MANAGEMENT OF FINANCIAL INSTITUTIONS AND MARKETS

CHAPTER FIVE
5. BANKING AND THE MANAGEMENT OF FINANCIAL
INSTITUTIONS
5.1. Chapter contents:
5.1.
The Bank Balance Sheet
5.2.
General Principles of Bank Management
5.2.1. Liquidity Management and the Role of Reserves
5.2.2. Asset Management
5.2.3. Liability Management
5.2.4.OFCapital
BALANCE SHEET A BAAdequacy
NKS Management
Balance sheet is a statement
atement that shows the firfirm’s asset
assets, lia
liabilit
bilit ies and capital on a part
particu
icular
dat
date. The bank’s balance sheet
sheet items are dimensio
dimensionally different
ifferent fro
from other balance shesheet of an
ordin
ordinary
ary firm
firm.
The balance sheet
sheet list
lists what
what the business owns (asset
(assets), what
what the fir firm owes to others(lia
hers(liabilit
bilit ies)
and what the owners have invest
invested ( cap
capital) as of a given t ime.
ime. The basic balance sheet
sheet equat
equation
expresses the relationship between these accounts as: -
Asset = Liabilities + capital
The cap
capital account (or net worth) is a residual that that can be calcu
calculat
lated by subtract
racting lia
liabilit
bilit ies
owed to credit
creditors fro
from the tottotal asset
ssets owned by the bank. nk. The right
ight-hand side of the equatequation
can be viewed as the sources of funds for a bank. bank. Funds are supplied by eit eit her cred
creditors
(liabilit
liabilities) or the owners (cap (capital).
l). The lift
lift-hand side of the equat
equat ion sho
shows the uses o f funds
(Assets) that the bank has obtained from rom the credi
creditors and owners.
The primary functfunction of a bank is accept
accepting deposits for credit creation purpose.
purpose. The bank is thus a
dealer in debts. It issues its own debt ebts (mainly depodeposit
sits) and it ho lds the debts of borro rrowers.
wers.
Bot
Both types of debts are recorded on the bank’s balance sheet sheet, whic
which is simp
simply a double entry try
statement of assets and liabili
liabilities.
Depo
Depositsits are the largest
largest sources of funds for most bank banks, but
but they are a mucmuch more impo important
source for small banks. nks. Borrowed funds are a more impo important
ant sources of funds for large banks.
Banks in general are thin hinly cap
capitalized, but
but sma
small banks tend to be bett better
er cap
capitalized than large
ones-Mo
ones-Most bank liabilit
liabilit ies are sho
short term.
erm. Becau
Because it is difficu
ifficult to attract
attract more depodeposit
sits and
investm
investments by smaller banks, thei their capi
capital
tal is relatively higher.
Economically deposit eposit account
accounts are similar to other sources of funds borro rrowed by the bank.
Legally, however, deposits take precedence over most other sources of borro rrowed fund
funds in case of a
bank failure.
failure. At the t ime the bank fails to meet meet depo
deposito
sitors claim their balance is reco recovered just
before other credito
creditors.
rs. Furthermore, insurance companies insure the holder lders of such accoaccount
unts
against any
any loss.
5.1.1. The Bank’s Liabil Liability Accounts
Maj
Major liabili
liability items of a bank shown on its balance sheet can be discussed as foll ollows.
i. Demand/checking Transactions Accounts:-Banks Accounts:-Banks hold a number of differ ifferent typeypes of
transact
ransact ion acco
account
unts, which are more commo mmonly called check
checking acco
account
unts or demand depo deposit sit

