The central bank and commercial banks have their distinct identities and functions. The central bank, through its function of the lender of the last resort, acts as an active agent of the government in implementing its monetary policies. In developed countries, the efficient carrying out of this function is easy. Also learned, Economic and Market Value Added, The Relationship between Central and Commercial Banks!
Learn, Explain The Relationship between Central and Commercial Banks!
The following concept of relationship below are;
Central Banks:
A central bank, reserve bank, or monetary authority is an institution that manages a state’s currency, money supply, and interest rates. Central banks also usually oversee the commercial banking system of their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monetary base in the state, and usually also prints the national currency, which usually serves as the state’s legal tender.
Central banks also act as a “lender of last resort” to the banking sector during times of financial crisis. Most central banks usually also have supervisory and regulatory powers to ensure the solvency of member institutions, prevent bank runs, and prevent reckless or fraudulent behavior by member banks.
Commercial Banks:
A commercial bank is an institution that provides services such as accepting deposits, providing business loans, and offering basic investment products. The commercial bank can also refer to a bank, or a division of a large bank, which more specifically deals with deposit and loan services provided to corporations or large/middle-sized business – as opposed to individual members of the public/small business.
In developing economies, however, this is not so simple. Here a case is often made for entry of the central bank in some selected fields to promote the development of the economy; besides ensuring the growth of a sound banking structure to cope with the increasing needs of credit. Commercial bankers take this as an encroachment on their field.
The Relationship between the commercial banks and the central banks:
The relationship between the commercial banks and the central bank has to be based on reciprocity. The commercial banks should conform to the spirit of central bank directives rather than letters. On the other side, the central bank should invariably satisfy the genuine needs of the commercial banks in times of stresses and strains. A moral code of conduct between the two will have to be evolved, accepted and followed.
They argue that the major part of the Central Bank’s funds comprise the reserves of the commercial banks meant for safeguarding their safety (liquidity). It would be immoral on the part of the central bank to compete in business with the commercial banks with their money. In view of the co-operation that the central bank often seeks from commercial banks for carrying out its policies, the central bank should not invite hostility from them by giving them unjust competition through its special privileges as the bankers’ bank and the banker of the government.
In spite of these arguments, opinion has gone in favor of the undertaking of some commercial business by the central bank, especially in underdeveloped economies. A small amount of business can hardly affect the liquidity position of the ‘creator of liquidity’. It is not at all necessary that the central bank uses the commercial banks’ funds for this. It can set up a separate department for commercial business and create resources also.
In fact, it may organize a special agent bank as its favored child for doing the arduous business necessary for economic development often avoided by commercial banks. Further, if the central bank feels that the steering wheel of credit control in its banks is loose and not functioning satisfactory, it may gain an edge of maneuverability by keeping in touch with the market through a limited amount of business.
Besides, in an agriculturally depressed economy like India, the central bank may take up the onus of developing a bill market, granting direct loans, or discounting good bills of exchange. As regards direct loans, it may be a bit difficult to democrat clearly the central bank’s field vis-a-vis that of the commercial banks.
The difficulty is removed if the central bank while doing ordinary commercial business keeps in mind that in its operations, the public interest and not profit-earning motive, prevails; what it can get done through commercial banks it never undertakes to do itself.
The various quantitative and qualitative instruments of credit control should be judiciously used by the central bank. No doubt, the bank has the drastic weapons of reserve ratio requirements, open market operations or changes in the bank rate, etc. but none of them is fool-proof.
After all, it is bank official on the spot who can judge between the credits asked for socially desirable productive purposes or credit being taken in the name of bonafide purposes, but to be used for some anti-social actions. Unless the commercial bank and the central bank provide willing co-operation, the one will be weakened and the other will be frustrated. This is why moral persuasion must be preferred now to direct action.
The commercial bank is the financial institution performs diverse types of functions. It satisfies the financial needs of sectors such as agriculture, industry, trade, communication, etc. That means they play a very significant role in a process of economic social needs. The functions performed by banks are changing according to change in time and recently they are becoming customer centric and widening their functions. Generally, the functions of commercial banks are divided into two categories viz. primary functions and the secondary functions. Also learned, Explain Primary and Secondary Functions of Commercial Banks!
Learn, Explain Primary and Secondary Functions of Commercial Banks!
The two most distinctive features of a commercial bank are borrowing and lending, i.e., acceptance of deposits and lending of money to projects to earn Interest (profit). In short, banks borrow to lend. The rate of interest offered by the banks to depositors is called the borrowing rate while the rate at which banks lend out is called lending rate.
