CHAPTER FIVE

COMMERCIAL BANK
Introduction
Historically, commercial bank came into being for its commercial purpose. The inception of
modern banking is the outcome of commercial bank.
In the words of Professor Roger, “the bank which deals with money and money’s worth with a
view to earning profit is known as ``Commercial bank.”
Professor Hart says, “A banker is one who, in the ordinary course of business, honours cheques
drawn upon him by persons for and for whom he receives money on current account.”
The objectives of a commercial bank
A. To establish as an institution for maximizing profits and to conduct overall economic
activities.
B. To collect savings or idle money from the public at a lower rate of interests and lend
these public money at a higher rate of interests.
C. To create propensity of savings amongst the people.
D. To motivate people for investing money with a view to bringing solvency in them.
E. To create money against money as an alternative for enhancing supply of money.
F. To build up capital through savings.
G. To expedite investments.
H. To extend services to the customers.
I. To maintain economic stability by means of controlling money market.
J. To extend co-operation and advices to the Govt. on economic issues.
To assist the Govt. for trade& business and socio-economic development
Functions of Commercial Bank
The functions of commercial bank are given below:
A. General Functions:
1. Receiving Deposits:
The first and foremost function of commercial bank is to receive or collect deposits from the
public in different forms of accounts e.g. current, savings, term deposits.

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No interest is charged in the current account, lower rate of interest is charged in the savings
account and comparatively higher interest rates charged in fixed deposits. Thus, commercial
bank builds up customer network.
2. Accommodation of loans and advances:
Commercial Bank attaches much importance to providing loans and advances at higher rates
than the deposit rates and thus earns profits on it. Working capital is accommodated to the
borrower for expansion and smooth running of business. In the similar manner, commercial bank
extends financial accommodation for the development of agriculture and industry. Credit
accommodation is provided to the entrepreneurs for reviving sick and old industries as per Govt.
directives. Thus, commercial bank also extends welfare services to the people at large.
3. Creation of Loan Deposits:
Commercial Bank not only receives deposits from public and accommodates loans to public but
also creates loan deposits. For example: while disbursing loans as per sanction stipulation, the
amount of loan is credited to the borrower’s account. The borrower may not withdraw the full
amount at a time. The residual amount i.e. balance left in the account creates loan deposits.
4. Creation of medium of exchange:
Central Bank has got exclusive right to issue notes. On the other hand, Commercial Bank creates
medium of exchange by issuing cheques. Like notes, cheque is transferrable being popularly
used in the banking transactions.
5. Contribution in foreign trade:
Commercial Bank plays a vital role in expediting foreign exchange and foreign trade business
e.g. import, export etc. It contributes greatly in the economy through import finance and export
finance and thus, earns foreign exchange for the country.
6. Formation of capital:
Commercial Bank extends financial assistance for the formation of capital in the trade,
commerce and industry in the country which expedites its economic development.
7. Creation of Investment Environment:
Commercial Bank plays a significant role in creating investment environments in the country.

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 B. Public Utility Functions:
In modern banking, commercial bank executes public utility services:
1. Remittance of Money:
Remittance of money to the public from one place to another is one of the functions of
commercial bank. Remittance is effected in the form of demand draft ,telegraphic transfer etc.
through different branches and correspondents home and abroad.
2. Help in trade and commerce:
Commercial Bank helps expand trade and commerce. In inland and foreign trade customers are
allowed credit accommodation in the form of letter of credit , bill purchased and discounted etc.
3. Safe custody of valuables:
Commercial Bank introduces locker‟ services to the customers for safe custody of valuables e.g.
documents, shares, securities etc.
4. Help in Foreign Exchange business:
While opening letter of credit, commercial bank obtains credit report of the suppliers and thus
help expedite import and export business.
5. Act as a Referee:
Commercial Bank acts as a referee for and on behalf of the customers.
6. Act as an Adviser:
Commercial Bank provides valuable advice to the customers on different products, business
growth and development, feasibility of business and industry.
7. Collect utility service bills:
As a social commitment, Commercial Bank collects utility service bills e.g. water, electricity,
gas, telephone etc. from the public.
8. Purchase and sale of prize bonds, shares etc.
Commercial Bank undertakes to purchase and sale of prize bonds, shares etc. as a part of social
commitment.
9. Help people travel abroad:
Commercial Bank helps customers in traveling abroad through issuance of travellers cheques,
drafts, cash etc. in favour of the customers.