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 MANAGEMENT OF FINANCIAL INSTITUTIONS AND MARKETS

acco
account
unts.
A demand depo deposit
sit or a check
checking account unt is an acco
account
unt where
whereby the owner is ent itled led to
receive his or her fund
funds on demand and to writ write check
checks on the acco
account
unt, whic
which trans
ransfers leg
lega l
ownership
wnership of funds to others.hers. Demand
Demand depodeposit
sits serve as the basic medium o f exchange in the
econ
economy. Individuals, government ent entities and business organizat
rganizat ions may own own them.
Legally a demand deposit
deposit is defined as a depodeposit
sit that
that is payable on demand or issued wit h an
original mat
maturit
urity of less than seven days.days. Becau
Because they are clo closely asso
associat
iated with consunsumer
transactions, demand deposits are relat relatively more impo important as a source of funds for small
consumer oriented banks than for large banks. The demand deposit deposits of indindividua
idual
corporat
rporations, state and
and local goververnment
nments areare held primar
imarily for transact
ransact ion purpo
purposes.
ses.
ii. Saving deposits: - saving accounts are the traditional form of savings held by most individuals
and non-profit organizations. They are a more important source of funds for small banks than
for large banks. Historically, savings deposit had low handling costs because of their low
activity level.
iii. Time deposits /time liabilities/ fixed deposits:-time deposits, unlike demand deposits, are
usually legally due as of a maturity date and funds connote be transferred to another party by
a written check. Both consumers and corporations can own them, and their characteristics
vary widely with respect to maturity, minimum amount, early withdrawal penalty,
negotiability and renewability. The principal types of bank time deposits are savings
certificates, money market certificates and certificates of deposits.
iv. Borrowed funds:-they are typically short-term borrowings by commercial banks from the
wholesale money markets or a national bank reserve. They are economically similar to
deposits but are not insured by the national bank. Borrowed funds are a source of funds
primarily for large banks. The principal types of borrowed funds are: borrowed
federal funds, repurchase agreements, Eurodollar, banker’s acceptances, Federal Reserve
Bank loans etc.
a. Feder
Federal Funds: For liquidit liquidity reasons, banks may hold reser reserves in excess of those
required by low.
low. A bank wit with mo
more excess reserreserves than it desires may lend reserve serves to
anot
another bank that hat does not have its required level of reser reserves or that desires add additional
reser
reserves to make more loans. ans. The buying (borrowing) and selling (lend lending) of reser
reserves
on depo
deposit
sit at the Federal Reserve banks (Nat (Nat ional bank reserve in our case) is called
tradin
trading in federal
federal fun
funds (or Fed FunFunds).
The matur
maturity of federal funds is usually one day, ay, but
but the loan may be cont inuo inuously
reser
reserved wit h the same or other bank banks in the federal funds mark market:- Federa
Federal Funds have
the charact
haracterist
ist ics that they are transferred immediat
immediately, wit with the cent
central reser
reserve giving
the rece
receiving bank cred credit the same day.day. By contrast, a chequcheque may take at lea least a day
to clear.
lear. An import
importantant compo
mponent of central
central funds is reserves of a bank that are borrowed
by another bank.
b. Repur
Repurchas
chase Agreements
Agreements: Repurchase agreement agreements (RPs) are a form of loan in whic which
the bank sells secur
securit ies (usu
(usually government
government secursecurities) to the lender but simult
simultaneously
cont
contract
racts to purchase the same secur securit ies ei
either on call
call or on a specified date at a priprice that
will
will produce an agreed yield.

