BCom 3rd Year Money Financial System Investment Policy Commercial Banks Notes 

BCom 3rd Year Money Financial System Investment Policy Commercial Banks Notes: Sources of funds of Commercial Banks Principles of Investment Policy Bank Types of banking Investment Exercise Questions Long Answer Questions Short Answer Questions  Objective Type Questions Statement are True or False :

BCom 3rd Year Nature Importance Financial Money Study Material notes 

INVESTMENT POLICY OF

COMMERCIAL BANKS

Like other commercial institutions. banks too are profit-earning establishments. It is the work culture of banks that they receive money from people and other sources and invest in profit giving fields. That is why Gizbert has described ‘a bank as a trader of money. Earning maximum profit in a legal way is the responsibility of a banking enterprise. But at the same time it is also a duty of the bank to meet the social obligations. For this banks invest the accepted deposits in different fields in such a way that there should be maximum profits, protection of money and maintenance of liquidity. In other words, the commercial banks work on the principle “Don’t put all the eggs in one basket” at the time of investment of money. Before clarifying the investment policy of bank it is essential to know as to which are the main sources of funds of commercial banks.

Money Financial System Investment

SOURCES OF FUNDS OF COMMERCIAL BANKS

Commercial banks in India get funds from internal as well as external sources. Among the internal sources, we include share capital, reserve funds, undistributed profit etc. On the other hand in the external sources, we include accepted deposits, loans from other commercial banks and loans from the Reserve Bank of India etc.

The source of funds of banks can be clarified through the following points :

(1) Share Capital: The banking organisation in the present time is operated in India on the basis of Joint Stock Company. So capital is obtained by banks by selling shares. The board of director of the bank decides it in the Memorandum of Association that what should be the capital of the bank. This capital is also called Registered Capital or the Nominal Capital. Some part of the Authorised Capital is issued in the market for sale, which is called Issued Capital. Among the Issued Shares, as many shares are applied by the people for purchasing are called Subscribed Capital. The part of the Subscribed Capital which is really paid by the people is called Paid-up Capital. According to Section 12 of Banking Regulation Act, the Subscribed Capital of the bank should not be less than the half of its Authorised Capital in India. Similarly, the paid-up capital should not be less than half of the Subscribed Capital.

(2) Reserve Fund: Due to being a company as Joint Stock Company, banks have to distribute their profits as dividends among the shareholders; but banks can’t distribute their total profit among shareholders. According to the Section 17 of Banking Regulation Act, 1949 for every banking company incorporated in  Banking System India it is essential that it must keep at least 20 percent of its net profit is Reserve Fund. More funds in the Reserve Fund is the indication of more faith public in the bank.

(3) Undistributed Profit : The remaining amount of the profit and local account which remains undistributed is called undistributed profit, the economia condition of the bank gets strengthened with it. It also raises the working capital of the bank.

(4) Deposits : Accepting deposits from people through various accounts is the primary function of the bank. Deposits from people are a big part of the bank’s capital. People deposit their small savings through various accounts on definite terms. They further hope that their money should be safe and they should get interest on their deposits. Banks accept deposits from people through Fixed Deposit Accounts, Current Accounts, Savings Bank Accounts, Recurring Deposits Accounts etc.

(5) Borrowing and Loans: Banks meet their needs in a general way by accepting share capital and deposits, but in special cases banks accept loan from commercial banks and the Reserve Bank of India. When a large number of customers come to withdraw their deposits at the same time and the bank is not able to fulfill such a sudden demand with the help of its general sources, it retains the faith of the people by taking loan form the Central bank of the country or from other commercial banks.

Money Financial System Investment

(6) Credit Creation : The system of granting loans and advances by the bank is such that bank doesn’t provide the entire sum of the sanctioned loan at one time but the entire amount is credited in the account of the borrower. The borrower withdraws money according to his/her needs. On the other hand the depositors also don’t withdraw all their deposits at the same time, but withdraw amount according to their needs. In this process, banks create credit and raise their funds.

PRINCIPLES OF INVESTMENT POLICY OF BANK

Banks invest money received through various sources at one place or the other. Banks get interest through investments and give interest on money received from share and deposits. In this condition, it becomes essential that banks should invest their resources at proper places. The policies and principles of bank keep on changing according to the circumstances of the country. So, the bank officials have to work on the basis of their prudence and experience. At present banks keep the following principles under consideration while investing their capital

(1) Safety of Funds : Safety of funds is the most important among the principles of investment policy of banks. Safety mustn’t be overlooked due to the hope of earning high profits. If banks neglect safety of funds at the time of investment, their can be problem of existence. Banks should keep in mind following points for the safety of investment.

