clearing all

8/2/2019 Clearing all

1/19

Assignments

March 28

2012

1-Clearing House 2-letter of credit its types 3- Forms of Securities 4-

Differences B/w Markup and interest 5-Differences between Commercial

and Central Bank

BANKING AND FINANCE

Aamir hussain

Reg no: 2214

Submitted to: Sir Tariq Mehmood


2/19

CLEARING

learing implies a system by which banks exchange cheques and other negotiableinstruments drawn on each other within a specified area and thereby secure payment fortheir clients through the clearing house at specified time in an efficient way. In practice,

the person receiving a cheque as rarely a depositor of the cheque at the same banks the drawer.

He deposits the cheque with his bank other than of payer for the collection of the amount. Now thebank in which the cheque has been deposited becomes a creditor of the drawers bank. The depositor bankwill pay his amount of the cheque by transferring it from cash reserves if there are no offsettingtransactions. The banks on which the cheques are drawn become in debt to the bank in which thecheques are deposited. At the same time, the banks receive large amounts of chequesdrawn on other banks giving claims of payment by them. The easy, safe and most efficient wayis to offset the reciprocal claims against the other and receive only the net amount owned bythem. This facility of net interbank payment is provided by the clearinghouse.

Clearing House:

A clearinghouse is an association of commercial banks set up in given locality for the purposeof interchange and settlement of credit claims. The function of clearinghouse is performed by thecentral bank of a country by tradition or by law. In past State bank was indulged in clearingfunction i.e. for the settlement of mutual obligations of different commercial banks. As all bankshave their accounts and keep a certain percentage of the cash deposits as a reserve with CentralBank, it becomes easy to set up their mutual obligations by off-setting their accounts

Functioning of Clearing House:

All the scheduled banks which are the member of clearing house, must maintain accounts withSBP, by debit and credit to which the clearing settlements are made. If on a particular day, a

bank delivers Cheque and other negotiable instruments worth more than the total amountof Cheque received by it that banks account with State Bank of Pakistan will be credited with thedifferential amount. If on the other hand the total amount of Cheque and other negotiableinstruments drawn on a certain bank by other banks is more than the total amount receivable byit from other banks, then this bank's account will be debited on that day.

National Institutional Facilitation Technologies:At present this function of state bank is performed by NIFT (National Institutional FacilitationTechnologies). And now clearing house is a place where NIFTs representatives of all scheduledbanks sit together and interchange their claims against each other with the help of controlling staffof State Bank of Pakistan and where there is no branch of State Bank of Pakistan the designated branch of

National Bank of Pakistan acts as controlling member instead of State Bank of Pakistan. Thisinstitution has been formed by the State Bank of Pakistan and it performs the duties of receivingall the clearing cheques from all the branches of all the banks and taking them to the state bank.At the SBP first the NIFT forms a list of all the cheques from all the banks and then forwards itto the SBP representative. That person categorizes all these cheques according to their respectivebanks and branches and forms another list of his own. Then these sorted cheques are again givento the NIFT agent and he then takes them to the head offices of their respective banks and from

C


3/19

there they are distributed to the respective branches also through NIFT. This way NIFT deliversall the cheques to their parent branch from which they have been issued

Rules & Regulations of NIFT:

Cheques and other negotiable instruments are sent through representative forexchange.

All the cheques and negotiable instruments must be properly stamped and suitablydischarged.

Each and every Cheque must be accompanied by an objection memo when returnedunpaid duly initialed.

Each bank is required to maintain sufficient funds in the principal account with SBP tomeet the payment obligations.

The State Bank of Pakistan debits the account of each member of the clearing house withthe proportionate working expenses incurred on the operation of clearing house. Theseexpenses are very nominal.

How settlement is done in NIFT?

