Sunday, November 27, 2016

AHSEC - Class 12: Banking Notes - Employment of Funds

Unit – 7: Employment of funds
Short Questions and Answers (1/2 Marks each)
1. What do you mean by employment of funds by a bank?                          2000
Ans: Use of funds of banking institution in various types of assets such as loans and advances to customer, investment in securities etc with a view to earn profit to run the business is called employment of funds.
2. Write the full form of SLR and CRR.
Ans: Statutory Liquidity Ratio and Cash Reserve Ratio
3. What do you mean liquidity of asset?              
Ans: Liquidity of assets means ability to convert the asset into cash within a short period of time and without any loss in its value. 
4. Cash is the most liquid asset. (State whether true or False)                                                    2009, 11
Ans: True.
5. The provision relating to maintenance of cash reserve ratio by banks is contained in:
Ans: RBI Act.
6. A transferable letter of credit cannot be transferred more than once.
Ans: True
7. Define Mortgage.                                       2012
Ans: A mortgage is the transfer of an interest in specific immovable property for the purpose of securing the payment of money advanced or to be advanced by way of loan.

8. Give the meaning of Cash Reserve Ratio.                                       
Ans: Commercial banks have to maintain statutory cash reserve in the Reserve Bank of India against their time and Demand liabilities which is called cash reserve ratio. The Cash Reserve Ratio (CRR) refers to the portion of total deposits of a commercial bank which it has to keep with the RBI in the form of cash reserves. Present CRR is 4%.
9. Give the meaning of Statutory Liquidity Ratio.                             2006, 08, 11, 14
Ans: Statutory Liquidity ratio of the total deposits of a bank which it has to maintain with itself in the form of liquid funds like government securities and cash in hand at any given conditions and point of time.
10. What is the meaning of Hypothecation?                       1999, 09, 11
Ans: Hypothecation is mode of creating a charge against a movable property for payment of a debt without transferring the possession of the property. The goods remain at the disposal and in the godown of the borrower. The bank is given access to goods whenever it so desires. The instrument which creates such charge is called the ‘letter of hypothecation’ which is handed over by the borrower to the creditor. This document empowers the banker to take possession of the property whenever he wishes to do so and sell the property if required to clear the dues.
11. Write a short note of Traveler’s Letter of Credit.
Ans: Traveler’s letters of Credit are issued by the banks for the convenience of the travelers. The travelers are saved from the risk of traveling with heavy cash with them. The facility of such letter of credit can be available both for traveling in or outsides the country.
12. Write short note on Commercial Letter of Credit.
Ans: Commercial Letter of Credit is used of financing foreign trade. Commercial Letter of Credit is used by different banks in different countries in different languages.
13. Mention some advantages of discounting of bills.
Ans: Advantages of discounting of bills are given below:
1)      Certainty of payment of the advance to the banker.
2)      Definite period of time of payment of the advance.
3)      The banker can obtain refinance facility from other financial institutions.
14. What is lien?
Ans: Lien is the right of the lender or creditor to retain the possession of the property given as security by the borrower or debtor until the debt is satisfied.
15. What is pledge?
Ans: Pledge is the delivery of goods by the borrower or debtor known as pledger to the lender or creditor known as pledgee as security for payment of a debt.
Long Answer Type Questions (Marks: 3/5/8 Marks each)
Q.1. What is liquidity and liquid assets? Explain its significance. What are the factors affecting quantum of cash balance of banks?
Ans. Liquidity means the ability of the bank to give cash on demand. Generally, the business of the bank depends upon the confidence of depositors on the bank and the depositors feel confident when they are sure that they can demand their money back at any time. Therefore, every bank must keep the adequate amount of liquid assets. The term liquid asset means those assets which can be readily converted into cash without any loss.  1999, 2009, 2011
According to R.S. Sayers’ “Liquidity is the word that the banker uses  to describe this ability to satisfy demands for cash in exchange for deposit.”
Liquidity depends on the availability of liquid assets. Liquid assets are those assets which can be easily converted into cash without loss. More the liquid assets, greater will be the liquidity and vice versa. The liquid assets of a bank are composed of the following:
a)      Cash in hand.
b)      Cash balance with RBI.
c)       Cash balance with other banks.
d)      Money at call and short notice.
e)      Investments.
f)       Advances.
