Banks, like other business firms, are profit-making institutions, though public-sector banks are also guided by broader social directives from the RBI. To earn a profit, a bank must place its funds in earning assets, mainly loans and advances and investments. While lending or investing, a bank must look at the net rate of return obtained and the associated risks of holding such earning assets. Furthermore, since a large part of its liabilities are payable in cash on demand, a bank must also consider the liquidity of its earning assets, that is, how easily it can convert its earning assets into cash at short notice and without loss.
Thus, the twin considerations of profitability and liquidity guide a bank in the selection of its asset portfolio. A bank tries to achieve the twin objectives by choosing a diversified and balanced asset portfolio in the light of institutional facilities available to it for converting its earning assets into cash at short notice and without loss and for short-term borrowing. In addition, it has also to observe various statutory requirements regarding cash reserves, liquid assets, and loans and advances. We describe below various classes of assets banks hold. They will also describe the uses of bank funds.
They are discussed in the decreasing order of liquidity and increasing order of profitability:
1. Cash
Cash, defined broadly, includes cash in hand and balances with other banks including the RBI. Banks hold balances with the RBI as they are required statutorily to do so under the cash reserve requirement. Such balances are called statutory or required reserves. Besides, banks hold voluntarily extra cash to meet the day-to-day drawals of it by their depositors.
Cash as defined above is not the same thing as cash reserves of banks. The latter includes only cash in hand with banks and their balances with the RBI only. The balances with other banks in whatever account are not counted as cash reserves.
The latter concept (of cash reserves) is useful for money-supply analysis and monetary policy, where we need to separate the monetary liabilities of the authorities from the monetary liabilities of banks. Inter-bank balances are not a part of the monetary liabilities of the monetary authority, whereas cash reserves are. These balances are only the liabilities of banks to each other. So, they are not included in cash reserves.
2. Money at Call at Short Notice
It is money lent to other banks, stock brokers, and other financial institutions for a very short period varying from 1 to 14 days. Banks place their surplus cash in such loans to earn some interest without straining much their liquidity. If cash position continues to be comfortable, call loans may be renewed day after day.
3. Investments
They are investments in securities usually classified under three heads of (a) government securities, (b) other approved securities and (c) other securities. Government securities are securities of both the central and state government including treasury bills, treasury deposit certificates, and postal obligations such as national plan certificates, national savings certificates, etc. Other approved securities are securities approved under the provisions of the Banking Regulation Act, 1949. They include securities of state- associated bodies such as electricity boards, housing boards, etc., debentures of LDBs, units of the UTI, shares of RRBs, etc.
A large part of the investment in government and other approved securities is required statutorily under the SLR requirement of the RBI. Any excess investment in these securities is held because banks can borrow from the RBI or others against these securities as collateral or sell them in the market to meet their need for sh. Thus, they are held by banks because they are more liquid than and advance even though the return from them is lower than from loans and advances.
4. Loans, Advances and Bills Discounted-or Purchased
They are the principal component of bank assets and the main source of income of banks. Collectively, they represent total ‘bank credit’ (to the commercial sector). Nothing more need be added here, bank advances in India are usually made in the form of cash credit and overdrafts. Loans may be demand loans or term loans. They may be repayable in single or many installments. We explain briefly these various forms of extending hank credit.
(a) Cash Credit
In India cash credit is the main form of bank credit. Under cash credit arrangements an acceptable borrower is first sanctioned a credit limit up to which he may borrow from the bank. But the actual utilization of the credit limit is governed by the borrower’s ‘withdrawing power’. The sanction of the credit limit is based on the overall creditworthiness of the borrower as assessed by the bank.
The ‘withdrawing power’, on the other hand, is determined by the value of the borrower’s current assets, adjusted for margin requirements as applicable to these assets. The current assets comprise mainly stocks of goods (raw materials, semi-manufactured and finished goods) and receivables or bills due from others. A borrower is required to submit a ‘stock statement’ of these assets every month to the bank.
This statement is supposed to act partly as evidence of the on-going production/ trade activity of the borrower and partly to act as a legal document with the bank, which may be used in case of default of bank advances.
