1.0. INTRODUCTION
In the last note, you read through important definitions of banks
and the evolution and growth
of banks. In this note, you are going to learn about what a
commercial bank is, its functions in
the economy, and the role it performs in the development of an
economy. Besides, you shall
also learn about how money or credit is created in an economy, the
limitations of the power
of banks to create credit and the concept of balance sheet.
2.0. OBJECTIVES
At the end of this note, you should be able to;
· Define and explain what a commercial bank is
· Enumerate and explain the functions of
Commercial banks
· List and discuss the roles of commercial banks
in economic development of a country
· Explain the concept of credit creation by
commercial banks
· Illustrate the process of credit creation by
commercial banks
· Discuss the limitation of the power of
commercial banks to create credit
· Define balance sheet
· Explain the asset and the liability sides of the
balance sheet
3.0. COMMERCIAL BANKING
3.1. What are Commercial Banks?
Commercial banks are those banks which perform all kinds of
banking functions
such as accepting deposits, advancing loans, credit creation, and
agency functions. They
are also called joint stock banks because they are organized in the
same manner as joint
stock companies. They usually advance short-term loans to
customers. Of late, they have
also started giving medium term and long-term loans in Nigeria. At
the expiration of the
date for all commercial banks in Nigeria to meet-up with the
N25billion minimum capital
requirement, the total of 25 commercial banks were able to meet up
with the N25billion
minimum capital requirement at December 31, 2005 (See table 1
below).
Table 1: Banks that met the N25billion
Capital Requirement and the banks constituting each group.
3.2. Functions of commercial Banks
The Commercial banks perform very important functions in any
economy. These
include;
Accepting Deposits: Commercial banks accept deposits from their
customers on current and / or
deposit accounts. Commercial banks perform this very important
function
to all sectors of the economy by making available the facilities
for the pooling of savings through
the acceptance of deposits from the public and then making these
funds available for
economically and socially desirable purposes.
Advancing Loans: Commercial banks give advances to customers in
the form of loans,
overdrafts, discounting bills of exchange and promissory notes. A
commercial bank lends
a certain percentage of the cash laying in deposit on higher
interest rate than it pays on such
deposits. The difference between the lending rate, and deposit
rate gives the bank its profits. In
making credit available, commercial banks are rendering great
social services; through their
actions production is increased, capital investments are expanded,
and a higher standard of living
is realized. The provision of credit facilities by commercial
banks is very important to the
economy, for it makes possible the financing of the agricultural,
commercial and industrial
activities of the nation.
Payments mechanism: Commercial banks make payments on behalf of
their clients and infact,
exercise agency services on behalf of their clients. That is,
periodic payments like
insurance premiums and hire purchase installments, collection of
cheques, stock and shares
transactions, dividend payments etc. This function becomes
increasingly important as more and
more Nigerians place greater reliance on the use of cheques and
credit cards.
Safe- keeping of valuables: Commercial banks safe-guard customers’ important
documents,
certificates, jewels, ornaments, deed, bills etc. This function
evolved during the
gold smith banking era when gold smiths head the strongest safe or
vaults that were difficult to
enter even by the best of burglers. The safe-keeping of valuables
is therefore, one of the oldest
functions performed by commercial banks.
Credit creation: Credit or money creation is one of the most
important functions of the
commercial banks in an economy. It is this function that
distinguishes commercial banks
from other institutions. The creation of credit is accomplished by
the lending and investing
activities of commercial banks in cooperation with the central
bank of the nation. Like other
financial institutions, they aim at earning profits. For this
purpose, they accept deposits and
advance loans by keeping small cash in reserve for day-to- day
transactions. When a bank
advances a loan, it opens an account in the name of the customer
and does not pay in cash but
allows him to draw the money by cheque according to his needs. By
granting a loan, the bank
creates credit or deposit.
Commercial banks make the use of
cheques : This eliminate the risks of
money being stolen as
well as other risks of carrying huge sums of money about.
