Chapter 68: Rise of American Accounts. "Hollywood ".
Some of the reasons responsible for the strain in the banking sector are :
1. Stress on quantitative and hurried increase in loans without proper assessment and at the expense of quality of assets.
2. Politically motivated or influenced sanction of loans, loan melas and waiver of loans.
3. Indiscriminate expansion of banking activities ignoring the basic canons of banking that is, safety, productivity and profitability.
4. Diversification of banking operations in unconventional areas without giving proper attention either to systematic development to back up succesful implementations of these new activities or to building up infrastructural facilities.
5. Lack of expertise within the banks to handle this complex banking scenario, and not much effort to improve the quality of personnel within the banking sector by equipping them to handle the growing challenges effectively.
6. Lack of effective management information system and control leading to blurred accountability at all levels.
7. Pressure on achieving the targets mechanically due to somewhat political pressure in decision-making in certain areas , and the interference of middlemen in the field of loans to weaker section of society leading to unethical practices in banking.
8. Growing complacent attitude of the trade unions of both officers and workmen staff, which has partially led to the deterioration of customer service.
9. The uniformity in various aspects of public sector banking operations led to lack of competition, excessive recruitment, higher operating expenses and lower income, lack of response to changing need due to rigidity and uniformity.
Regional Rural Banks (RRB's)
Regional Rural Banks were set up on the recommendations of a working group headed by M.Narasimham in 1975. The objective was to provide credit and other facilities to small and marginal farmers , agricultural labourers and artisans. The need was felt as commercial banks and co-operative banks were not able to serve these segments adequately. These banks are the third component of the multi-agency credit system for agriculture sector. There are regional banks with rural oriention. There are scheduled banks which are governed by Regional Rural Banks Act, 1976.
Distinction from commercial banks :
(1) The area of a RRB is limited to only a region, comprising of some districts of a state.
(2) These banks grant loan only to the rural agriculture sector and small artisans.
(3) The lending rates would be somewhat lower than the commercial banks.
(4) These are intended to eliminate money lenders.
(5) These banks are to supplement the effort of co-operative banks.
(6) Commercial banks sponsor RRB's.
The capital of RRB's comes in the proportion of 50:15:35 between Govt. of India, State Govt. and sponsoring commercial bank.
At present RRB's are working in all states except in Sikkim and Goa. The opening of new RRB's was stopped after April 1987 on the basis of recommendations of Kelkar Committee. With more autonomy, large number of RRB's have been able to improve their working. In fact, Narsimham Committee recommended that RRB's should be given freedom to perform all types of banking activities.
At the end of 1997-98 the number of RRB's was 196. To enable Regional Rural Banks to play a more effective role in rural credit, the Government has been providing capital through budgetary allocations. During 1998-99, the Government of India provided Rs 265 crore for rehabilitation and capitalisation of the RRB's.
PRIVATE SECTOR BANKS
In the post independence period, it was noticed that the private sector banks controlled by industrial houses were ignoring the rural areas and agricultural sector. This led to the setting up of the State Bank of India in 1955. Pro socialism thought led to the nationalisation of banks in 1969 and 1980. These steps brought more than 90 per cent of the commercial banking in the public sector.
NEW PHASE IN PRIVATE SECTOR BANKING
The economic reforms initiated in the aftermath of the 1991 crisis have brought winds of change in every segment of the economy. The process of reforming the banking industry was initiated in 1991 with the setting up of the Narsimham Committee which focussed on ways to improve the structure , organisation, functions and procedures of financial sector at large.
In accordance with the recommendations and as an attempt to deregulate the banking industry, the Reserve Bank of India , in January 1993, announced guidelines for entry of new commercial banks. For the first time in five decades, the banking policy for starting new private sector banks was framed.
As compared to old private sector banks the new private sector banks are showing much better performance. Within a short period that they have been in operations, the results have been excellent.
These banks are going to improve competition within the industry alongwith foreign banks. They are introducing superior levels of technology and customer satisfaction.
These new banks are strategic in their thinking and operations. For example, most of them have established strong relationships with foreign commercial banks or investment banks . This is helping them in having new concepts and products and access to latest banking technology.