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 MANAGEMENT OF FINANCIAL INSTITUTIONS AND MARKETS

Repurchase agreement agreements pay exp explicit

licit int
interest
erest and natnatures wit h an overn
ver igh
ight, whic
which are
subje
bject continuous renewal on a day day-to dayday basis.
basis. There are also term RP transactions that
are writ
written for maturi maturities up to 30 day days.
c. Bank
Bankers Acceptances: A banker’s accept acceptance is a draft draft draw
drawn on a bank by a
corpo
rporat ration to pay for merc merchandise. The draft draft promises payment
payment of a certain sum o f
money to its holder at some fut future datdate. What makes such draft drafts unique is thathat a bank
accept
cepts them by prearra prearrange
ngement, there by guara guaranteeing their payment at the stated time. ime.
In effect
effect, the bank has subst substituted its credcredit stand
anding for that
hat of the issuer.
Acceptances arise in a rather complicat licated way. A fir firm selling to anot
another fir
firm on cred
credit
may not kno know enough about the buyer to feel safe in accept accepting its pro
promise to pay.
pay. This
is part
particular
icularly likely to be the case wit with a foreign custo
customers
mers (fo
(foreign trade transact
transaction),
in part
part because it is more difficult difficult to sue in a foreigforeign court
urt than in a court in one’s own
count
untry, but but while the seller do does not not want
want to take the custo
customer
mer’s pro
promise to pay( I owe
you ( IOU) ), rat rather apprec
appreciat
iates to accept
accept the IOU of the cust customer’s bank. Hence a
financial instrument called a banker nker’s acceptan
acceptance was dev developed.
oped.
v. Capital
Capital Notes and and Bonds:
Bonds Issuing bonds to raise funds is a commo mmon pract
pract ice of most
indust
indus t r i a l fir
r ms.
fi ms . I t is o nly in rece
rec e nt years that a few large c o mmercial banks began raising
funds by selling sho short-term capcapital
tal not
notes or longer-term
onger-term bonbonds.
5.1.2. The Bank’s Capital Capital Accounts
Bank capital representrepresents the equ equity or ownership funds of a bank, and it is the acco accountunt against
which bank loans and secur security losses are charged.harged. The greatgreater the pro
proportion o f capcapital to
depo
deposit
sits, the great greater the prot protect
ection to depodeposit
sitors. Banks maintain much lower cap capital accountunts
than other
other businessesinesses. CapitCapital is a more impo important source of funds for sma small banks than for large
banks.
There are three principal types of cap
capital acco
account
unts for a commercial bank.
bank. Capital stock, retained
earnings and special reser
reserve acco
ccount
unts. Capital stock represent
represents the direct
irect invest
invest ments in to the
bank; retained earnings compr mprise that port
portion of the bank
bank’s pro
profit
fit that
hat is not paid out to
shareho
shareholders as dividends; special reserve acco
account
unts are set
set up to cover un-ant
un-ant icipat
ipated losses on
loans and invest
investments.
ments. Reser
Reserve acco
account
unts invo
involve no transfers of funds or sett
setting aside of cash.
They are merely a for
form of retained ear
earning
nings designed to reduce tax liabilit
liabilit ies and stockh
tockho
older
lder’s
claims on curren
current reven
revenues.
5.1.3. The Bank’s Asset Accounts
The earning assets of bank are typically classified as either loans or investments and there are
important differences between these two classes.
Loans are the primarimary business of bank and usua usually represe
represent an ongo
ngo ing relat
lat ionship
hip betbetwee
ween
the bank and it s borrorrowers.
wers. A loan is a highly personalized cont contract
ract between the borro rrower and
the bank and
an d is t ailo
ailo r - made to t he part
t icu
u
par ic lalar
r needs o f t h e custo
customer
mer.
. L o ans are t he mo s t impo
important
earni
earning assets held by banks. ks. They have high yields, but they are typically
pically not very
very liquid.
Invest
Investments, on the other hand, are standard andardized contractracts issued by large, well-k ll-known
borrowers and their purchase by the bank represent represents an imperso
impersonal or open market
market transact
transact ion.
Consequent
Consequently,
ly, they can be reso resold by the bank in seco secondar
ndary market
markets. Unlike loans, invest
investments

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MANAGEMENT OF FINANCIAL INSTITUTIONS AND MARKETS

represent
represent pure fina
financing becau
because the bank pro
provides no service to the ultimat
imate borro
rrower other
than the financing secur
securities is a muc
much more impo
important
ant asset
assets for sma
small banks than for large
ones. Large banks concentrate in commercial loans, while small banks focus on consu nsumer,
agri
agricul
culture and real
real estate loans.
A bank asset includes the foll following items and discussed as foll follows.
i. CasCash Assets: sets:
Cash items consist consist of vault
vault cash, reserve
reserves wit h the Federa Federal Reser
Reserve Bank (Nat (Nat ional Bank in
Ethiopia), and balances held at other banks and cash items in the pro process of collect llection. Cash asset
sset
are non-interest bear bearing funds.
funds. Banks try to minimize their holdings of these idle balances
wit hin their liquiditliquidity constraints.
constraints. Because large banks must hold larger amounts of legal
reser
reserves and have more checks draw drawn against
against them than sma small banks; cash item acco account
unts are
are
t ypica
ically a greater percentage of total total assets for larger than smaller banks.
a. Vaul lt
Vau Cas Cash h : Vault cash consist
consists of coin and currency held in the bank’s own vau vault. Banks
typically maint maintain only minimum amounts of vault vault cash because of the hig high cost of securcurit y,
storage
torage and transfer.
Vault cash, however, per perform two impo importantant funct
nctions for banks. nks. Fir First, it provid
provides banks
wit
wit h funds to meet the cash needs o f the public. public. Seco
Second, bankbanks can count unt vau
vault cash as part
part
of their legal reserve requi requirements.
b. Reserve
Reserves at Federa Federal Rese
Reserve Banks /National Bank: These deposits held by banks at the
National Bank represent the major portion of the bank’s legal reserve requirements and serve
as check- clearing and collect llection balances.
balances. Rather than physically transferr ransferring funds between
banks, check clear clearing and
and collect
llection can be done by simp simply debit bit ing or credit
credit ing a bank’s
acco
account
unt at the Nat National Bank. Banks may also transfer funds to other banks for reasons other
than check clearin earing
c. BalBalances of other other Bank
Banks: Banks hold demand depo deposit
sit balances of other bank banks for a
number of reaso reasons: to meetmeet state reserve requ requirement
irements by holding ing balances at appr approved
large banks and to secure correspo rrespondent services from large city banks.
d. Cash Items in the process of coll collection: This acco account
unt is the value of checks draw drawn on other
banks but but not yet yet collect
llected.
ed. After a check wr writt
itten on anot
another bank is deposit deposited into a
customer’s acco accountunt, the rece
receiving bank attempt empts to co collect
llect the funds thro hrough the checkheck
clear
learing mechanism
echanism.. This is done by prese present ing
ing the check to the bank on whic hich the check is
draw
drawn. Before collection, the funds are not ava availa
ilable to the bank and and sho
show up in the cash
items in the pro process of collect
llect ion accoccount.unt. At the time the funds beco become available to the bank,
the cash Items in the pro process of colle llect ion acco
account
unt is decrea
decreased (revert
(reverting the orig riginal ent
entry),
and the bank’s reserves are inc increased by the same amoun ount. The CIPC account is anal analogous to
the accounts recei receivable on the balance sheet of a non-financial corporati corporation. on.
ii. Inves
Investments ents:
The invest
investment
ment portportfolios of commercial bank banks are major use of funds by the banking syst system.
a. Bank Invest nvestmentments consist of primar imarily of TreasuTreasury SecurSecurit ies, Gover vernme
nment AgeAgency
Secur
cu r it ie s and Municipal Securi i
Secur est ies. . Bank investment portff
port ololi
ios serve several
severa l important
functi
unct i ons.
Fir
Fi rst, they cont contain short-term, highly market marketable secursecurit ies that
hat pro
provide liqu liquidit y to the bank.

