1.0 INTRODUCTION
In this note you are going to learn about the various theories of
banking. These theories
which are propounded by scholars who, bearing in mind the banks
unique type of business,
sought to provide solutions on how can the unique business
survive. These theories include the
Real Bills Doctrine, the shiftability theory, the anticipated
income theory, and the liability
management theory.
OBJECTIVES
At the end of this note, you should be able to;
· State and explain all the theories of banking
· Differentiate between all the theories of
banking
· Identify and explain the weaknesses of the
banking theories.
3.0. THEORIES OF BANKING
3.1. The
Real Bills Doctrine
The Real Bills Doctrine or the commercial loan theory states that
a commercial bank should
advance only short-term self-liquidating loans to business firms.
In other words, this theory holds
that banks should lend only on “short-term, self-liquidating
commercial papers. This is for the
simple reason that a bank has liabilities payable on demand, and
it cannot meet these obligations
if its assets are tied up for long periods of time. Rather, a bank
needs a continual and substantial
flow of cash moving through it in order to maintain its own liquidity,
and this cash flow can be
achieved only if the bank limits its lending activities to
short-term maturities.
Self-liquidating loans are those which are meant to finance the
production, and movement of
goods through the successive stages of production, storage,
transportation and distribution. When
such goods are ultimately sold, the loans are considered to
liquidate themselves automatically.
The theory states that when commercial banks make only short-term
self-liquidating productive
loans, the central bank, in turn should only lend to the banks on
the security of such short-term
loans. This principle would ensure the proper degree of liquidity
of each bank and the proper
money supply for the whole economy. This in essence aim at the
stabilization of the banking
system.
The weakness of this theory stems from the failure to realize that
the loans are made, given the
value of the goods and not the good itself; and also the value of
goods itself is subject to
variations, given the state of the economy.
3.2. The Shiftability Theory
The Central thesis of this theory holds that the liquidity of a
bank depends on its ability to shift
its assets to someone else without any material or capital loss
when the need for liquidity arises.
This theory asserted that if the commercial banks maintain a
substantial amount of assets that can
be shifted on to the other banks for cash without material loss in
case of necessity, then there is
no need to rely on maturities. According to this view, an asset to
be perfectly shiftable must be
immediately transferable without capital loss when the need for
liquidity arises. This is
particularly applicable to short-term markets investments, such as
treasury bills and bills of
exchange which can be immediately sold whenever it is necessary to
raise funds by banks. For
example, it is quite acceptable for a bank to hold short-term open
market investments in its
portfolio of assets, and if a large number of depositors decide to
withdraw their money, the bank
need only sell these investments, take the money thus required and
pay off its depositors.
Therefore, the theory tried to broaden the list of assets demand
legitimate for bank ownership,
and hence redirected the attention of banks and the banking
authorities from loans to investments
as a source of bank liquidity that is; the fundamental source of
liquidity is the banks secondary
resources.
The flaw of this theory does not lie on the theory itself, but on
the bank management practices to
which the theory led. One bank could obtain the needed liquidity
by shifting its assets but not so
possible when all members of the bank behave the same way (Fallacy
of composition). Hence,
the problem of liquidity of the whole banking system is simply not
solvable by commercial
banks alone. This is where a central bank that is prepared to act
quickly and decisively is an
absolute necessity.
3.3. The Anticipated Income Theory
According to this theory, regardless of the nature and character
of a borrower’s business, the
bank plans the liquidation of the loan from the anticipated income
of the borrower. This theory
opines that a bank should make long-term and non-business loans
since even a “real bill” is
repaid out of the future earnings of the borrower; i.e out of
anticipated income. At the time of
granting a loan, the banks take into consideration not only the
security, but the anticipated
earnings of the borrower. Thus a loan by the bank gets repaid out
of the future income of the
borrower in installments, instead of in lump sum at the maturity
of the loan.
3.4. The Liability Management Theory
According to this theory, there is no need for banks to grant
self-liquidating loans and keep
liquid assets because they can borrow reserve money in the money
market in case of need. A
bank can acquire reserves by creating additional liabilities
against itself from different sources.
These sources include the issuing of time certificates of
deposits, borrowing from other
commercial banks, borrowing from the central bank, raising of
capital funds by issuing shares,
and by ploughing back of profits.
Arguing that a bank can use its liabilities for liquidity
purposes, the theory opines that it can
manage its liabilities so that they actually become a source of
liquidity by going out to by money
when it needs it (for paying its demand deposits and meeting loan
requests). That is, liability
management suggests that the bank borrow the funds it needs by
means of various bank-related
money market instruments.
4.0. CONCLUSION
The note discusses four theories of banking which explains how the
banks try to survive in an
economy as a business entity.
5.0. SUMMARY
In this note, we have studied about;
i. The Real Bill Doctrine
ii. The Shiftability Theory
iii. The Anticipated Income Theory
iv. The Liability Management Theory
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