BANKING & INSURANCE - UNIVERSITY QUESTIONS

1. Discuss Banking & Nonbanking functions of Commercial banks. (15 mks)

Commercial banks play a significant role in all the economic activities of the nation.
The various functions of commercial banks may be classified into:

A. Primary Functions, and B. Secondary Functions.

A. PRIMARY FUNCTIONS

The primary functions can be classified into: (i) Accepting Deposits, (ii) Lending
Money and (iii) Creation of Credit

i. Accepting Deposits
The major source of funds in the bank’s are deposits. The various types of deposits are:
a) Fixed Deposits: It is a type of deposit for a fixed period of time with fixed rate
of interest. It can be also called a term deposit or time deposit as they are
deposited for a fixed time frame. FD usually carry a higher rate of interest.
b) Current or Demand Deposits: A current account is an running and active
account which may be operated upon any number of times during a working
day. There is no restrictions on the number of withdrawals and the amount of
withdrawals, from a current account. Current account suits the requirements of
businessman.
c) Recurring or Cumulative Deposits: A recurring deposit is a kind of deposit
which helps those people with regular income to deposit a fixed amount every
month into the account.
d) Savings Deposits: it is a type of bank account that allows the customer to deposit
money, keep it safe and withdraw funds, all while earning interest. It is meant
for lower and middle income groups.
e) Endowment Deposits: such deposits are made to meet expenses connected with
special purposes such as children’s education, marriage etc.

ii. Lending Money

This is another primary function of commercial banks. The banks lend money in
different forms:
 a) Overdraft: Overdraft is a facility extended by a commercial bank to its current
account operators, to meet their seasonal requirements of extra money. Through
this facility, the customer are allowed to draw more than what it stands to its
credit. The customer is permitted to withdraw the amount as and when required.
Interest is charged on the exact amount overdrawn.
b) Cash Credit: Cash credit is a credit facility sanctioned by banks on special
request by their current account customers for meeting their working capital
requirements. The4 amount sanctioned is credited to a separate account from
which withdrawal may be effected frequently. Interest is charged on the exact
amount withdrawn and utilised.
c) Discounting of Bills of Exchange: discounting is the process of encashing bills
of exchanges before their maturity, by the outright sale to the bank for an
amount lesser than its face value. It is a form of clean advance, the interest is
received by the banker in advance.
d) Loans and Advances: in the case of loan, the banker advances a lump sum for a
certain period at an agreed rate of interest. The entire amount is paid either in a
cash or by credit in his current account which can be withdrawn at any time.
Loans may be demand loans (short term loan) or term loans (medium or long
term loan)

iii. Creation of Credit

Creation of credit is a situation in which banks make more loans to consumers and
businessmen, with the result that the amount of money in circulation increases. This is
an important function of commercial banks. When a bank advances loan, it is not paid
in cash but it opens an account in the name of that customer and allows him/her to
withdraw the required amount. In this way, the bank creates credit or money which the
customer can further use for the purchase of goods or services and also for any payment
of debt.

B. SECONDARY FUNCTIONS

The modern commercial. Banks provide additional facilities to its customers. Such
functions can also be classified under two heads: (i) Agency Services and (ii) General Utility
Services.
 i. Agency Services
The banker acts as the agent of the customer in performing the following functions:
a) Payment and collection: Banker makes payments and receives money on behalf
of their customers. Payments of insurance premium, payments of membership
subscription to clubs or professional institution, payment of rents etc. are some
payments. Bank also make collection of dividends, pensions, rent etc. on behalf
of the customer.
b) Purchase and Sale of Securities: Banks undertake purchase and sale of securities
on behalf of the customer.
c) Acting as an Executor, Administrator and Trustee
d) Acting as an Attorney
e) Acting as Correspondents & Representatives

ii. General Utility Services or Non Banking functions

a) Safe Custody Of valuables: Banks accepts valuables for safe custody by hiring
the safe deposit lockers to the customers.
b) Remittance of funds: Banks remits fund from one place to another through the
network of their branches.
c) Issues letter of credit: it is a sort of guarantees to the xporter that his draft will
be honoured by a specified banker upto a certain amount as per the specified
terms.
d) Merchant banking services: banks offer Wide range of services such as
financial, technical, mechanical assistance in the formation of corporate units.
e) Provides financial services such as lease financing, factoring, underwriting of
securities etc.
f) Dealing in foreign exchange business.
2. Explain the Functions of Central Bank. (15 mks)

The functions of Central Bank, as mentioned by De Cock in his famous book ‘Central
Banking’, are as follows:

1. Monopoly Right of Note Issue

The Primary function of a Central Bank is to issue currency notes. The Central Bank
enjoys a complete monopoly of the note issue. This power is regulated by the
government. The volume of currency and credit are to be regulated from time to time
according to the requirements of the economy. The power to issue notes enables the
Central Bank to maintain the stability of the value of the currency.