(i) Banks should not invest their total capital with one person, in one area, one enterprise or one industry. If it is done and that class faces some crisis, the bank would also face that crisis. So banks should invest their capital in different areas.

(ii) Before advancing loans, banks should gather information regarding the nature/character, financial position and credit worthiness of the borrowers. Loans should be always granted to persons with good character, strong financial condition and good credit. Such loans don’t become Bad Debts.

(iii) Loans should be granted on safe and proper collateral. In case, the situation of non-repayment comes up the money can be obtained by selling the collateral.

(iv) As far as possible, banks should grant short-term loans only and avoid granting long-term loans. Short-term loans are considered safe.

(v) Banks should not very often grant loan on taking immovable assets as collateral.

(vi) Banks should not adopt Cheap Credit policy because it develops the tendency of extravagance among borrowers.

(2) Liquidity of Funds : Faith of people is essential for the success of banks. People deposit their money with banks with the hope that they can withdraw it any time they want to do so. To retain this faith of people banks should take care of liquidity, while investing their funds. Thus banks should invest their funds in such securities that can be sold without any loss in the hours of need. However banks retain a certain percent of cash funds to meet the demands of customers, when it appears to be inadequate there emerges, situation of the selling of shares. The point to be considered with the view of liquidity are:

(i) Bank should not invest their total capital. Instead they must retain 20 to 30 percent as Cash Funds. Though, the Cash Fund is a passive source, it is needed to retain the faith of people.

(ii) Funds should be invested in government securities. Blue chip companies and debentures which can be sold within a short time to obtain money.

(iii) In this respect Tannen says, “A true banker is one who well understands the differences between Bill of exchange and Mortgage. Bill of exchange is short-term credit investment, which can be easily converted into money in the hour of needs. But mortgage is an asset which can’t be suddenly changed into money. Due to this, demand requiring cash can’t be fulfilled at short notice.”

(3) Profitability of Funds: A Bank is a profit earning institution. It earns the maximum of its profit from investments. So, a bank should invest its surplus capital in such a way that it can get a good and steady income. But it is worthmentioning here that liquidity and profitability are contradictory to each other. If investment is done by keeping liquidity in mind, it will give less profit and if investment is done with the objective of earning more profit, it will have less liquidity. In other words, the more a bank will stress on profitability, the farther it will become from liquidity. But for banks, at the time of investment both liquidity and profitability are necessary elements of consideration. In this condition banks should invest their resources in different areas in such a way that a proper balance between liquidity and profitability can be maintained.

(4) Diversification of Risks : Diversification of Risks in the investment policy of the banks means that banks should not invest the entire surplus amount one enterprise, industry, area or place but diversify it. If the whole sum is invested in one area and that collapses due to any reasons, the bank would fail. for the sake of safety, the banks should diversify investment of their funds. or example, if the money is to be invested in shares only, then some part of it hould be invested in equity shares and the remaining in preference shares, bonds and debentures. Similarly if loans have to be granted to industries, should be distributed to different industries.

(5) Marketability: While investing money, banks should take care of the arketability of shares and assets. Marketability refers to the availability of markets, where shares and assets can be sold easily without any loss. Generally market for good shares and movable property is available, so these have the quality of marketability. On the contrary, there is no market for fixed assets like land, buildings etc. So with this point of view bank should not invest their money in fixed assets.

(6) Price Stability: However nobody knows what is stored in the future: yet banks should invest their capital on the basis of their experiences in such shares in whose price there is less fluctuation shares with high fluctuation may give better hopes of profit, but there is also an equal chance of acquiring loss.

(7) Exemption from Tax: For increasing their income banks should invest their surplus money in such shares, income from which is exempted from income tax and other taxes.

(8) Productivity of Funds: While investing money as loans, banks should give top priority to production sector. If it is done so, there is safety of investment.

(9) Study of Investment Policy of Central Banks: The Central Bank of the country is also called the bank of banks. The Central Bank regulates all the commercial banks of the country, so the commercial banks should study the investment policy of the Central Bank and take care of its guidelines.

(10) National Interest : It is true that the objective of a bank is to earn profit, but the social responsibilities are also associated with it. So while investing banks should keep the national interest also under consideration so that the maximum national development can be achieved.

Money Financial System Investment


TYPES OF BANKING INVESTMENT

Every commercial bank invests its funds in two ways—Non-profitable Investment and Profitable Investment. There is no fixed rule regarding the ratio between these two kinds of investments. So the banks must be rational in making a balance between the two while investing their funds.

