CHAPTER THREE

COMMERCIAL BANKING
INTRODUCTION
Banking occupies one of the most important positions in the modern economic world. It is
necessary for trade and industry. Hence it is one of the great agencies of commerce. Although
banking in one form or another has been in existence from very early times, modern banking is
of recent origin. It is one of the results of the Industrial Revolution and the child of economic
necessity. Its presence is very helpful to the economic activity and industrial progress of a
country.

Meaning of Commercial bank

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.

3.1. TYPES OF COMMERCIAL BANKS

Broadly speaking, banks can be classified into commercial banks and central bank.
Commercial banks are those which provide banking services for profit. The central bank has
the function of controlling commercial banks and various other economic activities. There
are many types of commercial banks such as deposit banks, industrial banks, savings banks,
agricultural banks, exchange banks, and miscellaneous banks.

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Deposit Banks: The most important type of deposit banks is the commercial banks.
They have connection with the commercial class of people. These banks accept
deposits from the public and lend them to needy parties. Since their deposits are
for short period only, these banks extend loans only for a short period. Ordinarily
these banks lend money for a period between 3 to 6 months. They do not like to lend
money for long periods or to invest their funds in any way in long term securities.

Industrial Banks: Industries require a huge capital for a long period to buy machinery
and equipment. Industrial banks help such industrialists. They provide long term loans
to industries. Besides, they buy shares and debentures of companies, and enable them
to have fixed capital. Sometimes, they even underwrite the debentures and shares of big
industrial concerns. The important functions of industrial banks are:
I. They accept long term deposits.
II. They meet the credit requirements of industries by extending long term loans.
III. These banks advise the industrial firms regarding the sale and purchase of shares
and debentures. The industrial banks play a vital role in accelerating industrial
development.
Savings Banks: These banks were specially established to encourage thrift among
small savers and therefore, they were willing to accept small sums as deposits. They
encourage savings of the poor and middle class people. In Ethiopia we do not have such
special institutions.

Agricultural Banks: Agriculture has its own problems and hence there are separate
banks to finance it. These banks are organized on co-operative lines and therefore
do not work on the principle of maximum profit for the shareholders. These banks
meet the credit requirements of the farmers through term loans, viz., short, medium
and long term loans. There are two types of agricultural banks,

I. Agricultural Co-operative Banks, and

II. Land Mortgage Banks. Co-operative Banks are mainly for short periods. For long
periods there are Land Mortgage Banks. Both these types of banks are performing
useful functions.

Exchange Banks: These banks finance mostly for the foreign trade of a country. Their main
function is to discount, accept and collect foreign bills of exchange. They buy and sell foreign
currency and thus help businessmen in their transactions. They also carry on the ordinary
banking business.
Miscellaneous Banks: There are certain kinds of banks which have arisen in due
course to meet the specialised needs of the people. In England and America, there are
investment banks whose object is to control the distribution of capital into several uses.
American Trade Unions have got labour banks, where the savings of the labourers are

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pooled together. In London, there are the London Discount House whose business is “to
go about the city seeking for bills to discount.” There are numerous types of different
banks in the world, carrying on one or the other banking business.

III.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.

Primary Functions
Primary banking functions of the commercial banks include:
I. Acceptance of deposits
II. Advancing loans
III. Creation of credit

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IV. Clearing of cheques
V. Financing foreign trade
VI. Remittance of funds
1. Acceptance of Deposits: Accepting deposits is the primary function of a commercial
bank mobilise 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 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 Br. 30,000/- in his current account in a bank but requires Br. 60,000/- to
meet his expenses. He may approach his bank and borrow the additional amount
of Br. 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

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 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 rediscount, the discounted bills 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 instalments 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

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 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 merely purveyors 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.
Secondary Functions

Secondary banking functions of the commercial banks include:

1. Agency Services
2. General Utility Services

These are discussed below.

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.
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.

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 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.
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.
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.

III.3. SOURCES OF BANK’S INCOME

A bank is a business organisation engaged in the business of borrowing and lending money.
A bank can earn income only if it borrows at a lower rate and lends at a higher rate. The
difference between the two rates will represent the costs incurred by the bank and the profit.
Bank also provides a number of services to its customers for which it charges commission.
This is also an important source of income. The followings are the various sources of a
bank’s profit:
1. Interest on Loans: The main function of a commercial bank is to borrow money for
the purpose of lending at a higher rate of interest. Bank grants various types of loans to
the industrialists and traders. The yields from loans constitute the major portion of the