There are two important principles which govern the issue of currency notes. They are
(1) Currency Principle and (2) Banking Principle. According to the currency principle,
the note issue should be restricted to the volume of gold held by the Central Bank. In
other words, there must be cent per cent gold backing. According to the banking
principle there is no need for cent per cent gold backing for the note issue. It is enough
if certain proportion of the note issue is covered by gold reserves, and full convertibility
is guaranteed.

2. Banker to the Government

Central Banks in all countries of the world act as banker, fiscal agent and advisers to
their respective Governments.

As a banker to the government, the Central Bank advances loans to government. It

accepts the deposits of cash, cheques and drafts and undertakes collection of cheque
and draft drawn on other banks. It undertakes the job of maintaining accounts of income
and expenditure of the government for the entire country free of charge.

Central Bank acts as an agent of the Government. It floats loans for the government and
manages the public debt. It also buys foreign currencies on behalf of the government.
Central bank also collects tax on behalf of the government.

Central Bank acts as the financial advisor to the government. The Central Bank gives
its expertise advises to government on the matters of deficit financing, economic
planning and devaluation of currency etc.
3. Lender of the Last Resort

The Central Bank has the duty to help commercial banks when they are in financial
crisis. When all the resources of the commercial banks have been exhausted, as the last
resort, they can approach the Central Bank for financial help. At this stage, the Central
Bank must come to the help of the commercial banks. Financial help is given by way
of rediscounting of bills of exchanges and grating loans against eligible collateral
securities. In this way, the Central Bank acts as the lender of the last resort.

4. Management of Clearing Operations

Every day each commercial bank receives a large number of cheques drawn on other
banks. Instead of each bank presenting these cheques over the counter of the bank, the
representatives of all these banks who are mutually indebted, meet in a particular place,
called ‘Clearing House’; and settle their accounts with the help of Central Bank by
adjusting entry in the books of accounts of each bank. In other words, clearing
operations refer to a process by which claims of banks against one another are settled
without the use of cash.

Clearing House is a place where inter-bank- indebtedness is to be cleared. In almost all

countries, the Central Bank acts as the Clearing Agent and manages the clearing
operations.

5. Management of Public Debt and Foreign Debt

Whenever government requires money, it is raised by issuing government securities to

the public and other institutions. Repayment of principal amount and interest,
maintenance of public debt account etc. will be done by the Central Banks of every
country on behalf of Central Government.

Moreover, the Central Bank is managing ‘Foreign Debt’. Government borrows money
from foreign countries and from international financial institutions like IMF, IBRD,
ADB, etc. for developmental activities.

6. Acting as the custodian of the nation’s gold and foreign exchange reserves

In every country, the Central Bank acts as the custodian of the nation’s gold and foreign
exchange reserves. The Central Bank acts as the custodian of the nation’s gold and
foreign exchange reserves for two reasons:
  The Central Bank is the agency for the issue of currency notes.
 As a banker to the government, the Central Bank is required to provide
sufficient foreign exchanges to the government for meeting its international
obligations.

7. Controller of Credit

The important function of the Central Bank is to maintain the internal and external
stability of the currency. The money supply in a country consists of:
 Currency notes issued by the Central Bank, and
 Credit money created by Commercial Banks.

If the total quantity of money in circulation is more compared to the requirements, there
is tendency for the prices to increase. The inflation will be injurious to the economy.
Therefore, it is the duty of the Central Bank to regulate the total money supply of the
country. The credit control function of the Central Bank is designed in such a way as to
regulate the credit creation activities of the commercial bank.

8. Developmental functions of a central bank

The important developmental functions taken up by the central bank of a developing

country are:

 Extends baniking facilities to unbanked and under banked areas

 Consolidate and streghthen the commercial banking system.
 Liberalise agriculture finance
 Streghten capital market and money market.
 Directs the flow of credit to productive channels etc.
3. Explain the Credit Control Methods.

Credit Control

The important function of the Central Bank is to maintain the internal and external stability of
the currency. The money supply in a country consists of:

 Currency notes issued by the Central Bank, and

 Credit money created by Commercial Banks.

If the total quantity of money in circulation is more compared to the requirements, there is
tendency for the prices to increase. The inflation will be injurious to the economy. Therefore,
it is the duty of the Central Bank to regulate the total money supply of the country. The credit
control function of the Central Bank is designed in such a way as to regulate the credit creation
activities of the commercial bank.

Methods of Credit Control

Central bank adopts several Quantitative and Qualitative Credit Control measures. The
quantitative methods aim to control the total quantity and cost of credit created by the banks,
whereas the qualitative methods control the use and direction of credit.