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C. Agency Functions:
Besides above stated functions, commercial bank acts as a representative of the customers.
1. Collection and payment:
Commercial Bank is engaged in collection and payment of cheque, bill of exchange, promissory
notes, pension, dividends, subscription, insurance premium, interest etc. on behalf of the clients.
2. Purchase and sale of shares and securities:
Commercial Bank is entrusted with the responsibility of purchase and sale of shares and
securities on behalf of the customers.
3. Maintenance of secrecy:
Maintenance of secrecy is one of the most important functions of commercial bank.
4. Act as a trustee:
Commercial Bank acts as a trustee on behalf of the customer.
5. Economic Development and Welfare activities:
Commercial Bank contributes much for the welfare and economic development of the country
Distinguish between Central Bank and Commercial Bank:
Central Bank and Commercial Bank are both financial institutions. But they have got
distinguishing features. Central Bank is meant for national welfare and Commercial Bank is
meant for earning profits. The following points of distinction between central bank and
commercial bank:

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 NO. . Points of distinction Central bank Commercial bank
Formation Central Bank is the sole banking Commercial Bank is formed
Institution which is established on the basis of Banking
through ordinance or special law Company Laws.
of the Government
Ownership Commercial Bank is formed on Commercial Bank is
the basis of Banking Company established under both govt.
Laws. and private Ownership.
Purpose To earn profit is not the main The main purpose of
purpose of central bank. Its main commercial bank is to earn
purpose is to control credit profit. Recovery of loan is the
system and money market main stay for generation of
profit
Number In a country there is only one In a country there may be
Central Bank more number of commercial
banks.
Control Central bank is conducted Commercial Bank is
exclusively under Government conducted under central
control bank‟s control.
Gov’t influence Government has direct influence Government has indirect
on Central Bank influence On Commercial
Bank through Central Bank
Currency market Central Bank organizes, controls Commercial Banks are the
and administers currency market members of the currency
market
Competition Central Bank does not compete Commercial Bank has to face
with other banks to face lot of competition
Representative Central Bank represents the Commercial Bank represents
country or state the Customers
Foreign Branch Central Bank has no branch Commercial Bank may have
abroad. many Branches abroad

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 Note issue Note issue is the primary Commercial bank cannot
function of central bank. issue the note
Credit control Central Bank controls credit. Commercial Bank assists
central bank In controlling
credit.
Clearing House Central Bank acts as a clearing Commercial banks are the
house for settlement of inter- members of the clearing
bank transactions house. They settle transactions
through clearing house
Nature Of work Central bank is not engaged in Commercial bank is engaged
general banking activities i.e. to in receiving deposits, paying
receive deposits, to lend, to money, creating loan etc.
create loan etc.
Foreign Exchange Central Bank controls foreign Commercial bank helps
exchange. central bank in controlling
foreign exchange
Investments Central bank does not Make any Commercial bank makes
investment for profitability investments in various sectors
purpose for the purpose of
profitability.
Refinance Facility Central bank refinances Commercial bank takes
commercial bank against first refinance facility from the
class securities, bill of exchange central bank
Development work Central Bank formulates policy Commercial bank participates
on development Work in the development program
Initiated by the central bank

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 Credit Creation
It is an open secret that the banks do not keep cent per cent reserve against deposits in order to
meet the demands of depositors. The bank is not a cloak room where you can keep your currency
notes or coins and claim those very notes or coins back when you desire. It is generally
understood that money received by the bank is meant to be advanced to others. A depositor has
to be content simply with the bank’s promise or undertaking to pay him back whenever he makes
a demand.
This bank is able to do with a very small reserve, because all the depositors do not come to
withdraw money simultaneously; some withdraw, while others deposit at the same time. The
bank is thus enabled to erect a vast superstructure of credit on the basis of a small cash reserve.
The bank is able to lend money and charge interest without parting with cash. The bank loan
creates a deposit or, as we have seen above, it creates a credit for the borrower.
Similarly, the bank buys securities and pays the seller with its own cheque which again is no
cash; it is just a promise to pay cash. The cheque is deposited in some bank and a deposit is
created or credit is created for the seller of the securities. This is credit creation.
Thus, term ‘credit creation’ implies a situation, to use Benham’s words, when “a bank may
receive interest simply by permitting customers to overdraw their accounts or by purchasing
securities and paying for them with its own cheques, thus increasing the total bank deposits.”
Limitations on Credit Creation:
From the account of credit creation given above, it would seem that the banks ‘reap where they
have not sown’. They advance loans or buy securities without actually paying cash. But they
earn interest on the loans they give, or earn dividends on the securities they purchase, all the
same. This is very tempting. They make profits without investing cash. They would, of course,
like to make as much profit, like this, as they can.
But they cannot go on expanding credit indefinitely. In their own interest, they have to apply the
brake and they do actually apply it, for it is well known that the profits made by the banks are not
very high. The overriding limitation arises from the obligation-of the banks to meet the demands
of their depositors.