To cover further against the risk of default, banks impose ‘margin requirements’ on borrowers, that is, they require borrowers to finance a part of their current assets (offered as primary security to banks) from their owned funds of other sources. (In addition, banks ask for second surety for whatever credit is granted.)
The advances made by banks cover only the rest (on average, the maximum of about 75 per cent) of the value of the primary security. The margin requirements vary from good to good, time to time, and with the credit standing of the borrower. The RBI uses variations in these requirements as an instrument of credit control.
In Case of acute shortage of particular commodities bank financing against the inventories of such commodities can be curtailed by raising the margin requirements for such commodities. Keeping in view the importance of the cash credit system in banking India.
(b) Overdrafts
An overdraft, as the name suggests, is an advance given by allowing a customer to overdraw his current account up to agreed limit. The overdraft facility is allowed on only current accounts. The security for an overdraft account may be person shares, debentures, government securities, life insurance policies, or fixed deposits.
An overdraft account is operated in the same way as a current account. The overdraft credit is different from cash credit in two respects of security and duration. Usually, for cash credit, the security offered is current assets of business, such as inventories of raw materials, goods in process or finished goods, and receivables.
In the case of overdraft, the security is generally in the form of financial assets held by the borrower. Then, generally, the overdraft is a temporary facility, whereas the cash credit account is a longer-run facility. Also, the rate of interest on overdraft credit is somewhat lower than on cash credit because of the difference in risk and servicing cost involved. In all other respects, overdraft credit is like cash credit. In the case of overdrafts, too, interest is charged only on credit actually utilised, not on the overdraft limit granted.
(c) Demand Loans
A demand loan is one that can be recalled on demand. It has no stated maturity. Such loans are mostly taken by security brokers and others whose credit needs fluctuate from day today. The salient feature of a loan is that the entire amount of the loan sanctioned is paid to the borrower in one lump sum by crediting the whole amount to a separate loan account.
Thus, the whole amount becomes immediately chargeable to interest, whatever the amount the borrower actually withdraws from the (loan) account. This makes loan credit costlier to the borrower than (say) cash credit.
Therefore, businessmen in need of supplementing their working capital prefer to borrow on cash credit basis. On the other hand, banks prefer demand loans, because they are repayable on demand, involve lower administrative costs, and earn interest on the full amount sanctioned and paid. The security against demand loans may also be personal, financial assets, or goods.
(d) Term Loans
A term loan is a loan with a fixed maturity period of more than one year. Generally this period is not longer than ten years. Term loans provide medium-or long-term funds to the borrowers. Most such loans are secured loans. Like demand loans, the whole amount of a term loan sanctioned is paid in one lump sum by crediting it to a separate loan account of the borrower. Thus, the entire amount becomes chargeable to interest.
The repayment is made scheduled, either in one installment at the maturity of the loan or in few installments after a certain agreed period. For making big term loans (of say, Rs. one crore or more) to big borrowers, banks have parted using the consortium method of financing in a few cases.
Under this method, a few banks get together to make the loan on participation basis. This obviates the dependence on multiple banking under which a borrower borrows from more than one bank to meet his credit needs. Consortium banking can make for better credit planning. Term loans as a form of bank credit are gaining rapidly in importance.
Various financial assets of a commercial bank
- Liquidity and Profitability
In order to be able to meet demands for cash as and when they are made a bank must not only arrange to have sufficient cash available but it must also distribute its assets in such a way that some of them can be readily converted into cash.
Thus, the bank’s cash reserves can be reinforced quickly in the event of heavy drawings on them. Assets which are readily convertible into cash are called liquid assets, the most liquid being cash itself. The shorter the length of a loan the more liquid because it will soon mature and be repayable in cash; the less profitable because, other things being equal the rate of interest varies directly with the loss of liquidity experienced by the lender.
Thus a bank faces something of a dilemma in trying to secure both liquidity and profitability. It satisfies these apparently incompatible requirements in the way it distributes its assets. These assets have been arranged in the following table with the most liquid but least profitable ones at the top and the least liquid but most profitable towards the bottom.
