Definition Bank funds chiefly consist in public deposits which must be returned one day, and is shown as a liability in the balance sheet of the bank. To follow the principles of using funds is to ensure not only the profit to the bank but also the return of the deposit with interest to depositors. The bank is custodian of the pubic money and must use it safely and productively.
PRINCIPLES OF EMPLOYING BANK FUNDS
(Principles of Investment)
The principles are as follows:
- Short-term loans
- Judicious utilization
- Legal requirements
- Financial liability structure
1. Safety: It is first and foremost principle that calls for the bank to be very cautious in using its funds to ensure their safety. Caution and safety stem from two facts:
a. It is a common principle of business enterprises to invest their money in such a way as to get it back with profit.
b.Eighty percent of the bank funds consist in public deposits which must be returned with interest.
Safety and caution in the investment ensure the return of the principal amount at a profit. To achieve it the bank should follow these practices:
a) It should issue secure loans and avoid unsecured loans.
b) It should not invest its funds in speculative businesses.
c) The portfolio of the bank investments should be wide and not restricted to a few.
d) Investments should be made on strong business houses.
e) The investment should be easily and readily returnable.
f) Risky business should be avoided.
2. Liquidity: Liquidity refers to the state of having assets (investments) that can easily be changed into cash.
Bank assets are of two kinds.
a. Liquid assets: Readily changeable to cash.
b. Fixed assets: Not readily changeable to cash, e.g buildings, plots, equipment, machinery.
Fixed assets may take from some months to years in changing them to cash. If the bank invests unnecessarily in these assets it liquidity position will become weak and technical solvency may be threatened. Inability of the bank to pay cash against cheques drawn on it refers to technical insolvency. So the bank funds should not be stuck in the long-term investments.
On the other hand, it only takes from some hours to a few days in converting liquid or current assets into cash.
Short-term investments may be as follows:
Short term loans
Discounting of bills of exchange
3. Diversity: Successful and safe employment of bank funds lies in its diversity. That is, the bank should have wide portfolio of investment. To ensure this factor it should not invest all or most of its funds in one industry or one company. If the company or the industry goes bankrupt all of the bank’s funds will be lost. The bank should not also advance its most funds to only a few borrowers.
It is therefore necessary for the bank:
a. To diversity its funds to various types of industries.
b. To advance to a greater number of business enterprises.
c. Not to advance a big amount to a single party. The bank should not put all its eggs in one basket.
4. Profitability: It is necessary for the bank to employ its funds in profitable projects so that it can meet not only its operational expenses but also its obligations to the deposit holders. It must employ its funds in financially sound projects and business organizations which have track record of paying regular profits
5. Short-term Loans: Investments are of two types:
a. Short term investments: these are the investments which come back with profit within one year.
b. Long term investment: these refer to those investments which have a life over one year and may extend to twenty to twenty-five years or even longer.
Most of the bank deposits are short-term investments. If the funds are employed in long-term investments the bank will find itself unable to meet its obligations of short-term deposits. Most of the deposits of the bank are in the current and saving accounts which are considered as short-term and can be withdrawn anytime.
Short-term investment includes advancing short-term loans, discounting bills of exchange, buying central bank’s treasury bills and other securities.
6. Judicious Utilization: As mentioned earlier, more than eighty percents of the bank funds consists in deposits and other liabilities. In other words, bankers’ own equity is less than twenty percent. From this fact it becomes clear that the bank should employ its funds, which is mostly a liability, very carefully and prudently. Injudicious and unwise utilization will render the bank unable to pay off its liabilities in the form of deposits.
7. Legal Constraints / Requirements: Banks are legally bound to follow rules laid down by the government and the central bank. Some of the legal requirements are as follows:
a. All scheduled commercial banks must keep a part of their deposits at the central bank.
b. No bank can lend a single party an amount larger than ten percent of its capital and surplus.
c. No bank can lend to its director an amount above a limit specified by the rules.
d. The bank can only invest in recognized portfolios.
e. No bank can invest in companies and businesses on the prohibited list that includes gambling, speculation, raffle schemes, and private establishments.
8. Financial Liability Structure: How the bank employs its funds also depends on its financial structure. One bank may have deposits mostly consisting in time deposit while the other has its most of funds in demand deposits. Both banks will have to follow different investment policies. The former will need less till cash and the latter will have to hold a greater amount of till cash to pay its cheques. Moreover, the former bank will have a greater opportunity to invest its funds more profitably than the latter. Thirdly, the latter bank can prefer advancing call loans to till cash.
EMPLOYEMENT / USES OF BANK FUNDS
Bank funds can be used in two ways:
- Non profitable use
- Profitable use
Non Profitable Uses: Banks must use some of its money without any profit. Such a use is compulsory by law and nature of the business. These are:
- Purchases of fixed assets.
