the current deposits and less than that on fixed deposit.
This system greatly encourages the habit of thrift or savings.
(c) Fixed Deposits: These deposits are also known as time deposits. These deposits cannot be
withdrawn before the expiry of the period for which they are deposited or without giving a
prior notice for withdrawal. If the depositor is in need of money, he has to borrow on the
security of this account and pay a slightly higher rate of interest to the bank. They are
attracted by the payment of interest which is usually higher for longer period. Fixed deposits
are liked by depositors both for their safety and as well as for their interest.

2. Advancing Loans: The second primary function of a commercial bank is to make loans and
advances to all types of persons, particularly to businessmen and entrepreneurs. Loans are
made against personal security, gold and silver, stocks of goods and other assets. The most
common way of lending is by:

(a) Overdraft Facilities: In this case, the depositor in a current account is allowed to draw over
and above his account up to a previously agreed limit. Suppose a businessman has only ETB
30,000/- in his current account in a bank but requires ETB 60,000/- to meet his expenses. He
may approach his bank and borrow the additional amount of ETB 30,000/-. The bank allows
the customer to overdraw his account through cheques. The bank, however, charges interest
only on the amount overdrawn from the account.
(b) Cash Credit: Under this account, the bank gives loans to the borrowers against certain
security. But the entire loan is not given at one particular time, instead the amount is credited
into his account in the bank; but under emergency cash will be given. The borrower is
required to pay interest only on the amount of credit availed to him. He will be allowed to
withdraw small sums of money according to his requirements through cheques, but he cannot
exceed the credit limit allowed to him. Besides, the bank can also give specified loan to a
person, for a firm against some collateral security. The bank can recall such loans at its
option.
(c) Discounting Bills of Exchange: This is another type of lending which is very popular with
the modern banks. The holder of a bill can get it discounted by the bank, when he is in need
of money. After deducting its commission, the bank pays the present price of the bill to the
holder. Such bills form good investment for a bank. They provide a very liquid asset which
can be quickly turned into cash. The commercial banks can re-discount, the discounted bills
Compiled by: Getachew Yitbarek (MSc) - Lecturer at Accounting and Finance Department, DTU 3
 with the central banks when they are in need of money. These bills are safe and secured bills.
When the bill matures the bank can secure its payment from the party which had accepted the
bill.
(d) Money at Call: Bank also grant loans for a very short period, generally not exceeding 7 days
to the borrowers, usually dealers or brokers in stock exchange markets against collateral
securities like stock or equity shares, debentures, etc., offered by them. Such advances are
repayable immediately at short notice hence, they are described as money at call or call
money.
(e) Term Loans: Banks give term loans to traders, industrialists and now to agriculturists also
against some collateral securities. Term loans are so-called because their maturity period
varies between 1 to 10 years. Term loans, as such, provide intermediate or working capital
funds to the borrowers. Sometimes, two or more banks may jointly provide large term loans
to the borrower against a common security. Such loans are called participation loans or
consortium finance.
(f) Consumer Credit: Banks also grant credit to households in a limited amount to buy some
durable consumer goods such as television sets, refrigerators, etc., or to meet some personal
needs like payment of hospital bills etc. Such consumer credit is made in a lump sum and is
repayable in installments in a short time.
(g) Miscellaneous Advances: Among other forms of bank advances there are packing credits
given to exporters for a short duration, export bills purchased/discounted, import finance-
advances against import bills, finance to the self-employed, credit to the public sector, credit
to the cooperative sector and above all, credit to the weaker sections of the community at
concessional rates.
3. Creation of Credit: A unique function of the bank is to create credit. Banks supply money to
traders and manufacturers. They also create or manufacture money. Bank deposits are
regarded as money. They are as good as cash. The reason is they can be used for the purchase
of goods and services and also in payment of debts. When a bank grants a loan to its
customer, it does not pay cash. It simply credits the account of the borrower. He can withdraw
the amount whenever he wants by a cheque. In this case, bank has created a deposit without
receiving cash. That is, banks are said to have created credit. Sayers says “banks are not

Compiled by: Getachew Yitbarek (MSc) - Lecturer at Accounting and Finance Department, DTU 4
 merely purveyors/transmitters of money, but also in an important sense, manufacturers of
money.”
4. Promote the Use of Cheques: The commercial banks render an important service by
providing to their customers a cheap medium of exchange like cheques. It is found much
more convenient to settle debts through cheques rather than through the use of cash. The
cheque is the most developed type of credit instrument in the money market.

