FUNCTION OF COMMERCIAL BANKS Definition of Bank: A bank is an institution which deals money and credit BANK means:”the 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 or otherwise.” The following are some of features which represents/refers the term bank in modern times: i. It deals with money; it accepts deposits and advances loans. ii. It also deals with credit; it has the ability to create credit i.e., the ability to expand its liabilities as a multiple of its cash reserves. iii. It is commercial institution; it aims at earning profit. iv. It is a unique financial institution that creates demand deposits which serves as a medium of exchange and , as a result, the banks manage the payment system of the country. Functions of Commercial Banks: A commercial bank act as an intermediary between savers and investors. It mobilizes the dormant savings of the public in form of deposits. A. Primary Function The primary functions of a bank are the receipt of deposits repayable on demand and provision of credit facilities to merchants and manufacturers for productive purposes. 1. Accepting Deposits: i. Fixed Deposit Account: Money in these accounts is deposited for fixed period of time. ii. Current Deposit Account: Money from these accounts can be withdrawn any number or many times. Normally, no interest is paid on these accounts iii. Saving Deposit Account: The aim of this account is to encourage thrift and mobilize small savings of the public. iv. Recurring Deposit Account: The purpose of these accounts is to encourage regular savings particularly by fixed income group. Generally money in these accounts is deposited in monthly installments for a fixed period. 2. Advancing of Loans: i. Money-at-call and Short-notice: Such loans can be for a very short period and can be called back by the banks at a very short notice, say one day to fourteen days .These loans are ca inter –bank loans. ii. Cash credit: It is made generally against hypothecation or pledge of goods with the bank. It may be renewed after the expiry of the period. The advantage of the system is that the borrower need not withdraw the whole of the sanctioned amount. Interest is charged only on the amount utilized. iii. Overdraft: Sometimes, the bank provides overdraft facilities to its customers through which they are allowed to withdraw more than their deposits. Interest is charged from the customers on the over drawn amount. It requires previous arrangement. The customer is allowed to draw more than the balance in his account. 1

. The higher the cash-reserve ratio. houses. 4. v. the higher will be the credit multiplier. The bill or voucher for goods purchased is sent by the vendor to the banker. 3. Loans: Loan is given for a fixed period at an agreed rate of interest . Thus. Credit Creation: When a bank advances a loan to its customer it does not give cash but opens an account in the borrower’s name and credit s the amount of loan to this account.Discounting the Bills of Exchange: This is another popular type of lending by the modern banks. Through a cheque. the depositor directs the bankers to make payments to the payee. In addition to personal security. the lower will be the credit multiplier : the lower nthe cash reserve ratio.1000 Rs. it creates an equal amount of bank deposit. where k is the credit multiplier and r is the cash.200 Rs. TVs. whenever. vi. and flats etc. The bank may ask for surety. Through this method. Credit Cards: Banks are issuing credit cards to individuals in order to enable them buy goods without carrying cash. vii. a bank grants a loan. 2 iv. Credit card facility is made available for specified amounts. Banks can create such deposits several times or their cash reserves. refridgerators.800 (Intial primary deposits) (Intial excess reserves ∆R) B 800 160 640 C 640 128 512 D 512 102 410 Total 5000 1000 4000 Credit Multipler : Cedit creation thus depends upon the ratio of cash reserves to deposits. a holder of a bill of exchange can get it discounted by the bank. The credit or the deposits mulitiplier is : k = 1/r. Assumption: All taransction one throught abnks complete eceomy follws chque system Credit Creation= Total derivation despoits (DD) ________________________ Initial excess reserves (DR) TABLE 1 Multpile Credit Creation by Banking System Banks Primary Deposits Cash Reserves Credit Creation or Derivative r=20% Deposits (∆D) A Rs. are accepting credit cards.It is made normally against the security. travel agencies. sellers of goods etc. Hotels. collateral security is to be provided by the borrower. Promoting Cheque System: Banks also create a very useful medium of exchange in the form of cheques. Personal Loans: Loans are given to salaried employees to buy consumer durables like scooters.reserve ratio.

