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Unit-1: Commercial Bank

Meaning of Bank

Bank is an institution authorized by a government to accept deposits, pay interest, clear cheques,

issue loans, act as an intermediary in financial transactions and provide other financial services

to its customers.

Meaning of Commercial Bank

Commercial bank is a financial institution that accepts deposit from account holders and lends

money who wants to implement for productive purposes.

Example: State Bank of India, ICICI, IDBI, Vijaya Bank, Bank of India etc. are the Commercial

Banks in India.

Significance of Commercial Banks

Commercial Banks play a vital and dynamic role in the economic life of the nation as they keep

the wheels of trade, commerce and industry. They mobilize the dormant funds into a productive

channel. The significance of the Commercial Banks can be summarized as follows:

i) Capital Formation: Banks facilitate capital formation by promoting savings.

ii) Innovation: Bank credit enables the enterprises to innovate and invest and thus uplift

economic activity.

iii) Monetary Policy: A well-developed banking system is required to promote economic

development by controlling a period of inflation and deflation.

iv) Credit Creations: Credit creation enables the expansion of business and mitigation of

unemployment and raises production.

v) Encouragement of Trade and Industry: Banking system encourages trade and industry by

providing long-term loans to traders and industrialists at low rates.

vi) Promotion of Habit of saving: Banks encourage savings habit by accepting, deposits and

giving interests on it.

vii) Volume of Production: Production volume can be increased by expansion of credit by

banks.

viii) Technology: Commercial banks use and update the latest technology and providing the

better services to customers.

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Role of Commercial Bank

Commercial banks play an important and active role in the economic development of a country.

If the banking system in a country is effective, efficient and disciplined it brings about a rapid

growth in the various sectors of the economy. The following is the significance of commercial

banks in the economic development of a country:

1. Promotion of capital formation: Commercial banks accept deposits from individuals and

businesses, these deposits are then made available to the businesses which make use of them for

productive purposes in the country.

2. Encourage to Invest in new enterprises: Businessmen normally hesitate to invest their

money in risky enterprises. The commercial banks generally provide short and medium term

loans to entrepreneurs to invest in new enterprises and adopt new methods of production. The

provision of timely credit increases the productive capacity of the economy.

3. Promotion of trade and industry: With the growth of commercial banking, there is vast

expansion in trade and industry. The use of bank draft, check, bill of exchange, credit cards and

letters of credit etc has revolutionized both national and international trade.

4. Development of agriculture: The commercial banks particularly in developing countries are

now providing credit for development of agriculture and small scale industries in rural areas. The

provision of credit to agriculture sector has greatly helped in raising agriculture productivity and

income of the farmers.

5. Balanced development of different States: The commercial banks play an important role in

achieving balanced development in different states of the country. They help in transferring

surplus capital from developed regions to the less developed regions.

6. Influencing economic activity: The banks can also influence the economic activity of the

country through its influence on a. Availability of credit b. The rate of interest If the commercial

banks are able to increase the amount of money in circulation through credit creation or by

lowering the rate of interest, it directly affects economic development.

7. Implementation of Monetary policy: The central bank of the country controls and regulates

volume of credit through the active cooperation of the banking system in the country. It helps in

bringing price stability and promotes economic growth within the shortest possible period of

time.

8. Encourage for Export promotion: In order to increase the exports of the country, the

commercial banks have established export promotion cells. They provide information about

general trade and economic conditions both inside and outside the country to its customers. The

banks are therefore, making positive contribution in the process of economic development.

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Functions of Commercial Bank

Important functions of Commercial Banks are given below:

1. PRIMARY FUNCTIONS

Primary banking functions of the commercial banks include:

i) Acceptance of deposits, ii) Advancing loans, iii) Creation of credit

iv) Clearing of cheques, v) Financing foreign trade, vi) Remittance of funds

i) ACCEPTANCE OF DEPOSITS

Commercial bank accepts various types of deposits from public especially from its clients. These

deposits are payable after a certain time period. Banks generally accept three types of deposits

viz., (a) Current Deposits (b) Savings Deposits (c) Fixed Deposits and d) Recurring Deposit.

(a) Current Deposits: These deposits are also known as demand deposits. These deposits can be

withdrawn at any time. Generally, no interest is allowed on current deposits, and in case, the

customer is required to leave a minimum balance undrawn with the bank.