Presume that MCB got the cheques, which are drawn on HBL, UBL and ACBL for amountsRs.50,000/-,Rs.30,000/- and Rs.15,000/- respectively, its total being Rs.95,000/-. It means that this amount is

to be credited to MCB A/c with SBP. On the other hand the cheques drawn on MCB are fromHBL, UBL & ACBL of Rs.15, 000/- Rs.75,000/- and Rs.30,000/- respectively, its total beingRs.1,20,000/-. It means that this amount is to be debited from MCB A/c.The difference betweenRs. 95.000/- credit and Rs.120.000/- debit is Rs. 25,000/- debit, which means the house, isagainst MCB for Rs. 25,000/-.If we separately show it then, MCB has to receive Rs.50, 000/-from HBL and to pay Rs.15,000/-to HBL so difference is Rs.35,000/- credit. MCB has to receiveRs.30,000/- from UBL and to payRs.75,000/- to UBL so difference is Rs.45,000/- debit. MCBhas to receive from ACBL Rs.15,000/-and to pay Rs.30,000/- to MCB so differenceis Rs.15,000/- debit.

GRAND TOTAL: + 35,000 - 45,000 -15,000 = -25,000 i.e. Rs.25, 000/-

debit.Hence MCB A/c with State Bank of Pakistan will be debited with Rs.25, 000/- and the contrawill be other banks accounts respectively. This is called as "Debit and Credit Rule. The amountsand numbers of instruments received are entered in the House Book from the main schedules ofthe respective banks. The State Bank of Pakistan maintains two major books for clearing housepurpose.


4/19

1) House Register:

This book contains the information about the amounts and number of cheques received anddelivered by each bank is noted down. Its columns are just like our clearing house-page.

2) House Balance Book:

This book contains the amount and number of cheques received and delivered by each bank aswell as the amounts which are to be received and paid to respective banks through their accountsby State Bank of Pakistan is written down. This book has the following columns:-Both sides ofthis book are balanced. Vouchers are prepared from the slips received from the respective banksand the amounts are compared with this balance book.

CLEARING DEPARTMENT


5/19

Clearing department performs following functions.

To accept transfer, transfer delivery, clearing and collection cheques from the customers of thebranch and to arrange for their collection.

Transfer cheques:Are those cheques, which are collected and paid by the same branch of bank.

Transfer delivery cheques:Are those cheques, which are collected and paid by two different branches of the same bank,situated in the same city?

Clearing cheques:Are those cheques, which are drawn on the branches of some other bank of the same city or ofthe same area, which is covered by particular clearing house?

Collection cheques:Are those cheques, which are drawn on the branches of either the same bank or of another bank, but thosebranches, are not in the same city or they are not the members of clearing house.

To arrange the payment of cheques drawn on the branch and given for collection to anyother branch on MCB or any other members or sub member of the local clearing house.

To collect amount of cheques drawn on members, sub-member of local clearing house,sent for collection by MCB Branches, not represented at the local clearing house

Receiving and scrutinizing the cheques and other deposit instruments, and the pay-in-slipat the counter.

Fixing the stamps.

Scrutiny and receipt by the authorized officer.

Returning the counter foil to the depositor.

Certificate and confirmation by the officer in charge of the department.


6/19

Separating the cheque into transfer, transfer delivery, and clearing cheques

Outward Clearing at the Branch:

of funds of local cheques deposited by the customer drawn on other Banks is called

Outward clearing

When the account holder of our bank receives payment from any other party in the formof cheque, and that cheque is not of our bank or branch, and our account holder deposits it in hisMCB account then that cheque has to pass from the process of outward clearing. All the chequesdeposited in one day of other banks are then again sent through the NIFT to the SBP which sendsthem to the head offices of their respective banks which through NIFT sends the instruments tothe respective branches from which they were issued.

This process of outward clearing is of three days.

Out-Word Clearing Book:

The bank uses outward clearing register for the purpose of recording all the details of thecheques that the bank has delivered to other banks.

Scrutiny of Out Ward Clearing Instruments:

The following points are to be taken into consideration while an instrument is accepted at thecounter to be presented in Outward Clearing:

The name of the branch appears on its face where it is drawn on.

It should not be stale or postdated or without date.

Amount in words and figures does not differ.

Signature of the drawer appears on the face of instrument.

Instrument is not mutilated.

There should be no material alteration if so, it should be properly authenticated.


7/19

If order instrument, suitably endorsed and the last endorsee's account being credited.

Endorsement is in accordance with the crossings if any. The amount of the instrument is same as mentioned on the paying-in-slip and counterfoil.

