Commercial Banks

A letter of credit (L/C) is a written undertaking issued by a bank, on the request of a buyer (importer), promising to pay the seller (exporter) a stated amount if the seller presents the documents required by the credit. It is widely used in international trade because it protects both parties.

A deposit is money placed with a bank or financial institution for safekeeping and return. The main types are:

1. Current deposit. Withdrawable at any time by cheque; usually pays no or very low interest; used mainly by businesses for day-to-day transactions.
2. Savings deposit. For households and individuals; pays interest, and withdrawals are allowed but may be limited in number or amount.
3. Fixed (term) deposit. Money is kept for a fixed period such as 6 months or 1 year at a higher rate of interest; early withdrawal usually brings a penalty or loss of interest.
4. Call deposit. A large short-term deposit repayable on demand or at very short notice, usually interest bearing; used by institutions with surplus cash.
5. Recurring deposit. The customer deposits a fixed amount every month for a set period and receives the total with interest at the end, which encourages regular saving.

They differ in liquidity and interest: the more liquid the deposit, the lower the interest it pays.

(b) Accepting deposits from the general public

Accepting deposits from the general public is a function of commercial banks; a central bank deals with the government and commercial banks, not the general public.

Primary functions of a commercial bank (any five):

1. Accepting deposits. This is the oldest and most basic function. A commercial bank collects the idle savings of the public and keeps them safe. It accepts deposits in three main forms:

   • Current account — withdrawable any number of times by cheque, no interest paid, meant for traders.
   • Saving account — limited withdrawals, a small rate of interest allowed, meant for salaried and middle-class people.
   • Fixed deposit account — deposited for a fixed period at a higher rate of interest, withdrawn only on maturity.

2. Advancing loans. The bank lends out the deposits it has collected, in the form of cash credit, overdraft, discounting of bills, or term loans. It charges interest at a rate higher than the rate it pays on deposits; the difference (spread) is its main source of profit. Loans may be short-term or long-term, secured or unsecured.

3. Creating credit. Commercial banks are able to create credit many times over the primary deposits they receive. When a bank grants a loan, it does not always pay cash; it credits the borrower's account with a deposit. Since only a fraction of deposits is kept as reserve, the banking system as a whole can expand deposits by a multiple of the initial deposit. This is called credit creation, and it is a function unique to banks.

4. Transferring money. Banks provide an easy and safe means of transferring funds from one place or person to another through cheques, drafts, mail transfers, and electronic transfers. This saves the cost and risk of carrying cash and settles transactions quickly.

5. Agency functions. As an agent of its customers, the bank collects cheques, bills and dividends, pays insurance premiums, rent and taxes, purchases and sells securities, and acts as executor or trustee on behalf of customers. For these services it earns a commission.

Other primary functions that may be written instead: discounting bills of exchange, providing overdraft and cash credit facilities, and dealing in foreign exchange.

Credit creation by commercial banks is the process by which banks expand the total money supply in the economy by lending out a part of the deposits they receive. Banks keep only a fraction of deposits as cash reserve (the legal reserve ratio) and lend the rest, and this process repeats itself through the banking system, multiplying the original deposit several times.

Process of credit creation

1. Primary deposit: A customer deposits cash, say Rs 10,000, in Bank A. This is the primary deposit.
2. Keeping cash reserve: The bank is required to keep a certain percentage of deposits as reserve. Suppose the cash reserve ratio (CRR) is 20%. Bank A keeps Rs 2,000 and is free to lend the remaining Rs 8,000.
3. First round of lending: Bank A lends Rs 8,000 to a borrower, who pays it to someone else. That person deposits Rs 8,000 in Bank B. The money supply has now increased by Rs 8,000 in the form of a new deposit.
4. Second round of lending: Bank B keeps 20% of Rs 8,000 = Rs 1,600 and lends Rs 6,400. This amount is again deposited in Bank C, which keeps 20% and lends the rest.
5. Continuation: This chain continues, with each round's deposit being 80% of the previous round's deposit.

Total credit creation

$\text{Total deposits} = \text{Initial deposit} \times \frac{1}{\text{CRR}} = 10{,}000 \times \frac{1}{0.20} = \text{Rs } 50{,}000$

So an initial deposit of Rs 10,000 creates total deposits (and hence credit) of Rs 50,000 in the banking system. The multiplier $\frac{1}{\text{CRR}} = 5$ is called the credit multiplier.

