Commercial banks: functions, balance sheet, and liquidity versus profitability
Money Banking and International Trade · Unit II · Topic 6 of 16 · 6 min read
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1. Meaning
A commercial bank is a financial institution that accepts deposits from the public, repayable on demand or otherwise, and lends or invests them for profit. Section 5(b) of the Banking Regulation Act, 1949 defines “banking” as accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise. Crowther: the banker is “a dealer in debts, his own and other people’s.” The legal side is covered in Bank: definition, kinds of banks and their functions.
Kinds: commercial banks (public sector, private sector, foreign, regional rural banks), co-operative banks, small finance banks and payments banks; and, by structure, unit banking and branch banking.
2. Functions of a commercial bank
(a) Primary functions
- Accepting deposits:
- current (demand) deposits, repayable on demand, usually without interest, used by businesses;
- savings deposits, with limited withdrawals and modest interest;
- fixed (time) deposits, for a fixed period at a higher rate;
- recurring deposits, a fixed sum paid in every month.
- Lending:
- loans (a lump sum credited to the borrower’s account, with interest on the whole);
- cash credit (a limit against security of stocks, interest only on the amount used);
- overdraft (drawing beyond the balance in a current account);
- discounting of bills of exchange;
- term loans for industry, agriculture, housing and education.
- Credit creation: through lending, banks create derivative deposits many times their cash reserves (see the next note).
(b) Agency functions
- collecting cheques, bills, dividends and interest for customers;
- making payments on standing instructions: insurance premia, rent, loan instalments;
- buying and selling securities for customers;
- acting as trustee, executor and attorney;
- remittance of funds by draft, NEFT and RTGS; collecting taxes for the government.
(c) General utility functions
- safe deposit lockers and safe custody of valuables;
- letters of credit and bank guarantees for trade;
- dealing in foreign exchange and financing foreign trade;
- underwriting issues of shares and debentures;
- providing credit information and business advice.
(d) Modern functions
ATM, debit and credit cards, internet and mobile banking, UPI, bancassurance and distribution of mutual funds, priority sector lending and financial inclusion schemes. Banks also act as channels of monetary policy, since changes in the repo rate reach borrowers through bank lending rates.
3. The balance sheet of a commercial bank
A bank’s balance sheet is a statement of its liabilities (sources of funds) and assets (uses of funds) on a given date. In India it is prepared in Form A of the Third Schedule to the Banking Regulation Act, 1949, with the items supported by schedules. Specimen (Rs. crore):
| Capital and liabilities | Rs. | Assets | Rs. |
|---|---|---|---|
| 1. Capital | 500 | 1. Cash in hand and balances with RBI | 2,400 |
| 2. Reserves and surplus | 1,500 | 2. Balances with other banks, money at call and short notice | 1,600 |
| 3. Deposits (demand, savings, term) | 40,000 | 3. Investments (government and other securities) | 11,000 |
| 4. Borrowings | 2,000 | 4. Advances (bills discounted, cash credit, overdrafts, term loans) | 28,000 |
| 5. Other liabilities and provisions | 1,000 | 5. Fixed assets | 800 |
| 6. Other assets | 1,200 | ||
| Total | 45,000 | Total | 45,000 |
Contingent liabilities (guarantees given, acceptances, letters of credit) are shown below the balance sheet, not in the total.
Reading the liabilities side
- Capital and reserves are the owners’ funds, small in proportion (here under 5 per cent) but the cushion against losses; the RBI prescribes capital adequacy under the Basel norms.
- Deposits are the bulk of a bank’s resources (here about 89 per cent). A bank trades mainly on borrowed money.
- Borrowings are from the RBI, other banks and institutions.
Reading the assets side
Assets are arranged in descending order of liquidity and, broadly, ascending order of profitability:
- Cash and balances with the RBI: perfectly liquid, earns nothing; includes the cash reserve ratio balance (section 42, RBI Act).
- Money at call and short notice: almost as liquid, small return; the bank’s second line of defence.
- Investments: mainly government securities, a large part held to meet the statutory liquidity ratio (section 24, BR Act); liquid and safe, moderate yield.
- Advances: the most profitable and least liquid asset; here 70 per cent of deposits (the credit-deposit ratio).
- Fixed and other assets: premises and equipment, which earn nothing directly.
In the specimen, cash and RBI balances are 6 per cent of deposits, and the first two items together 10 per cent: the bank keeps a tenth of its deposits in near-cash form and lends or invests the rest.
4. Liquidity versus profitability
A bank must follow three principles: liquidity (the ability to pay depositors on demand), profitability (earning enough to pay interest, costs and dividends), and safety or solvency (lending only on sound security). Liquidity and profitability pull in opposite directions:
- Cash is completely liquid but earns nothing; long-term loans earn the most but cannot be turned into cash quickly.
- If a bank keeps too much cash, it loses income; if it lends too much, it risks being unable to meet withdrawals, and a run on the bank can destroy it.
Sayers described banking as the art of reconciling these conflicting aims. The bank does so by spreading its assets along a ladder from cash to long-term advances, as the balance sheet above shows: each step gives up some liquidity for more profit.
Theories of liquidity management
- Commercial loan (real bills) theory: lend only short term against self-liquidating trade bills, which repay themselves when the goods are sold.
- Shiftability theory (H.G. Moulton): liquidity lies in holding assets that can be shifted to another bank or the central bank without loss, such as government securities.
- Anticipated income theory (H.V. Prochnow): a loan is liquid if it is repaid in instalments from the borrower’s expected income, which justifies term loans.
- Liabilities management theory: banks can obtain liquidity by borrowing (call money, CDs, repo) rather than only by holding liquid assets.
How this is examined
For “functions of commercial banks”, use the four heads in section 2 with brief explanations; ten marks need about a dozen points. For the balance sheet note, draw the specimen table (the totals must agree), then explain each side and the order of liquidity. For “liquidity and profitability”, state the conflict, the ladder of assets and two of the theories. The August 2024 paper also asked “What is a bank? Explain the types of bank” and “Services of commercial banks”: use sections 1 and 2.
Now try the real questions: Money Banking and International Trade past question papers.