Significance of liquidity: The term liquidity has special significance in banking business. The deposits accepted by a bank are largely payable on demand. In other words, the depositor has the right to withdraw money as and when they needs. The banker must pay his depositors on demand. In case a bank fails to pay cash on demand to the depositors on account of shortages of liquid cash, it may lose the trust and confidence of the public which will ultimately result in the closure of the bank. Thus, the banker must safeguard his position by maintaining sufficient liquid assets with him to meet the demand of the depositors for cash.
Factors determining the cash balances: The following factors help the banks to decide the quantum of cash balances to be maintained:
1)      Banking habit: Banking habits play a significant role in determining the cash balances of a bank. Banking habits refers to the utilisation of banking services by the public. If the people have e-banking habits then the use of cash in transaction is reduced and the banks need to keep lesser amount of liquid cash.
2)      Structure of banking: The banking structure of the country also influence the liquidity requirements of the bank. In a branch banking system, the banks can function with less cash reserves because in case of emergency cash can be transferred from one branch to another. Whereas in unit banking system higher cash reserve is required.
3)      Nature of bank accounts: The nature of deposit accounts viz. savings, current or fixed accounts affect the amount of cash balance to be kept by the banks. In case of fixed deposit account holders, the bank can manage with less cash balance as against current account where it must keep larger cash balance.
4)      Type of depositors: The type of depositors is another determinant of cash balance of the banks. If the majority of the depositors of the bank are business firms, corporations, schools, college etc. the bank will have to maintain high liquidity because of unpredictable. On the other hand, if the deposits are mostly by individual customers and are of personal nature, the bank can operate with less liquid cash.
5)      Nature of advances: The nature of advances of bank i.e. loans, cash credit, overdraft and purchasing and discounting of bills also affect the size of the cash balances of the bank.
6)      Seasonal requirements: The banks have to take into consideration the seasonal requirements of credit from the customers. It is an established fact that during busy seasons e.g. festivals, sowing, harvesting etc. seasons, there is increased demand for credit. Hence, the banks should keep large amount of cash.
7)      Nature of business condition: The prevailing business condition in the country has its influence on the cash balances of a bank. When the condition is good, there is greater demand for cash. On the other hand, when the business is dull there is less borrowing from the banks.
8)      Existence of clearing house arrangements: Cash balance of a bank also depends upon the availability of clearing house facilities. Clearing house settles inter-bank claims. If there is a clearing house, inter-bank claims can be easily settled and the banks need not keep large cash balances.
Q.2. Discuss the different forms of liquid assets.
Ans: The different forms of liquid assets are:
a)      Cash in hand: Cash is the most liquid but non earning asset and is considered as the first line of defence. Every bank keeps certain amount of cash in order to meet the cash requirements of its depositors.
b)      Statutory cash balances with the Reserve Bank: Commercial banks have to maintain statutory cash reserve in the Reserve Bank of India against their time and Demand liabilities which is called cash reserve ratio. The Cash Reserve Ratio (CRR) refers to the portion of total deposits of a commercial bank which it has to keep with the RBI in the form of cash reserves. Present CRR is 4%.
c)       Balances with other banks: Besides Cash Reserve Ratio, every bank in India has to maintain statutory liquidity ratio under Sec 24 of Banking Regulation Act. 1949. It is that ratio of the total deposits of a bank which it has to maintain with itself in the form of liquid funds like government securities and cash in hand at any given conditions and point of time.
d)      Money at call and short notice: This refers to loans which are recoverable by the bank on demand or at a very short notice. The loans are for a maximum period of 15 days. Such loans are earning as well as highly liquid assets which can be converted into cash quickly and without loss.                               2000
e)      Investment: Banks also invest greater part of their resources in different kinds of shares, stocks and securities. Securities include securities of the central and state government, treasury bills and bonds etc.
Q.3. Discuss briefly about the different types of Loans and advances granted by a commercial bank.  2011
Ans: Different types of loans and advances granted by a commercial bank are discussed below:
(i)      Cash Credit: Cash Credit is a type of advance wherein a banker permits his customer to borrow money upto a particular limit by a bond of credit with one or more securities. The advantage associated with this system is that a customer can withdrawn money as and when required. The bank will charge interest only on the actual amount withdrawn by the customer. Many industrial concerns and business houses borrow money in this form.
(ii)    Overdraft: An overdraft is an arrangement by which the customer is allowed to overdraw his account. It is granted against some collateral securities. The facility to overdraw is allowed through current account only. Interest is charged on the exact amount of overdrawn subject to the payment of minimum amount by way of interest.