Types of Investment

(A) Non-profitable Investment                                    (B) Profitable Investment

(1) Cash Reserve                                                                (1) Money at Call and Short Notice

(2) Dead Stock                                                                    (2) Discounting of Bills

(3) Investment in Securities

(4)  Loans and Advances

(A) Non-profitable Investments : Banks do not get any direct profit from the non-profitable investment, but with the objective of fulfilling the cash demands of the customers and ensuring security it becomes essential that banks should invest a part of their money in non-profitable field. There are two non-profitable investments of banks :

(1) Cash Reserve: Banks have to keep a part of their deposits as liquid money to fulfill the cash demands of their customers. The more the amount of cash with the bank, the sooner they would be able to fulfill the demands of cash by the customers. But banks can’t keep their total deposits with them because won’t earn any income. So, banks keep only a certain portion of their deposits as liquid money. Now the question arises as to what percent of the total deposits should be kept by the banks as liquid money. There is no fixed rule or law

Investment Policy of Commercial Banks 39 regarding this, but certain points are kept under consideration by banks while deciding the amount of cash reserves. Those points are:

(1) Legal Requirements : According to Section 42 of the Reserve Bank of India Act, 1934 every commercial bank has to keep a certain part of its deposits with Reserve Bank of India. Initially this ratio was 5 percent of demand deposits and 2 percent of the fixed deposits. After two amendments in 1962 the Reserve Bank got the right of a Joint Ratio in place of two different ratios. The Cash Reserve Ratio was fixed to be 5 percent in June, 1973 and 7 percent in September, 1973. Later it was frequently raised. It was fixed at 8.5 percent in August 1983, 10 percent in October, 1987 and 15 percent in April, 1991. But it was greatly reduced in the onset of 21st Century. The Cash Reserve Ratio was fixed at 4.5 percent on 31st March, 2004 which was again made 4.75 percent on 18th September, 2004. It was slightly changed to be 5 percent on 2nd October, 2004. Again on 23rd December, 2006 it was rechanged to be 5.25 percent. According to the declaration made on 21st April, 2009 it has been fixed at 5 percent.

(ii) Nature of Investment: The amount of Cash Reserve also depends to the maximum part on their investment in good securities, Bill of exchange and other liquid sources, they need to keep less amount of Cash Reserve. On the contrary, if banks invest their money in non-liquid assets, there is a need of keeping a bigger amount of Cash Reserve.

(iii) Banking Habit among People: Banking habit develops among people according to the Cash Reserve of banks. They start making their monetary transactions by cheques. In this condition there is a need of keeping less Cash Reserve. Opposite to it, if people make all their transactions in cash, banks have to keep a bigger amount of Cash Reserve.

(iv) Facilities of Clearing House : The more an area has the facility of Clearing House, the less is the need of keeping Cash Reserve by banks. The reason behind this condition is that they make the most of their transactions by cheques only. So banks have to keep less amount of Cash Reserve. But if there is not much facility of Clearing houses, banks have to do most of their transactions in Cash and hence they need to keep a higher amount of Cash Reserve.

(v) Size of Deposits : What amount of Cash Reserve should be kept by banks is largely determined by the number of their customers and the size of deposits. If the number of customers is less and the size of deposit is big, there would be the need of keeping a lesser amount of Cash Reserve. On the contrary, if the number of customers is more and the size of deposits is small, the banks would need to keep a higher Cash Reserve.

(vi) Nature of Accounts : Customers of banks deposit their money with banks through various kinds of accounts. If the banks have more and more current accounts they would need to keep a higher Cash Reserve. The reason is that the holders of current accounts demand cash frequently. But if banks have more number of Fixed Deposit Accounts and Recurring Deposit Accounts, banks can maintain themselves with lesser Cash Reserve.

(vii) Business Conditions : Booms and depressions are common in the economy. When there is a boom, there is abundance of cash in the trading World. In such a condition people deposit/invest their money instead of withdrawing money from banks. But in the times of depressions, there is an economic crisis. In such conditions, people tend to withdraw their deposit from banks. So, the demand of cash increases. Thus when there is a tendency of rise in trade and economy, banks need to keep less amount as Cash Reserve and when there is a tendency of fall, they have to keep a higher Cash Reserve.

(viii) Cash Reserve Policy of other Banks: The Cash Reserve Policy of one bank influences the Cash Reserve Policy of other banks also. While deciding its Cash Reserve Policy a bank observes the Cash Reserve Policy of its supportive as well as competitive banks.