The title of account on the paying-in-slip is that of payee or endorsee (with the exceptionof bearer cheque)

If an instrument is in order then our bank's special crossing stamp is affixed across theface of the instrument. Clearing stamp is affixed on the face of the instruments, paying-in-slip and counterfoil (The stamp is affixed in such a manner that half appears onpaying-in-slip and half on counterfoil).

The instrument is suitably discharged, where a bearer cheque does not require anydischarge and also an instrument in favor of a bank need not be discharged.

The instrument along with paying-in-slip is retained while the counterfoil is given to thecustomer duly signed.

Procedure of Outward Clearing:

Then the following steps are to be taken:-

The particulars of the instruments and the pay-in-slips or credit vouchers are entered inthe Outward Clearing Register and calculate the total amount.

Paste the crossing stamp and clearing stamp at the face of these instruments.

Paste the payees account credited stamp at the back of these instruments.

Calculate the amount of all these instruments from vouchers and tally with the registertotal.

Prepare the delivery summery report.


8/19

Prepare the Clearing Bundle Cover.

Also prepare the Add List.

After each and every thing is completed, put all these instruments into the NIFT bag andclose this bag with seal.

The schedules are prepared in triplicate, two copies of which are attached with therelevant instruments and the third is kept as office copy.

The instruments along with duplicate schedules and summary report are delivered toNIFT carrier.

However the amount is kept in float till final status of various instruments is known fromrespective paying banks in second dealing.

The entry of the instruments returned unpaid is made in Cheques Returned Register.If the instrument is not to be presented again in clearing then a covering memo is

prepared. The covering memo along with returned instrument and objection memo is sentto the customer who deposited the same in his account

b) Inward Clearing:

Payment of cheques of our customers drawn on MCB


9/19

Letter of Credit

Letter of Credit (L/C):

A Letter of Credit is an undertaking/instrument issued by a bank on behalf of the Buyer/Importer

in favor of the exporter whereby the bank undertakes to pay the exporter a certain fixed amountagainst delivery of documents specified in the credit within a stipulated time if the terms andconditions of the credit are compiled with.According to Article 2 of UCPDC 600, Credit means any arrangement, however named ordescribed, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank tohonor a complyingpresentation.A more wider and comprehensive definition of a Letter of Credit has been given in Article-2 ofUCPDC 500 as under:-For the purpose of these article, the expression, documentaryCredit(s)and stand by Letter(s)of credit (hereinafter referred to as Credit(s) mean any arrangement, however named ordescribed whereby a bank (the issuingbank) acting at the request and on the instruction of a

customer the Applicants) on or its own behalf.i) Is to make a payment to or to the order of a third party (the Beneficiary) or is to accept andPay bills of exchange (Drafts) drawn by the beneficiary, orii) Authorize another bank to effect such payment or to accept and pay such bills of exchangeor (Drafts), oriii) Authorize another bank to negotiate against stipulated document(s) provided that the termsand conditions of the credit arc complied with.

Kinds of letter of Credit L/C

Letter of Credit can be divided into broad categories.1. Letter of Commercial credit

2. Letter of Travelers facility.Letters of Commercial Credit:

These credits are used for business purposes.they are of the following types:
http://www.bankingnfinance.com/what-is-letter-of-credit-definition-types-parties-and-tenor-of-lc/letter-of-credit-lc-2/


10/19

Confirmed or Irrevocable Credit: By issuing this type of credit the bank gives an undertaking toaccept and pay the bill of exchange drawn on it.

Unconfirmed or Revocable Credits:

When the bank does not give an undertaking to accept and pay the bill drawn on it,it is called

unconfirmed credit. It simply states that the bank is willing to honor the bill drawn under thecredit unless the credit is cancelled

Acceptance Credits:

When the credits provide for bills to be accepted by the bank instead of the importer, it is calledacceptance credit. Such credits save time and risk of lose of bill during transit.Document Credits: Such credits provide for bill to be accompanied by necessary documentsindulging railway receipts, shipping papers, insurance receipt, and bill of landing.Clean or non-Documentary credits:

When the credit does not require attaching necessary documents with the bill, it is known asclean or non-documentary credit.Omnibus Credits:

It is granted to those exporters who possess high credit standing. They can draw full amount on abank against the pledge of general lien on their goods.Fixed Credits:

When credits are available for fixed total amount wither in one or several bills, it is called fixedcredits.Revolving credits:

Where credits are automatically renewable under certain conditions, they are known as revolvingcredits.Divisible Credit:

Where the credit allows its holder to transfer drawing rights in parts of the total amount of creditto the other party, it is known as divisible credit.