Two limitations of credit creation

1. Cash reserve ratio: A high CRR leaves less cash with banks to lend, so credit creation is limited. The multiplier falls as CRR rises.
2. Availability of borrowers and cash: If there are not enough willing and creditworthy borrowers, or if depositors withdraw cash heavily (leaving banks short of liquid funds), banks cannot create credit to the full extent.

Meaning of a commercial bank

A commercial bank is a financial institution that accepts deposits from the public, lends money to individuals and businesses, and provides other financial services with the motive of earning profit. It is established under the Bank and Financial Institutions Act (BAFIA) of Nepal and licensed by Nepal Rastra Bank. It accepts demand deposits (current accounts) and time deposits (savings and fixed deposits), provides loans and advances, and performs agency functions such as collecting cheques, transferring money, and issuing letters of credit. In Nepal, institutions such as Nepal Bank Limited, Rastriya Banijya Bank, Nabil Bank, and Nepal Investment Bank are examples of commercial banks.

Role of commercial banks in the economic development of Nepal

1. Mobilisation of savings: Commercial banks collect scattered and idle savings of people through various deposit schemes and channel them into productive investment. In a country like Nepal, where most people have low incomes and little habit of banking, this mobilisation is vital for capital formation.

2. Provision of credit: They provide short-term, medium-term, and long-term loans to trade, industry, agriculture, and services. This helps farmers buy seeds and fertilisers, small entrepreneurs start businesses, and industries expand production, thereby raising national output and employment.

3. Capital formation: By encouraging savings and investing them in productive sectors, commercial banks help build physical and financial capital, which is the base of long-run economic growth.

4. Development of agriculture and industry: Banks provide agricultural loans, small and medium enterprise loans, and industrial loans at concessional rates under the direction of Nepal Rastra Bank. This supports the modernisation of agriculture and the growth of industries, which are the backbone of Nepal's economy.

5. Promotion of trade and commerce: Through letters of credit, bank guarantees, bill discounting, and remittance services, commercial banks facilitate both internal and foreign trade. This helps expand markets and earn foreign exchange.

6. Support to infrastructure and priority sectors: Under NRB's directives, commercial banks must invest a certain percentage of their loans in deprived sectors, agriculture, energy, tourism, and small industries. This directs funds to areas that need them most for national development.

7. Employment generation: Commercial banks themselves provide direct employment to thousands of people, and by financing industries and businesses they create indirect employment opportunities, helping reduce unemployment and poverty.

8. Collection and transfer of remittances: A large part of Nepal's economy depends on remittances sent by workers abroad. Commercial banks provide safe and quick remittance services, which increases household income, savings, and investment in the country.

9. Monetary policy transmission: Commercial banks act as the channel through which Nepal Rastra Bank implements its monetary policy. By expanding or contracting credit, they influence money supply, prices, and investment in the economy.

10. Financial inclusion and social welfare: Through branch expansion in rural areas, mobile banking, and microfinance-linked services, commercial banks bring banking facilities to remote and unbanked people. This promotes financial inclusion and balanced regional development.

Conclusion

Commercial banks are thus not merely profit-seeking institutions but important instruments of economic development. In Nepal, where capital is scarce and the economy is developing, they mobilise savings, supply credit, support agriculture and industry, promote trade, and help reduce poverty. Their efficient and honest functioning is essential for the rapid economic development of the country.

Definition. A central bank is the apex financial institution of a country that controls the monetary and banking system, issues currency, and acts as banker to the government and other banks. In Nepal it is Nepal Rastra Bank (NRB), established in 1956.

Main functions

1. Issue of currency. It has the sole right to issue notes, which keeps the money supply uniform and trusted.
2. Banker, agent and adviser to the government. It keeps the government's accounts, manages public debt and gives advice on financial matters.
3. Banker to banks. It holds the cash reserves of commercial banks, acts as the lender of last resort and settles inter-bank payments.
4. Monetary policy and credit control. It controls the money supply and credit through the bank rate, cash reserve ratio, statutory liquidity ratio, open market operations and selective controls, to keep prices and growth stable.
5. Custodian of foreign exchange reserves. It manages the reserves and exchange rate policy, and maintains the external value of the currency.
6. Supervision and regulation. It licenses, inspects and regulates banks and financial institutions to keep the system sound and protect depositors.
7. Development functions. It supports financial inclusion, priority sector lending and the development of the financial system.