(b) Savings Deposits: This is meant mainly for professional men and middle class people to help

them deposit their small savings. It can be opened without any introduction. Money can be

deposited at any time but the maximum cannot go beyond a certain limit.

(c) Fixed Deposits: These deposits are also known as time deposits. These deposits cannot be

withdrawn before the expiry of the period for which they are deposited or without giving a prior

notice for withdrawal.

d) Recurring Deposit: Recurring Deposits are a special kind of Term Deposits offered by banks

in India which help people with regular incomes to deposit a fixed amount every month into their

Recurring Deposit account and earn interest at the rate applicable to Fixed Deposits. It is similar

to making FDs of a certain amount in monthly installments, for example Rs 1000 every month.

ii) ADVANCING LOANS

Loans are made against personal security, gold and silver, stocks of goods and other assets. The

second primary function of a commercial bank is to make loans and advances to all types of

persons, particularly to businessmen and entrepreneurs. The most common way of advancing

loans are given below:

(a) Overdraft Facilities: In this case, the depositor in a current account is allowed to draw over
and above his account up to a previously agreed limit. Suppose a businessman has only Rs.

6,000/- in his current account in a bank but requires Rs. 12,000/- to meet his expenses. He may

approach his bank and borrow the additional amount of Rs. 6,000/-.

(b) Cash Credit: Under this account, the bank gives loans to the borrowers against certain

security. But the entire loan is not given at one particular time, instead the amount is credited

into his account in the bank; but under emergency cash will be given. The borrower is required to

pay interest only on the amount of credit availed to him.

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(c) Discounting Bills of Exchange: This is another type of lending which is very popular with

the modern banks. The holder of a bill can get it discounted by the bank, when he is in need of

money. After deducting its commission, the bank pays the present price of the bill to the holder.

Such bills form good investment for a bank.

(d) Money at Call: Banks grant loans for a very short period, generally not exceeding 7 days to

the borrowers, usually dealers or brokers in stock exchange markets against collateral securities

like stock or equity shares, debentures, etc., offered by them. Such advances are repayable

immediately at short notice hence; they are described as money at call or call money.

(e) Term Loans: Banks give term loans to traders, industrialists and now to agriculturists also

against some collateral securities. Term loans are so-called because their maturity period varies

between 1 to 10 years.

(f) Consumer Credit: Banks also grant credit to households in a limited amount to buy some

durable consumer goods such as television sets, refrigerators, etc., or to meet some personal

needs like payment of hospital bills etc. Such consumer credit is made in a lump sum and is

repayable in installments in a short time.

(g) Miscellaneous Advances: The other forms of bank advances there are packing credits given

to exporters for a short duration, export bills purchased/discounted, import finance-advances

against import bills, finance to the self employed, credit to the public sector and credit to the

cooperative sector.

iii) CREATION OF CREDIT

Credit creation is the multiple expansions of banks demand deposits. It is an open secret now that

banks advance a major portion of their deposits to the borrowers and keep smaller parts of

deposits to the customers on demand. Even then the customers of the banks have full confidence

that the depositor’s lying in the banks is quite safe and can be withdrawn on demand.

iv) PROMOTE THE USE OF CHEQUES, DD OR ONLINE TRANSACTIONS

The commercial banks render an important service by providing to their customers a cheap

medium of exchange like cheques. It is found much more convenient to settle debts through

cheques rather than through the use of cash. The cheque is the most developed type of credit

instrument in the money market.

v) FINANCING FOR INTERNAL AND FOREIGN TRADE

The bank finances internal and foreign trade through discounting of exchange bills. Sometimes,

the bank gives short-term loans to traders on the security of commercial papers. This discounting

business greatly facilitates the movement of internal and external trade.

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vi) REMITTANCE OF FUNDS

Commercial banks, on account of their network of branches throughout the country, also provide

facilities to remit funds from one place to another for their customers by issuing bank drafts, mail

transfers or telegraphic transfers on nominal commission charges. As compared to the postal

money orders or other instruments, bank drafts have proved to be a much cheaper mode of

transferring money and have helped the business community considerably.