The difference between the rates is called ‘spread’ which is appropriated by the banks. Mind, all financial institutions are not commercial banks because only those which perform dual functions of (i) accepting deposits and (ii) giving loans are termed as commercial banks. For example, post offices are not the bank because they do not give loans. Functions of commercial banks are classified into two main categories: (A) Primary functions, and (B) Secondary functions.
Let us know about each of them:
(A) Primary Functions:
The Following primary functions below are:
1. It accepts deposits:
A commercial bank accepts deposits in the form of current, savings and fixed deposits. It collects the surplus balances of the Individuals, firms, and finances the temporary needs of commercial transactions. The first task is, therefore, the collection of the savings of the public. The bank does this by accepting deposits from its customers. Deposits are the lifeline of banks.
Deposits are of three types as under:
(i) Current account deposits:
Such deposits are payable on demand and are, therefore, called demand deposits. These can be withdrawn by the depositors any number of times depending upon the balance in the account. The bank does not pay any Interest on these deposits but provides cheque facilities.
These accounts are generally maintained by businessmen and Industrialists who receive and make business payments of large amounts through cheques.
(ii) Fixed deposits (Time deposits):
Fixed deposits have a fixed period of maturity and are referred to as time deposits. These are deposits for a fixed term, i.e., the period of time ranging from a few days to a few years. These are neither payable on demand nor they enjoy cheque facilities.
They can be withdrawn only after the maturity of the specified fixed period. They carry a higher rate of interest. They are not treated as a part of the money supply Recurring deposit in which a regular deposit of an agreed sum is made is also a variant of fixed deposits.
(iii) Savings account deposits:
These are deposits whose main objective is to save. The savings account is most suitable for individual households. They combine the features of both current account and fixed deposits. They are payable on demand and also withdrawable by cheque.
But the bank gives this facility with some restrictions, e.g., a bank may allow four or five cheques in a month. Interest paid on savings account deposits in lesser than that of fixed deposit.
Difference between demand deposits and time (term) deposits:
Two traditional forms of deposits are demand deposit and term (or time) deposit:
Deposits which can be withdrawn on demand by depositors are called demand deposits, e.g., current account deposits are called demand deposits because they are payable on demand but saving account deposits do not qualify because of certain conditions on withdrawal. No interest is paid on them. Term deposits, also called time deposits, are deposits which are payable only after the expiry of the specified period.
Demand deposits do not carry interest whereas time deposits carry a fixed rate of interest.
Demand deposits are highly liquid whereas time deposits are less liquid,
Demand deposits are chequable deposits whereas time deposits are not.
2. It gives loans and advances:
The second major function of a commercial bank is to give loans and advances particularly to businessmen and entrepreneurs and thereby earn interest. This is, in fact, the main source of income of the bank. A bank keeps a certain portion of the deposits with itself as the reserve and gives (lends) the balance to the borrowers as loans and advances in the form of cash credit, demand loans, short-run loans, overdraft as explained under.
(i) Cash Credit:
An eligible borrower has first sanctioned a credit limit and within that limit, he is allowed to withdraw a certain amount on a given security. The withdrawing power depends upon the borrower’s current assets, the stock statement of which is submitted by him to the bank as the basis of security. Interest is charged by the bank on the drawn or utilized the portion of credit (loan).
(ii) Demand Loans:
A loan which can be recalled on demand is called demand loan. There is no stated maturity. The entire loan amount is paid in lump sum by crediting it to the loan account of the borrower. Those like security brokers whose credit needs fluctuate generally, take such loans on personal security and financial assets.
(iii) Short-term Loans:
Short-term loans are given against some security as personal loans to finance working capital or as priority sector advances. The entire amount is repaid either in one installment or in a number of installments over the period of the loan.
Investment:
Commercial banks invest their surplus fund in 3 types of securities:
(i) Government securities, (ii) Other approved securities and (iii) Other securities. Banks earn interest on these securities.
(B) Secondary Functions:
Apart from the above-mentioned two primaries (major) functions, commercial banks perform the following secondary functions also.
3. Discounting bills of exchange or bundles:
A bill of exchange represents a promise to pay a fixed amount of money at a specific point of time in future. It can also be encashed earlier through the discounting process of a commercial bank. Alternatively, a bill of exchange is a document acknowledging the amount of money owed in consideration of goods received. It is a paper asset signed by the debtor and the creditor for a fixed amount payable on a fixed date. It works like this.
Suppose, A buys goods from B, he may not pay B immediately but instead give B a bill of exchange stating the amount of money owed and the time when A will settle the debt. Suppose, B wants the money immediately, he will present the bill of exchange (Hundi) to the bank for discounting. The bank will deduct the commission and pay to B the present value of the bill. When the bill matures after the specified period, the bank will get payment from A.