Letters of Travellers Facility:

Such letters issued to the travelers. It is risky to carry money in foreign country and may be lost,

stolen, or robbed. These letters are substillutue to their money and can be cashed at designatedbank at the place of visit. These are of following typesTravellers Cheque:

These cheques are draft which is issued to tourists. They are used for noncommercial purposesand these are drawn by the holder on the issuing bank for round sums. These are specializedcheques made available to overseas travellers and converted into the currency of the country of


11/19

destination. Travellers cheques are issued in several denominations in a local or forign currency.The issuing bank accepts the return of unused cheques at a little Commission.At the time od issue , the holder signs the cheque in the presence of manager of issuing bank andthen the cashing bank and the row signatures must agree.Travellers cheques can only be issued after fulfilling exchange control regulations set by thecentral bank of a country.

Circular Cheque/Credit:

banks issue such cheques to their agents branches, or correspondents in foreign countries to sellthem to visitors to country of the issuing bank. For instance, Habib bank, Karachi issues circularcheques to its branch in London to sell them to resident Pakistanis who want to visit Pakistani.These cheques are issued under the foreign exchange law of Great Britain.Travellers Commercial Letter of credit: These Cheques are issued to businessman who want tomake purchases abroad but are reluctant or afraid to carry with them huge amount in cash. Thesecheques are accompanied by necessary shipping documents.Limited letter Credit: unlike circular L/C which is useful in many countries at a time, the limitedletter of credit is issued only on a branch or an agent of specified country. It is useful in other

places.Circular or World-wide letter of credit: This type of Cheque is available with any of thebankscorrespondents and agents abroad.

Tenor of the Letter of Credit (L/C):

All credits must clearly indicate whether they are, available by sight payment, by deferredpayment, by acceptance or by negotiation-1) Sight payment .. to pay at sight.2) Deferred payment .. to pay on maturity date(s) determinable in accordance with the

stipulation of the credit3) By acceptance .. maturity date will be counted from the date of acceptance ofdraft by the applicant4) By negotiation ..maturity date will be counted from the date of negotiation ofdocument.If the credit provides for negotiation to pay without recourse to drawers and/or bonafied holders,draft(s) drawn by the beneficiary and/or document(s) presented under the credit. A credit shouldnot be issued available by draft(s) on the applicant. If the credit & nevertheless calls for draft(s)on the applicant, bank will consider such draft(s) as an additional document(s).


12/19

MORTGAGE

MORTGAGE:mortgage as the transfer of interest in specific immovable property for the purposeof securing the payment of money, advanced or to be advanced by way of loan, an existing or

future debt, or the performance of an engagement which may give rise to a pecuniary liability.

The transferor is called the mortgagor, the transferee is a mortgagee. The principal money andinterest thereon, the payment of which is secured are called the mortgage money.

mortgage-an agreement which allows you to borrow money from a bank or similar organization,

especially in order to buy a house or apartment, or the amount of money itself

Mortgage loan types

There are many types of mortgages used worldwide, but several factors broadly define the

characteristics of the mortgage. All of these may be subject to local regulation and legal

requirements.

Interest: interest may be fixed for the life of the loan or variable, and change at certain pre-defined periods; the interest rate can also, of course, be higher or lower.

Term: mortgage loans generally have a maximum term, that is, the number of years afterwhich an amortizing loan will be repaid. Some mortgage loans may have no amortization, orrequire full repayment of any remaining balance at a certain date, or evennegative

amortization.

Payment amount and frequency: the amount paid per period and the frequency of payments;in some cases, the amount paid per period may change or the borrower may have the optionto increase or decrease the amount paid.