2. SECONDARY FUNCTIONS

Secondary banking functions of the commercial banks include:

i) Agency Services

ii) General Utility Services

i) AGENCY SERVICES

Commercial banks act as attorney for their clients. They buy and sell shares and bonds, receive

and pay utility bills, premiums, dividends, rents and interest for their clients. Banks also perform

certain agency functions for and on behalf of their customers. The agency services are of

immense value to the people at large. The various agency services rendered by banks are as

follows:

(a) Collection and Payment of Credit Instruments: Banks collect and pay various credit

instruments like cheques, bills of exchange, promissory notes etc., on behalf of their customers.

(b) Purchase and Sale of Securities: Banks purchase and sell various securities like shares,

stocks, bonds, debentures on behalf of their customers.

(c) Collection of Dividends on Shares: Banks collect dividends and interest on shares and

debentures of their customers and credit them to their accounts.

(d) Acts as Correspondent: Sometimes banks act as representative and correspondents of their

customers. They get passports, traveler’s tickets and even secure air and sea passages for their

customers.

(e) Income-tax Consultancy: Banks may also employ income tax experts to prepare income tax

returns for their customers and to help them to get refund of income tax.

(f) Execution of Standing Orders: Banks execute the standing instructions of their customers

for making various periodic payments. They pay subscriptions, rents, insurance premium etc., on
behalf of their customers.

(g) Acts as Trustee and Executor: Banks preserve the ‘Wills’ of their customers and execute

them after their death.

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ii) GENERAL UTILITY SERVICES

General utility services are those services which are rendered by commercial banks not only to

the customers but also to the general public. In addition to agency services, the modern banks

provide many general utility services for the community as given below:

a) Safety Locker Facility

b) Collection of Cheque amount

c) Issuing Letter of Credit

d) Bank Drafts

e) ATM

f) Debit Card

g) Credit Card

h) Tele-Banking

i) Internet Banking

a) Safety Locker Facility

A bank undertakes the safe custody of the customer’s valuables and documents by providing a

safe deposit vault. These are kept in specially constructed strong rooms. There are lockers

available to the customer on a nominal charge. There are two keys for each locker, one is given

to the customer and the other remains with the Bank Manager. The locker is opened as well as

closed by both the keys one after another.

b) Collection of Cheques

The customers deposit cheques, bills of exchange and promissory note into their accounts with

the banks. These instruments are collected by the bank on behalf of their customers and credited

to their accounts. These services are provided by the cheques, bills and promissory notes issued

on branches out of the city are collected with some nominal charges for postage etc. this is a very

popular and essential service provided by the banks to their customers.

c) Issuing Letter of Credit

A letter of credit is a commercial instrument of assured payment. It is widely used by the

businessman for various purposes. The bank undertakes to make payment to a seller on

production of documents stipulated in the letter of credit. It specifies as to when payment is to be

made which may be either on presentation of documents by the paying bank or at some future

date depending upon the terms stipulated in the letter.

d) Bank Drafts

A bank draft is an order from one branch to another branch of the same bank to pay a specified

sum of money to a person named therein or to his order. A draft is always payable on demand.

Banks issue drafts at the request of the customers on their branches at the place of destination for

remitting money from one place to another place.

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e) Automated Teller Machine (ATM)

ATM is a channel of banking service to its customers. It’s traditional and primary use is to

dispense cash upon insertion of a plastic card and its unique PIN i.e. Personal Identification

Number. The banks issue ATM card to their customers having current or savings account

holding a certain minimum balance in their accounts.

f) Debit Card

A debit card is a plastic card that provides an alternative payment method to cash when making

purchases. Functionally, it can be called an electronic check, as the funds are withdrawn directly

from either the bank account or from the remaining balance on the card. In some cases, the cards

are designed exclusively for use on the Internet, and so there is no physical card.

g) Credit Card

A credit card is an instrument of payment. It is a source of revolving credit. The cards are plastic

cards issued by the banks to their customers. The name of the customer, card number and expiry

date are printed on the plastic cards. Some banks also use the photograph of the customers on the

credit card. The cardholder can buy goods or services from various merchant establishments

where such arrangements exist.

h) Tele Banking

Telephone banking is a service provided by a Commercial Banks, which allows its customers to

perform transactions over the telephone. Most telephone banking services use an automated

phone answering system with phone keypad response or voice recognition capability.

i) Internet Banking

Internet is a channel of service to banking customers. The access to account information as well

as transaction is offered through the world-wide-web network of computers on the internet. Each

account holder is provided with a PIN similar to that of ATM or phone banking. The access to

the account is allowed to the customer upon a match of the account details and PIN entered on

the computer system.