4. Overdraft facility:
An overdraft is an advance given by allowing a customer keeping the current account to overdraw his current account up to an agreed limit. It is a facility to a depositor for overdrawing the amount than the balance amount in his account.
In other words, depositors of current account make the arrangement with the banks that in case a cheque has been drawn by them which are not covered by the deposit, then the bank should grant overdraft and honor the cheque. The security for the overdraft is generally financial assets like shares, debentures, life insurance policies of the account holder, etc.
Difference between Overdraft facility and Loan:
Overdraft is made without security in current account but loans are given against security.
In the case of the loan, the borrower has to pay interest on full amount sanctioned but in the case of an overdraft, the borrower is given the facility of borrowing only as much as he requires.
Whereas the borrower of loan pays Interest on the amount outstanding against him but the customer of overdraft pays interest on the daily balance.
5. Agency functions of the bank:
The bank acts as an agent of its customers and gets the commission for performing agency functions as under:
Transfer of funds: It provides a facility for cheap and easy remittance of funds from place-to-place through demand drafts, mail transfers, telegraphic transfers, etc.
Collection of funds: It collects funds through cheques, bills, bundles and demand drafts on behalf of its customers.
Payments of various items: It makes payment of taxes. Insurance premium, bills, etc. as per the directions of its customers.
Purchase and sale of shares and securities: It buys sells and keeps in safe custody securities and shares on behalf of its customers.
Collection of dividends, interest on shares and debentures is made on behalf of its customers.
Acts as Trustee and Executor of the property of its customers on the advice of its customers.
Letters of References: It gives information about the economic position of its customers to traders and provides similar information about other traders to its customers.
6. Performing general utility services:
The banks provide many general utility services, some of which are as under:
Traveler’s cheques. The banks issue traveler’s cheques and gift cheques.
Locker facility. The customers can keep their ornaments and important documents in lockers for safe custody.
Underwriting securities issued by the government, public or private bodies.
Purchase and sale of foreign exchange (currency).
Primary Functions of Commercial Banks:
Commercial Banks performs various primary functions some of them are given below
Accepting Deposits: Commercial bank accepts various types of deposits from the public especially from its clients. It includes saving account deposits, recurring account deposits, fixed deposits, etc. These deposits are payable after a certain time period.
Making Advances: The commercial banks provide loans and advances of various forms. It includes an overdraft facility, cash credit, bill discounting, etc. They also give demand and demand and term loans to all types of clients against proper security.
Credit creation: It is the most significant function of commercial banks. While sanctioning a loan to a customer, a bank does not provide cash to the borrower Instead it opens a deposit account from where the borrower can withdraw. In other words, while sanctioning a loan a bank automatically creates deposits. This is known as a credit creation from the commercial bank.
Secondary Functions of Commercial Banks:
Along with the primary functions each commercial bank has to perform several secondary functions too. It includes many agency functions or general utility functions.
The secondary functions of commercial banks can be divided into agency functions and utility functions.
Agency Functions: Various agency functions of commercial banks are.
To collect and clear cheque, dividends and interest warrant.
To make payment of rent, insurance premium, etc.
To deal in foreign exchange transactions.
To purchase and sell securities.
To act as trustee, attorney, correspondent, and executor.
To accept tax proceeds and tax returns.
General Utility Functions: The general utility functions of the commercial banks include.
To provide a safety locker facility to customers.
To provide money transfer facility.
To issue a traveler’s cheque.
To act as referees.
To accept various bills for payment e.g phone bills, gas bills, water bills, etc.
To provide merchant banking facility.
To provide various cards such as credit cards, debit cards, Smart cards, etc.
Commercial Banks: Banks have developed around 200 years ago. The nature of banks has changed as time has changed. This article explains Banks and their topics – Meaning, Functions, and Significances. The term bank relates to financial transactions. It is a financial establishment that uses, money deposited by customers for investment, pays it out when required, makes loans at interest exchanges currency, etc. however to understand the concept in detail we need to see some of its definitions. Many economists have tried to give different meanings to the term bank.
Learn, Explain Commercial Banks: Meaning, Functions, and Significances.
Meaning of Commercial Banks:
A commercial bank is a financial institution that performs the functions of accepting deposits from the general public and giving loans for investment to earn a profit. Banks, as their name suggests, ax profit-seeking institutions, i.e., they do banking business to earn a profit.