Unlike the banks of yester years, these banks have a specific business focus. They are targetting specific products and customer groups rather than the entire financial sector. Most of them are targetting midsized corporates. They are specialising in certain segments like investment banking, trade finance and foreign exchange services. They are really going to globalise Indian banking.
The customer oriented shift given by these banks is going to improve service and innovate products. With the launch of Automatic Teller Machines (ATM's) , they will provide round the clock banking.
The role of private sector banks will become more important, note worthy and catalytic as most of them are backed by established financial institutions.
FOREIGN BANKS
Foreign banks are those banks which are registered or incorporated outside India. They have an office or branch in India. These banks had their presence from the British period. With the changes in the banking policy in post 1993 period, the number of foreign banks will increase. The globalisation of Indian economy will encourage the presence of more foreign banks.
The number of banks have shown an increase in number over the years. The number of foreign banks ( their branches ) which stood at 15(71) in 1961 rose to 30(156) in 1996. At the end of June 2000 , 186 branch offices of 44 foreign banks were operating in India. Besides performing banking functions, foreign banks play an important role in shaping the attitudes and policies of foreign governments, companies and their clients towards India. They perform following additional functions :
(a) providing finance for power generation , telecommunications, and mining projects in India .
(b) help foreign companies and Indian companies enter into joint ventures and collaborations.
(c) managing and syndicating euro-issues of debt and equity of the Indian companies.
(d) managing data and information system by using latest technology , and
(e) help in bringing together FIIs and the Indian companies.
SOURCES AND EMPLOYMENT OF FUNDS
Sources and employment of commercial bank's funds can be well understood with the profoma balance sheet of a commercial bank.
Sources of Funds
From the balance sheet , we can identify the following main sources of bank's funds.
1. Capital (Schedule 1) . This represents the following :
(a) Nationalised Banks. Capital owned by the Central Government and the shareholders of the bank.
(b) Foreign Banks. The amount brought by bank by way of start up capital as prescribed by RBI and the amount of deposit kept with RBI as per the provisions of the Banking Regulation Act, 1949.
(c) Other Banks. The amount contributed by the shareholders of the bank.
In India, share capital of the banking company consists of only equity shares or such preference shares as may have been issued prior to 15th July , 1945.
2. Reserves and Surplus (Schedule 2). This comprises the following :
(a) Statutory Reserve. According to Section 17 of the Banking Regulation Act, 1949 , every banking company is required to transfer atleast 20% of its profits each year prior to declaration of dividend to the reserve fund. Such a reserve is termed as Statutory Reserve.
(b) Capital Reserve. The reserve created out of capital profits.
(c) Share Premium. Premium received by a banking company on issue of share capital.
(d) Revenue and other Reserves. The item includes all reserves other than those classified as capital reserve. They include dividend equalisation reserve, debenture redemption reserve, contingency reserve, etc.
3. Depisits (Schedule 3) . Deposits are a major source for the funds of a banking company . They constitute more than 80% of a commercial bank's funds. Depisits can be classified into three categories (1) demand deposits, (2) savings bank deposits and (3) fixed deposits.
4. Borrowings (Schedule 4). A banking company may borrow from other sister institutions. Usually these borrowings are for short-term and to meet the urgent requirements of funds.
5. Other Liabilities (Schedule 5). These include the following :
(a) Bills Payable. This represents letters of credit or bank drafts issued by the bank in favour if third parties, for their customers in lieu of the funds received from them.
(b) Inter office adjustments (Net). This term represents the debts on account of incomplete recording of transactions between one branch or between one branch and the head office.
It may be a debit or a credit balance. In case of a credit balance, it should be shown under this head . It may be noted that only net portion is to be shown of inter-office accounts , inland as well as foreign.
(c) Intetest accrued. It includes interest accrued but not due on depisits and borrowings.
(d) Others. This includes a provisions for income-tax and other taxes like interest tax, surplus provisions for bad debts, proposed dividend, staff security deposits, etc.
(e) Balance of profits. This include balance of profit after appropriations . In case of a loss the balance may be shown as a deduction.