Meaning of Credit Creation

Credit creation is the power of commercial banks to expand secondary deposits either through

the process of issuing loans or through investment in securities. Credit creation is the multiple

expansions of banks demand deposits.

Credit Creation by Commercial Banks

The creation of credit or deposits is one of the most vital operations of the commercial banks.

Similar to other corporations, banks aim at earnings profits. For this intention, they accept cash

in demand deposits and advance loans on credit to customers. When a bank advances funds, it

does not pay the amount in currency notes. However, it introduces a current account in the name

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of the investor and lets him to withdraw the necessary amount by cheques. By this way, banks

create deposits or credit. The stability of price level is an essential condition for the economic

development. It highly depends upon the demand and supply of money. The supply of money

includes the legal tender money and bank money.

The legal tender money is issued by the Central Bank or the government of the country in the

form of Bank/Currency notes while the bank money is created by the banks.

The bank money consists of bank deposits. Cheques drawn on bank deposits act as the legal

tender money, i.e., with cheques payment obligation can be settled. Thus, banks are not merely

purveyors of money but also the manufacturers of money.

The creation of credit or deposits may be arrived in the following two ways:

1. Primary deposit and 2. Derivative deposits

1. Primary Deposits

When customer deposits cash to commercial bank, the deposit is called as the primary deposit.

Primary deposits arise or formed when cash or cheque is deposited by customers. When a person

deposits money or cheque, the bank will credit his account. The customer is free to withdraw the

amount whenever he wants by cheques. These deposits are called “primary deposits” or “cash

deposits.”
2. Derivative Deposits

Deposits which arise on account of granting loan or purchase of assets by a bank are called

“derivative deposits.” When a bank grants a loan to a customer it does not usually pay the

amount in cash, instead it credits an account with the amount of loan. That is, the bank places a

deposit at the borrower's disposal and he can freely withdraw the amount as he likes. The loan

which a banker grants to a customer usually large corporate creates additional deposits, i.e., by

advancing loans, banks create deposits and thus, create money. So "Money is said to be created

when the banks, through their lending activities, make a net addition to the total supply of money

in the economy".

Techniques of Credit Creation

1. Credit creation by overdraft and 2. Credit creation by purchase of securities

1. Credit creation by overdraft

By over drafting bank creates credit. Secondly bank purchases the securities and pays them with

its own cheques. The holders of these cheques deposit them in the same banks. This creates

deposit which is nothing other than creation of credit.

2. Credit creation by purchase of securities

When loans are advanced, it is not given in cash. The bank opens a deposit account in the name

of the borrower and allows him draw to draw whenever required. The loan advanced by cheques

results in the creation of new demand deposits. Sometimes, a question arises that it borrowers

with draw these deposits for the repayment to other persons, then how the banks will create

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credit. The answer is that other persons who receive money may also be the clients of the bank.

Naturally they will also deposit their cash in the bank. The process remains continue. We can
explain it by the following example:

Example

Suppose a person deposits 1,000 in a bank. According to experience bank can keep 20% cash

reserve to meet the demands of the depositors, and can lend the rest safely to the borrowers. If

the entire bank maintains a reserve ratio of 20% then banks can succeed in creating a credit a

credit of Rs. 5000 against an original deposit of Rs. 1,000 in cash.

Meaning of Capital Formation

Capital formation means increasing the stock of real capital in a country. Capital formation

involves making of more capital goods such as machines, tools, factories, transport equipment,

materials, electricity, etc., which are all used for future production of goods.