- Maintaining cash reserve / till cash
- Bank reserve at the central bank
Purchases of Fixed Assets: To carry out its business the bank must invest in (i.e buy) fixed assets which include building, land, furniture, fixture, equipment, as typewriters, cars, vans, computers, etc. These assets do not yield a direct profit or income but are necessary to carry out the business.
Cash Reserve / Till Cash: The bank must keep a sufficient amount of cash in the reserve to meet checking obligations.
This cash remains in the vaults of the bank and does bring no profits, but it is essential to keep it up to make payments against the cheques presented at the bank for cash.
Bank Reserve: All scheduled commercial banks are bound to keep a certain prt of their deposits at the central bank as mandatory bank reserve. This reserve at the central bank yields no profit to the bank. In the USA commercial banks can put their mandatory reserve in other commercial banks also with no profit as usual.
PROFITABLE USE Profitable use of funds refers to investment that yields profit to the bank. Banks must invest profitability to meet expenses, distribute dividends, pay interest.
Profitable use may be classified as follows:
Lending: Banks employ their funds in advancing money and in return get interet income. The loans are provided to the following businesses.
- Commercial and industrial concerns
- House building companies
Banks lend their funds in the following ways:
- Call loans
- Cash credit
- Discounting bills of exchange
1. Call Loans: They are made for a very short period of time, which ranges from few hours to a few weeks, or they may be called bank any time. The rate of interest on them is low. The call loan is secured and backed by collateral. In case of default or nonpayment it is forfeited.
2 Overdrafts: The current accountholder can, with the sanction of the bank, overdraw money from his account. The bank charges interest on the amount overdrawn. F the sanction is for Rs. 5000 in overdraft but the accountholder overdraws only Rs. 2000 the interest will be charged on Rs. 2000 only. Overdrafts are secured and short-term loans, and mostly used by businessmen to meet their day to day need for cash.
3. Cash Credits: They are like overdraft with the exception that here interest is charged on at least 50 percent, no matter the amount has been overdrawn less than 50 percent of the sanctioned amount. Some banks charge on a minimum 25 percent.
4. Loans: They are different from overdraft and cash loans in that the bank charges interest on the whole sanctioned no matter the whole amount is not withdrawn. The payment of the loans is made in lumpsum.
5. Discounting Bills of Exchange: Banks employ their funds in discounting bills of exchange. Discounting by the bank refers to purchasing the bill at a discount. Generally, the bill period runs form thirty to ninety days. So is the period for discounting. The interest is charged for the period the bill cashed or discounted. The discount is the amount deducted by the bank form the bill as an interest for the period for which the bill is still to run. Discounting is an important source of income for banks. Unlike Pakistan, in developed countries the commercial banks’ large amount of funds go to the discounting of bills. If the bank needs money before the bills fall due it will go to the central bank for their rediscounting.
Investment: Investments refers to buying shares, bonds, debentures, treasury bills in the open market. Banks earn money in the form of dividends, interests and capital gains. Shares and bonds can be bought and sold at the stock exchange. The bank employs its fund in the following types of investments.
1. Government Securities: They are referred to gold edged securities because they are the safest investments. They are of the following kinds.
a. Treasury bills: Federal governments issue these bills through their central ranging from three to twelve months. Their face value runs into millions of rupees. They yield a sizable profit to the bank but much money is stuck up in them.
b. Treasury notes / coupons: They are also issued through the central bank. They are different from the treasury bills in that they are long-term investment and are issued for a period ranging from one year to seven years.
c. Treasury bonds: They are issued for a very long period ranging from 25 to 50 years. In the US they are very common.
Though the last two investments are long-term, they can be sold any time at the stock exchange. Therefore, these investments are also liquid.
2. Provincial and Local Government Bonds: Provincial and local governments need funds to carry out their day-to-day functions. Some of these requirements are financed by the grant-in-aid of the federal government and the provincial and local taxes. Since it takes time to collect taxes and governments cannot stop their functions they issue bonds to raise needed funds. The commercial banks heavily invests in them because income from them is tax-free. These bonds may be both short-term and long-term.
3. Foreign Government’s Bonds: Foreign governments raise funds by issuing bonds on the international markets. The commercial banks prefer them because they are extremely secured, carry good rate of interest, and yield foreign exchange.
4. Other Securities: Other securities include bonds or debentures issued by the following government institutions:
i) Municipal Corporations.
ii) Municipal committees and boards.
iii) Public utility corporations, as electricity, gas, telecommunication companies and semi-government institutions and banks.
i) Port trusts, etc
Commercial banks invest in all of them because they are also secured and offer farily large interest rate.
5. Corporate Securities: Public limited companies float their shares and bonds through stock exchanges. Commercial banks purchase them provided the company is financially sound and its business is progressive. Although they are long-term investment but can be sold any time on the stock exchange.