From the above it can be concluded that the main sources of a bank's funds are : share capital, retained earnings, deposits from the public and borrowings from other banks or banks agents etc. As a matter of fact, deposit from the public constitutes largest source of a bank's funds. Thus, about 85 to 95 per cent of a bank's funds are from share capital, retained earnings and deposits. Besides these sources the banks raise their working funds in the form of refinancing facilities from different financial institutions viz. Industrial Development Bank of India (IDBI) , in respect of term loans to medium and large scale industries, Small Industries Development Bank of India (SIDBI) in respect of loans to SSI Units, National Bank for Agricultural & Rural Development (NABARD) in respect of agricultural credit, Export Import Bank of India (EXIM Bank) in respect of financial facilities to import and export trade etc. Besides these banks get bills rediscounting facilities from the Reserve Bank of India under its bill market scheme. If necessary, bank also go to call money markets for financing emergency requirements.
The various sources of working funds have their own merits and demerits, as given below :
1. Deposits. Deposits are a major source of finance. They may be in the form of current deposits, savings deposit or fixed deposits. Current deposits are advantageous to the banks since no interest is payable on such deposits. However, such deposits cannot be a major source of working funds because of frequent transactions and their availability only in metropolitian or urban areas. Savings bank deposits are mainly available in residential areas. They are also not a major source of a bank's funds since they are payable on demand and without much restriction on the amount of withdrawal. Term deposits are a major source of finance . They can be mobilised at all centres both in rural and urban because of higher rate of interest payable on them. Though the bank has to pay higher rate of interest on such deposits yet in view of the fact that these deposits are for a fixed period, they become an important source of working funds of a bank. Of course, all deposits are subject to SLR and CRR requirements and therefore to a certain extent the commercial banks are restrained from making a profitable investment of funds raised through deposits.
2. Borrowings. Banking companies borrow from time to time from other banking institutions and agents. These borrowings are for temporary period. However, their cost is quite high and therefore such borrowings are not considered to be a profitable source of financing.
3. Refinancing from Financial Institutions. Refinancing and rediscounting facilities are made available to the commercial banks by specialised financial institutions at attractive terms. Hence, it is a popular source of financing. However, funds are made available only for a limited period and are to be rapid back on specified dates to the concerned financial institutions . This may sometimes put the concerned bank in difficulties if it is not in a position to recover the advance from the party for which it obtained refinance facility.
Employment of Funds/Assets of Bank
The proforma balance sheet shows the following as applications of a bank's funds :
1. Cash in hand and with Reserve Bank (Schedule6). This includes :
(1) Cash balance maintained by a bank with itself. This balance is maintained by the bank to meet any demand on its funds by its customers. The amount remains idle and is a non-earning asset for the bank. The amount of such cash will be small if the customers are banking minded, the bank has a large number of small deposit holders and there is availability of clearing house facilities. In the absence of these factors the bank will have to maintain heavy cash reserve. The bank's own experience and specific circumstances will also affect the sizes of cash reserve.
(2) Cash with Reserve Bank. This refers to the cash balance maintained by a commercial bank with the Reserve Bank of India. According to Section 42 of the Reserve Bank of India Act, every scheduled bank has to maintain a sum equal to at least 3% of its time and demand liabilities in India as cash reserve with the Reserve Bank of India. The Reserve Bank has the power to increase the percentage.
Thus , a part of the reserve maintained by the commercial banks with the Reserve Bank is an income earning asset. Of course, the interest paid by the Reserve Bank is hardly sufficient to meet the cost of these funds to the commercial banks.
2. Balance with other Banks and Money at Call and Short Notice (Schedule 7)
(1) Balance with other banks. The banks keep money deposited with other banks besides the Central Bank of the country. This money can be drawn by the banks as when the need arises. This is therefore termed as " the first line of defence " . The balances either carry no interest or interest at a very nominal rate.
(2) Money at call and short notice. This represents the loans given by one bank to another for a short period. Call loans are repayable at any time the banker recalls them while short notice advances are repayable within a short notice of (say) 24 hours. The maximum notice period is usually of a week. These loans carry a low rate of interest but they certainly ensure more liquidity to the investing bank. Such money is, therefore , taken as "second line of defence".