Investment Policy of Commercial Bank

Investments form a significant portion of a bank's assets, next only to loans and advances, and

are an important source of overall income. Commercial banks' investments are of three broad

types: (a) Government securities and (b) other approved securities. These three are also

categorized into SLR (Statutory Liquidity Ratio) investment and non-SLR investments. SLR

investments comprise Government and other approved securities, while non-SLR investments

consist of 'other securities' which comprise commercial papers, shares, bonds and debentures

issued by the corporate sector. Under the SLR requirement, banks are required to invest a

prescribed minimum of their net demand and time liabilities (NDTL) in Government- and other

approved securities under the BR act, 1949. (Note that SLR is prescribed in terms of banks'

liabilities and not assets). This provision amounts to 'directed investment', as the law directs

banks to invest a certain minimum part of their NDTL in specific securities. While the SLR

provision reduces a bank's flexibility to determine its asset mix, it helps the Government finance

its fiscal deficit. It is the RBI that lays down guidelines regarding investments in SLR and nonSLR
securities. Bank investments are handled by banks through their respective Treasury

Department.
Area of Investment Policy

1. Government Security

A Government security is a tradable instrument issued by the Central Government or the State

Governments. It acknowledges the Government’s debt obligation. Such securities are short term

(usually called treasury bills, with original maturities of less than one year) or long term (usually

called Government bonds or dated securities with original maturity of one year or more).

a) Treasury Bills (T-bills)

Treasury bills or T-bills, which are money market instruments, are short term debt instruments

issued by the Government of India and are presently issued in three tenors, namely, 91 day, 182

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day and 364 day. Treasury bills are zero coupon securities and pay no interest. They are issued at

a discount and redeemed at the face value at maturity. For example, a 91 day Treasury bill of

Rs.100/- (face value) may be issued at say Rs. 98.20, that is, at a discount of say, Rs.1.80 and

would be redeemed at the face value of Rs.100/-.

b) Cash Management Bills (CMBs)

Government of India, in consultation with the Reserve Bank of India, has decided to issue a new

short-term instrument, known as Cash Management Bills (CMBs), to meet the temporary

mismatches in the cash flow of the Government. The CMBs have the generic character of T-bills

but are issued for maturities less than 91 days.

c) Bonds

i) Fixed Rate Bonds: These are bonds on which the coupon rate is fixed for the entire life of the

bond. Most Government bonds are issued as fixed rate bonds.

For example – 8.24% GS2018 was issued on April 22, 2008 for a tenor of 10 years maturing on
April 22, 2018. Coupon on this security will be paid half-yearly at 4.12% (half yearly payment

being the half of the annual coupon of 8.24%) of the face value on October 22 and April 22 of

each year.

ii) Floating Rate Bonds: Floating Rate Bonds are securities which do not have a fixed coupon

rate. The coupon is re-set at pre-announced intervals (say, every six months or one year) by

adding a spread over a base rate.

In the case of most floating rate bonds issued by the Government of India so far, the base rate is

the weighted average cut-off yield of the last three 364- day Treasury Bills auctions preceding

the coupon re-set date and the spread is decided through the auction. Floating Rate Bonds were

first issued in September 1995 in India.

For example, a Floating Rate Bond was issued on July 2, 2002 for a tenor of 15 years, thus

maturing on July 2, 2017. The base rate on the bond for the coupon payments was fixed at 6.50%

being the weighted average rate of implicit yield on 364-day Treasury Bills during the preceding

six auctions. In the bond auction, a cut-off spread (markup over the benchmark rate) of 34 basis

points (0.34%) was decided. Hence the coupon for the first six months was fixed at 6.84%.

iii) Zero Coupon Bonds: Zero coupon bonds are bonds with no coupon payments. Like

Treasury Bills, they are issued at a discount to the face value. The Government of India issued

such securities in the nineties. It has not issued zero coupon bonds after that.

d. State Development Loans (SDLs)

State Governments also raise loans from the market. SDLs are dated securities issued through an

auction similar to the auctions conducted for dated securities issued by the Central Government.

Interest is serviced at half-yearly intervals and the principal is repaid on the maturity date. Like

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dated securities issued by the Central Government, SDLs issued by the State Governments

qualify for SLR. They are also eligible as collaterals for borrowing through market repo as well

as borrowing by eligible entities from the RBI under the Liquidity Adjustment Facility (LAF).

2. Other approved securities

Bank may invest its surplus funds in any commercial, private & cooperative Banks but if any

such bank provides considerably higher rate of interest then its financial position has to be

analyzed.