They generally finance trade and commerce with short-term loans. They charge a high rate of interest from the borrowers but pay much less rate of Interest to their depositors with the result that the difference between the two rates of interest becomes the main source of profit of the banks. Most of the Indian joint stock Banks are Commercial Banks such as Punjab National Bank, Allahabad Bank, Canara Bank, Andhra Bank, Bank of Baroda, etc.
Definitions of Commercial Banks:
While defining the term banks it takes into account what type of task performs by the banks. Some of the famous definitions are given below:
According to Prof. Sayers,
“A bank is an institution whose debts are widely accepted in settlement of other people’s debts to each other.”
In this definition, Sayers has emphasized the transactions from debts raised by a financial institution.
According to the Indian Banking Company Act 1949,
“A banking company means any company which transacts the business of banking. Banking means accepting for the purpose of lending or investment of deposits of money from the public, payable on demand or otherwise and withdrawable by cheque, draft or otherwise.”
Nature of Commercial Banks:
They are an organization that normally performs certain financial transactions. It performs the twin task of accepting deposits from members of the public and making advances to needy and worthy people from society. When banks accept deposits its liabilities increase and it becomes a debtor, but when it makes advances its assets increase and it becomes a creditor. Banking transactions are socially and legally approved. It is responsible for maintaining the deposits of its account holders.
Functions of Commercial Banks:
The main functions of commercial banks are accepting deposits from the public and advancing them loans. However, besides these functions, there are many other functions that these banks perform.
Paul Samuelson has defined the functions of the Commercial bank in the following words:
“The Primary economic function of a commercial bank is to receive demand deposits and honor cheques drawn upon them. A second important function is to lend money to local merchants farmers and industrialists.”
The major functions performed by the commercial banks are:
Accepting Deposits:
This is one of the primary functions of commercial banks. The banks accept different types of deposits, the deposits may broadly classify as demand deposits and time deposits. The former refers to the deposits which are repayable by the banks on demand by the depositors, while the time deposits are accepted by the banks for a fixed period before the expiry of which they don’t return the deposit.
The demand deposits include the current account deposits and savings bank account deposits. These two types of deposits earn a very low rate of interest as they can withdraw at any time. In the case of savings deposits, the depositor did not allow withdrawing more than a fixed number of times or amount over some time.
More things:
The time or term deposits include the fixed deposit and recurring deposits. In the former, a sum deposits for a fixed period determined at the time of deposit and never allows to withdrawal before the expiry of the period of deposit. Any such foreclosures will invite a penalty apart from forfeiting the interest.
Recurring deposits are the type of deposits in which a depositor agrees to deposit a fixed sum of amount every month for several months as determined in advance, and at the end of which the depositor will be repaid his deposit amount along with interest. Every bank will be interested in mobilizing as much deposit as possible as it would improve its liquidity with which the bank can meet its liabilities and expand its business.
Advancing of Loans:
They accept deposits and use them for the expansion of their business. The banks never keep the deposits mobilized idle. After keeping some cash reserve, they invest the funds and earn. They also lend loans and advances to the common men after satisfying themselves about the creditworthiness of the borrowers. They grant different types of loans like ordinary loans in which the banks lend money against collateral security.
Cash credit is another type of loan in which the entire amount sanctioned credits into the borrower’s account and he permits to withdraw only a specified sum at a time. Overdraft is yet another facility under which the customer allows to withdraw an amount subject to the ceiling fixed, from his account and he pays interest on the amount of overdrawn.
Discounting bills of exchange is another type of advance granted by the banks in which a genuine trade bill discount by the banks and the holder of the bill gives the amount and the banks arrange to collect the due from the drawer of the bill on the date of maturity.
Investment of Funds:
One of the main functions of commercial banks is to invest their funds so as learn interest and returns apart from productively utilizing their funds. In India as per the statutes, banks must invest a part of their total investments in government securities and other approved securities to impart liquidity.
Banks apart from enabling them to earn out of their investments, nowadays have set up mutual funds through which they mobilize funds from the people who invest them in very attractive projects which is a help rendered to the investors who otherwise will not have the benefit of participating in the project. Banks administer these mutual funds through specialists and experts whose services are not available to the common men.
Agency Functions of Commercial Banks:
Banks function as the agent of their customers and help them in several ways. For these agency services, the banks charge a nominal amount. The agency services include the transfer of customer’s funds, collection of funds on behalf of the customers, transactions in the shares and securities for their customers, collection of dividends on shares and interest on debentures for their customers, payments of subscriptions, dues, bills, premia on behalf of the customers, acting as the Trustees and Executor of the customers, offering financial and other consultancy services, acting as correspondents of the customers, etc.