3. Investments (Schedule 8) These include securities of the Central and State Governments, shares, debentures or bonds, gold, etc. Investments enable the banks to earn higher income as compared to money at call or short notice besides maintaining their liquidity pisition. The banks prefer securities of the Central/State Governments and Semi-Government securities (bonds issued by public sector corporations) as compared to shares and debentures of companies on account of steady return, and safety of investment. Moreover, in India, according to Section24 of the Banking Regulation Act, 1949, every banking company is required to maintain in India in cash, gold or unencumbered approved : securities, an amount equivalent to at least 25% of its time and demand liabilities. This is known as Statutory Liquidity Ratio (SLR). The Reserve Bank can increase this ratio upto 40%.
4. Advances (Schedule 9). A major portion of bank's funds is used for this purpose and this is also a major source of a bank's income. As a matter of fact more than 50% of a bank's funds are employed in granting advances and they contribute to more than 80% of the bank's income.
Advances can be of the following types :
(1) Loans, cash credit and overdrafts.
(2) Bills discounted and purchased.
Advances may be secured as well as unsecured. Of course, in both the cases the banks give emphasis on the creditworthiness of the borrower. However, in case of unsecured advances, this aspect is all the more important.
5. Fixed Assets (Schedule 10). These comprise of premises, furniture and other assets which are meant for use in the business and not for conversion into cash. These are the least liquid assets and also the least paying. A banker, therefore, invests the least possible amount in these assets.
6. Other Assets (Schedule 11). These comprise of inter-office adjustments (net), tax paid in advance, stationery and stamps, non-banking assets in satisfaction of claims.
Non-banking assets represent those assets which a banking company may have to take in its possession because of the failure of a customer to repay the loan in time. Such an asset should be disposed of by a banking company within seven years if its acquisition .
7. Contingent Liabilities (Schedule 12). Contingent liabilities are those liabilities which may or may not happen. These are to be shown outside the balance sheet. They comprise of the following items :
1. Claims against the bank not acknowledged as debts.
2. Liability for partly paid investments.
3. Liability on account of outstanding forward exchange contracts.
4. Guarantees given on behalf of constituents :
(1) In India
(2) Outside India
5. Acceptances, endorsements and other obligations.
6. Other items for which the bank in contingently liable.
INVESTMENT POLICY OF COMMERCIAL BANKS
Investment policy of a commercial bank involves appropriated allocation and distribution of funds among various assets in such a way that the main objective of liquidity, solvency and profitability are achieved. Funds of a bank may be deployed for :
(1) investment in government and corporate securities.
(2) extending loans and advances to the customer in the form of cash credits, overdrafts, term loans, bills purchased and discounted.
(3) purchase of fixed assets, and
(4) keeping cash in hand and with RBI etc.
The bank deposits are socially insured, therefore there has to be social accountability in lending of banks. It has social obligation of meeting diverse credit needs of different sections of the society, without taking undue risks or endangering the public deposits. The banks, particularly the nationalised banks have to keep allocation or end use as an important criterion while taking decisions. The proper allocation and utilisation of funds is the point of emphasis in such banks. The objectives of lending have also undergone change in their emohasis. A bank is expected to meet its obligation towards various sectors e.g. priority sector , in addition to the profit or dividend consideration some of the obligations which have to be kept in mind while deciding investment policy are :
(1) Towards owners : The bank has the obligation to pay a fair return on investment. The capital base on which dividend is to be paid is known. However, the return has to be related to investment made by new owners i.e., dividend yield will be more important than the rate of dividend.
(2) Towards workers: Workers should have a share in the surplus created. The quality of workers attracted depends upon the wages offered. The human resources with the banks will be better, if they offer better salaries.
(3) Towards depositors : The banks have the obligation to give expected standards of service to the depositors. The depositors must be satisfied with the services rendered. The services can be improved through proper training of manpower.
(4) To create a good financial base to strengthen internal financial structure with a view to meet contingencies which may arise relating to the accounts of depositors.
(5) To create and make best use for growth in size and geographical spread. To open more branches and see that all of them make contribution to banks profits.
(6) To help in regional development, which in turn will create better economic and banking conditions.
Any organisation, including as bank can meet its obligations only from surpluses generated. A healthy organisation will always be in a position to meet its obligations reasonably at all points of time. A conflict can arise in deciding the priority in which obligations are to be fulfilled. A bank should be able to arrive at a compromise and evolve policies to be followed consistently over a period of time for the accomplishment of objectives. Every bank should be able to spell out its goals clearly , which it wants to attain over a period of time.