(iii)   Loan: Loan is an advance in lump sum amount the whole of which is withdrawn and is supported to be rapid generally wholly at one time. It is made with or without security. It is given for a fixed period at in agreed rate of interest. Repayments may be made in installments or at the expiry of a certain period.
(iv)  Discounting of Bills of Exchange: The bank also gives advances to their customers by discounting their bills. The net amount after deducting the amount of discount is credited to the account of customer. The bank may discount the bills with or without any security from the debtor in addition to the personal security of one or more person already liable on the bill.
Q.4. Distinguish between loans, cash credit and overdraft.
Ans: Difference between Loan, Cash Credit and Overdraft:
Basis
Loan
Cash Credit
Overdraft
1. Mode
A loan may be given in cash or by credit to the account of the borrower.
Cash credit is always given through the current account.
Overdraft is granted to the current account holders.
2. Borrower
The borrower of loan may be a customer of the bank or otherwise.
The borrower of cash credit becomes customer of the bank when he open the current account.
An existing customer having current account is granted over draft facility by the bank.
3. Security
A loan may be granted against tangible securities or personal guarantee of the borrower.
Cash credit is always given against some tangible securities.
Overdraft may be clean, partly secured or fully secured.
4. Interest
Interest is charged on the entire amount of loan.
Interest is payable only on the amount actually utilised by the borrower.
Interest is payable on the amount overdrawn from the current account.
5. Rate of interest
The rate of interest charged by the bank in case of loan is lower than that of the cash credit and overdraft.
The interest rate in case of cash credit is higher than that of the loan and overdraft.
The rate of interest in case of overdraft is higher as compared to loans but lower than cash credit.
6. Maturity
A loan has a specific maturity date and is repayable after a fixed period to time.
Cash credit do not have a fixed maturity date and it is technically repayable on demand.
Overdraft is repayable on demand and do not have any maturity date.
7. Period of advance
A loan may be taken by the borrower for short, or medium or long period of time.
Cash credit may be obtained by the borrower for short, medium or long period of time.
Overdraft is a short term temporary arrangement.
8. Number of withdrawals
In case of loan, funds are withdrawn once be the borrower.
In case of cash credit funds are withdrawn number of times by the borrower.
In case of overdraft, funds are withdrawn number of times.

Q.5. Discuss the lending principles followed by commercial banks while granting loans to customer.   
Ans: The principles of sound lending by commercial banks are:
a)      Safety of principal: The first and foremost principle of lending is to ensure the safety of the funds lent. It means that the borrower is in a position to repay the loans, along with interest, according to the terms of the loan contract. The repayment of the loan depends upon the borrower’s (i) capacity to pay and (ii) willingness to pay. The banker should, therefore, take utmost care in ensuring that the enterprise or business to which a loan in to be granted is a sound one and the borrower is capable to repay it successfully.
b)      Profitability: Commercial banks are profit earning institutions. They must employ their funds profitably so as to earn sufficient income out of which to pay interest to the depositors, salaries to the staff and to meet various other establishment expenses and distribute dividends to the shareholder. The sound principle of lending does not sacrifice safety or liquidity for the sake of higher profitability.
c)       Marketability or Liquidity: Liquidity of loans is another principle of sound lending. The term liquidity of loan indicates quick realisation of loans from the borrowers. Banks are essentially dealers in short term funds and therefore, they lend money mainly for short term period. The banker should see that the borrower is able to repay the loan on demand or within a short notice.
d)      Purpose of the loan: Before granting loans, the banker should examine the purpose for which the loan is demanded. If the loan is granted for productive purpose, thereby the borrower will make much profit and he will be able to pay back the loan. In no case, loan is granted for unproductive purpose.
e)      Diversification: The element of risk in relation to loans cannot be totally eliminated, it can only be reduced. Risks of lending can be reduced by diversifying the loans. While granting loans, the banker should not grant a major part of the loan to one single particular person or particular firm or an industry. If the banker grants loans and advances to a number of firms, persons or industries, the banker will not suffer a heavy loss even if a particular firm or industry does not repay the loan.
f)       National policies: Banks have certain social responsibilities towards society also. The banks have to take into account the economic and social priorities of the country beside safety, liquidity and profitability. While formulating the lending policy, the banks are guided by the government policies in relation to disbursal of credit. Thus, national interest and policies are influence the lending decisions of banks.