Prepayment: some types of mortgages may limit or restrict prepayment of all or a portion ofthe loan, or require payment of a penalty to the lender for prepayment.

The two basic types of amortized loans are thefixed rate mortgage(FRM) andadjustable-ratemortgage(ARM) (also known as afloating rateorvariable rate mortgage). In many countries

(such as the United States), floating rate mortgages are the norm and will simply be referred to as

mortgages. Combinations of fixed and floating rate are also common, whereby a mortgage loan

will have a fixed rate for some period, and vary after the end of that period.

In a fixed rate mortgage, the interest rate, and hence periodic payment, remains fixed for thelife (or term) of the loan. Therefore the payment is fixed, although ancillary costs (such as

property taxes and insurance) can and do change. For a fixed rate mortgage, payments for

principal and interest should not change over the life of the loan,

In an adjustable rate mortgage, the interest rate is generally fixed for a period of time, afterwhich it will periodically (for example, annually or monthly) adjust up or down to some

market index. Adjustable rates transfer part of the interest rate risk from the lender to the

borrower, and thus are widely used where fixed rate funding is difficult to obtain or

prohibitively expensive. Since the risk is transferred to the borrower, the initial interest rate

may be from 0.5% to 2% lower than the average 30-year fixed rate; the size of the price

differential will be related to debt market conditions, including theyield curve.
http://en.wikipedia.org/wiki/Negative_amortizationhttp://en.wikipedia.org/wiki/Negative_amortizationhttp://en.wikipedia.org/wiki/Negative_amortizationhttp://en.wikipedia.org/wiki/Negative_amortizationhttp://en.wikipedia.org/wiki/Fixed_rate_mortgagehttp://en.wikipedia.org/wiki/Fixed_rate_mortgagehttp://en.wikipedia.org/wiki/Fixed_rate_mortgagehttp://en.wikipedia.org/wiki/Adjustable-rate_mortgagehttp://en.wikipedia.org/wiki/Adjustable-rate_mortgagehttp://en.wikipedia.org/wiki/Adjustable-rate_mortgagehttp://en.wikipedia.org/wiki/Adjustable-rate_mortgagehttp://en.wikipedia.org/wiki/Floating_interest_ratehttp://en.wikipedia.org/wiki/Floating_interest_ratehttp://en.wikipedia.org/wiki/Floating_interest_ratehttp://en.wikipedia.org/wiki/Variable_rate_mortgagehttp://en.wikipedia.org/wiki/Variable_rate_mortgagehttp://en.wikipedia.org/wiki/Variable_rate_mortgagehttp://en.wikipedia.org/wiki/Yield_curvehttp://en.wikipedia.org/wiki/Yield_curvehttp://en.wikipedia.org/wiki/Yield_curvehttp://en.wikipedia.org/wiki/Yield_curvehttp://en.wikipedia.org/wiki/Variable_rate_mortgagehttp://en.wikipedia.org/wiki/Floating_interest_ratehttp://en.wikipedia.org/wiki/Adjustable-rate_mortgagehttp://en.wikipedia.org/wiki/Adjustable-rate_mortgagehttp://en.wikipedia.org/wiki/Fixed_rate_mortgagehttp://en.wikipedia.org/wiki/Negative_amortizationhttp://en.wikipedia.org/wiki/Negative_amortization


13/19

The charge to the borrower depends upon the credit risk in addition to the interest rate risk.

Themortgage origination and underwriting processinvolves checking credit scores, debt-to-

income, downpayments, and assets.Jumbo mortgagesandsubprime lendingare not supported bygovernment guarantees and face higher interest rates. Other innovations described below can

affect the rates as well.

PLEDGE:pledge as bailment of goods as security for payment of a debt or performance of a promise.

The person who offers the security is called pawner or pledger and the bailee is called the

pawnee or pledgee. In case of pledge:

There should be bailment of goods; and

The objective of the bailment should be to hold the goods as security for the payment of a debt or

the performance of a promise. The bailment should be on behalf of a debtor or an intending

debtor.

The pawner or pledger remains the owner of the property except to the extent of interest which

rests with the pledge because of the loan borrowed from the bank.

There is actual or constructive delivery of goods.