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MANAGEMENT OF FINANCIAL INSTITUTIONS AND MARKETS

These short-t
short-term secur
securities are held in lieu of non int interest
erest-bear
-bearing reserves to the maximum
maximum
exten
extent possibl
possible.
Sec
Second,
ond, the invest
investment portfo
portfolio contains long-t
ng-term secur
securities that
hat are purchased for their
incom
income potential
potential. Their inco
income generat
generating abilit
ability is hig
high. However, their
their marketabilit
marketabilit y and
liquidity
liquidity is low com
compared to primary
primary & secondary reserves.
Finall
inally, they provide the bank with tax benefit
benefits and diversificat
iversification beyo
beyond that
hat possible wi
with
only a loan portf
portfoli
olio.
b. Feder
Federal funds sol sold (National
(National Bank Funds Sol Sold): They correspo
rrespond to the lend
lending of excess
bank reserve
serves in the Federa
Federal Funds market market discussed ear earlier.
ier. Banks that
hat sell (lend) excess
reser
reserves in the Fed Federa
eral Funds marketmarket acquacquire asset
sets (Federa
(Federa l Funds sold) and lose a
corresponding amount of reserves on the balance sheet. sheet. Ban
Banks that borr
orrow Federal Funds gain
reserves but acquire a liabilit
liability (Federa
(Federal Funds Purchased).
Purchased). These transact
transact ions are reserved
when the borro rrowing
wing bank ret returns the reserserves
ves to the selling
lling bank.
nk. A Fed Funds transaction
is basically an unsecured loan fro from one bank to anot another, usually for a perio
period of one dayday.
Thus the Fed Funds rate is the interbank
inter ank lending rate.
rate.
c. Other
her A ssets: Fixed asset
asse t s are t he m o st impo
important
ant gro
group in this cat catego
egory and incinclude
suc
such reareal asset
ssets as furniture, banking equipmentequipment and the bank bank’s real estestate build
ildings.
Other iteitems considered as asset items are; prepaid expenses, inco income earned but not
collect
llected, foreign currenc
currency ho lding ings, and any
any direct lease financing.