The effectiveness of a bank in meeting its obligations has to be reviewed through a well defined procedure. It will be better to look at the obligations which could not be fulfilled rather than the positive figures and ratios worked out for the purpose. The framework in the form of obligations, goals and review calls upon the bank to formulate a lending policy which would lead to generation of desired surpluses.
FACTORS AFFECTING INVESTMENT POLICY
Number of factors influence and determine the investment policy of a bank. The important ones are listed below :
1. Portfolio Consideration
Portfolio considerations have a very important influence on the Investment loan policy of a bank. The total deployment of funds should be such that any gradual or sudden change in economic environment should not affect the aggregate funds adversely. Liquidity consideration will make investment in government securities desirable, but the earnings in such securities will not be based on the cost of deposits. However, this will enable a bank to meet statutory liquidity ratio requirement. To cover up the loss , banks have to deploy the remaining funds at higher rates to other sectors of economy. A part of the funds will be required to meet the priority sector quota. At this stage also there is need to deploy funds in different industries and different sectors, so that environmental changes get absorbed easily. Excessive involvement in any area of advances on any count is likely to create problems. There should be no excess involvement with a borrower, industry, trade or geographical area. The excess involvement in any area has to be avoided even if the proposal from the borrower, industry or area is otherwise sound. The need is to have a balanced portfolio in the long run. This requirement calls for a policy decision regarding extent of involvement in any area by considering :
(1) the person, activity and region.
(2) time roll-over of funds and pissibility to withdraw from commitment.
(3) income generated from deployment of funds , and
(4) expected environmental changes.
The objective is safety of funds deployed in the long run.
2. Marketing of Funds.
Portfolio needs will decide the need for deployment of funds. The standards determined will have to be achieved. The bank has to reach the market to make desirable deployment of funds rather than being dictated by the market. The lending policy has to be evolved from marketing point of view. The experience shows that most of the borrowing units go through the stages of initial development, growth to maturity, stability and stagnation. It will not be desirable to get blocked with units which are stagnating . This may lead to the stagnation of the bank itself. It is necessary to locate borrowing units at the stage of initial development and growth. It may not be profitable to begin with, but will yield goods results in due course. The policy should aim at having maximum number of growing stage accounts and minimum number of stagnating accounts, a good number of initial development stage accounts and a fair number of steady accounts. This will require policy decisions regarding :
(1) new activities, areas and borrowers.
(2) review of stagnating accounts, over-saturated areas.
(3) promotional activities in worth while areas.
3. Flexibility in Deployment of Funds
The deployment of funds should meet the expectations of depositors, borrowers and society. The funds available should match with the demand of borrowers. Sometimes, the funds available at a given point of time may exceed the demand for short term loans. The desire and need to generate returns may push banks towards making commitments for longer period and doubtful cash inflows. This can harm the interest of the bank. Similarly, deficit funds situations may result in hurried withdrawal of facilities. This will be detrimental to the interest of borrowers and economy. The loan policy has to work out plans to meet in an orderly fashion peaks and troughs in demand and supply of funds. This requires flexibility.
The pisition of a bank becomes inflexible due to term loan commitments and inflexible financial position of some of the borrowers. Liquidity can be ensured by keeping a constant watch on activities and position of the borrower. A classification of the borrowers according to the flexibility can also help. The bank can ensure flexibility by making two types of commitments to borrowers i.e., basic and optional. Basic commitment is the one to which bank is absolutely committed. Optional commitment is linked to the succesful management of the account by the borrower and its own financial position. In India, the fund position itself is flexible as the bank can borrow from the Reserve Bank of India and the call money market. This factor will force banks to incorporate in lending policy the norms for classification and grading, flexibility built up, basic and optional commitments, alternate methods of raising funds and their cost.
4. Human Resources
Human factors like attitudes, skills equations, and leadership will also influence the policies of a commercial bank . No policy can be succesfully implemented unless, the problems in this area adequately tackled. Much depends upon the expertise and ability of its officers. It can not afford to lend in an area where it lacks expert personnel. Some banks are doing very well in non-fund activities because of the expertise available with it.
The professional knowledge cannot be bought or built by outsiders. It has to be developed in the banks by line executives. Outside experts can only initiate and stimulate. The importance of this factor can be gauged from the fact that many banks do not undertake many activities which are undertaken by bigger and professionally managed banks.