Pledge is not created in respect of future goods. The goods must be specific and be capable of

identification.

The goods must be in possession of pledgee. Otherwise there is no pledge.

Pledge agreement may be oral or implied.

HYPOTHECATION:

Hypothecation is a charge against property for an amount of debt where neither ownership norpossession is passed to the creditor. Hypothecation is a charge against movable property. Thegoods will, unlike a pledge, be retained by the borrower and be in the borrowers possession. Theborrower gives only a letter stating that the goods are hypothecated to the banker as security forthe loan granted. There will be no transfer of the property to the borrower.

Features: It is an equitable charge created against immovable property.Neither the possession nor the ownership of the property is transferred to the banker.The contents of the letter of hypothecation determine the rights of the banker.The banker has the right to take possession of the property (if there is default) and sell thehypothecated goods to realize his dues.If selling rights are not incorporated in the letter, the banker has to approach a court of law torecover the dues against the hypothecated property.H knowledge of the banker or the hypothecated property can be pledged to another personprovided the pledgee has no knowledge of the previous hypothecation. Hypothecated goods canbe sold any time to the genuine purchaser for value without the
http://en.wikipedia.org/wiki/Mortgage_loan#Originationhttp://en.wikipedia.org/wiki/Mortgage_loan#Originationhttp://en.wikipedia.org/wiki/Mortgage_loan#Originationhttp://en.wikipedia.org/wiki/Jumbo_mortgagehttp://en.wikipedia.org/wiki/Jumbo_mortgagehttp://en.wikipedia.org/wiki/Jumbo_mortgagehttp://en.wikipedia.org/wiki/Subprime_lendinghttp://en.wikipedia.org/wiki/Subprime_lendinghttp://en.wikipedia.org/wiki/Subprime_lendinghttp://en.wikipedia.org/wiki/Subprime_lendinghttp://en.wikipedia.org/wiki/Jumbo_mortgagehttp://en.wikipedia.org/wiki/Mortgage_loan#Origination


14/19

Markup

The difference between an investment's lowest current offering price among dealers and the

higher price a dealer charges a customer. Markups occur when dealers act as principals (buying

and selling securities from their own accounts, at their own risk), as opposed to brokers

(receiving a fee for facilitating a transaction).

Certain securities are available for purchase by retail investors from dealers who sell the

securities directly from their own accounts. The dealer's only compensation for the sale comes in

the form of the markup, the difference between the price the security was purchased at and the

price the dealer charges to the retail investor. The dealer assumes some risk by acting in this

capacity, as the market price of the security in his or her inventory could drop before he/she is

able to sell to investors.

Dont confuse markup with profit. If you want a certain percentage of profit and you estimate

your costs and add the desired profit percentage as markup, youre making an error. Your profit

should be a percentage of the selling price, not a markup on cost.

To determine markup (and profit):

Estimate your costs. Deduct the desired profit percentage from 100 percent. Divide the desired profit percentage by this figure. Multiply your cost by the result. This will be your profit.

Example: Cost of job is $100,000. Desired profit percentage is 15%. Subtract 15% from 100%.

Balance is 85%. Divide 15% by 85%. Quotient is 17.65%. Multiply $100,000 by 17.65%, or

.1765. The result is $17,650. Estimated selling price of $117,650 gives you a 15% profit.

By using this formula, you will see that a profit of 25 percent on the selling price is greater than a

30 percent markup on cost.

What is Interest?

Interest is the cost of using somebody elses money. When you borrow money, you pay

interest. When you lend money, you earn interest. Learn more about what interest is and

how it works.

A question may help you get a handle on how interest works: what does it take to borrowmoney? The answer: more money. You can borrow money for a home, a business, or

almost anything else. In return, youll have to pay that money back along with a little

extra. The extra money is interest.

Interest is the price you pay (or a fee if you prefer) to use somebody elses money.Earning Interest


15/19

When you lend money, you often earn interest. For example, depositing money into abank account is like lending money to the bank. Theyll use your cash to make loans

(charging borrowers more interest than they pay you). The bank pays you interest when

you use savings accounts and certificates of deposit (CDs) because they want you to keep

your money at the bank. Unless you have something better to do with the funds, youll

leave it in the bank to earn interest.