Purchase and Sale of Foreign Exchange:
The banks account for by far the largest proportion of all trading of both a commercial and speculative nature and operate within what knows as the interbank market. This is essentially a market composed solely of commercial and investments that buy and sell currencies from each other.
Strict trading relationships exist between the member banks and lines of credit are established between these banks before they are permitted to trade. They are a fundamental part of the foreign exchange market as they not only trade on their behalf and for their customers but also provide the channel through which all other participants must trade.
They are in essence the principal sellers within the Forex market. One important thing to remember is that commercial and investment banks do not only trade on behalf of their customers but also trade on their behalf through proprietary desks, whose sole purpose is to make a profit for the bank. It should always remember that commercial banks have exceptional knowledge of the marketplace and the ability to monitor the activities of other participants such as the central banks, investment funds, and hedge funds.
Financing Domestic and International Trade:
This is a major function of commercial banks. International trade depends to a large extent on the financial and other support given by the banks. Apart from encouraging bills transactions, the banks also issue the letter of credit facilitating the importers to conduct their trade smoothly.
The banks also process all the documents through consultancy services and reduce the botheration of the traders. They also lend based on commercial bills, warehouse receipts, etc., which help the traders to expand their business.
Creation of Credit:
It is worth noting the credit created by the commercial banks. In the process of their lending operations, they create credit. The process involves the following mechanism; whenever the banks lend loans, they do not pay cash to the be borrowers; instead, they credit the accounts of the borrowers and allow them to withdraw from their accounts.
This means every loan given will create a deposit for the banks. Since every deposit is equal to money, banks are said to be creating money in the form of credit. As a result, the volume of funds required by the trade. The government and the country are met by the banks without any necessity to use actual cash.
Other Functions:
Other functions of commercial banks include providing safety vault facilities for the customers, issuing traveler’s cheques acting as referees of their customers in times of need, compiling statistics and other valuable information, underwriting the issue of shares and debentures, honoring the bills drawn on them by their customers, providing consultancy services on financial and investment matters to customers, etc.
In the process of performing all the above-mentioned services. The banks play a key role in economic development and nation-building. They help the country in achieving its socio-economic objectives. With the nationalization of banks, the priority sector and the needy people provide sufficient funds which helm them in establishing themselves. In this way, the banks provide a firm and durable foundation for the economic development of every country.
Commercial Banks: Meaning, Functions, and Significances!
Types of Commercial Banks:
The following chart depicts the main types of commercial banks in India.
Scheduled Banks and Non-scheduled Banks:
Banks classify into two broad categories—scheduled banks and non-scheduled banks.
Scheduled banks are those banks which include in the Second Schedule of the Reserve Bank of India. A scheduled bank must have a paid-up capital and reserves of at least Rs 5 lakh. RBI provides special facilities including credit to scheduled banks. Some of the important scheduled banks are the State Bank of India and its subsidiary banks, nationalized banks, foreign banks, etc.
Non-scheduled Banks:
The banks which did not include in the Second Schedule of RBI are known as non-scheduled banks. A non-scheduled bank has a paid-up capital and reserves of less than Rs 5 lakh. Such banks are small banks and their field of operation also limited.
A passing reference to some other types of commercial banks will be informative.
Industrial Banks provide finance to industrial concerns by subscribing (buying) shares and debentures of companies and also giving long-term loans to acquire machinery, plants, etc. Foreign Exchange Banks are commercial banks that are branches of foreign banks and facilitate international financial transactions through buying and selling of foreign bills.
Agricultural Banks finance agriculture and provide long-term loans for buying tractors and installing tube wells. Saving Banks mobilize small savings of the people in the savings account, e.g., Post office savings bank. Cooperative Banks organizing by the people for their collective benefits. They advance loans to their members at a fair rate of interest.
The Significances of Commercial Banks:
Banks play such an important role in the economic development of a country that a modern industrial economy cannot exist without them. They constitute a Nerve center of production, trade, and industry of a country.
In the words of Wick-sell,
“Bank is the heart and central point of the modern exchange economy.”
The following points highlight the significance of commercial banks:
They promote savings and accelerate the rate of capital formation.
They are the source of finance and credit for trade and industry.
It promotes balanced regional development by opening branches in backward areas.
Bank credit enables entrepreneurs to innovate and invest which accelerates the process of economic development.
They help in promoting large-scale production and growth of priority sectors such as agriculture, small-scale industry, retail trade, and export.
They create credit in the sense that they can give more loans and advances than the cash position of the depositor’s permits.
It helps commerce and industry to expand their field of operation.
Thus, they make optimum utilization of resources possible.