5.2. GENERAL PRINCIPLES OF BANK MANAGEMENT

The main purpose/object
purpose/objective of bank management is for pro profit
fit. However, profits must
must be earned
without sacr
sacrificing bank safet
safety; that is to mean, adequat
adequate liqu
liquidit y and solvency.
lvency. Further, banks
must manage interest rate risk to prot
protect
ect the liqu
liquidit y and cap
capital posit
sit ion. An understand
understanding of
the int
interrelat
errelationships amo
among these important concepts is essent
essential to the pro
proper manageme
management of a
bank.
5.2.1. Liquidity Management
Liquidit
Liquidity management is one of the current bank management management strat rategie
egies for maintmaintainaining
sufficient liquidit
liquidity and solvency while maximizing over all bank pro profitfits. Reliance on a sing single
source of liquidit
liquidit y is r isky,
isky, be it shift a ble, sho
o rt-t
sh rt- t erm secur
secu r it ies o r antt i
an ipac ipat
t ed inco
inc o me fro
from
loans.
oans. Several import
important
ant developments in bank liqu liquiidity pract
pract ices have taken plac lace. The first
first is
asset management; the second is liabilitliability management-acqu
management-acquiring ing liquliquidit y fro from the liabilit
liabilit y sid
side
of the balanc
balance sheet
sheet. In practice, banks obtained liabilit
liability fro
from both oth sides of the balanc balance sheet
sheet.
Now let us look in to these two approaches one by one.
i. Asset Managem
nagement: A commercial bank requires liquidit liquidity to acco
accommo
mmodat
date depo
deposit
sit
withdrawa
hdrawals or to pay other
other liabilit
liabilities as they mat
mature. Payment of witwithdrawals can be
made only fro from asset
assets. All cas cash acco
account
unts are available to the bank
bank for payment
yment of
immed
immediat
iate withdrawa
hdrawals at no cost of the bank.
All other
other asset
assets must be convert
nverted intinto cash asset
sets. The conversion process invo
involves time
and expense to sell the assets as well the risk that
hat the asset
asset may be sold below their purchase
price.

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MANAGEMENT OF FINANCIAL INSTITUTIONS AND MARKETS

This situat
situation is referred as capitcapital or price risk.
isk. The liquidit
liquidity power, inco
income earning
capacit
capacit y and purpose of different assets of the bank are different which can be summarized as
foll
ollows.
ows.
 Cash is more liquid than other assets.
 Short-term securitsecurities are more liquid than long-t
long-term secur
securities because of their
superi
superior marketabili
arketability.
 Long-term secur securities are more liquid than term loans because of their super superior
conv
convertibil
ertibiliity.
 Short
Short-term invest
investments are more liquid than long term inve investments because
cause of the
smaller pri
price risk.
Because of the differ
different natures of asset
assets, Asset
Assets Manage
Management
ment classifie
lassifies bank asset
assets into
into gro
groups
as; primary
primary reserves, secondary
secondary reserves, bank loans and investm
investment for incom
income and tax shields.
a. Primary ReserReserves:
ves Primar
Primary reser
reserves are the cash asset ssets on a bank’s balance sheet sheet. They
consist of vau vault cash, deposit
deposits at correspo
rrespondent
ndent bankbanks, and depo deposit
sits held at the central
bank.
nk. Primar
Primary reserves are immediately available at no cost to the bank to accommodate
deposi
deposit withdrawals.
thdrawals. They are none in interest yieldin
ielding asset.
asset. Therefore banks try try to minimize
thei
their hol
holdings of primary
primary reserves.
b. Secondar
Secondary Res Reserves: SecoSecondar
ndary reser
reserves are sho short-t
rt-term asset
assets that
hat can be convert
nverted quick
quickly
into
into cash at a price near their purchase price. ice. Their main purpose is to provide that hat bank
wit
with add
additional liquliquidit y while safely earning some interest interest inco
income. Seco Secondar
ndary reser
reserves
consist
nsist of treasur
reasury bills, sho short-term agency secur securit ies, bills o f exchange, etc. Because the
secur
securities that
hat compompose seco
secondar
ndary reser
reserves are highly marketable and have low default risk,
they have yields below the yie yields of loans and other investm investment securi
securities hel
held by the bank.
c. Bank Loans
Loans: AftAfter the bank has sat sat isfied its unexpect
nexpected need needs for cash, bank manage nagement
can concen centrat
rate on its primary business-making loans to business firms and individuals. individuals.
Business loans are generall
generally less liquid and risk iskier than other other bank asset ssets and as a resu
result,
typica
ically carr
arry the highighest
hest yie
yield of all
all bank assets and off offer the greatest potenti
potential for profi
profit.
d. Inves
nvestments: The funds remaining after the bank has sat satisfied
isfied its loan demand is then
ava
availa
ilable for open-market invest investments.
ments. The primary funct function of the investment portfolio is
to provid
provide inco
income and tax advantages to the bank rat rather than liqu liquidit y. Open -Market
invest
investments are typically long-t ng-term secur
securities that that are less market marketable and have hig higher
defau
fault risk than secondar ndary reser
reserves.
These invest
investments, therefo
herefore, offer greatgreater incoincome pot potent
ential to the bank.bank. Invest
Investments for
inco
inc o me include long-term m treasuryy
ong-ter treasur secur securi it ies, municipal
municipa l bonds, and agency
agenc securities.
y securi
ii. Liabil
Liability managem
management:
Liabilit
Liability management
management argues that banks can use the liabilit liability side of their balance sheet sheet for
liquidi
liquidity. Hist
Historically, bankbanks had alwalways treatreated their lia liabilit
bilit y struct
ructure as a fixe
fixed pool
ool o f funds,
at least in the sho short run. Bank asset holdings were tailo ailored to the depo deposit var
variabilit
bilit y
characterist
characteristics of their liabilit
liabilities. Under liabilit liability management, however, banks target asset
growt
growth as given and then adjust adjust their liabilit
liabilit ies as needed. Thus, when a bank needs add additional
funds for liquidity or any any other purpose, it merely
merely buys the funds in the money markets.