Periodically (every month or quarter, for example) the bank pays interest. Youll see your

account balance go up, and you can either spend the money or keep it in the account so it

continues to earn interest. Your savings can build momentum when this happens -- you

earn interest on money that already earned interest. This process is called compounding.

Paying Interest

When you borrow money, you generally have to pay interest. You may not notice thatyoure paying interest, especially with loans like home loans and auto loans. The interest

you pay is baked into your monthly payment calculation. With every monthly paymentyou repay a portion of your original loan and a portion of your interest costs.

Calculating Interest

How much interest are we talking about? It depends on a few factors: Interest rate Loan term Loan amount As these inputs increase, so does the amount of interest. To understand what interest does

to your particular situation, run some numbers. Play with a few calculators and figure out

how to optimize your saving and borrowing.
http://banking.about.com/od/loans/a/Loan-Term.htmhttp://banking.about.com/od/loans/a/Loan-Term.htm


16/19

Differences between Commercial and Central Banking

I. Introduction:

Probably the most important industry to any economy is the commercial banking

industry. Commercial banks act as financial intermediaries, taking in deposits from one group in

society and making loans to another group in society. Most commercial banks are corporations

and are therefore in business to make profits. However, because banks are so important to the

economy, and because the element of public trust is so crucial to their well being, the banking

industry is usually highly regulated by the government. Whenever the public loses confidence in

the solvency of a bank, they will rush to the bank and attempt to withdraw their deposited

money. We call this a "bank run". If there are widespread bank runs in the economy, there will

be a severe recession, with many bankruptcies and rising unemployment. This is precisely whatbank regulators want to avoid.

Like all businesses, commercial banks have both assets and liabilities. The major

liabilities of commercial banks are the various deposits which they offer to their customers. In

Taiwan, these include checking deposits, savings deposits, passbook savings accounts, time

deposits, and time saving deposits. Banks can also issue bonds (sometimes called financial

bonds) and borrow funds, both of which act as liabilities to the banks. On the asset side of the

ledger there are three principal items. These include the reserves of the banks, the securitieswhich they hold, and the various loans which they make to borrowers. The difference between

the assets and liabilities of a bank represents its net worth or owners equity.

Commercial banks are important to the economy because they reduce the cost of

transactions between savers and investors, and between consumers and producers. They also

affect the amount of credit extended to borrowers. Finally, they provide a relatively safe and

convenient means for savers to hold their wealth.

II. Asset Management of Banks


17/19

In order to earn a profit, banks must carefully manage the asset side of their balancesheet. Naturally, this involves two factors: (1) the amount of resources which the bank has

available, and (2) the attitude which the bank has towards risk and return. The amount of

resources which the bank has is determined by its capital invested, its retained earnings, and its

deposits. The bank must decide how to allocate its resources among its reserves, securities, and

loans -- that is, its assets.

A bank's reserves are defined as its vault cash plus its money deposited with the central

bank. The central bank acts as a bank for commercial banks. Just as you have a deposit account

with a commercial bank, your bank has a deposit account with the central bank. These deposits

are called reserves. A bank must keep a minimum amount of reserves on deposit with the central

bank. We call these the required reserves. Banks usually keep their total reserves above the

required reserve amount. Excess reserves are defined as total reserves minus required reserves.

Both excess and required reserves are deposited at the central bank.

Commercial banks do not earn interest on their reserves. Therefore, they will not want to

hold a large amount of excess reserves. Required reserves are relatively easy to determine

because they are a percentage of the bank's deposits. Each type of deposit will have a required

percentage called the required reserve ratio. For example, if saving deposits are $100 and the

required reserve ratio for saving deposits is 15%, then the required reserves on such saving

deposits is $15. The required reserve ratios are determined by the central bank.

While it is easy to determine required reserves, it is not easy to determine excess

reserves. If the outlook for the economy is good, then banks may decide to hold less excess

reserves. However, if the economy goes into recession, banks may become more conservative

and decide to hold greater excess reserves. Excess reserves can also be affected by changes in

interest rates.