5. Financing Internal and Foreign Trade: The bank finances internal and foreign trade through
discounting of exchange bills. Sometimes, the bank gives short-term loans to traders on the
security of commercial papers. This discounting business greatly facilitates the movement of
internal and external trade.
6. Remittance of Funds: Commercial banks, on account of their network of branches
throughout the country, also provide facilities to remit funds from one place to another for
their customers by issuing bank drafts, mail transfers or telegraphic transfers on nominal
commission charges. As compared to the postal money orders or other instruments bank drafts
have proved to be a much cheaper mode of transferring money and has helped the business
community considerably.

B. Secondary Functions
Secondary banking functions of the commercial banks include:

1. Agency Services
2. General Utility Services

These are discussed below.

1. Agency Services: Banks also perform certain agency functions for and on behalf of their
customers. The agency services are of immense value to the people at large. The various
agency services rendered by banks are as follows:
(a) Collection and Payment of Credit Instruments: Banks collect and pay various credit
instruments like cheques, bills of exchange, promissory notes etc., on behalf of their
customers.
(b) Purchase and Sale of Securities: Banks purchase and sell various securities like shares,
stocks, bonds, debentures on behalf of their customers.

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(c) Collection of Dividends on Shares: Banks collect dividends and interest on shares and
debentures of their customers and credit them to their accounts.
(d) Acts as Correspondent: Sometimes banks act as representative and correspondents of their
customers. They get passports, traveller‟s tickets and even secure air and sea passages for
their customers.
(e) Income-tax Consultancy: Banks may also employ income tax experts to prepare income tax
returns for their customers and to help them to get refund of income tax.
(f) Execution of Standing Orders: Banks execute the standing instructions of their customers
for making various periodic payments. They pay subscriptions, rents, insurance premia etc.,
on behalf of their customers.
(g) Acts as Trustee and Executor: Banks preserve the „Wills‟ of their customers and execute
them after their death.
2. General Utility Services: In addition to agency services, the modern banks provide many
general utility services for the community as given.

(a) Locker Facility: Bank provide locker facility to their customers. The customers can keep
their valuables, such as gold and silver ornaments, important documents; shares and
debentures in these lockers for safe custody.
(b) Traveller’s Cheques and Credit Cards: Banks issue traveller‟s cheques to help their
customers to travel without the fear of theft or loss of money. With this facility, the
customers need not take the risk of carrying cash with them during their travels.
(c) Letter of Credit: Letters of credit are issued by the banks to their customers certifying their
credit worthiness. Letters of credit are very useful in foreign trade.
(d) Collection of Statistics: Banks collect statistics giving important information relating to
trade, commerce, industries, money and banking. They also publish valuable journals and
bulletins containing articles on economic and financial matters.
(e) Acting Referee: Banks may act as referees with respect to the financial standing, business
reputation and respectability of customers.
(f) Underwriting Securities: Banks underwrite the shares and debentures issued by the
Government, public or private companies.

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(g) Gift Cheques: Some banks issue cheques of various denominations to be used on auspicious
occasions.
(h) Accepting Bills of Exchange on Behalf of Customers: Sometimes, banks accept bills of
exchange, internal as well as foreign, on behalf of their customers. It enables customers to
import goods.
(i) Merchant Banking: Some commercial banks have opened merchant banking divisions to
provide merchant banking services.
3.2.1. Difference Between Primary and Secondary Functions of Commercial Banks
Primary Functions Secondary Functions
1. They the main activities of the bank 1. They are secondary activities of the bank
2. They are the main sources of income of 2. They are not the main sources of income
the bank of the bank
3. They are obligatory on the part of the 3. These are not obligatory on part of bank to
bank to perform perform. But generally all commercial
banks perform these activities.

3.3. Credit Creation

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.

3.3.1. Basis of Credit Creation

The basis of credit money is the bank deposits. The bank deposits are of two kinds: viz., (1)
Primary deposits, and (2) Derivative deposits.