2.” Thus. the profit expecations are high. by creating derivative deposits) to the public. In the words of Crowther. There will be lesser credit creation. Avilability of Securities.e. Bank loans are granted against secrities. Amount of Cash. The extent of destruction of credit depends upon cash-reerve ratio. Availability of Borrwers. during the period of business prosperity. Banks create credit by granting loens ( i. Development of banking system and the banking habits of the people also influence the extent of credit creation. b) To limit the liability of insurer and to keep him in permissible limits of financial capacity. there will be no credit creation. 6. On the other hand. If people prefer to make transaction through cash and not by cheques. Higher the cashreserve ratio.e. greater will be the destrustion of credit: lower the cash-reserve ratio. to create credit) is restricted by the availability of good secutities. when due to low profit expections businessmen do not come forward to borrow from banks. the banks can destory credit by reducing loans. 3 . greater will be the credit creation. the power of the bank to turn other assets into money (i. The extent of credit creation primarily depends upon the amount of the cash possessed by the banks. Similarly. 3. The central bank has the power to influence the money supply in the country. Monetary Policy. Banking Habits. Objectives of the Re-insurance a) To safeguard the interest of insurers by wider distribution of risks.Contraction of credit. During depression. Larger the amount of cash with the banking system. Limitations of credit creation: 1. The extent of credit creation largely depends upon the monetary policy of the central bank of the country. “ The bank does not create money out of thin air: it transmutes other forms of wealth into money. It can use various methods of credit control to influence the banks to expands the contract credit. the businessmen approach the banks for loans and there will be greater creation. Banks create credit by means of loans and advances. Cash-Reserve Ratio. smaller will be the credit destruction. credit creation will be very small. Therefore the extent of credit creation depends on the availability of borrowers. Business Conditions. The size of credit multiplier is inversely realted to the cash-reserve ratio. 4. the banks will be left with a smaller cash. 5. If there are no borrowers. and vice versa. Credit creation is further limited by the nature of business conditions.

The principle is useful in deciding the actual cause of loss when a number of causes have contributed for the occurrence of loss. To earn profit by retaining the difference between the two premiums. Good faith refers to absence of fraud on the part of the parties to the contract. insurable interest refers to interest in the life of the insured person. the proximate cause for the loss is considered and not the remote cause of loss incurred. Indemnity: Indemnity refers to make good for the loss and nothing moiré than the actual loss. For example. the banker has insurable interest in the properties mortgaged by the lenders. The principle of indemnity is applied to all the insurance contacts where the loss suffered by the insured can be measured. The party proposing to take the insurance policy has to disclose all the material facts relevant to the contract to the insurer.c) d) e) f) To stabilize the underwritings over a period of time. all the insurance contracts except life insurance are the contracts of indemnity. To safeguard against serious effects of uncertainties. Principles of Insurance: a) Insurable Interest b) Utmost Good Faith c) Indemnity d) Proximate Cause e) Subrogation f) Contribution g) Mitigation of Loss Insurable Interest: A person said to have an insurable interest if he is financially benefited by the existence of property and is prejudiced by its loss. destruction or non existence. Causa proxima is a Latin term which means nearest proximate or immediate cause. The insurer’s actual loss is indemnified on the occurence3 of certain event. Proximate Cause: It is also called principles of causa proxima. In case of life insurance policy. Utmost Good Faith: The contract of insurance are considered as contracts of ‘ubereimae fidei’ which means contract requires absolute and utmost good faith on the part of all the parties concerned with the contract. Subrogation: 4 . In determining the liability of the insurer. or the husband may have insurable interest in his own life or in the wife’s life. otherwise it lacks good faith and leads to invalidation of contract. Hence. To help in the steady accumulation of reserves by the insurer.

but it also creates self-confidence. n) Credit facility: The policies –issued by insurance companies can be made used to raise policy loans from insurance company as well traders are in a position to 5 . judging the viability of projects becomes very easier with the insurance. Hence. They are General insurance. Hence. Life insurance. accidents fire and similar other calamities of nature. sickness. The principle of contribution ensures equitable distribution of losses among the insurers. h) Earns foreign exchange i) Funds for investment: Insurance provides funds for investment in socially useful ventures which leads to industrial development of the country. j) Promotes thrift k) Checks inflation l) Develop self confidence: Insurance not only provides security for the insured. That means only assets of profitable projects are insured. KINDS OF INSURANCE: a) On the basis of commercial point of view: Keeping in view the Commercial aspects. to cover a proportionate amount from other insurers who are liable for the loss. b) On the basis of development point of view: The various insurances be classified on the basis of development are marine. This will help to judge the profitability of the project and unprofitable and non viable units are denied the benefits of insurance. g) Loss reduction: Insurance helps in the loss reduction.Contribution: It is the right of an insurer who has paid a policy. social and miscellaneous insurance. disease. disability. since the insurance companies advise the adoption of various measures to reduce the losses or risks. This enables the insured to take up any venture with confidence and works for the success of the project. fire life. Social insurance. the insurance policies are grouped under three heads. It says that the duty of the insured is to take all such steps to minimize the loss as would have been taken by any person who is not insured. Mitigation of Loss: This principle is related to minimizing or decreasing the severity of loss. The premium that is collected from the insured helps to employ or invest in profitable segments. unemployment5. the insured should not be negligent and passive at the time of loss. old age. m) Social security: Insurance acts as an instrument to fight against evils of poverty. ADVANTAGES OF INSURANCE: a) Provides certainty b) Distribution of losses c) Provides security d) Generates capital e) Increases efficiency f) Profitability of the project: The process of insurance requires examination of viability investigation of assets or project.

