Commercial Bank Management

Name: Shilpika Shetty

Roll No: B067

SAP ID: 80125190058

Q1.

(a) Should Reserve Bank of India be independent? Explain carefully.

Answer:

Yess, I feel the Reserve Bank of India should be an Independent bank.

As we all know, a central bank performs the following important functions for the country:

 Controlling the money supply

 Ensuring financial stability
 Regulating the financial sector and banks
 Regulating the Forex market and exchange rates
 Regulating credit and setting the interest rates on borrowing and lending money
 Most Important: Keeping inflation in check.

To perform these complex and technical functions, the proper structure of the central bank is
important. Globally, a central bank is an institution separate from the government, but that’s not
the case in our country.

An independent central bank can take its decisions for macroeconomic stability without considering
political windfalls. Hence, the autonomy of the central bank is essential for ensuring stable and
sustainable growth in any economy.

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(b) What services are rendered by Reserve Bank of India as banker to the Government?

Answer:

RBI is known as the banker’s bank, the services rendered to the government are as follows:

 The RBI acts as banker to the government the Central as well as state governments.
 It transacts all banking business of the government, which involves the receipt and payment
of money on behalf of the government and carrying out of its exchange, remittance and
other banking operations.
 Governments keep their cash balances on current account deposit with the RBI. As
government’s banker, the RBI provides short-term credit to the government to meet any
shortfalls in its receipts over its disbursements.
 It also provides short-term credit to state governments as ways and means advances. But,
some state governments do resort to over-drafts at times for short periods.
 As government’s banker, the RBI is also charged with the responsibility of managing the
public (i.e., the government) debt.
 In discharge of this responsibility, the RBI manages all new issues of government loans,
services the public debt outstanding, and nurses the market for government securities.
 The last function is very important for the success of government’s borrowing programme
from the public (including banks), which has itself become increasingly important for
mobilising resources for financing public-sector projects.
 The most important of these measures is the statutory requirement for investment in
government securities.

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(c) Why is Reserve Bank of India called lender of the last resort. What services are granted by
RBI in this capacity?

Answer:

As a Banker to Banks, the Reserve Bank also acts as the ‘lender of the last resort’. It can come to
the rescue of a bank that is solvent but faces temporary liquidity problems by supplying it with
much needed liquidity when no one else is willing to extend credit to that bank. The Reserve
Bank extends this facility to protect the interest of the depositors of the bank and to prevent
possible failure of the bank, which in turn may also affect other banks and institutions and can
have an adverse impact on financial stability and thus on the economy.

Basically, in simple words Reserve Bank of India is the central bank of India. At the time of
liquidity crisis faced by the commercial banks, RBI gives loans to the commercial banks to meet
their financial crisis and thus, it acts as a lender of last resort.

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 (d) What is the necessity of exercising control over credit created by banks? Enumerate the
various methods of credit control available to RBI.

Answer:

Commercial banks create credit in the process of lending. They have the power of credit
creation. The important of credit in the settlement of business transactions has increased.

1) Importance of Credit Control: To obtain stability in the internal price level.

2) To attain stability in exchange rate.
3) To stabilize money market of a country.
4) To eliminate business cycles –inflation & depression –by controlling supply of credit.
5) To maximize income, employment & output in a country.
6) To meet the financial requirements of an economy not only during normal times but also
during emergency or war
7) To help the economic growth of a country within specified period of time.

The methods employed by the RBI to control credit creation are: Quantitative Method and
Qualitative Method.

 Quantitative or traditional methods of credit control include banks rate policy, open market
operations and variable reserve ratio. Qualitative or selective methods of credit control
include regulation of margin requirement, credit rationing, regulation of consumer credit
and direct action. Quantitative Method include Bank Rate, Open Market Operations,
Variable Reserve Ratios.
 The qualitative or selective methods of credit control are adopted by the Central Bank in its
pursuit of economic stabilisation and as part of credit management. They Include Margin
Requirements, Credit Rationing, Regulation of Consumer Credit, Moral Suasion.

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Q2.

(a) What is the basis of credit creation in a commercial bank?

Answer:

A central bank is the primary source of money supply in an economy through circulation of currency.
It ensures the availability of currency for meeting the transaction needs of an economy and
facilitating various economic activities, such as production, distribution, and consumption. However,
for this purpose, the central bank needs to depend upon the reserves of commercial banks. These
reserves of commercial banks are the secondary source of money supply in an economy. The most
important function of a commercial bank is the creation of credit.

Commercial banks create credit by advancing loans and purchasing securities. They lend money to
individuals and businesses out of deposits accepted from the public. However, commercial banks
cannot use the entire amount of public deposits for lending purposes. They are required to keep a
certain amount as reserve with the central bank for serving the cash requirements of depositors.
After keeping the required amount of reserves, commercial banks can lend the remaining portion of
public deposits.