Acting as referees: Commercial banks act as referees as to the
integrity and standing of their
customers.
Accelerating economic development: Their activities accelerate the economic
development of a
nation since they act as intermediaries between large number of
depositors and borrowers.
Financing foreign trade: A commercial bank finances foreign trade of its
customers by
accepting foreign bills of exchange and collecting them from
foreign banks. It also transacts
other foreign exchange business and buys and sells foreign
currency. We can thus conclude that
the financing of foreign trade by commercial banks contributes to
a free flow of trade between
nations than if these services were not in existence.
3.3. The role of Commercial
Banks in Economic Development
Apart from performing the usual commercial banking functions,
banks in developing
countries plays an effective role in their economic development.
The majority of people in such
counties are poor, unemployed and engaged in traditional agriculture.
There is usually acute
shortage of capital, underdeveloped transport and industrial
sector. The commercial banks help
in overcoming these obstacles and promote economic development.
The role commercial banks
plays in developing economy include;
Commercial banks encourage savings: Since investments are made out of savings, the
establishment of commercial banks, especially, in the rural areas
makes savings possible.
Commercial banks help in mobilizing savings through a network of
branch banking. They
include the low income earners to save by introducing variety of
deposit schemes to suit the
needs of individual depositors. They also mobilize idle savings of
the few rich. By mobilizing
savings, the banks channelled them into productive investments,
hence economic development is
enhanced.
Commercial banks provide capital needed for
development: Businessmen and / or
entrepreneurs obtain both short – term and medium loans and
overdrafts from commercial banks
to start off new industries or engage in other development
efforts.
Commercial banks enhance domestic trade: Commercial banks encourage trading
activities within the country through making the use of cheques
possible. This is more so, when
they provide facilities for clearing these cheques possible.
Commercial banks enhance the development of
international trade: These include acting as
referees to importers, providing travellers’ cheques, opening
letters of credit as well as providing
credit for exports. All these helps to promote international
trade.
Commercial banks encourage investment: They provide direct loans to the government and
individuals for investment purposes. They also buy government
treasury bills or shares and thus
provide money for investment or development purposes.
Commercial banks provide managerial and
financial advice in the economy: They provide
managerial advice to small scale industrialists who do not engage
the services of specialists.
They also render financial advice to their customers which include
the viability of projects,
loans, as well as the nature of business to invest in to the avoid
bankruptcy.
Commercial banks help in monetary policy
implementation: The commercial banks
help the
economic development of a country by faithfully following the
monetary policy of the central
bank. As a matter of fact, the central bank depends upon the
commercial banks for the success of
its policy of monetary management in keeping with the requirement
of a developing economy.
3.4. Credit Creation by commercial Banks
3.4.1. The concept of Credit Creation
The creation of credit or deposits is one of the most important
functions of commercial
banks. Like other corporations, banks aim at earning profits. For
this purpose, they accept cash in
demand deposits and advance loans on credit to customers. When a
bank advances a loan, it does
not pay the amount in cash. But it opens a current account in his
name and allows him to
withdraw the required sum by cheques. In this way, the bank
creates credit or deposits. Thus, the
principal process by which the banking system creates deposits is
the granting of loans and
overdrafts. Every loan and overdraft approved by a bank creates a
new deposit. Upon the
granting of a bank facility, the customer can draw a cheques to
effect a payment. Usually, the
cheque is paid to another bank account. After the cheque has been
cleared, there is an increase in
the total deposits in the banking system as a new deposit has been
created. To illustrate the
process of deposit creation, let us show an initial cash deposit
of N10,000 can yield total bank
deposit of 100,000.
To do this, we make the following assumptions.
i. The banking system is
comprised of several banks.
ii. The statutory reserve
ratio (i.e. cash to be retained) is 10%.
iii. Banks have made loans
up to the limit set by the reserve requirement before the
receipt of the additional
cash.
iv. All bank loans are
withdrawn by borrowers in currency which is spent and re
deposited by the ultimate
recipients of the money in the same or another bank.
v. One of the banks receive
N10,000 in cash.
vi. There no cash or
leakage in the banking system.
vii. There are
credit-worthy customers of banks willing to borrow as much as banks are
able and willing to lend.