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MANAGEMENT OF FINANCIAL INSTITUTIONS AND MARKETS

The liabilit
liability management theory is based on the assumpt assumption that cert certain t ypes of bank liabilit
liabilit ies
are ver
very sensit
sensitive to int interest
erest rat
rate cha
change
nges. Thus, by raising the int interest
erest rat
rate paid on these
liabilit
liabilities abo
above the market rat rate, a bank can immed immediat iately attract
tract add
addit ional funds. On the other
hand, by lower wering the rat rate paid on these lia liabilit
bilit ies, a bank may allo llow funds to run off as the
liabilit
liabilities mature.
mature. Bank liabilit
liabilities emplo
employed in liabilitliability management are negot negotiable cert certificat
ificates
of deposits (CDs), Federal funds, Repurchase agreeme reements, Commerciammercial pap paper, and Euro Eurodollar
borrowi
orrowings. These secur securit ies are sensit
sensitive to interest rat rates, and have market markets large eno enough to
accommodate the act activit
ivities of the commercia
mmercial banking syst system. Other bank liabilit liabilit ies, such
uch as
savings account
accounts or demand deposit deposits are not as int interest
erest rat
rate sensit
sensit ive, and change nges in the posted
offer
offering rate will not resu result in notable immed
immediat iate inflows or outflo flows of funds. Long- term debt
and bank capital are not not appropriat
appropriate for use in lia liabilit
bilit y management
management becau because of the time it takes
to bring this secur
securit ies to market
market. The liquidit
liquidity gained by liabilit liabilit y management is use full to a
ban
bank in sevseveral
eral way
ways.
- First, it can be used to count unteract deposit
deposit in follo llows and out follo llows and reduce their
var
variabilit
iabilit y. Sudden or unexpected deposit deposit out out follo
follows can be offset ffset immed
immedia iattely by the
purc
purchase of new funds.
- SecSecond,
ond, funds attrac ttractted through liabilit
liability management
management strat rategy may be used to meet meet
increase
increased demands for loan by the bank bank’s custo customers.
mers. Customers need not not be denied loans
because of a lack of funds. As long as the expect expected marg marginal ret return of the new loans
exceed
xceeds the expe xpected marginal cost of funds, the bank can increase its inco income by
acqu
acquiring the add additional funds through liabili liability management.
Consider the following example.example. A bank needs addit additional funds because of a sudde sudden decrease
in deposit
deposits or a sudden demand for loans. ans. UndUnder tradittraditional asset
asset management
management, the bank
would
ould sell
- Treasur
Treasury, bills or some other money market securit securities to obtain the needed funds. In
contrast
rast, using liabilit
liability management
management, the bank could buy Federal Funds or issu issue nego
negotiable
CDs to obtain the funds.
iii. Liability Management and Credit Credit-Creat
-Creatiion
As already explained banks mobilize deposits and grant grant loans and advances. nces. The amo amount
unt of
loans granted by banks can be more than the amount of deposi deposits they
they mobilize.
obilize. The banks are not
merely purpurveyo
veyor of money but in an import important ant sense, manufact factures of mo ney. The The pro process o f
mult
multiplying one deposit after keeping the minimum balance requir required may be sanctsanctioned as a loan to
different
different perso
persons, it is going ing to be a chain effect ffect andand entered as depo deposit and also lso as loanoan
disbursement in several banks in known as credi credit creati
creation.
In a countr
country,y, the total quantum of money in circu irculat
lation incinclude
ludes not only the leg legal tender mo ney
issued by the banker.
banker. Bank depositdeposits are also also known as bank money. While grant granting loans,
inst
instead of paying the amo amount
unt in cash to the loane, banks cred credit the amoun ount to the acco
accountunts of the
custom
customers.
ers. Most of the custo customers
mers use cheques and draft drafts for mak making payme yments to differe
different
parti
parties. Thus, addit
additional deposits are also created on which banks get interest. interest.
5.2.2. The Process of Cre
Credit Creati
Creation
While explaining the import
importance of cap
capital, Js.
Js. Mill writes “………t
“………though, cred credit is but
but a
transfer of capit
capital fro
from hand to hand it is genera
generally and nat
naturally a transfer to hand more