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 (b) What are the limitations of credit creation?

Answer:

The following are the limitations on the power of commercial banks to create credit:

 Cash: The credit creation power of banks depends upon the amount of cash they possess.
The larger the cash, the larger the amount of credit that can be created by banks.
 Securities: An important factor that limits the power of a bank to create credit is the
availability of adequate securities. A bank advances loans to its customers on the basis of a
security, or a bill, or a share, or a stock or a building, or some other type of asset.
 Banking by People: The banking habits of the people also govern the power of credit
creation on the part of banks. If people are not in the habit of using cheques, the grant of
loans will lead to the withdrawal of cash from the credit creation stream of the banking
system. This reduces the power of banks to create credit to the desired level.
 Legal reserve ratio: The minimum legal reserve ratio of cash to deposits fixed by the central
bank is an important factor which determines the power of banks of creates credit.
 Excess reserves: The process of credit creation is based on the assumption that banks stick
to the required reserve ratio fixed by the central bank. If banks keep more cash in reserves
than the legal reserve requirements, their power to create credit is limited to that extent.
 Banks Behaviour: The power of credit creation is further limited by the behaviour of other
banks. If some of the banks do not advance loans to the extent required of the banking
system, the chain of credit expansion will be broken. Consequently, the banking system will
not be “loaned up”.
 Credit control policy of the central bank: The power of commercial banks to create credit is
also limited by the credit control policy of the central bank. The central bank influences the
amount of cash reserves with banks by open market operations, discount rate policy and
varying margin requirements. Accordingly, it affects the credit expansion or contraction by
commercial banks.

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(c) Suppose you are the loan officer in a commercial bank and a customer approaches you for
sanctioning working capital facilities of Rs 500 crores. Explain

(i) how you would assess the working capital requirements for the company.

(ii) step-by-step process of sanctioning the w/c facilities from start to finish.

Answer:

The term “Working Capital” means, the funds required by a company, enterprise to carry on with
daily operations.

Any enterprise whether industrial, trading or other acquires two types of assets to run its business as
has already been emphasised time and again. It requires fixed assets which are necessary for
carrying on the production/business such as land and buildings, plant and machinery, furniture and
fixtures etc. For a going concern these assets are of permanent nature and are not to be sold. The
other types of assets required for day to day working of a unit are known as current assets which are
floating in nature and keep changing during the course of business. It is these 'current assets' which
are generally referred to as 'working capital'. We are by now already aware of the short-term nature
of these assets which are classified as current assets. It may be noted here that there may not be any
fixed ratio between the fixed assets and floating assets for different projects as their requirement
would differ depending upon the nature of project. Big industrial projects may require substantial
investment in fixed assets and also large investment for working capital. The trading units may not
require heavy investment in fixed assets while they may be carrying huge stocks in trade. The service
units may hardly require any working capital and all investment may be blocked in creation of fixed
assets.

i. I will follow the below to assess the working capital requirements for the company.
 The level of current assets required to be held by any unit which is adequate for its day-
to-day functioning.
 The mode of financing of these current assets.
 The total amount by which current assets exceed current financial liabilities is called
working capital. The formula to calculate working capital is: Working Capital = Current
Assets — Current Liabilities.
 This net working capital is also sometimes referred to as 'liquid surplus' with the firm
and has been margin available for working capital requirements of the unit. Financing of
working capital has been the exclusive domain of commercial banks while they also
grant term loans for creation of fixed assets either on their own or in consortium with
State level/All India financial institutions. The financial institutions are also now
considering sanction of working capital loans.
 The current assets in the example given in the earlier paragraph are financed asunder:
 Current Assets = Current liabilities + Working capital limits from banks + Margin from
long-term liabilities.
 Working Capital Management” is managing the short-term fund requirements through
the firm’s short-term assets and short-term liabilities
 One of the main objectives of Working Capital Management is to convert Cash to Cash (C
to C) in a cyclical form called as “working capital cycle.

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(ii) step-by-step process of sanctioning the w/c facilities from start to finish.

The Working Capital Cycle operates in the following manner:

1. A borrowing company here the customer has availed the Working Capital finance from the bank
after necessary credit appraisal from the bank.

2. The borrower converts cash into raw materials, and in turn into semi-finished and finished goods
depending on the production schedule

3. The finished goods are sold on a credit sales basis i.e. purchase made by the customer for which
payment is delayed

4. Bills of exchange are drawn by the seller of goods on the buyer as per payment terms of the goods
supplied which becomes the bills receivable for the seller

5. On the due date when the bills are paid by the drawee (buyer) the seller repays the W/C loan

The length of the working capital cycle depends upon:

1. The stocks of raw material to be held.

2. The period of time for converting the raw materials to semi-finished and finished goods.

3. The credit period to extended to the purchasers (debtors). The longer the working capital cycle
the funds required for the firm would be more.

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