5. Credit Needs of the Area
The lending policy shall take note of the credit needs of the area served by it. If a bank is located in agriculture belt, it should be able to meet the credit needs of farmers, otherwise it will result into funds drain to other areas. In fact, the most of the lending opportunities will emerge from the dominant economic activity of the area. If a bank fails to meet the local needs there will be little justification of its operations in that area.
PRINCIPLES/OBJECTIVES OF INVESTMENT POLICY
The commercial banks while making advances/investments have to keep into consideration certain important principles. These are explained as follows :
1. Liquidity
Commercial banks are dealers in debts. The deposits with them are the debts of others. These are payable on demand, with the exception of time deposits. Thus, the commercial banks conractually are under an obligation to pay fixed currency amounts on demand or on very short notice. Obviously, it becomes obligatory for the commercial banks to maintain sufficient cash and liquid assets in order to meet claims for payments . The capacity of the bank to make the cash available on demand is called liquidity. Prof.Sayers has described liquidity as, " the word that the banker uses to describe the ability to satisfy demands for cash in exchange of deposits."
Althogh the deposits are payable on demand, it is most unlikely that demand for repayment of all deposits will be made at the same time. It means, a bank is expected to keep only a portion of its total deposits as liquid assets. The problem before the bank is, as to what proportion of the assets should be kept in liquid form to ensure safe liquidity position.
The proportion of the assets required to be maintained as liquid assets will be guided by the following considerations :
(1) Ownership of demand deposits : The ownership of the demand deposits is a factor which a bank consider while determining its liquidity requirements. If the ownership of large deposits is with individuals through personnel accounts, banks can reasonably expect that total of such deposits will remain fairly stable , with withdrawals being offset by the new depisits. On the other hand, the behaviour of accounts owned by business firms and corporations is likely to be erratic, with wide fluctuations in deposits and withdrawals. Such accounts are totally unstable, so the bank has to maintain a higher degree of liquidity for such deposits.
(2) Requisite cash or liquid reserves : In most of the countries banks are required to maintain certain minimum cash reserves by law, usually under instructions from the central bank or government. Sometimes it is done under conventions enforced by the bankers association. Ultimately liquidity of the bank will be affected by these reserves.
(3) Banking habits of the population : Banking habits of the people greatly influence the liquidity requirements . In developed countries , where cheques or other credit instruments are frequently used as a means of payments, the use of cash gets reduced e.g. credit cards are extremely popular in the U.S.A . In that country most of the purchases are made on credit cards, and people keep only minimal cash them. This in turn diminishes the luquidity requirements of the commercial banks. In India, however it is not so.
(4) Seasonal requirements. A bank has to keep in mind the seasonal requirements of the customers. During the festival seasons. it can expect more withdrawals than the deposits. Seasonal nature of the business of the deposit holders will also influence the liquidity needs.
(5) Structure of banking : The structure of the banking system in a country will also be one of the determinants of commercial bank's liquidity requirements. Under unit banking a higher liquidity has to be maintained because of small scale operations . In contrast, in branch banking system , banks can function with lower liquidity. In case of need , the cash can be transferred from one branch to another. Moreover, the chances of panic withdrawals in branch banking system are less.
(6) State of the money market : The need for liquidity is also guided by the state of the money market. If the money market is well developed, the bank can operate with lesser cash reserves. It can afford to buy and sell short term securities in the money market as and when need arises. On the other hand, in an undeveloped or underdeveloped money market, banks have to keep higher cash and liquid reserves.
In a nutshell, banks keep a variety of factors in mind , like ownership or deposits, their stability, seasonal factors and the state of money market, etc., while determining their liquidity needs.
2. Solvency
The capacity of the bank to meet its demand liabilities is it's liquidity and the capacity to meet its liabilities in the long run is it's solvency. Thus the solvency of a bank depends upon the relationship between its total liabilities and total assets. To the solvent, the realisable value of the total assets at any time must be at least equal to total liabilities, public will loose confidence in the bank. Once the public loses confidence in the bank it will be very difficult for it survive. This is the problem of solvency.
