Page 111 - DCOM208_BANKING_THEORY_AND_PRACTICE

Banking Theory and Practice

Notes 4. Banker must always insist upon collaterals, margins and guarantees in addition to the
personal promise of the borrower.
Thus, a bank should lend money after ensuring its full safety of repayment; otherwise the
banker will not be in a position to repay the deposits. Consequently, he will lose public confidence
and thus subsequently may get ruined.

7.4.2 Liquidity

Liquidity means ease of conversion of an asset into cash. As a major part of commercial bank
liabilities is payable either on demand or on short notice, the banker should ensure that the
loans are liquid. Liquidity, thus, signifies the readiness with which the bank can convert its
assets into cash with no or insignificant (small) loss.
1. A loan will be liquid if it has been given for a short period to finance some purchases of
stock, raw materials, etc.
2. A banker should give short-term advances which can be recalled in time to satisfy the
demands of the depositors.

3. Bank should not lend short period funds for a long time. As in that case, the loans and
advances will tend to be less liquid, and it would be a great problem for it to realise cash
in case of an emergency.
4. Loans, to be liquid, should be given against the security of quickly realizable assets so that
in case the borrower defaults in repayment; these might be readily converted into cash.
5. Cost of borrowing from the Reserve Bank of India:
(i) It is related to the net liquidity ratio.
(ii) Net liquidity ratio is the ratio of the net liquid assets of the borrowing bank to its
aggregate demand and time liabilities.
(iii) The net liquidity ratio of a bank must be equal to the specified limit or above it, so
that it may obtain a loan from the Reserve Bank at the bank rate.
(iv) With every one percent drop in the net liquidity ratio of the borrowing bank, the
cost of lending by the Reserve Bank goes up by one percent.

7.4.3 Diversification of Risks

A banker should adhere to the principle of diversification (spread) of risks while lending funds.
Diversification implies the dispersal (lending) of funds over a large number of borrowers and
borrowing firms situated in different parts of the country. In other words, a bank should not
lend money to a few entities. Also, a bank should lend money in different types and ranges of
interest whereby some are risky, some with less risk and some risk-free.
Purposes of this principle are:
1. Minimizing the risk inherent in the grant of loans.
2. It is a defensive policy to protect the bank against risk.
3. Also, a device for increasing the average return on a fund that might otherwise, for the
sake of safety, be confined to risk-free assets providing little or no return.
4. A banker should remember that if he puts all his eggs in one basket he may lose all of
them together at a time. In view of this, he should avoid concentrating the bank’s funds in
a few customers. If these few customers do not pay then the bank may go bankrupt.

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