3.4.2. An illustration of the Process of
Credit Creation.
Gigyang Bank Plc on receiving the first deposit of N10,000 places
N1,000 in reserve and
proceeds to lend the balance of N9,000. This is lent to its
customer Mr. X to enable him to pay
for some merchandise purchased from ROTRITNEN, who pay the cheque
into ROTRITNEN’S
account with Zingak Bank Plc. Zingak Bank Plc keeps 10% of the
deposit as reserves and
proceeds to lend 90% of the deposit (N8,100) to its customer
Ritgak, who after his account has
been credited, issues a cheque for the amount to Tongak Motors to
pay for the cost of a new car,
thus further creating a deposit within the banking system. When
the original cash deposit of
10,000 has been used up and no bank has any excess reserve to
lend, deposit will amount to
N100,000 (Ten times the cash deposit), while total loans will
amount to N90,000. This process
goes on and on and can be measured by the credit creation
multiplier which is calculated as;
Total Amount of New Deposits Created = 100,000 = 10.
Amount of Original Advance 10,000
The deposit creation process is shown in the table below.
Money creation – The multiplier effect
10% Reserve Ratio.
Deposits Reserves Loans extended
(10%) (90%)
N N N
Original Deposit 10,000
1,000 9,000
Redeposit - 1st 9,000 900
8,100
Redeposit - 2nd 8,100 810
72,290
Redeposit - 3rd 7,290 729
6,561
Redeposit - 4th 6,561 656
5,905
Redeposited-5th 5,905 591
5,314
Redeposit - 6th 5,314 531
4,782
Redeposit - 7th 4,782 478
4,303
Redeposit - 8th 4,303 430
3,872
Redeposit - 9th 3,872 387
3,484
Redeposit - 10th 3,484 348
3,135
Redeposit - 11th 3,135 313
2,821
Redeposit - 12th 2,821
282 2,538
Redeposit - 13th 2,538 253
2,284
Redeposit - 14th 2,284 228
2,055
Redeposit - 15th 2,055 205
1,849
Redeposit - 16th 1,849 184
1,664
Redeposit - 17th 1,664 166
1,497
Redeposit - 18th 1,497 149
1,347
Redeposit - 19th 1,347 134
1,212
Redeposit - 20th 1212 121
1,090
Maximum possible : : :
Deposits : : :
10,000 10,000
90,000
The importance of the rate of reserve ratio must be noted. For
instance, the higher the
percentage of the ratio, the lower the ability of the bank (s) to
create deposit and the lower the
percentage, higher the ability of the bank (s) to create deposit.
3.4.3. Limitation of the Power of Banks to
Create Credit
Although banks have the ability to create credit in the economy,
their ability to do this is
constrained by a number of factors. The following are some of the
limitations of the power of
commercial banks to create credit.
Availability of Cash: The credit creation power of banks depends upon
the amount of cash they
possess. The larger the cash, the large the amount of credit that
can be created by banks. The
amount of cash that a bank has in its vaults cannot be determined
by it. It depends upon the
primary deposits with the bank. The bank’s power of creating
credit is thus limited by the cash it
possesses.
Minimum Reserve Ratio (MRR): The minimum legal reserve ratio of cash to deposit
fixed by
the central bank is an important factor which determines the power
of banks to create credit. The
higher this ratio (MRR), the lower the power of banks to create
credit, and the lower the ratio,
the higher the power of banks to create credit.
Availability of collateral
securities: An important factor that
limits the power of a bank to create
credit is the availability of collateral securities. If securities
are not available with the public, a
bank cannot create credit. Therefore the more available collateral
securities with the public, the
more loans will be granted and vice versa. Hence, credit creation
depends on the availability of
securities.
