Functions of a commercial bank, Macroeconomics

Functions of a Commercial Bank

1. Credit Creation

Creation of credit is a major function of a commercial bank. When a bank creates credit or advances loans, there tends to be a multiple expansion of credit in the banking system. Let us first understand how a single bank, which is a part of a multi-bank banking system, creates money.

Let us take a hypothetical example of a bank, Bank A which is formed with a share capital of Rs.5,00,000. The balance sheet of the bank would read as

Balance Sheet of Bank A

Liabilities

Rs.

Assets

Rs.

Capital

5,00,000

   Cash

5,00,000

Let us assume that the bank starts operating.

Accepting Deposits: The two main functions of a commercial bank are to accept deposits and to make loans. Let us suppose a person say Z deposits Rs.3,00,000 in the bank. The balance sheet now reads like this -

Balance Sheet of Bank A

Liabilities

Rs.

Assets-

Rs.

Capital

Demand deposits

5,00,000

3,00,000

        Cash

 

8,00,000

 

2. Maintaining Reserves: Being a commercial bank, the bank A has to fulfill two legal requirements - (1) It must satisfy the cash reserve requirement and (2) It must meet statutory liquidity requirement. Every commercial bank must keep on deposit with the Reserve Bank certain amount of funds equal to a specified percentage of its own deposit liabilities. This specified percentage is the Cash Reserve Ratio (CRR).

Thus, CRR = Bank's required deposit in RBI Commercial bank's deposit liabilities.

At present, a commercial bank has to maintain a CRR of 15%.

Having accepted Rs.3,00,000, Bank A has to keep Rs.45,000 (i.e. 15% of 3,00,000) as cash reserve or reserves in the RBI.

In addition to CRR, the banks have to meet the statutory liquidity requirement i.e. it has to maintain with itself a minimum amount of liquid assets equal to not less than a specified percentage of outstanding deposit liabilities. At present, SLR is 34.75%. For simplicity, let us assume SLR to be 35%. Thus, in our example Bank A has to set aside Rs.1,05,000 as liquid assets out of its cash balance. The balance sheet will appear as 

Balance Sheet of Bank A

Liabilities                           Rs.                Assets                             Rs.

Capital

Demand deposits

5,00,000

3,00,000

Cash

Reserves with RBI

Required liquid assets

6,50,000

45,000

1,05,000

Banks are also allowed to maintain extra reserves with RBI apart from just the cash reserves that they have to maintain with the RBI. Banks, generally maintain these extra reserves to avoid inconvenience of sending additional reserves to the RBI each time its demand deposits increase, and also it will earn interest on these extra reserves. In our example if our Bank A assumes to maintain extra reserves of Rs.6,00,000 leaving cash of Rs.50,000 the balance sheet would appear as follows:

Balance Sheet of A

Liabilities                           Rs.                Assets                             Rs.

Capital

Demand deposits

5,00,000

3,00,000

Cash

Reserves with RBI

Required liquid assets

50,000

6,45,000

1,05,000

What is the rationale underlying the requirement of CRR and SLR. Basically, one might think that the purpose of maintaining these reserves is to enhance the liquidity of a bank and thereby protect commercial bank depositors from losses. But, this is not so because cash reserves with the RBI are not an available pool of liquid funds upon which commercial banks can rely in times of emergency and even if all required reserves were accessible and legally usable by commercial banks, they would be grossly insufficient to meet a serious 'run' on a commercial bank.

Then, what is the purpose of these reserves? Control is the answer. Required reserves are means by which RBI can influence the lending ability of the commercial banks. It can invoke certain policies which either increase or decrease commercial bank reserves and thereby affect the ability of the banks to grant credit.

3. Clearing Cheques: Now, let us see what happens if the depositor Z draws a cheque of Rs.1,50,000 against Bank A in favor of another person, say Y - (i) Y deposits this cheque  in his account in his bank, say Bank B. Bank B increases Y's demand deposits in its balance sheet by Rs.1,50,000 - (ii) Then, Bank B sents this cheque to the clearing agency of RBI where Bank B's reserves are increased by Rs.1,50,000 and Bank A's reserves are decreased by the same Rs.1,50,000 - (iii) The cleared cheque is then sent to Bank A which reduces demand deposits of Z by Rs.1,50,000 - (iv) Changes in demand deposits of both the banks effect the holdings of liquid assets of the banks. Fall in demand deposits of Bank A by Rs.1,50,000 will reduce its required liquid assets by Rs.52,500 (i.e. assuming SLR at 35%). Similarly, increase in demand deposits of Bank B by Rs.1,50,000 increases its required liquid assets by Rs.52,500. The Balance Sheet would appear as under:

Balance Sheet of A

Liabilities                           Rs.                Assets                             Rs.

Capital

Demand deposits

5,00,000

3,00,000

Cash

Reserves with RBI

Required liquid assets

50,000

6,45,000

1,05,000                                                                  

Posted Date: 9/18/2012 6:20:38 AM | Location : United States







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