1. Primary 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

Compiled by: Getachew Yitbarek (MSc) - Lecturer at Accounting and Finance Department, DTU 7
 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.
2. Derivative Deposits: 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.”

Compiled by: Getachew Yitbarek (MSc) - Lecturer at Accounting and Finance Department, DTU 8
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.”

3.3.2. Process of Credit Creation

An important aspect of the credit creating function of the commercial banks is the process of
multiple-expansion of credit. The banking system as a whole can create credit which is several
times more than the original increase in the deposits of a bank. This process is called the
multiple-expansion or multiple-creation of credit. Similarly, if there is withdrawal from any
one bank, it leads to the process of multiple-contraction of credit. The process of multiple credit-
expansion can be illustrated by assuming

(a) The existence of a number of banks, A, B, C etc., each with different sets of depositors.
(b) Every bank has to keep 10% of cash reserves, according to law, and,
(c) A new deposit of ETB 1,000 has been made with bank A to start with.

Suppose, a person deposits ETB 1,000 cash in Bank A. As a result, the deposits of bank A
increase by ETB 1,000 and cash also increases by ETB 1,000. The balance sheet of the bank is as
follows:

Balance Sheet of Bank A

Liabilities ETB Assets ETB

New Deposit 1,000.00 New Cash 1,000.00
Total 1,000.00 1,000.00

Under the double entry system, the amount of ETB 1,000 is shown on both sides. The deposit of
ETB 1,000 is a liability for the bank and it is also an asset to the bank. Bank A has to keep only
10% cash reserve, i.e., ETB 100 against its new deposit and it has a surplus of ETB 900 which it
can profitably employ in the assets like loans. Suppose bank A gives a loan to X, who uses the
amount to pay off his creditors. After the loan has been made and the amount so withdrawn by X
to pay off his creditors, the balance sheet of bank A will be as follows:

Compiled by: Getachew Yitbarek (MSc) - Lecturer at Accounting and Finance Department, DTU 9
Balance Sheet of Bank A

Liabilities ETB Assets ETB

Deposit 1,000.00 Cash 100.00
Loan to X 900.00
Total 1,000.00 1,000.00

Suppose X purchase goods of the value of ETB 900 from Y and pay cash. Y deposits the amount
with Bank B. The deposits of Bank B now increase by ETB 900 and its cash also increases by
ETB 900. After keeping a cash reserve of ETB 90, Bank B is free to lend the balance of ETB 810
to anyone. Suppose bank B lends ETB 810 to Z, who uses the amount to pay off his creditors.
The balance sheet of bank B will be as follows:

Balance Sheet of Bank B

Liabilities ETB Assets ETB

Deposit 900.00 Cash 90.00
Loan to Z 810.00
Total 900.00 900.00

Suppose Z purchases goods of the value of ETB 810 from S and pays the amount. S deposits the
amount of ETB 810 in bank C. Bank C now keeps 10% as reserve (ETB 81) and lends ETB 729
to a merchant. The balance sheet of bank C will be as follows:

Balance Sheet of Bank C

Liabilities ETB Assets ETB

Deposit 810.00 Cash 81.00
Loan 729.00
Total 810.00 810.00

Thus, looking at the banking system as a whole, the position will be as follow:

Compiled by: Getachew Yitbarek (MSc) - Lecturer at Accounting and Finance Department, DTU 10
Name of Bank Deposits ETB Cash Reserve ETB Loan ETB
Bank A 1,000.00 100.00 900.00
Bank B 900.00 90.00 810.00
Bank C 810.00 81.00 729.00
Total 2,710.00 271.00 2,439.00

It is clear from the above that out of the initial primary deposit, bank advanced ETB 900 as a
loan. It formed the primary deposit of bank B, which in turn advanced ETB 810 as loan. This
sum again formed the primary deposit of bank C, which in turn advanced ETB 729 as loan. Thus,
the initial primary deposit of ETB 1,000 resulted in bank credit of ETB 2439 in three banks.

There will be many banks in the country and the above process of credit expansion will come to
an end when no bank has an excess reserve to lend. In the above example, there will be 10 fold
increase in credit because the cash ratio is 10%. The total volume of credit created in the
banking system depends on the cash ratio. If the cash ratio is 10% there will be 10 fold increase.
If it is 20%, there will be 5 fold increase. When the banking system receives an additional
primary deposit, there will be multiple expansion of credit. When the banking system loses cash,
there will be multiple contraction of credit.