Banking habit of the people: The banking habit of the people also govern the
power of credit
creation on the part of banks. If people are not in the habit of
using cheques, the grant of loans
will lead to the withdrawal of cash from the credit creation
stream of the banking system. This
reduces the power of banks to create credit to desired level.
Leakages: If there are leakages in the credit creation
stream of the banking system, credit
expansion will not reach the required level, given the legal
reserve ratio. It is possible that some
persons who receive cheques do not deposit them in their bank account,
but withdraw the money
in cash for spending or for hoarding at home. The extent to which
the amount of cash is
withdrawn from the chain of credit expansion, the power of the
banking system to create credit is
limited.
Credit Control policy of the Central
Bank: The power of commercial
banks to create credit is
also limited by the credit control policy of the central bank. The
central bank influences the
amount of cash reserves with banks by open market operations,
discount rate policy, etc.
accordingly, it affects the credit expansion or contraction by
commercial banks.
Economic climate: Banks ability to create credit is also limited
by the economic climate
prevailing in an economy. In other words, their power to create
credit depends upon the
economic climate in the country. In boom periods, investment opportunities
increase and
businessmen take more loans from banks, therefore credit expands.
But in depression period
when business activity is at a low level, banks cannot force
business community to take loans
from them. Thus the economic climate in a country determines the
power of banks to create
credit.
Behavior other banks: The power of credit creation is further limited
by the behavior of other
banks. If some banks do not advance loans to the extent required
of the banking system, the
banking system will not be “loaned up”.
3.5. Balance Sheet of Commercial Banks
3.5.1. What is a Balance sheet?
A balance sheet is a statement which shows the assets and
liabilities of a commercial
bank on a particular date at the end of one year. The assets are
shown on the right hand – side
and the liabilities on the left hand side. The balance sheet of a
commercial bank provides a
picture of its functioning. The balance sheet of a bank gives the
true picture of how a bank is
doing, how strong the bank is financially, how it is affected by
monetary policy at the time of the
balance sheet, and what uses the bank put its money into. As in
the case of every company, the
assets and liabilities of a bank must balance.
Every student of economics and banking should be able to analyses
the balance sheet of a
bank to be able to know the financial strength of the bank and the
trend of monetary market. The
format of a balance sheet which every commercial bank in Nigeria
is required by section 27 of
Decree No. 25 of 1991 to publish not later than four months after
the end of its financial year is
shown as below.
3.5.2. A Form of Balance sheet of
Commercial Banks
LIABILIBILITIES ASSETS
1. Share Capital 1.
Cash
2. Reserve fund 2.
Balances with the central
Bank and other banks
3. Deposits 3.
Money at call
4. Borrowings from other banks 4.
Bills discounted and
Purchased
5. Bills payables 5.
Investments
6. Bills for collection 6.
Loans, advances, cash
credits and overdrafts.
7. Acceptances, endorsements 7.
Liabilities of customers f
and other obligations
endorsements and other obligations.
8. Contingent liabilities 8.
Fixed assets
9. Profit Loss 9. Profit and loss
3.5.3 Distribution of Assets
The assets of a bank are those items from which it receives income
and profit. The items
on the asset-side of a balance sheet include the following:
viii. The first item on the asset side is the cash in liquid form
consisting of coins and
currency notes lying in reserve with it and in its branches to
meet the demand of their
customers. An important function of a commercial bank is to
provide its customers
with notes and coins they need at the right time, in the right
place and in the right
denomination they require by keeping cash in the bank vaults and
balances at the
central bank of Nigeria (CBN).
ix. The second item on the right hand side of the commercial banks
balance sheet is in
the form of balances with the central banks and other banks. The
commercial banks
are required to keep a certain percentage of their time and demand
deposits with the
central bank. They are the assets of the bank because it can
withdraw from them in
cash in case of emergency or when seasonal demand for cash is
high.
x. The third item, money at call relates to very short – term
loans advances to bill
brokers, discount houses and acceptance houses. The banks charges
low interest on
these loans.