In conclusion, it may be said that due consideration of all the principles are necessary, while evaluating a loan proposal.
Q.6. What do you mean by investments? Mention the principles of sound investment. 2003, 05, 08,
Ans: Investment: The term investment means employment of funds to buy an asset. Here investment means employment of funds by the banks to buy securities from the market. The securities which are purchased by the banker from the market includes:
a)      Government securities: These are the securities which are issued by the governments to raise funds such as Stock, Bearer bonds and Promissory notes.
b)      Semi-government securities: These are the securities which are issued by semi-govt. organisations like Municipal Corporations and these securities include debentures or bonds.
c)       Industrial securities: There are the securities which are issued by industrial or business concerns such as shares and debentures.
Investment by banks in these securities constitutes the “third line of defence” of the banks.
Principles of Sound Investment: Banks are one of the genuine investors in the securities market. Banks invest in the market in the hope of earning some return. Since, banks deals in borrowed funds, therefore a banker must select the securities very carefully and follow the following principles of sound investments:
1)      Safety of principal: A banker deals in borrowed funds and therefore his main consideration is safety of principal invested in securities. The banker has to ensure that the principal amount invested by him remain safe. The safety of investments depend on the solvency and ability of the issuing authorities to honour their commitment made to the investors. The government and semi-government securities are the safest securities because they are guaranteed by the government.
2)      Price stability: The price of security selected by the banker should remain stable. The safety of investments depends on the stability in the prices of securities. Banker should prefer those securities whose prices remain fairly stable over a period of time. The Prices of government securities remain stable and do not fluctuate.
3)      Marketability or liquidity: The primary objective of buying securities by the banker is to earn income and at the same time maintain his liquidity position. Thus, the banker should see that the security in which he can be sold in the market without loss of time and money. Marketability of securities ensures liquidity of investments. Government and semi-government securities are highly liquid as they have a ready market.
4)      Profitability or yield: After ensuring the safety of the principal money invested in securities, the banker should consider the returns from the investments. The banker should not give undue importance to higher yields at the cost of safety. The banker should not expect windfall profit, because high profit may bear the germ of loss.
5)      Diversification of Investment: The banker should diversify the risk involved in investment by investing in wide variety of securities issued by wide variety of business enterprises belonging to different trade and industry.
6)      Refinance: To ensure the liquidity of his investments the banker has to see that the security is eligible to obtain refinance from the Central Bank and other refinancing institutions.
In conclusion, it may be said that for a banker the government and semi-government securities are most ideal for investment of funds. Government securities with virtually no risks, have a ready market, are eligible for refinance and bring reasonably good return.
Q.7. What do you mean by Letter of Credit? Mention the various parties of a letter of credit.
Ans: A Letter of Credit is an arrangement whereby, a bank acting at the request and in accordance with the instructions of customer, is to make payment to or to the order of a third party. It is one of the convenient methods of solving some practical problems of the business in the domestic and international markets. In actual practice, a letter of credit means, “a document issued by a banker authorizing the banker to whom it is addressed to honour the bills of the person named therein to the extent of certain amount.”
The various parties of a letter of credit are:
a)      The Buyer: The buyer who is the importer applies to the bank for the opening of a letter of credit.
b)      The Beneficiary: The seller, who is exporter, is the beneficiary of the letter of credit.
c)       Issuing Bank: The bank which issues the letter of credit at the request of the buyer is the issuing bank.
d)      Notifying Bank: the notifying bank is the correspondent bank situated in the same place as that of the seller which advices the credit to the beneficiary.
e)      Negotiating Bank: It is the bank which negotiates the bills or drafts under the letter of credit.
f)       Confirming Bank: It is the bank the seller insists that the credit must be confirmed by it.
g)      Paying Bank: The paying bank is the bank on which the bill or draft is drawn. It can be the confirming bank, the issuing bank or the notifying bank.
8. What the various types of letter of credit?
Ans: Various types of letter of credit are:  
(A) Traveler’s Letter Credit.
a)      Circular Note.
b)      Circular Cheque.
c)       Traveler’s Cheques.
(B) Commercial Letter of Credit.
a)      Documentary and clean letter of credit.
b)      Revocable and irrecoverable Letter of Credit.
c)       Fixed and revoling Letter of Credit.
d)      Confirmed and Unconfirmed Letter of Credit.
e)      Red clause Letter of Credit.
f)       Transferable and Non-transferable letter of credit.
g)      With and Without Resource Letter of credit.

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