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MANAGEMENT OF FINANCIAL INSTITUTIONS AND MARKETS

competent
competent to emplo
employ the capital more effect
effect ive
ively in pro
product
duction”.
n”. Cred
Credit has assu
assumed such
uch an
import
important
ant role that it is ver
very difficult
difficult for us to imag
imagine the funct
nct ioning of a modern eco
economy
without credi
credit.
The term" Credit" is der
derived fro
from the Lat
Latin word "Credo
"Credo" whic
which simp
simply mea
means belie
lief or trust.
trust. In
the modern commercial world, cred credit refers to the fait h or confide
nfidence o f the cred
creditor in the
capaci
capacity of the debtor to fulfill his promise to pay
pay some amount in a certain peri
period of time.
1st Pr
Primar
imary And Secondar Secondary Deposits: One of the most most import
important
ant funct
functions of a commer mmercial
bank is to creat
create credit
credit. Commercial banks creat create cred
credit on the basis o f their depo deposit sits and loans.
ans.
These depo o
dep si sit
t s mainly depe
dep e nd upo
upo n t he banking habits o f the peop
pe ople
le.
. The initt
ini iaiatt ive for making
deposits comes fro fro m the c u s tomers
tomers. . In order to attt ract
at rac t more deposit
deposi frt s froo m the public, banks
o ffer differe
ifferent rat rates of int interest
erest on var various types of deposit deposits. By mobilizingbilizing more depo depositsits the
banker will be able ble to creat
create more cred credit.
When an individual deposit deposits money wit h a bank, the bank cred credits his accoccountunt with the amoun ount of
his deposi
deposit. Similarly when a customer deposits cheques, drafts or bills for collect collection, the banker,
on realizat
realization of the amoun ount, credit
credit the acco accountunt of the custcustomer.
mer. All these t ypes of depo deposit
sits are
called primary deposits.deposits. If people decide to keep more money with the banks, the volume o f
primar
imary deposit
deposits may be more. re. All these depositdeposits are not kept kept idle wit h the bank in the form of
idle cash holdings.
ldings . T hese p r imarr y
ima dep sidepo o sit
t s are used by commerc
mmercial banks to creat create some
addit
additional deposits.
deposits. As these add additional deposit
deposits are creat created frofrom the primar imary depo deposit sits, they are
call
called
ed der
derived deposits.
2nd Pr
Process of Credit Creation: Let Let us study now the pro process of cred credit creat
creation, the differe ifferent
met
methods ado adopted there herefore and the limi limitati
tations faced by the bankers in this directi rection.
- Granting Loans Loans " Loans creat create depo
deposit sits" When a bank gra grants a loan to its custo customer mer it does not
genera
generally pay cash as the borrower may not require it immed immediat iately.
ly. It credit credits the
individual's acco accountunt witwith the amount of the loan. an. Thus, wit without rece receiving any cas cash or
cheque or draft draft or any other other cred
credit instru
instrument
ment from the cust customer, the banker creates an
add
additional depo depositsit simp
simple by gra grant ing a loan oan to
to the cust
customer.
mer. The banker supp supplies a pass book ook
and a cheque
heque book ook. The banker allo llows him to wit withdraw the deposit deposit from his account account as and
when the custocustomer mer like
likes. Thus by grant granting loans banks create addit additional depo deposit sits. Hence, it
is right
ight ly said that hat “deposits are the childre hildren o f loans".
- Discounting
Discounting Bills Bills of Exchange:
xchange Der Derived depo deposit
sits are creat
created when a bank disco iscountunts a bill of
exchange.
nge. The bank does not pay cash.. It cred credits the acco ccount
unt of the custo custome merr with the
amoun
ount equa
equal to the value lue of the discount unted bill
bill. Thus the bank bank's depo
deposit sits increase
increase equa equal to
the value o f the disco iscount
unted bill.
bill. In this case also the bank creat creates a deposit
deposits increase equal to
the value o f the disco iscount
unted bill.
bill. In this case also also the bank creates a deposi deposit without receiving
any cash.
- Purchasing Securities: When a banker purchases Government Government bonds and secur securities fro from a
custo
stomer it will cred credit the customer's accounts wit with the valu value of the secur curity. In this
inst
instance also lso, the banker creat creates a deposideposit without receiving cash. It is clear from the abo above
descr
descript
iption that the commercial banks creat create addaddit ional or derived deposi deposits which will will add
to the total
total supply
supply of money oney or the purchasing power of the communi community.

