Forms of Lending/ Advances by the Bank

Banks lend for working capital requirements in the form of:

1. Loans

2. Cash credit

3. Overdraft

1. Loans: This is the oldest and very popular form of lending by the banks. In case of loans, financial assistance is given for a specific purpose and for a fixed period. The customer can withdraw the entire amount of loan in a single installment. As such, interest is payable on the entire amount. In case he needs the funds again, he has to make a fresh application for a new loan or renewal of the existing one. Ordinarily, the loans are repayable in one installment. However, a customer may return the loan in more than one installment also.

2. Cash Credit: Cash credit is the most popular method of lending by the banks in India. It accounts for more than two third of total bank credit. Under cash credit system, a limit, called the credit limit is specified by the bank. A borrower is entitled to borrow up to that limit. It is granted against the security of tangible assets or guarantee. The borrower can withdraw money, any number of times up to that limit. He can also deposit any amount of surplus funds with him from time to time. He is charged interest on the actual amount withdrawn and for the period such amount is drawn.

3. Overdraft: One of the main advantages of a current account is that, its holder can avail of the facility of overdraft. An overdraft facility is granted to a customer on a written request. Sometimes, it may be implied where a customer overdraws his account and the bank honors his cheques.

The bank should obtain a written request from the customer. He should also settle the terms and conditions and the rate of interest chargeable. It is usual to obtain a promissory note from the customer to cover the overdraft.

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Central Bank is a Banker to Commercial Banks

Broadly speaking, the central bank acts as the banker’s bank in three different capacities:

(a) It acts as the custodian of the cash reserves of the commercial banks

(b) It acts as the lender of the last resort

(c) It is the bank of central clearance, settlement and transfer.

We shall now discuss these three functions one by one.

(a) It acts as the custodian of the cash reserves of commercial banks: Commercial banks keep part of their cash balances as deposits with the central bank of a country known as centralization of cash reserves. Part of these balances are meant for clearing purposes, that is, payment by one bank to another will be simple book entry adjustment in the books of the central bank. There are many advantages when all banks keep part of their cash reserves with the central bank of the country. In the first place, with the same amount of cash reserves, a large amount of credit creation is possible. Secondly, centralized cash reserves will enable commercial banks to meet crises and emergencies. Thirdly, it enables the central bank to provide additional funds to those banking institutions which are in temporary difficulties. Lastly, it enables the central bank to influence and control the credit creation of commercial banks by making the cash reserves of the latter more or less.

(b) Lender of the last resort: As the banker’s bank, the central bank can never refuse to accommodate commercial banks. Any commercial bank wanting accommodation from the central bank can do so by re discounting (selling) eligible securities with the central bank or can borrow from the central bank against eligible securities.

By lender of the last resort, it is implied that the latter assumes the responsibility of meeting directly or indirectly all reasonable demands for accommodation by commercial banks in times of difficulties and crisis.

(c) Clearing agent: As the central bank becomes the custodian of cash reserves of commercial banks, it is but logical for it to act as a settlement bank or a clearing house for other banks. As all banks have their accounts with the central bank, the claims of banks against each other are settled by simple transfers from and to their accounts. This method of settling accounts through the central bank, apart from being convenient, is economical as regards the use of cash. Since claims are adjusted through accounts, there is usually no need for cash. It also strengthens the banking system by reducing withdrawals of cash in times of crisis.

Furthermore, it keeps the central bank of informed about the state of liquidity of commercial banks in regard to their assets.

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Usefulness of a Developed Money Market

The money market is an important institution in a modern economy and it has influenced profoundly industrial and commercial developments:

(a) In Financing Industry and Commerce: In the first place, the money market is of very great help in financing industry and commerce. Industries are helped in their working capital requirements through the system of finance bills, commercial paper, and so on. It has played a very important part in the financing of trade and commerce. Both internal as well as international trade is normally financed through the system of bills of exchange which are discounted by the bill market.

(b) Investment of Short-term Funds: The money market plays a very important role in providing necessary assets for the investment of short-term funds of commercial banks. Commercial banks find such assets in the call money market as well as in the bill market. Thus, the money market offers the commercial banks a very good means of temporarily employing their funds in liquid or near-money investments.

(c) Help to the Central Bank: The money market is of great help to the central bank of the country. For one thing, the money market and short-term rates of interest which prevail there serve as a good barometer of monetary and banking conditions in the country and thus provide a valuable guide to the determination of central banking policy. For another, the developed money market being a highly integrated structure enables the central bank to deal with the most sensitive of the sub-markets so that the influence of the operation of the central bank may spread to other sections also.

(d) Help to the Government: Lastly, the money market helps the government. The money market supplies the government with necessary short-term funds through the treasury bills.

Thus, a developed money market is of great assistance to industry and commerce, to the commercial banking system, to the central bank of the country and to the government.

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Financial Institutions of the Money Market

The money market may also be analyzed on the basis of the different institutions engaged in lending and borrowing short-term funds. The nature of these institutions may differ from country to country. The same institutions may also function both as borrower and as lender in the market. The lenders are:

1. The Central Bank: It is the lender of last resort. It lends money to commercial banks when they approach for financial assistance.

2. Commercial Banks: They form the most important class of lenders in the money market. They also borrow from the central bank directly or indirectly. The money that they lend comes from the public in the form of deposits repayable on demand. These funds are invested in various forms of assets. These assets which are considered the secondary reserve for the bank are closely linked with the money market.

3. Institutional Investors: They include savings banks, insurance companies, trust companies and investment trusts. The portion of their funds kept invested in liquid assets finds its way into the money market.

4. Private Individuals, Partnerships and Companies: Normally this group may not be interested in short-term funds. If the interest rates become attractive, they may divert a portion of their surplus funds to the money market.

The borrowers in the money market must satisfy certain conditions regarding the paper they offer for discounting. “The paper must be absolutely liquid, easily realizable and short of maturity.” These conditions are satisfied by bill brokers and dealers in stock exchange.

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