Investment of the liquid surplus funds from time to time has to be made in such a way that there

should not be any difficulty in meeting out the funds requirement for daily clearing adjustment as

well as payment of the deposits on due dates of maturity.

a) Commercial Papers

A commercial paper is an unsecured short-term instrument issued by the large banks and

corporations in the form of promissory note, negotiable and transferable by endorsement and

delivery with a fixed maturity period to meet the short-term financial requirement.

b) Certificate of Deposits

Certificates of deposit are unsecured, negotiable, short-term instruments in bearer form, issued

by commercial banks and development financial institutions.

c) Repurchase Agreement (Repo)

Repo is a money market instrument, which enables collateralized short term borrowing and

lending through sale/purchase operations in debt instruments. Under a repo transaction, a holder

of securities sells them to an investor with an agreement to repurchase at a predetermined date

and rate. It is a temporary sale of debt involving full transfer of ownership of the securities, that

is, the assignment of voting and financial rights.

d) Commercial bill market

Commercial bill is a short term, negotiable, and self-liquidating instrument with low risk. It
enhances he liability to make payment in a fixed date when goods are bought on credit.

According to the Indian Negotiable Instruments Act, 1881, bill or exchange is a written

instrument containing an unconditional order, signed by the maker, directing to pay a certain

amount of money only to a particular person, or to the bearer of the instrument.

Meaning of Liquidity

Liquidity is the ability to quickly convert an investment or asset into cash. This is a measure of

the extent to which a person or organization has cash to meet immediate and short-term

obligations or assets that can be quickly converted to do this.

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Meaning of Profitability

Profitability is defined as the potential of a company to exceed its overall revenue from its total

expenses which results in profit generation.

A business must achieve profitability in order to sustain its operations. Profitability measures the

efficiency of the company. Profitability is measured as a ratio of profit to revenue.

Profitability of Commercial Bank

Profitability is the ability of a business to earn a profit. A profit is what is left of the revenue a

business generates after it pays all expenses directly related to the generation of the revenue,

such as producing a product, and other expenses related to the conduct of the business' activities.

Equally important is the principle of 'profitability' in bank advance like other commercial

institutions, banks must make profits. Firstly, they have to pay interest on the deposits received

by them. They have to incur expenses on establishment, rent, stationery, etc.

They have to make provision for depreciation of their fixed assets and also for any possible bad

or doubtful debts. After meeting all these items of expenditure which enter the running cost of
banks, a reasonable profit must be made; otherwise, it will not be possible to carry anything to

the reserve or pay dividend to the shareholders. It is after considering all these factors that a bank

decides upon its lending rate. It is sometimes possible that a particular transaction may not

appear profitable in itself, but there may be some ancillary business available, such as deposits

from the borrower's other concerns or his foreign exchange business, which may be highly

remunerative. In this way, the transaction may on the whole be profitable for the bank. It should,

however, be noted that lending rates are affected by the Bank Rate, inter-bank competition and

the Central Bank's directives (e.g. Directives of Reserve Bank of India), if any. The rates may

also differ depending on the borrower's credit, nature of security, mode of charge, and form and

type of advance, whether it is a cash credit, loan pre-shipment finance or a consumer loan, etc.

Factors Affecting the Profitability of Commercial Banks

Various Factors Affecting the Profitability of Commercial Banks are:

i) Level of competition

Increase in competition generally leads to higher operating costs. This leads to lower

profitability.

ii) Cost of funds

Cost of funds are the expenses incurred on obtaining funds from various sources in the form of

share capital, reserves, deposits, and borrowings. Thus, it generally refers to interest expenses.

Lower the cost of funds, higher the profitability.

iii) Level of Non-performing assets (NPAs)

The profitability of a bank is inversely related to the level of NPAs. Hence, over the years, the

NPAs of commercial banks have greatly declined.

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iv) Level of technology

Use of upgraded technology normally leads to decline in the operating costs of banks. This

improves the profitability of banks.

v) Risk cost

This cost is associated to the probable annual loss on assets. They include provisions made

towards bad debts and doubtful debts. Lower risk costs increase the profitability of banks.

vi) Operating Costs: Operating costs are the expenses incurred in the functioning of the bank.

Excluding cost of funds, all other expenses are operating costs. Lower operating costs give rise

to greater profitability of the banks.

vii) Spread

Spread is defined as the difference between the interest received (interest income) and the

interest paid (interest expense). Higher spread indicates more efficient financial intermediation

and higher net income. Thus, higher spread leads to higher profitability.

viii) Non-interest income

It is the income derived from non-financial assets and services. It includes commission &

brokerage on remittance facility, rent of locker facility, fees for underwriting and financial

guarantees, etc. This income adds to the profitability of banks.