xi. The fourth item of assets relates to bills discounted and
purchased. The bank earns
profit by discounting bills of exchange and treasury bills of 90
days duration. Some
bills of exchange are accepted by a commercial bank on behalf of
its customers which
it ultimately purchases. They are a liability but they are
included under assets because
the bank can get them rediscounted from the central bank in case
of need.
xii. The fifth item, investments by the bank in government
securities, state bonds and
industrial shares, yields a fixed income to the bank. The bank can
sell its securities
when there is need for more cash.
xiii. The sixth item relating to loans and advances is the most
profitable source of bank
assets as the bank charges interest at a rate higher than the bank
rate. The bank makes
advances on the basis of cash credits and overdrafts and loans on
the basis of
recognized securities.
xiv. The seventh item included liabilities of the banks customers
which the bank has
accepted and endorsed on their behalf. They are the assets of the
bank because the
liabilities of customers remain in the custody of the bank. The
bank charges a
minimal commission for all acceptances and endorsements which is a
source of
income.
xv. The eighth item relates to the value of permanent assets of
the bank in the form of
property, furniture, fixtures, etc. They are shown in the balance
sheet after allowing
for deprecation every year.
xvi. The last item include profits retained by the bank after
paying corporation tax and
profits to shareholders.
3.5.4. Distribution of liabilities (Sources
of Funds)
The liabilities of a commercial bank are claims on it, these are
items which form the
sources of its funds. These liabilities are in the real sense of
it, public funds, hence they
show the sources of funds for the banks which they invest to make
profit.
i. The first item on the liabilities side is the share capital of
the bank which is
contributed by its share holders and is a liability to them.
ii. The second item is the reserve fund which consists of
accumulated resources
which are meant to meet contingencies such as losses in any year.
The bank is
required to keep a certain percentage of its annual profits in the
reserve fund.
The reserve fund is also a liability to shareholders.
iii. The third item comprises both the time and demand deposits.
Deposits are the
debts of the bank to its customers. They are the main source from
which the
bank gets funds for investment and are indirectly the source of
its income. By
keeping a certain percentage of its time and demand deposits in
cash, the bank
lends the remaining amount on interest.
iv. The fourth item is the borrowings from other banks. The bank
usually borrows
secured and unsecured loans from the central bank. Secured loans
are on the
basis of some recognized securities and unsecured loans out of its
reserve
funds lying with the central bank.
v. The fifth item is the bills payables. Bills payables refer to
the bills which the
bank pays out of its resources.
vi. Bills for collection constitute the sixth item on the
liabilities side of the
balance sheet of the commercial bank. These are the bills of
exchange which
the bank collects on behalf of its customers and credits the
amount to their
accounts. Hence it is a liability to the bank.
vii. The seventh item is the acceptance and endorsement of bills
of exchange by
the bank on behalf of its customers. These are the claims on the
bank which
it has to meet when the bills mature.
viii. The eighth item is the contingent liabilities which relate
to those claims on the
bank which are unforeseen such as outstanding forward exchange
contracts,
claims on acknowledged debts, etc.
ix. The last item is the profit and loss which shows profit
payable to shareholders
which are liabilities on the bank.
The balance sheet of a particular bank shows its financial
soundness. By studying the balance
sheets of the major commercial banks of a country, you can be well
informed about the trend of
monetary market. The bank balance sheet reflects banks credit
extension on its asset side in loans
and investments, and on the liabilities side reflects the bank’s
operations as an intermediary in
time of deposits and its role as an element in the nation’s
monetary system in demand deposits.
4.0. CONCLUSION
The foregone analyses indicate that commercial banks are
indispensable in the development
process of an economy. Therefore, it is very essential for the
government to provide the
necessary conducive atmosphere for commercial banks to operate in
the economy.
5.0. SUMMARY
In this note, we have learned about;
i. What a commercial bank is,
ii. The functions of commercial banks,
iii. The role of commercial banks in economic development of a
country
iv. The concept of credit creation by commercial banks
v. The limitations of the power of banks to create credit
vi. The concept of a balance sheet
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