(2) Dead Stock: To run their business banks have to invest a part of their money in such assets which don’t earn them any direct income. For example, we can take investments in construction of office buildings, decoration of buildings, furnitures, lockers, fans, almiras, generators etc. There is no direct income from these investments, so these are called dead stock. Such investments are needed for security of investment and running of banking enterprise.

(B) Profitable Investment: Due to being profit earning enterprises, banks invest most of their money in profit-earning areas. The profitable investments of banks are :

(1) Money at Call and Short Notice : The nature of this loan given by the bank is short-term. Generally its period is from 1 to 15 days. Banks can get such loans repaid at short notice or without any prior notice. Banks earn some interest on such loans. For being short-term loans, these have the features of liquidity. After the Cash Reserve it is the second most liquid fund of banks such loans are in maximum use in bill market but there is scarcity of organised bill market in India, so its use in India is giving loans by one bank to other.

(2) Discounting of Bills: Banks invest their money by discounting of bills too. This is also a short-term investment of banks. This is generally for a period of three months. If the holders of such bills need money before the maturity, they get it by discounting of bills by commercial banks. The discounts that banks get on such bills are the income of banks. On the maturity of bills the banks get the total amount of the bills from the drawee of the bills. If the commercial banks need cash money before the maturity of bills, they can get it by their rediscounting by Reserve Bank of India. This way commercial banks meet the need of Cash money.

(3) Investment in Securities : Every commercial bank of the country invests a part of its money in the securities of the Central and State government. Such investments help the governments on one hand and on the other hand investment is safe. Similarly banks invest money in the shares and bonds of Blue chip companies as well. Investments in the securities of such companies are suitable with the view of safety and liquidity.

(4) Loans and Advances : Loans and advances comprise the important areas of the investment of their money by commercial banks. Banks grant loans and advances to persons, firms, industries etc. on the guarantee of various kinds of collaterals. There is a lack of liquidity in such investments. So, banks get a higher interest on these. Banks should work very cautiously in such investments from the view point of safety. Banks in India invest the maximum part of their sources in this field. So banks get maximum income from this area.. Loans od advances are granted by banks in different ways. Some examples are: (1) Ceneral Loans and advances (11) Cash Credit and (III) Overdrafts. (These points have been discussed in details in the Chapter 2 regar Commercial Banks’

In this way it is clear that banks should not invest just in one field. Instead, la invest in various areas to get the benefit of liquidity safety. profitability, marketability etc.

Money Financial System Investment

EXERCISE QUESTIONS 

Long Answer Type Questions

1 Describe the various types of investment of a commercial bank.

2 Discuss the investment policy of commercial banks. Illustrate your answer by referring to commercial banks in India.

3 “A good bank should keep a balance between liquidity and profitability”. Explain this statement.

4. What are the principles governing the distribution of funds of a commercial bank?

5. Explain the important sources of funds of a commercial bank.

Short Answer Type Questions

1 What do you mean by liquidity ?

2. What is profitability ?

3. What is profitless investment?

4. What do you mean by cash reserve ?

5. What are the sources of funds of a bank?

Money Financial System Investment

III. Objective Type Questions

Choose the correct option

1 Which of these is a non-profitable investment ?

(a) Treasury Bill

(b) Discounting of Bills

(c) Cash Reserve

(d) Money at Call and Short Notice

2. Which of these is a principle of investment by banks ?

(a) Safety

(b) Profitability

(c) Diversification of Risks

(d) All of these

3. Which source of bank is more liquid ?

(a) Cash Reserve

(b) Money at Call and Short Notice

(c) Investments in Shares of Blue Chip Companies

(d) Loan and Advances

4. The determining factor of the Cash Reserve is/are :

(a) Nature of Investment

(b) Banking Habit among People

(c) Nature of Accounts

(d) All of these

5. Building of a bank is ………….

(a) Profitable Investment

(b) Dead Stock

(c) An Expense

(d) None of these

6. Which of these is not a liability of banks?

(a) Share Capital

(b) Deposits

(c) Loans and Advances

(d) Reserve Funds

[Ans. : 1. (c), 2. (d), 3. (a), 4. (d), 5. (b), 6. (c)

Money Financial System Investment

State whether the following statements are True or False :

1 Banks increase their fund also by creating credit.

2. Share Capital is one of the sources of funds.

3. Discounting of bills is the profitless investment of a bank.

4. A commercial bank is prift making institution.

5. Cash reserve is a prifitable investment of a bank. oans and advances comprise the important areas of the investment of their money by commercial banks.

Ans. :1. True, 2. True, 3. False, 4. True, 5. False, 6. True.]

Money Financial System Investment