A. Quantitative Credit Control Methods

1) Bank rate policy

Bank rate is the rate at which the Central Bank of the country allows finance to commercial
banks for short period. It can also be said that the bank rate or discount rate is the rate at which
the Central Bank is prepared to discount the first class bills of exchange and government
securities held by the commercial banks.

Working of the Bank Rate Policy:

When the Central Bank feels that the inflation in the country is on account of excessive creation
of credit by commercial banks, it raises the bank rate. Following this, the lending rate of
commercial banks goes up. A rise in interest rate discourages fresh loans and puts pressure on
borrowers to repay their past debts. As a result, business activities are curtailed. Fall in business
activities leads to contraction of money supply. Thus, raising of bank rate controls inflation.

The opposite happens in times of deflation. The Central Bank reduces the bank rate to expand
credit. Following this, the commercial banks reduce their lending rates. As the cost of loan is
low, businessmen are encouraged to borrow more and make more investments. Thus, lowering
of the bank rate offsets the deflationary tendencies in the economy

2) Open Market Operations

Open market operations mean buying and selling of commercial papers and government
securities in the market by the Central Bank.

Working of open market operations:

In periods of inflation, the Central Bank sells the securities in the market. If the buyers are
individual, firms etc., they make payments by withdrawing from their deposits with the banks.
If the buyers are commercial banks their cash holding with the Central Bank get reduced. So,
the banks are forced to stop granting fresh loans and recall loans already granted and the
investment activity in the country gets slackened and the inflationary situation will be reduced.

During the periods of depression, the Central Bank purchases securities in the open market and
pays cash to the sellers of securities. The public deposit their money with the banks. This
increases the cash balances of commercial banks which is used to give fresh loans.

3) Variable Cash Reserve Ratio

Every commercial bank is required by law to maintain certain percentage of its deposit with
the Central Bank which is called the Cash Reserve Ratio. The Central Bank has the power to
change the percentage of cash reserves to be kept with it. By changing the reserve requirement,
the force Central bank is able to restrict the amount of cash with the commercial banks and
force them to curtail or expand credit.

Working of CRR

When the Central Bank raises the reserve ratio, the commercial banks have to keep more cash
with the Central Bank. Consequently the amount of money available with the banks declines.
Hence, they are compelled to reduce their lending activities.

On the other hand, if the Central Bank wants to expand credit, it lowers the reserve ratio.
Consequently the commercial banks is left with more amount of loan to grant.

Thus, by varying the reserve ratio of commercial banks, the Central Bank influences the power
of credit creation and thereby controls credit in the economy.
B. Qualitative Credit Control Methods or Selective Credit Control

1). Rationing of Credit

This is the oldest method of credit control. It aims to control and regulate the purposes for
which credit is granted by commercial banks. Credit rationing is generally of two types.

 Variable Portfolio Ceiling, and

 Variable Capital Asset Ratio

2). Direct Action

Direct action refers to the directions and controls which the Central Bank may enforce on all
banks or a particular bank concerning their lending and investment. The Central Bank may
issue directives from time to time to the banks to follow a particular policy regarding loans and
advances. The direct action also includes coercive measures taken by the Central Bank against
the offending bank.

3). Margin Requirements

This method is usually adopted to control the speculative activities in the securities. Under this
method, the central bank prescribes the margin to be kept for loans against stock exchange
securities. When the commercial banks grants loans and advances against securities, they will
not give the full value of securities as loans. They keep a margin between the value of securities
and the amount of loan. Central bank raises the margin to curtail credit and reduces the margin
to expand credit.

4). Regulation of Consumer Credit

Under this method, credit granted to customers for purchase of durable goods is regulated. The
Central Bank is given powers to regulate terms and conditions of credit given to consumers. In
the case of financing through Hire Purchase or Instalment system, this regulation of consumer
credit can be followed. In the case of inflation, the central bank raises the minimum down
payments, and reduces the number of instalments. This results in contraction of credit. During
depression, the central bank encourages credit to consumers. The amount of down payment is
reduced and the number of instalments are increased.
5). Moral Suasion

Moral suasion implies persuasion and request made by the Central Bank to the commercial
banks to follow certain policy in the interest of the economy. During inflation the Central Bank
may persuade the banks not to apply for further accommodation or not to use the funds already
obtained for financing non-essential activities. During depression, it may request banks to
extend credit liberally.

6). Publicity

Quite a number of Central Banks use publicity as an instrument of credit control. They regularly
publish statements of assets and liabilities of commercial banks for the information to the
public. They also publish reports of general money market and banking conditions. This is a
way of exerting moral pressure on the commercial banks and also make the public aware of the
policies being adopted by banks and the Central Bank in the light of the prevailing economic
conditions in the country.