What is a commercial paper? A commercial paper is an unsecured promissory note issued with a fixed maturity by a company approved by RBI, negotiable by endorsement and delivery, issued in bearer form and issued at such discount on the face value as may be determent by the issuing company. The concept of Commercial Paper: Definition, Features of Commercial Paper, and Advantages of Commercial Paper. Implications of Commercial Paper, Impact on commercial banks, Commercial Paper in India, Future of Commercial Paper in India, Commercial Paper Market in Other Countries, and RBI Guidelines on Commercial Paper Issue. Also learned, Merchant Banking, Commercial Paper: Definition, Features, and Advantages!
Learn, Explain each topic of Commercial Paper: Definition, Features, and Advantages!
Commercial paper is an unsecured and discounted promissory note issued to finance the short-term credit needs of large institutional buyers. Banks, corporations, and foreign governments commonly use this type of funding.
#Definition:
Commercial Paper or CP is defined as a short-term, unsecured money market instrument, issued as a promissory note by big corporations having excellent credit ratings. As the instrument is not backed by collateral, only large firms with considerable financial strength are authorized to issue the instrument.
Why Needed this?
Commercial paper is issued by a wide variety of domestic and foreign firms, including financial companies, banks, and industrial firms. Major investors in the commercial paper include money market mutual funds and commercial bank trust departments. These large institutional investors often prefer the cost savings inherent in using commercial paper instead of traditional bank loans.
#Features of Commercial Paper:
Commercial paper is a short-term money market instrument comprising since promissory note with a fixed maturity.
It is a certificate evidencing an unsecured corporate debt of short-term maturity.
Commercial paper is issued at a discount to face value basis but it can be issued in interest-bearing form.
The issuer promises to pay the buyer some fixed amount on some future period but pledge no assets, only his liquidity and established earning power, to guarantee that promise.
Commercial paper can be issued directly by a company to investors or through banks/merchant banks.
#Advantages of Commercial Paper:
Simplicity:
The advantage of commercial paper lies in its simplicity. It involves hardly any documentation between the issuer and the investor.
Flexibility:
The issuer can issue commercial paper with the maturities tailored to match the cash flow of the company.
Easy To Raise Long-Term Capital:
The companies which are able to raise funds through commercial paper become better known in the financial world and are thereby placed in a more favorable position for rising such long them capital as they may, from time to time, as required. Thus there is an inbuilt incentive for companies to remain financially strong.
High Returns:
The commercial paper provides investors with higher returns than they could get from the banking system.
Movement of Funds:
Commercial paper facilities securitization of loans resulting in the creation of a secondary market for the paper and efficient movement of funds providing cash surplus to cash deficit entities.
#Implications of Commercial Paper:
The issue of commercial paper is an important step in disintermediation bringing a large number of borrowers as well as investors in touch with each other, without the intervention of the banking system as the financial intermediary. Directly from borrowers can get at least 20% of their working capital requirements directly from the market at rates which can be more advantageous than borrowing through a bank.
The forts class borrowers have the prestige of joining the elitist commercial paper club with the approval of CRISIL, the banking system, and the RBI, however, RBI has presently stipulated that the working capital limits of the banks will be reduced to the extent of an issue of commercial paper. Industrialists have already made a plea that the issue of commercial paper should be outside the scheme of bank finance and other guidelines.
Such as, the recommendation of banks and approval of RBI has not accepted the plea at present as commercial paper is an unsecured borrowing and not related to a trade transaction. The main aim of the RBI is to ensure that commercial paper develops a sound money market instrument.si, in the initial stages emphasis should be on the quality rather than quantity.
#Impact on commercial banks:
The impact of the issue of commercial paper on commercial banks would be of two dimensions. One is that banks themselves can invest in commercial paper and show this as the short-term investment. The second aspect is that the banks are likely to lose interest on the working capital loan which has been hitherto lent to the companies, which have now started borrowing through commercial paper.
Further, the larger companies might avail of the cheap funds available in the market during the slack season worsening the bank’s surplus fund position\, but come to the banking system for borrowing during the busy season when funds are costly. This would mean the banks are the losers with a clear impact on profitability.
However, the banks stand to gain by charging the higher interest rate on reinstated portion especially of it done during the busy season and by way of service charge for providing standby facilities and issuing and paying commission. Further, when large borrowers are able to borrow directly from the market, banks will correspondingly be freed from the pressure on resources.
#Impact on the Economy:
The process of disintermediation is taking place in the free economies all over the world. With the introduction of CP financial disintermediation has been gaining momentum in the Indian economy. If CPs are allowed to free play, large companies, as well as banks, would learn to operate in a competitive atmosphere with more efficiently. This result greater excellence in the service of banks as well as management of finance by companies.