The liabilities of a bank are fixed in terms of the monetary unit of country , i.e., liabilities will not diminish unless they are paid off. But the same is not true about the assets. The value of the assets is not constant or fixed. A substantial fall in the realisable value of assets will threaten the solvency of the bank. As a situation of insolvency can arise only if there is a fall in the realisable value of assets- the factors which cause change in the value of assets are the factors to be considered in portfolio management to ensure solvency. These factors are discussed below :
(1) Loss or misappropriation of assets. Loss or mis-appropriation of the assets of a bank can bring down the realisable value of assets lower than the total liabilities. The main asset of a commerciall bank is cash, which can be easily misappropriated or robbed. Continuous exposure to large amounts of cash may tempt dishonest employees to misappropriate it. There can also be loss of cash on account of bank robberies. But in modern branch banking system, the loss in the value of assets on account of this factor is unlikely to endanger the solvency of the bank in view of the large quantum of deposits with different branches.
(2) Risk of default. The future is always uncertain. One of the uncertainties of the future or a commercial bank is the risk of default, but still the risk remains. The business fortunes of the borrowing firm may turn for the worse leading to default. Further, a firm to which loan was advanced on its present strength may incur additional debts in future, thus impairing the overall chances of repayment. The bank tries to minimise the risk of default by judiciously emoloying the funds investments and lendings.
(3) Risk of interest rate fluctuation. The second uncertainty of future for a bank is the fluctuations in the interest rates. The risk is inherent in loans or investments, calling for fixed payments over a period of time. There is an inverse relationships between the market value of investments or securities and the interest rate.
3. Profitability
Commercial banks are profit making institutions. So, the income is the third important consideration for the banks in portfolio management. It must earn sufficient revenue to meet the costs and then yield a reasonable return for the owners.
Apparently, income consideration is a sub-ordinate consideration to liquidity and solvency . However, it must be appreciated that in the long run higher incom can be ensured only by maintaining a sound liquidity and solvency pisition. Liquidity and solvency cannot be sacrificed in the quest of higher earnings. The bank can earn income only if it survives and it cannot survive without liquidity and solvency.
Liquidity and solvency are the primary considerations for a commercial bank and income is a secondary consideration. The secondary consideration cannot be achieved at the cost of the primary considerations.
CONFLICTS IN INVESTMENT OBJECTIVES
1. Conflict between income and solvency. Income and solvency are the two pulls working in opposite directions. A bank aiming at increasing the income will go for a high yield investment, a high yield investment is likely to carry more risk with it because 'the higher the risk, the higher the gains'. So if the bank decides to employ funds in the assets which are giving a higher return, although they are risky propositions, it will endanger the solvency of the bank. It can be explained with the help of a simple example. A bond or security with a longer period to run for maturity will gave a higher return, but at the same time it runs a risk that if the interest rates increase in future, the market price of the security will fall. The market price of the security has an inverse relationship with the interest rate fluctuations. The chances of the interest rate variations, i.e., increase are more in the long run. Thus a long bill with higher returns runs a higher risk of fall in the market value on account of increase in the interest rate in future.
A bank will earn high earnings if all goes well with risky propositions, but if something goes wrong, it will face insolvency . However, the bank can reasonably reconcile the opposite considerations by diversifying the employment of funds. An appropriate 'assets mix' can definitely take care of both the factors. It should be kept in mind that although income and solvency are opposing considerations, yet they are not irreconciliable.
2. Conflict between liquidity and income. There is an inverse relationship between liquidity and income. A bank can earn income only by foregoing liquidity. For liquidity the bank needs cash - but cash does not earn anything. As soon as it thinks of earning income, it can do so only at the cost of liquidity. An asset which earns more will definitely be less liquid. In the opinion if J.L .Hanson, "a commercial bank is torn between two conflicting motives : on the one hand the bank would like to expand his loans in order to earn more profits, and on the other, the bank is anxious to hold sufficient cash so that he can at all times fulfil the obligations to pay cash on demand. " Similarly, J.Harvey and M.Johnson felt that, "liquidity and profitability pull in opposite directions - the shorter the period of loan, the greater is the bank's liquidity , but the less it will earn by way of interest ."
J.Harvey and M.Johnson used the following "Bank Credit Pyramid" to depict these two opposing considerations. So the bank should strike a balance between liquidity and income while managing its portfolios.