In India. c) Modifications to traditional forms: With the globalization of insurance industry. IRDA was established in the year 2000. Privatization.N Malhotra Committee constituted by the Government in April 1993. The Liberalization. mergers between small and medium insurance companies to form large international insurance companies. climate. Everything is changing according to the need of the time. including India. b) Change of Market Environment: The environmental changes that took place are internet sales.raise loans and get credit facilities from various financial institutions like banks and other lending institutions. insurance losses due to urbanization. Trends in Global Insurance Industry: a) Concentration and centralization processes: The concentration and centralization processes found in the global insurance industry are. 1938. liberalization regulations of financial and insurance markets. change and private property cost increase. modifications have been made to traditional forms and types of insurance services and new insurance products Benefits of globalization: 6 . which marked the opening act of the insurance sector to private participation and foreign investment. LIMITATIONS / CRITICISM OF INSURANCE: a) Sharing of loss b) Real value of money c) Lack of confidence d) Cumbersome formalities GLOBALISATION OF INSURANCE Change is the eternal law of nature. and Globalization have become the basic concepts of success in all aspects of development Insurance being an integral part of financial service could not claim immunity to the impact of the globalization process and opened up to private and global players world over. and passing the IRDA Act if 1999. by an Act of parliament. insurance companies and credit companies to form transnational functional groups. formation of strategic alliances between insurance and re-insurance companies. many MNCs are now entering into the insurance sector which is now a booming sector. in accordance with the recommendations made by R. the process of liberalization and opening of insurance sector to private and foreign players started taking shape as part of the series of financial and economic reforms brought by the government in the late 1990s. of insurance and re-insurance products. Globalization has been the basic mantra after 1991. fusion of banks. By amending the relevant provisions of the insurance Act. Hence.

there was a paradigm shift in the government policies with the advent of economic liberalization. was appointed in 1993 by the government to review the working of the insurance industry. the insurance companies can enhance the efficiency of the local insurance market by providing superior customer services. Uniform regulatory environment: Sharing the expertise across borders benefits both consumers and the industry. INSURANCE SECTOR REFORMSIN INDIA Reforms during 1990-2000: In 1991. A committee reforms in the insurance sector. 29 regulations have been notified covering the following areas of insurance 7 .It helps in mobilizing national savings and the narrow the investment gap of developing economies. there has been a dramatic increase in professionalism throughout the industry as companies apply best practices developed by innovators in market to other markets around the world. there are possibilities for growthin the insurance industry. Prohibition o composite insurers Permitting foreign companies to enter the foreign companies in the joint venture mode with domestic companies Introduction of alternate distribution channels for ensuring a rapid growth of insurance companies. The important recommendations were: Permitting private companies with a minimum paid up capital of rs. as a whole has created a uniform regulatory environment Free flow of managerial talent: Globalization has resulted in free flow of managerial talent across borders. Hence. introduce new products and transfer technology and managerial knowhoe. Thus .Provides stability and proper management: Many countries are moving away from protectionism and state control in the insurance sector Growth in business:A new middle class is emerging around the world.100crores to enter the industry. Insurance Regulatory and Development Authority act was passed Reforms have included the setting up of Insurance Regulatory and Development Authority(IRDA). IRDA’s hallmark o0f openness and transparency is giving +ve results. Increase in professionalism: Over the years. To opertaionalize various provisions of the IRDA Act and Insurance Act. To increase the penetration of Insurance in the country. Superior customer service: With globalization. Setting up of an insurance regulatory body making the controller of insurance independent. popularly known as Malhotra Committee. which helps to understand regulatory environment of different countries for taking appropriate decisions for improving insurance business. The government respond positively by establishing an Interim Insurance Regulatory Authority in January 1996.