Recent Trends:
RBI has liberalized the terms of issues of CP from May 30, 1991.
According to the liberalized terms, the proposal by eligible companies for the issues of CP would not require the approval of RBI.
Such companies would have to submit the proposal to the financing bank which provided working capital facility either as a sole bank or as a leader of the consortium.
The bank, on being satisfied with the compliance of the norms would take the proposal on the record before the issue of commercial paper.
RBI has further relaxed the rules in June 1992,
The minimum working capital limit required by a company to issue CP has been reduced to Rs. 5 crores. The ceiling on the amount of which can be raised through CP has been raised to 75% of working capital.
A closely held company has also been permitted to borrow through CPs provided all the criteria are met. The minimum rating required from CRISIL has been lowered to P2 from 1994 – 95, the standby facility by banks for CP has been abolished.
When CPs are issued, banks will have to effect a pro-rata reduction in the criteria are met. The while minimum rating needed from ICRA is A2 instead of A1.
According to the RBI monetary policy for the second half of 1994 – 95,
The standby facility by banks for CP has been abolished. When CPs are issued, banks will have to effect a pro-rata reduction in the cash credit limit and it will be no longer necessary for banks to restore the cash credit limit to meet the liability on the maturity of CPs. This will import a measure of independence to CP as a money market instrument.
#Commercial Paper in India:
In India, on the recommendations of the Vaghul working Group, the RBI announced on 27th March 1989, that commercial paper will be introduced soon in the Indian money market. The recommendations of the Vaghul Working Group on the introduction of commercial paper in Indian money market areas flowers:
There is a need to have a limited introduction of commercial paper. It should be carefully planned and the eligibility criteria for the issuer should be sufficiently rigorous to ensure that the commercial paper market develops on healthy lines.
Initially, access to the commercial paper market should be registered to rated companies having a net worth of Rs. 5 cores and above with good dividend payment record.
The commercial paper market should function within the overall discipline of CAS. The RBI would have to administer the entry on the market, the amount if each issue the total quantum that can be raised in a year.
Ni restriction is placed on the commercial paper market except by way of the minimum size of the note. The size of the single issue should not be less than Rs. 1 core and the size of each lot should not be less than Rs. 5 lakhs.
The commercial paper should be excluded from the stipulations on insecure advances in the case of banks.
The commercial paper would not be tied to any transaction and the maturity period may be 7 days and above but not exceeding six months, backed up if necessary by a revolving underwriting facility of fewer than three years.
The using company should have a net worth of not less than Rs. 5 cores, a debt quality ratio of not more than 105, current ratio of more than 1033, a debt servicing ratio closer to 2, and be listed on the stock exchange.
The interest rate on commercial paper would be market dominated and the paper could be issued at a discount to face value or could be interest bearing.
The commercial paper should not be subject to stamp duty at the time of issue as well as at the time transfer by endorsement and delivery.
On the recommendations of the Vaghul Working Group, the RBI announced on 27th March 1989 that commercial paper will be introduced soon in the Indian money market. Detailed guidelines were issued in December 1989, through non-Banking companies (acceptance of Deposits through commercial paper) Direction, 1989 and finally, the commercial papers were instructed in India from 1st January 1990.
RBI Guidelines on Commercial Paper Issue:
The important guidelines are:
A company can issue commercial paper only if it has: 1) A tangible net worth of not less than Rs. 10croes as per the latest balance sheet. 2) The minimum current ratio of 1.33:1. 3) A fund based working capital limit of Rs. 25 crores or more. 4) A debt servicing ratio closer to 2. 5) The company is listed on a stock exchange. 6) Subject to CAS discipline. 7) It is classified under Health Code no. 1 by the financing banks, and. 8) The issuing company would need to obtain p1 from CRISIL.
The commercial paper shall be issued in multiples of Rs. 25 lakhs but the minimum amount to be invested by a single investor shall be Rs. 1 crore.
The commercial paper shall be issued for minimum maturity period of 7 days and the maximum period of 6 months from the date of issue. There will be no grace period on maturity.
Another aggregate amount shall not exceed 20% of the issuer’s fund based working capital.
The commercial paper is issued in the form of using promissory notes, negotiable by endorsement and delivery. The rate of discount could be freely determined by the issuing company. The issuing company has to bear all flotation cost, including stamp duty, dealers, fee and credit rating agency fee.
The issue of commercial paper cannot be underwritten or co-opted in any manner. However, commercial banks can provide standby facility for the redemption of the paper on the maturity date.