Regulation and Control of Commercial Banks by RBI

The Financial Institutions includes Development Financial Institutions (DFIs) and Non-Banking

Financial Companies (NBFCs). Following are the principle guidelines which are related to the

Regulation and Control of Commercial Banks issued by RBI:

1. Licensing Requirements

To do a business of commercial banking in India, whether it is India or Foreign, a license from

RBI is required. Opening of Branches is handled by the Branch Authorization Policy. At present,

Indian banks no longer require a license from the Reserve Bank for opening a branch at a place
with population of below 50,000.

2. Corporate Governance in Banks

One of the policy objectives of RBI is to ensure high-quality corporate governance in banks. RBI

has issued guidelines for ‘fit and proper’ criteria for director of banks. One of these guidelines is

that the directors of the banks should have special knowledge / experience in the various banking

related areas. RBI can also appoint additional directors to the board of a banking company.

3. Interest Rates

The interest rates on most of the categories of deposits and lending transactions have been

deregulated and are largely determined by banks. Reserve Bank regulates the interest rates on

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savings bank accounts and deposits of non-resident Indians (NRI), small loans up to rupees two

lakh, export credits and a few other categories of advances.

4. Prudential Norms

Prudential Norms refers to ideal / responsible norms maintained by the banks. RBI issues

“Prudential Norms” to be followed by the commercial banks to strengthen the balance sheets of

banks. Some of them are related to income recognition, asset classification and provisioning,

capital adequacy, investments portfolio and capital market exposures. RBI has issued its

guidelines under the Basel II for risk management.

5. Disclosure Norms

One of the important tools for marketing discipline is to maintain public disclosure of relevant

information. As per RBI’s directives, the banks are required to make disclosures of their annual

reports and some other documents about their capital adequacy, asset quality, liquidity, earnings

aspects and penalties imposed on them by the regulator.

6. Para – banking Activities

Para - banking activities are those activities which don’t come under the traditional banking

activities. Examples of such activities are asset management, mutual funds business, insurance

business, merchant banking activities, factoring services, venture capital, card business, equity

participation in venture funds and leasing. The RBI has permitted banks to undertake these

activities under the guidelines issued by it from time to time.

7. Annual Inspection

RBI undertakes annual on-site inspection of banks to assess their financial health and to evaluate

their performance in terms of quality of management, capital adequacy, asset quality, earnings,

liquidity position as well as internal control systems. Based on the findings of the inspection,

banks are assigned supervisory ratings.

8. Anti-Money Laundering Norms

KYC norms (Know Your Customer) Anti- Money Laundering (AML) and Combating Financing

of Terrorism (CFT) guidelines are some of the major issues on which RBI keeps issuing its

norms and guidelines.

Important Questions

Section-A

1. What is Bank? May-2013

2. What is Commercial Bank? May-2013, 2016, Nov. 2014

3. State any two roles of Commercial Bank.

4. Mention any two functions of Commercial Bank.

5. State any two public or general utility functions of Banks. Dec-2007

6. What is Creation of Credit? Dec. 2010

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7. What is Primary Deposit?

8. Give the meaning of Derivative Deposit.

9. What is Cash Credit? Dec-2005

10. What is Liquidity? May-2013, Dec-2009

11. Give the meaning of Profitability.

12. What is Remittance of Funds?

14. What is Letter of Credit?

15. Give the meaning of Investment Policy. Nov. 2014

16. What are Government Securities?

Section-B

1. Discuss significance of Commercial Banks.

2. Explain techniques of Credit Creation by Commercial Banks. Dec. 2010

3. What are the agency services of Commercial Bank? Discuss.

4. Discuss about Letter of Credit.

5. Explain various Government Securities.

6. What are the factors affecting the Profitability of Commercial Banks?

Section-C

1. Discuss various roles of Commercial Bank.

2. Explain techniques of Credit Creation. Dec-2010

3. Discuss Primary and Secondary functions of Commercial Banks. May-2013, Dec-2009

4. Explain Investment Policy of Commercial Bank. Dec-2010

5. Discuss various factors affecting the Profitability of Commercial Banks.

6. Explain regulation and control of Commercial Banks by RBI. Dec-2007, 2009, No. 2014

7. Discuss the main sources of funds for Commercial banks. May 2016