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Balance Sheet of Banks
A balance sheet (aka statement of condition, statement of financial position) is a financial
report that shows the value of a company's assets, liabilities, and owner's equity on a specific
date, usually at the end of an accounting period, such as a quarter or a year. An asset is anything
that can be sold for value. A liability is an obligation that must eventually be paid, and, hence, it
is a claim on assets. The owner's equity in a bank is often referred to as bank capital, which is
what is left when all assets have been sold and all liabilities have been paid. The relationship of
the assets, liabilities, and owner's equity of a bank is shown by the following equation:
Bank Assets = Bank Liabilities + Bank Capital
A bank uses liabilities to buy assets, which earns its income. By using liabilities, such as deposits
or borrowings, to finance assets, such as loans to individuals or businesses, or to buy interest
earning securities, the owners of the bank can leverage their bank capital to earn much more than
would otherwise be possible using only the bank's capital. Assets and liabilities are further
distinguished as being either current or long-term. Current assets are assets expected to be sold
or otherwise converted to cash within 1 year; otherwise, the assets are long-term
(aka noncurrent assets). Current liabilities are expected to be paid within 1 year; otherwise,
the liabilities are long-term (aka noncurrent liabilities). Working capital is the excess of
current assets over current liabilities, a measure of its liquidity, meaning its ability to meet short-
term liabilities:
Working Capital = Current Assets – Current Liabilities
Generally, working capital should be sufficient to meet current liabilities. However, it should not
be excessive, since capital in the form of long-term assets usually has a higher return. The excess
of the bank's long-term assets over its long-term liabilities is an indication of its solvency its
ability to continue as a going concern.
Asset: uses of funds
Assets earn revenue for the bank and includes cash, securities, loans, and property and
equipment that allows it to operate

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Cash and cash equivalent
One of the major services of a bank is to supply cash on demand, whether it is a depositor
withdrawing money or writing a check, or a bank customer drawing on a credit line. A bank also
needs funds to pay bills, but while bills are predictable in both amount and timing, cash
withdrawals by customers are not.
Hence, a bank must maintain a certain level of cash compared to its liabilities to maintain
solvency. A bank must hold some cash as reserves, which is the amount of money held in a
bank's account at the Federal Reserve (Fed). The Federal Reserve determines the legal reserves
which is the minimum amount of cash that banks must hold in their accounts to ensure the safety
of banks and also allows the Fed to effect monetary policy by adjusting the reserve level. Often,
banks will keep excess reserves for greater safety.
To do business at its branches and automated teller machines (ATMs), a bank also needs vault
cash, which includes not only cash in its vaults, but also cash elsewhere on a bank's premises,
such as in teller drawers, and the cash in its ATM machines.
Some banks, usually smaller banks, also have accounts at larger banks, called correspondent
banks. Which are usually larger banks that often borrow from the smaller banks or perform
services for them? This relationship makes lending expeditious because many of these smaller
banks are rural and have excess reserves whereas the larger banks in the cities usually have a
deficiency of reserves.

Another source of cash is cash in the process of collection. When a banks receives a check, it
must present the check to the bank on which it is drawn for payment, and, previously, this has
taken several days. Nowadays, checks are being processed electronically and many transfers of
funds are being conducted electronically instead of using checks. So this category of cash is
diminishing significantly, and will probably disappear when all financial transactions finally
become electronic.

Cash equivalents are another short-term asset, so-called because they are nearly equivalent to
cash: short-term investments that can either be used as cash or can be quickly converted to cash
without loss of value, such as demand deposits, T-bills, and commercial paper.

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A primary characteristic of financial instrument that are classified as cash equivalents is that they
have a short-term maturity of 3 months or less, so interest rate risk is minimal, and they are the
most highly rated securities or issued by a government that can print its own money, such as the
T-bill issued by the US government, so there is little credit risk.
Securities
The primary securities that banks own are united state treasury and municipal bond. These bonds
can be sold quickly in the secondary market when a bank needs more cash, so they are often
referred to as secondary reserves.
The recent credit crisis has also underscored the fact that banks held many asset backed
securities as well. United States banks are not permitted to own stocks, because of their risk, but,
ironically, they can hold much riskier securities called derivatives
Loans are the major asset for most banks. They earn more interest than banks have to pay on
deposits, and, thus, are a major source of revenue for a bank. Often banks will sell the loans,
such as mortgages, credit card and auto loan receivables to be securitized into asset-backed
securities which can be sold to investors. This allows banks to make more loans while also
earning origination fees and/or servicing fees on the securitized loans.
Loans include the following major types:
 Business loans, usually called commercial and industrial
(C&I) loans
 Real estate loans
o residential mortgages
o home equity loans
o commercial mortgages
 Consumer loans
o credit cards
o auto loans
 Interbank loans

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