7). Control of Bank Advances through Directives

Under this method, the Central Bank controls bank advances by issuing directives to the
commercial banks in respect of their lending operations from time to time. Central Bank’s
directives to the commercial banks in respect of lending can be in the form of written orders,
appeals or warnings. The directives are intended to realise the following

 To control the lending policies of the commercial banks.

 To direct the flow of credit from less productive uses to more productive uses.
 To fix the maximum limits of credit for certain purposes.
 To prohibit for certain undesirable activities.
4. Explain the technique of Credit Creation by commercial banks. (15 mks)

Credit Creation

Commercial banks deal in money. They borrow money from those who have surplus, and
lend it to those who are in need. As they deal in money, they are called dealers in money
or suppliers of money. In addition to borrowing and lending of money, commercial banks
‘manufacture’ or ‘create money’. So, they are called ‘manufacturers of money’.

Deposits received by banks can be classified into (1) Primary Deposit, (2) Derivative or
Active Deposit.

Primary Deposit

When a bank receives cash from a depositor, it opens an account in the name of depositor
and credits the amount received to the depositors account. Such bank deposits are called
primary deposits, ‘passive deposits’ or ‘cash deposits’. This deposit forms the basis for the
loan transactions of a bank.

Derivative Deposits

By using cash received from the depositors, the banks grant advances to businessmen or
buys assets such as bills, bonds, etc. from the market. Whenever a bank grants a loan or
buys an asset, it does not usually pay cash for it. Instead of paying the cash, the bank
actually places the amount of loan in the account of the borrower. Thus, the borrower
acquires a claim against a bank just as he has deposited a sum of money. These deposits
are derived from the primary deposit and hence they are known as 'derivative deposit’
or secondary deposits’ or ‘active deposit’. If the banker has more primary deposit, he can
lend more and create more deposit.

Technique of credit creation

Deposits create loans and loans create deposits. A bank can advance money in various
forms only if it has cash or primary deposits in its hands. Thus, the various forms of
advances are made possible by the primary deposits in the hands of a bank.

The process of credit creation is based on certain assumptions which are as follows.
 There are a number of banks in the country. Hence, the amount borrowed from one
bank reaches to some other banks as deposits.
 There is no leakage. The amount lent is deposited in the same bank or with some
other bank.
 All banks keep the same percentage of cash reserves.

Suppose a person deposits Rs10,000 with Bank A and there are a number of banks in
the country which follow the cash reserve ratio of 10%. In this case, cash balance of the
Bank A will increase by 10,000. The effect of this deposit is shown in the following
balance sheet as follows:

Balance Sheet of Bank A

Liabilities Rs. Assets Rs.

Deposists 10,000 Cash 10,000

If the bank were to keep 100% cashreserve, there will be no change in the balance sheet
and there will be no credit creation by the bank. Credit creation takes place only when
a bank grants a loan. If the cash reserve ratio is10%, the bank can lend upto Rs 9,000
out of the primary deposits of Rs 10,000, as the bank has to keep only Rs 1000 in cash..
Suppose Mr. X approaches the Bank A for a loan of Rs 9,000 and the bank grants him
the loan then this transaction will appear in the balance sheet as follows:

Balance Sheet of Bank A

Liabilities Rs. Assets Rs.

Deposists 10,000 Cash 1,000
Loan to X 9,000

10,000 10,000

Suppose the borrower (Mr. X) purchases goods from Mr. M and makes him the
payment of Rs 9,000 who deposits the amount with the Bank B. The deposits of the
 Bank B increases by Rs 9,000 and cash reserves also by Rs 9,000. The Bank B can lend
the amount by retaining 10% of it. If the bank advances loans to Mr. Y, then the position
of the Bank B will be as follows:

Balance Sheet of Bank B

Liabilities Rs. Assets Rs.

Deposists 9,000 Cash 900
Loan to Y 8,100

9,000 9,000

The borrower (Mr. Y) can make payment to some other person, Mr. R in some
settlement, who may deposit the amount with Bank C. Bank C will also keep 10% of
the deposits and lend the balance to another customer Z amounting to Rs. 7,290. If this
happens, the effect of this transaction will appear in the Balance sheet of Bank C as
under:

Balance Sheet of Bank C

Liabilities Rs. Assets Rs.

Deposists 8,100 Cash 810
Loan to Y 7,290

8,100 8,100

5. What is meant by Retail Banking? Discuss the driving factors and challenges of Retail
banking in India. (15 mks) (Refer text pg no: 1.23)

6. CORE Banking Solutions - merits (4 mks) (Refer text pg no: 1.21)

7. Bank mergers merits with examples (4 mks) (Refer text pg no: 1.24)

8. What is repo rate and reverse repo rate? (2 mks) (Refer text pg no: 1.35)

9. What is meant by Liquidity risk of a bank?

10. Define the term banking as per BRA, 1949. (2 mks) (Refer text pg no: 1.1)