Investment in the commercial paper can be made by any person or banks or corporate bodies registered or incorporated in India and un-incorporated bodies too. Non-resident Indians can invest in the commercial paper on non-repatriation basis.
The companies issuing commercial paper would be required to ensure that the relevant provisions of the various statutes such as companies Act, 1956, the IT At, 1961 and the Negotiable Instruments Act, 1981 are complied with.
Procedure and Time Frame Doe Issue Commercial Paper:
Application to RBI through financing bank or leader of the consortium bank for working capital facilities together with a certificate from the credit rating agency.
RBI to communicate in writing their decision on the amount of commercial paper to be issued to the lender bank.
The issue of commercial paper to be completed within 2 weeks from the date of approval of RBI through a private placement.
The issue may be spread shall bear the same maturity date.
Issuing company to advise RBI through the bank/leader of the bank, the amount of actual issue of commercial paper within 3 days of completion of the issue.
Future of Commercial Paper in India:
Corporate enterprises requiring burgeoning funds to meet their expanding needs find it easier and cheaper to raise funds from the market by issuing commercial paper. Further, it provides the greater degree of flexibility in business finance to the issui9ng company in as much it can decide the quantum of CP and its maturity on the basis of its future cash flows. CPs have made a good start.
Since the inception of CPs in India in January 1990, 23 companies have issued CPs worth RS. 419.4 crore till June 1991. The total issues amounted to Rs. 9,000 crore in June 1994. The outstanding amount of CPs stood art Rs. 4,770 crore on March 31, 1999, and increased to Rs. 7,814 crore on March 31. 2000.
The issues of CPs declined to Rs. 5,663 crore on March 31, 2000. It shows that the CP market is moribund. There is no increase in issuer base. i.e. the same companies are tapping this market for funds. The secondary market is virtually non-existent. Only commercial banks pick these papers and hold till mortuary. No secondary market is allowed to develop on any significant scale. Further, trading is cumbersome as procedural requirements are onerous.
The stamp duty payable by banks subscribing charged to non-banking entities like primary dealer, corporate and non-banks instead of directly subscribing to them. The structural rigidities such as rating requirements, the timing of issue, terms of issue, maturity ranges denominational rang and interest rate stand in the way of developing the commercial paper market. The removal of stringent conditions and imposing o such regulatory measures justifiable to issues, investors and dealers will improve the potentiality of CP as a source of corporate financing.
Commercial Paper: Definition, Features, and Advantages!
Commercial Paper Market in Other Countries:
The roots of commercial paper can be traced way back to the early nineteenth century when the firms in the USA began selling open market paper as a substitute for bank loan needed for short-term requirements but it developed only in the 1920s. The development of consumer finance companies in the 1920s and the high cost of bank credit resulting from the incidence of compulsory reserve requirements in the 1960s contributed to the popularity of commercial paper in the USA.
Today, the US commercial paper market is the largest in the worlds. The outstanding amount at the end of 1990 in the US commercial paper market stood at $557.8 billion. The commercial paper issues in the US are exempted from the requirement if the issue of prospectus so long as proceeds are used to finance current transitions and the paper’s mortuary is less than 270 days.
Most of the commercial paper market in Europe is modeled on the lines of the US market. In the UK the Sterling Commercial Paper Market was launched in May 1986. In the UK, the borrower must be listed in the stock exchange and he must meet assets of least $50 million. However, rating by credit agencies is not required. The maturities of commercial paper must be between 7 and 364 days. The commercial paper is exempted from stamp duty.
In finance, commercial papers were thought of as a fixable alternative to bank loans. The commercial paper was introduced in December 1985. Commercial paper can be issued only by non-bank French companies and subsidiaries of foreign companies. The papers are in bearer form. It can be either issued by dealers or placed directly.
The maturity ranges from ten days to seven years. Rating by credit agencies is essential. To protect investors. Law contains fairly extensive disclosure requirements and requires publication of regular finance statements by issue. The outstanding amount at the end of 1990 in France Commercial paper market was $31 billion.
The Canadian commercial paper market was launched in the 1950s. The commercial paper is generally used in terms of 30days to 365 days although terms such as overnight are available. The commercial paper issued by Canadian companies is normally secured by the pledge of assets. The outstanding amount at the end of 1990 in the commercial market was $26.8 billion.
In Japan, the yen commercial paper market was opened in November 1987. The commercial paper issues carry maturities from two weeks to nine months. Japan stands second in the commercial paper market in the world an outstanding amount of $117.3 billion in 1990.
In 1980s many other countries launched the commercial paper market, notably Sweden (early 1980s), Spain (1982s), Hong Kong (1982), Singapore (1984), Norway (1984).