The extent to which the banks can create credit together could be found out with the help of the
credit multiplier formula. The formula is:

Where: K is the credit multiplier, and r the required reserves. If the reserve ratio is 10% the size
of credit multiplier will be:

It means that the banking system can create credit together which is ten times more than the
original increase in the deposits. It should be noted here that the size of credit multiplier is
inversely related to the percentage of cash reserves the banks have to maintain. If the reserve

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ratio increases, the size of credit multiplier is reduced and if the reserve ratio is reduced, the size
of credit multiplier will increase.

3.3.3. Leaf and Cannon Criticism of Theory of Credit Creation

Walter Leaf and Edwin Cannon objected to the theory of credit creation. According to them, the
commercial bank cannot lend anything more than what it receives as cash from deposits. But the
contention of Leaf and Cannon that banks cannot create credit is wrong due to the following
reasons:

(a) A single bank may not be able to create derivative deposits in excess of its cash reserves. But
the banking system as a whole can do what a single bank cannot do.
(b) As Crowther points out that the total net deposits of commercial banks are for in excess of
their cash reserves. It means they can create credit.

3.3.4. Limitation on Credit Creation

The commercial banks do not have unlimited power of credit creation. Their power to create
credit is limited by the following factors:

1. Amount of Cash: 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.
2. Cash Reserve Ratio: 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.
3. Banking Habits of the People: 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

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 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.
4. Nature of Business Conditions in the Economy: 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.
5. Leakages in Credit-Creation: 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.
6. Sound Securities: 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.”
7. Liquidity Preference: If people desire to hold more cash, the power of banks to create credit
is reduced.
8. Monetary Policy of the Central Bank: 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.

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3.4. Balance Sheet of Banks

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.

Balance Sheet of the Bank

Liabilities Assets
1. Capital 1. Cash
a. Authorized capital a. Cash on hand
b. Issued capital b. Cash with central Bank and other banks
c. Subscribed capital
d. Paid-up-capital
2. Reserve Fund 2. Money at call and short notice
3. Deposits 3. Bills discount
4. Borrowings from other banks 4. Bills for collection
5. Bills Payable 5. Investments
6. Acceptance and endorsements 6. Loans and Advances
7. Contingent liabilities 7. Acceptance and endorsement
8. Profit and loss account 8. Fixed assets
9. Bills of Collection

Liabilities

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 analyze the various items on the liabilities side.
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1. Capital: The bank has to raise capital before commencing its business. Authorized capital is
the maximum capital upto which the bank is empowered to raise capital by the Memorandum
of Association. Generally, the entire authorized capital is not raised from the public. That part
of authorized 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.
2. Reserve Fund: 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.
3. Deposits: 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.
4. Borrowings from Other Banks: 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.
5. Bills Payable: 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.
6. Acceptances and Endorsements: 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.
7. Contingent Liabilities: Contingent liabilities comprise of those liabilities which are not
known in advance and are unforeseeable. Every bank makes some provision for contingent
liabilities.

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8. Profit and Loss Account: 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.
9. Bills for Collection: 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.

Assets

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 analyze the various items on the assets side.

1. Cash: 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 defense to
the bank.
2. Money at Call and Short Notice: 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
Compiled by: Getachew Yitbarek (MSc) - Lecturer at Accounting and Finance Department, DTU 16
 time, this item yields income to the bank. The significance of money at call and short notice is
that it is used by the banks to effect desirable adjustments in the balance sheet. This process is
called „Window Dressing‟. This item constitutes the „third line of defense‟ to the bank.
3. Bills Discounted: 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.
4. Bills for Collection: As mentioned earlier, this item appears on both sides of the balance
sheet.
5. Investments: 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.
6. Loans and Advances: 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.

7. Acceptances and Endorsements: As discussed earlier, this item appears as a contra item on
both sides of the balance sheet.

8. Fixed Assets: 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.

Compiled by: Getachew Yitbarek (MSc) - Lecturer at Accounting and Finance Department, DTU 17