It seeks to fix the minimum investment limit for health insurance companies at Rs. 3. A penalty not exceeding Rs. It empowers the government to transfer more than 90% of the surplus funds of the LIC to a separate account to be maintained by the LIC.25 crore could be imposed if an insurer fails to comply with the obligations for rural or social sectors or third party insurance of motor vehicles. It paved the way for formulating regulations for payment of commission and control of management expenses.However. It made Life Insurance Council self-regulating bodies . Distinction is made between a beneficiary nominee and a collector nominee in life insurance policies 7.50crores to Rs. The bill provides the insurance companies to raise newer capital through newer capital instruments on the pattern of banks 2. the power of adjudication will be with IRDA and appeal against the decisions of IRDA will rest with Securities Appellate Tribunal.50 crore to encourage companies with a smaller capital launch health insurance business. It permits foreign insurers to setup branches in India to do away with divestment restrictions on Indian promoters of insurance companies to enable entry of more players into the sector. 100 crores. Oriental Insurance Company.e. investment and solvency. 6. Re insurance Protection of policy holders Reforms during 2001 to 2008: Insurance laws(amendment bills): The billseeks to increase the cap on foreign investment in private companiesin the sector from 26% to 49% It permits state owned general insurance companies to go public and raise funds from capital markets It raises the minimum capital of government owned Life Insurance Corporation of India from Rs. The Insurance Laws (Amendment) Bill 2008 1. Code of conduct required for insurance intermediaries Appointed Actuary Financial reporting. New India Assurance. 25 crore and imprisonment up to 10 years. 4.Registration of insurers Licensing of Agents and others insurance intermediaries. It empowers the government to further raise the capital of the LIC and four state-owned general insurance companies i. All penalties realized would be the credited to the Consolidated Fund of India. 5. United India Insurance snd National Insurance Companyare also empowered to raise funds from the capital market witk the consent Are also empowered to raise funds from the capital market with the consent of the government. With regard to penalties and fines the bills says that the insurance companies carrying on insurance on insurance business without registration could lead to a fine up to Rs. 8 .

8. The dealers in 9 . They also in their turn increase the rate of interest they charge on loans. The responsibility of appointing insurance agent rests with the insurer s and IRDA would regulate their eligibility. qualifications and other aspects. 7. When the banks rate is raised the commerical banks find that the cost of borrowing from the central bank has increased.

Higher rate of interest will check borrowing fromn commercial banks and so the volume of credit tends to decline.finished and semi-finished goods will find that the ‘cost of holding’ goods has increased. In India there is a legal compulsion that banks shall maintain with the Reserve Bank cash reserves of not less than 3 % of their total time and demand liabilities. With the help of these weapons the central bank can direct the flow of the resources into essential lines. and unencumbed approved securities When SLR is increased there will be less credit creation. The term Operations refers to the purchase or sale of any kinds of paper by the central bank. Moral Persuasion and Direct Action: When certain commercial banks pursue an unsound credit policy or when they borrow excessively. It may prescribe margins against secured advances . This is another weapon of Quantative Control available to the Reserve Bank of India. The purchase or sale of securities tends to increase or decrease the quantity of money in circulation as well as the cash reserves of the commercial banks directly and immediately. implies persuading the banks not to ask for further loans. the central bank may refuse to grant further loans or rediscount bills. The central bank may prohibit or caution bank lending against particular type of securities. gold. Moral persuasion. They place less orders with the manufacturers and hence the manbufacturers redue output . They try to repay bank loans by reducing stocks. But the term is restricted to puschase or sale of Government securities . Open market opertions.n Variation of Cash Reserve Ratio (CRR): Commercial banks in all countries maintain with the central banks some cash reserves. 2. It may charge penal rates of interest . It can prevent speculation and hoarding of commodities. When CRR is increased there is less credit creation in the market as such due to which there will less amount for credit creation. on the other hand. The bank rate can thus be used to control inflationary conditons. Statutory Liquidity Ratio (SLR): Scheduled banks will have to maintain in addition to CRR. And when their decreased SLR there will be more credit creation.It may regulate hire-purchase and installment transactions. this instrument is also used to control credit situation . The central 10 . The significance if these cash ratios is that the central bank can control credit by varying them within certain limits. 25 percent of their net total demand and time liabilities in the form of cash.Such a policy is termed as direct action. It can even stipulate the rates of interest on different types of bank advances. The opposite will happen when central bank lowers its bank rate. Selective Credit Controls: Selective methods of credit control regulate the use of credit by discriminating between essential and non-essential purposes. And when there is less CRR there will be more credit creation. The demand for goods and therefore their prices fall. so the factors of production will be thrown out of employment and their money incomes decrease.

bank may request the banks not to use the accommodation obtained for financing speculative or non-essential transactions . Legally. it will buy back the securities at a slightly higher price. SLR. the different in price representing the interest o 11 . Reserve Bank of India and Economic Development: Reserve Bank and commercial banks Reserve banks and Monetary Stability RBI control and regulate the money supply by using bank rate.From its very first inception the RBI has attending to agricultural finance. the borrower sells the securities to the lending bank for cash. openmarket operation. IT does not directly lend to agriculturist. and CRR Reserve Bank and Agricultural Credit It established NABARD to look agricultural matters. Repo A repurchase agreement or ready forward deal is a secured short-term loan usually by one bank to another against government securities. with the stipulation that at the end of the borrowing term.

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