The rupee assets of the banks include the notes and coin held in their vaults and the bankers’ balances at the Central Bank are part of the banks’ reserves. The bankers’ balances at the Central Bank are a bit like your own deposit at a bank.
Just as you sign cheques to pay your debts or expenditures, banks will meet their balances at the Central Bank. The banks also hold some liquid assets and these are loans to financial intermediaries, government bills and other securities.
These liquid assets earn a rate of interest, but banks make the most of their money by giving loans and overdrafts to people and business. These items come under the heading of advances. The banks also make money by lending in other currencies to businesses, other banks and governments.
It represents a bank’s holding of notes and coins to meet the immediate requirements of its customers. Nowadays, there is no limit set on the amount of cash which banks in India must hold and it is taken for granted that they will hold enough to maintain their depositors’ confidence. The general rule seems to be to hold something in the region of 4% of total assets in the form of cash.
It represents the commercial banks’ accounts with the central bank. When banks in India require notes or corns they obtain them from the Central Bank by drawing on their accounts there in the same way as their customers obtain it from them. The banks also use their central bank accounts for setting debts among themselves. This process is known as the clearing system.
- Money at Call and Short Notice
This consists mainly of day-to-day loans to the money market but also includes some seven-day and fourteen- day loans to the same body and to the stock exchange. This asset is by nature very liquid and enables a bank to recall loans quickly in order to reinforce its cash.
Being so very short these loans carry a very low rate of interest; consequently they are not very profitable. The money market consists of discount houses. Then, main function is to discount bills of exchange.
These bills may be commercial bills, or Treasury Bills. A bill is a promise to pay a fixed amount usually in three months’ time. Thus a firm, or the Treasury, can borrow money by issuing a promise to pay in three months. A discount house may buy such a bill at a discount, i.e., it may buy a Rs.100 bill for Rs 90.00. In this case the rate of discount is 10% (per annum).
This discount house may later sell the bill to a bank, i.e., rediscount it, but when it matures the bill will be presented for payment at its face value. The discount houses finance their operations by borrowing ‘on call or at short notice’ from the commercial banks and they make their profits out of the fractional differences between the rates of interest they have to pay the banks and the slightly higher rates they can charge for discounting bills.
Another link between the banks and the money market lies in the way in which the banks acquire their own portfolios of bills. By agreement the banks do not tender directly for these bills but instead buy them from the discount houses when they have two months or less to run. They also buy them in such a way that a regular number mature each week, thus providing an opportunity for reinforcing their cash bases.
Thus, the money market provides two notable services to the banks. It enables them to earn some return on funds which would otherwise have to be held as cash and it also strengthens their liquidity as regards their bill portfolios.
- Government Securities with One Year or Less to Maturity
These securities consist of central government stocks and nationalised industries’ stocks guaranteed by the government. Since they are so close to the date when they are due for redemption, i.e., repayment at their face value, they can be sold for amounts very near to that value. Thus banks can sell them to obtain cash without suffering any loss. They are very liquid assets.
These are receipts for specified sums deposited with an institution in the banking sector for a stated period of up to five years. They earn a fixed rate of interest and can be bought and sold freely.
These consist mainly of government stock which is always marketable at the stock exchange, even though a loss may be involved by a sale at an inopportune moment. The classification of investments as more liquid than advances can be justified by the greater ease with which investments can be converted into cash, for the latter, although they can technically be recalled at a moment’s notice, can in fact only be converted into cash if the borrower is in a position to repay, and, of course, at the risk of the bank losing its customer if any inconvenience is caused.
These are the principal profit earning assets of the commercial banks. They composed mainly of customers’ overdrafts whereby in return for interest being paid on the amount actually drawn, banks agree to customers over-drawing their accounts, i.e., running into debt, up to stated amounts. These facilities are usually limited to relatively short periods of time, e.g., 6 to 12 months, but they are renewable by agreement.
These may be called for the central bank when it wishes to restrict the banks’ ability to extend credit to their customers. Conversely, a release of existing special deposits will encourage bank lending. As any release of these deposits depends entirely on the central bank they are illiquid and, as they carry only a low rate of interest, they are not profitable assets.
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