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 income of a bank. The banks grant loans generally for short periods. But now the banks
also advance call loans which can be called at a very short notice. Such loans are granted
to share brokers and other banks. These assets are highly liquid because they can be
called at any time. Moreover, they are source of income to the bank.
2. Interest on Investments: Banks also invest an important portion of their resources
in government and other first class industrial securities. The interest and dividend
received from time to time on these investments is a source of income for the banks.
Bank also earn some income when the market prices of these securities rise.
3. Discounts: Commercial banks invest a part of their funds in bills of exchange by
discounting them. Banks discount both foreign and inland bills of exchange, or in
other words, they purchase the bills at discount and receive the full amount at the
date of maturity. For instance, if a bill of Br. 1000 is discounted for Br. 975, the
bank earns a discount of Br. 25 because bank pays Br. 975 today, but will get Br.
1000 on the due date. Discount, as a matter of fact, is the interest on the amount
paid for the remaining period of the bill. The rate of discount on bills of exchange is
slightly lower than the interest rate charged on loans and advances because bills are
considered to be highly liquid assets.
4. Commission, Brokerage, etc.: Banks perform numerous services to their
customers and charge commission, etc., for such services. Banks collect cheques,
rents, dividends, etc., accepts bills of exchange, issue drafts and letters of credit
and collect pensions and salaries on behalf of their customers. They pay insurance
premiums, rents, taxes etc., on behalf of their customers. For all these services banks
charge their commission. They also earn locker rents for providing safety vaults to
their customers. Recently the banks have also started underwriting the shares and
debentures issued by the joint stock companies for which they receive underwriting
commission.
Commercial banks also deal in foreign exchange. They sell demand drafts, issue letters of
credit and help remittance of funds in foreign countries. They also act as brokers in
foreign
exchange. Banks earn income out of these operations.

III.4.BALANCE SHEET OF THE BANK

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.
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 analyse the various items on the
liabilities side.
1. Capital: 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

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 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.
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.
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

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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.

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 defence 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 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 defence’ 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.

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III.5. 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:
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 honour 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 well known 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. 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 ‘C’ s 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.
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

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 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.
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.
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 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.
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III.6.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.

3.6.1. 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
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.” Thus,

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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.”
3.6.2. 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 cash reserves, according to law, and,
C. A new deposit of Br. 1,000 has been made with bank A to start with. Suppose, a person
deposits Br. 1,000 cash in Bank A. As a result, the deposits of bank A increase by Br.
1,000 and cash also increases by Br. 1,000. The balance sheet of the bank is as fallows:

Assets Br. Liabilities Br.

New Cash 1,000. New deposit 1,000.
Total 1,000. 1,000.

Under the double entry system, the amount of Br. 1,000 is shown on both sides. The deposit
of Br. 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., Br. 100 against its new deposit and it has a surplus of Br. 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:

Assets Br. Liabilities Br.

New Cash 100. deposit 1,000.
Loan to X 900
Total 1,000. 1,000.

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

Assets Br. Liabilities Br.

New Cash 90 deposit 900
Loan 810
Total 900 900

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

Assets Br. Liabilities Br.

Cash 81 deposit 810
Loan 729
Total 810 810

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

Name of bank Deposits Br. Cash reserve Br. Loan Br.

Bank A 1000 100 900
Bank B 900 90 810
Bank C 810 81 729
Total 2710 271 2439

It is clear from the above that out of the initial primary deposit, bank advanced Br.900 as a loan.
It formed the primary deposit of bank B, which in turn advanced Br.810 as loan. This sum again
formed, the primary deposit of bank C, which in turn advanced Br.729 as loan. Thus the inital
primary deposit of Br.1,000 resulted in bank credit of Br.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.
3.6.3. Leaf and Cannon Criticism
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.

3.6.4. 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:
I. 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.
II. 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.
III. 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 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.
IV. 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.
V. 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.

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 VI. 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.”
VII. Liquidity Preference: If people desire to hold more cash, the power of banks to
create credit is reduced.
VIII. 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.

III.7.COMMERCIAL BANKS AND ECONOMIC DEVELOPMENT

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 Ethiopia, 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 :
 Accelerating the Rate of Capital Formation: 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.
 Provision of Finance and Credit: 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.
 Monetisation of Economy: 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

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 rural and backward areas can promote the process of monetization (conversion of debt into
money) in the economy.
 Innovations: Innovations are an essential prerequisite for economic development. These
innovations are mostly financed by bank credit in the developed countries. But in
developing 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.
 Implementation of Monetary Policy: 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.
 Encouragement to Right Type of Industries: 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.
 Development of Agriculture: 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, NBE, Development Ethiopia Bank of and other commercial
banks are granting short term, medium-term and long-term loans to agriculture and small-
scale industries.
 Regional Development: 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.
 Promote Industrial Development: 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 installment system by guaranteeing deferred
payments. Thus, banks promote or encourage industrial development.
 Promote Commercial Virtues: 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.”

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 Fulfillment of Socio-economic Objectives: 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. 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 subserve national priorities and objectives.” A well-developed banking system provides
a firm and durable foundation for the economic development of the country.

Questions for Discussion

1. What is a commercial bank? What are the main functions performed by commercial
banks? How far are they useful for economic development?
2. State the kinds of commercial banks.
3. What do you understand by a commercial bank’s balance sheet? What specific
information does it convey?
4. What is the investment policy of a commercial bank? Explain the factors that constitute
for formulating a suitable investment policy.
5. What is credit creation? How banks create credit? What are the limitations of credit
creation?
6. Discuss the role of banks in a developing economy.

19 | P a g e by Misraku M.