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MANAGEMENT OF FINANCIAL INSTITUTIONS AND MARKETS

3rd Multiple Expansion Of Credit Or Extent Of Credit Creation: eation The bank receives depo deposit
sits
fro
from the public.blic. The banker pays int interest
erest on these depo
deposit
sits. He cannot
cannot affo
afford to keep the
depo
depositsits idle.
le. Therefo
Therefore he lends them to the needy people ople and inst
institutions at higher rat
rates of
int
interest
erest to make some pro profit
fit. But how much can be he lend is an import important
ant aspect of cred
credit
creat
creation. Generally the bankers know by exper experience that
hat a part of the depo
deposit
sits can lent
lent as all
customers
tomers do not wit withdr
hdraw all their depo
deposit
sits at the same t ime.
ime. Some people may withdraw
money from the bank, while others may depo eposit
sit new money. ney. The new deposit
deposits and
withdrawals of ever every day may tend to be equa equal in suc
such a way that
hat the money held by a bank
may
may not change substanti
substantially
ally over a short peri
period.
4th Deposit MulMultipl tiplier
ier: The amount
amount of credit
credit created by the bank
banking syst
system as a whole depe depends
upo
up o n t he liqu
liqu i d i t y rat
rat io or percent
percen t age o f cash t o be kept
kep t by t he b a n k s agaa inst
ag ins t t h e ir depo
deposit
sits.
This percent
percentage will determine the deposit mult iplier. lier. Wit
With the follo llowing formula the
depo
deposit
sit mult iplier can be cal calculated.
5.3. SUMMARY
SUMMARY
A Bank is an inst
institution that invo
involves is accept
accepting deposit
deposits, advancing loans,
oans, creat
create credit
credits, offer
foreign exchange ser
services, create credit
credit money-c
y-cheques offers age
agency ser
service
vices, and the like.
like. It is
organized on the joint
int company basis so as to increase the ret returns of shareho
shareholders in a form of
dividen
dend. A bank wen
went thro
hrough different
ifferent stages of develo
development
ments before it reac
reaches to the prese
present
day
day devel
development.
opment.
A moder
modern bank raises funds using different metho
methods such as; collect
llecting paid up cap
capital fro
fro m
share holders, accept
accepting deposits in a for form of current
current acco
account
unts, time depo
deposit
sits and saving
deposi
deposits.
ts. A bank can be organized on different basis such as; branch bank banking, unit
unit banking,
group banking, chain banking, inv
v estm
in est m en t banking, a n d mixed b anking systems.
Commercial Banks are profit-maximizing business firms whose primary source of income is
interest earned on loans and investment securities. Like all business firms, banks strive for higher
profits. The trade-off between profitability and safety is more acute for banks than for most other
businesses because banks have low capital-to-assets ratios and because most bank liabilities are
short-term.
Banks have two basic tools for maintaintainin
ining
g suffic
fficient liqu
liquidit y: 1) Asset
Asset Managenagement and 2)
Liabilit
Liability Management.
Management. Under asset
asset management
management, bank
banks use liqu
liquidit y stored on the asset
asset side o f
the balance sheet in the for
form of excess reserves and market marketable securcurit ies. Under liabilit
liabilit y
management, banks obtain liquidit
liquidity by increasing liabilit
liabilities such as Federal Funds or by issu issuing
certificates of deposi
deposits.
Banks are required by law to maint
maintain minminimu
imum reserves equa
equal to a percent
percentage of their depo
deposit
sits
and designated as non-deposi
non-deposit liabili
liabilities.

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