Thus a bank has to strike an optimal balance between the three considerations of liquidity, solvency and income.
Let us now discuss the various theories of investment.
1. Traditional Theory or Banking Theory or Real Bills Doctrine. The advocates of this theory argue that commercial banks should give only short term, productive and self liquidating loans. Thus banks will not invest in long term assets or fixed assets. This theory favours investment in short term securities or lending for the purpose of working capital requirements . There will not be any risk of bad debts as the loan is a productive loan and in case it is for a particular transaction, repayment will be coming at the completion of transaction. Securities which are purchased will also be self-liquidating . Thus, a fair degree of liquidity will be maintained throughout. However, the theory has been found to be unsuitable for developing countries like India, where commercial banks are expected to play the role of an instrument of growth.
2. The Shiftability Theory. The proponents of shiftability theory believe that liquidity does not depend upon the short term maturity but on the shiftability of the investments. If the long term investments could be easily shifted to the assets portfolio of other bank (s), it will not affect adversely the liquidity of the bank. Liquidity means that the bank should be able to produce cash as and when required. This can be easily achieved by selling off the easily marketable investments or securities in the money market. The theory overcomes the weakness of traditional theory, as it will be more conducive and accomodating for the industry, trade and commerce.
However, this theory also suffers from certain weaknesses. It is not always possible to shift the securities at will. During the period of depression , it becomes difficult to sell off the corporate securities like shares and debentures. But despite the limitations, reasonable luquidity can be maintained by following shiftability theory.
3. The Anticipated Income Theory. This theory is the modern theory . Its approach is to maintain liquidity on the basis of antucipated income of a borrower rather than on the basis of the maturity or shiftability of investments. This approach has widened the area of commercial banking operations by extending it to medium and long term loans. A bank following this approach will not hesitate to extend loan for a relatively longer period provided it is satisfied that the antucipated income will be sufficient to repay the loan along with the interest. Such a loan will strike a better balance between liquidity and profitability cinsiderations of the commercial bank.
4. Liquidity Management Approach.In recent times , a new approach to bank's portfolio management had emerged. The approach emphasizes the profit maximisation and substantially undermines the need for large cash reserves and self-liquidating advances. The approach assumes a highly developed money market. In a developed money market it ahould not be difficult to manage its liquidity needs by mobilising funds from the money market. The co-ordination between various branches or banks should also reduce the actual cash requirements . The approach favours managing urgent liquidity needs from alternative sources like current profits, borrowing from money market or central bank of the country, etc.
COMMERCIAL BANKS AND ECONOMIC DEVELOPMENT
Finance is a scarce resource. It lubricates the entire monetary and financial system and ensures smooth operation. The commercial banks as the most important financial institutions play an important role in the economic development of a country. The experience shows that as and when the banking sector of an economy gets into trouble , the economic development of the country suffers . It is for this reason that the financial sector reforms are being giving lot of importance in the process of liberalisation of economy. Concerning the role of commercial banks in the economic development following points are noteworthy.
1. Mobilisation of Savings. In order to accumulate wealth, an economy must save. The commonest form of savings is that done by individuals who consume less than their total income. The savings accumulated with individuals or organisations would do no good if not converted into real wealth. These savings must be mobilised and put into productive investments to create real wealth. The most important role in mobilisation of the savings of the society is played by the commercial banks. The reach of the commercial banks in this regard is tremendous.
2. Role in Implementation of Monetary Policy. In a liberalised economy, the monetary policy of the central bank of the country is a very important instrument of economic policy. The management of crucial factors for the sound health of economy demands that the monetary policy must be implemented effectively . This in turn requires a sound banking system. The effectiveness of the monetary policy depends upon the co-operation of commercial banks.
3. Directing Funds into Desired Channels. Every state wants a balanced growth of all the sectors of the economy. It wants the funds to flow into productive channels. Only this will ensure proper growth of the economy. If funds flow into speculative activities, the financial system may come under stress. This can be achieved with the help of commercial banks.
4. Implementation of the Policies of the Government. The commercial banks have an important role in the proper implementation of economic policies of the government concerning development of various sectors of the economy. The flow of funds into priority sector areas like agriculture and exports can be ensured only through commercial banks.
It is impossible to visualize economic development without commercial banks.
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