Commercial banks can also use their resources to purchase securities. Usually, these

securities include government debt, but some countries such as Taiwan allow banks to buy

corporate bonds and stock. Private securities often involve greater risk, but they also have

greater returns to compensate for this higher risk. In Taiwan, banks often buy T-Bills and CD's

issued by the Central Bank of China. They also buy government bonds issued by the Ministry of

Finance, the provincial government, and the city governments. These carry little risk of default,

but there is still the problem of price risk associated with changes in interest rates.


18/19

Commercial banks also earn interest by making loans. These include business loans,

mortgage loans, and consumer loans. Consumer loans include credit extended by the bank for

credit card purchases. Mortgages are long term loans taken out for the purchase of a house or

land. The house or land acts to collateralize the loan. Firms often borrow funds to finance their

inventories, and these inventories act to collateralize the loan. Loans which have collateral are

called secured loans. Loans which do not have collateral are called unsecured loans. Unsecured

loans will have higher interest rates associated with them due to higher risk premiums.

III. The Role of the Central Bank

The central bank of an economy is often called the banker's bank. It accepts deposits

from commercial banks (which we call reserves), it buys securities from and sells securities tocommercial banks, and it makes loans to banks which are short of funds. Moreover, it facilitates

the transfer of funds between banks. The central bank also oversee the operation of banks, and it

often helps to stabilize the foreign exchange markets.

The major goals of the central bank are to provide adequate funds to promote stable

economic growth and a stable price level. It does this by regulating the amount of loanable

reserves in the banking system. The central bank has three major tools which it can use to

accomplish its goals. First, it can change the required reserve ratios. This will not change theoverall level of reserves, but it will affect the amount of excess reserves that can be loaned out by

banks. Second, it can change the interest rate charged banks for loans from the central bank.

This interest rate is called the central bank discount rate (sometimes called the rediscount rate).

Changes in the discount rate can affect the overall level of reserves in the banking system.

Finally, it can buy or sell government securities. When it buys bonds from the banks, this is

called an open market purchase. When it sell bonds to banks or the public, this is called an open

market sale. We call this kind of buying and selling of securities open market operations. Open

market operations can likewise change the overall level of reserves in the banking system. The

central bank's monetary policy consists of decisions on how best to use these three tools.

The central bank has a balance sheet, although it is not a corporation. The assets of the

central bank consists of foreign exchange reserves, loans to commercial banks, gold, and

government bonds. It's liabilities consist of currency, reserves, and securities which it has issued

and sold to banks. Economists are particularly concerned with changes in currency and reserves.

The sum of these two items is called the monetary base (or high powered money). Small


19/19

changes in the monetary base can lead to large changes in the money supply, which is defined as

currency plus commercial bank deposits. The central bank can use its three tools of monetary

policy to affect the level of the monetary base, and thus change the money supply.

Basic differencesThere are certain basic differences between a central bank and a commercial bank. They are:

(i) The central bank is the apex monetary institution, which has been specially empowered to

exercise control over the banking system of the country. The commercial bank, on the contrary,

is a constituent unit of the banking system.

(ii) The central bank does not operate with a profit motive. The primary aim of the central bank

is to achieve the objectives of the economic policy of the government and maximise the public

welfare through monetary measures. The commercial banks, on the other hand, have profit

earning as their primary objective.

(iii) The central bank is generally a state-owned institution, while the commercial banks are

normally privately owned institutions.

(jv) The central bank does not deal directly with the Public. The commercial banks, on the

contrary, directly deal with the public.

(v) The central bank does not compete with the commercial banks. Rather it helps them by acting

as the lender of the last resort.

(vi) The central bank has the monopoly of note-issue, whereas the commercial banks do notenjoy such right.

(vii) The central bank is the custodian of the foreign exchange reserves of the country. The

commercial banks are only the dealers in foreign exchange.

(viii) The central bank acts as the banker to the government, the commercial banks act as bankers

to the general public.

(ix) The central bank acts as the bankers' bank : (a) The commercial banks arc required to keep a

certain proportion of their reserves with central bank ; (b) the central bank helps them at the time

of emergency ; and (c) the central bank acts as the clearing house for the commercial banks. But,

the Commercial banks perform no such function.

clearing all

Documents