Investment Policy – Liquidity Versus Profitability

Investment Policy – Liquidity Versus Profitability

The primary purpose of a commercial bank like all other business is to make profit. Hence, in its investment policy or acquisition of assets, it will be influenced by the consideration of profit. But a bank is also a very sensitive institution and must always keep in view its one security.  Since a bank acquires assets keeps mainly out of the deposits of the public, its operations, survival and continued existence will therefore depend upon the confidence of the depositing public. Hence safety first is the rule and after it then banks tries to make maximum profit.

This safety rule can be discussed under two headings liquidity and shift ability. Liquidity has been defined as a company’s capacity to produce and stock enough cash on as it is demanded. A bank should render on obligation to repay its customers balances either on demand or whenever amounts credited to them become due. For this reason a bank must hold some cash (Which may include balances at central bank and with other banks) and keep a further proportion of its assets in form that can readily be converted into cash. It is only this way that confidence in the banking system can be maintained.

Shift ability in Investment Policy implies that the type of assets acquired by a bank should of the country particularly in times of crisis or emergency when a bank faces the threat of a run. An asset is shift able, to the central bank if it fulfills certain eligibility rules. In general, a prudent banker will always prefer securities which can be quickly disposed of all in the market and which are easily shift able.

It is easy to see therefore from the fore going that a good investment policy should be one that balances profitability with liquidity. Both objectives appear contradictory in the sense that a bank that seeks maximum profits may invest its funds in lines which are highly remunerative but which are risky in the same sense if not being easily convertible to cash when the need arises whereas a bank that is swayed by safety considerations may not earn much profits because safe investments are generally not very remunerative.

This safety is attained when the banker keeps a high proportion of cash reserves against deposits. Too much caution will mean too little profit while reckless lending may endanger the safety is attained in safety of the bank itself. A wise banker therefore strives to keep adequate cash balances to meet the daily and seasonal demands of depositors of cash demand, at the same time he or she should make such loans and investments which are safe and which promise good earnings.

Liquid Assets Of Banks (Investment Policy)

Traditionally, the banking system regards as assets a liquid assets if it can be readily sold or marketed, in essence if the owner can count with absolute certainty on turning it into cash at very short count with notice and without loss of value.

In that light cash is the most perfect liquid assets, but it is useless from the point of view of profit liquid assets of the bank, other liquid assets includes money at call and short notice. This is a highly liquid assets includes money at cal and short notice. This is a highly liquid assets in that the bank at very short notice can recall it. Bills come next in the order of liquidity since they are short term securities with little or no risk of loss.

Government securities other than bills of exchange and treasury bills are also highly liquid but their prices are liable to fluctuate resulting in capital gain or loss so that they are not easily regarded as liquid assets. From this explanation, it becomes obvious that of liquid assets, there are those which are apparently liquid and those which are really liquid.

Factors Determining Liquidity Of Banks (Investment Policy)

The central bank of a country has power to and often determines the liquidity of the commercial banking system. The top management of a bank can also determine the liquidity of the bank given the nature of business conditions in such a country.

The amount of liquid assets which banks maintain depends on many factors such as;

1. The extent of liquid reserve considered essential by or for the banking community through regulation or by convention.
2. The banking habits of the people which in turn depends upon the nature of the economy. In advanced economics where people have developed the chequing habit, the use of cash is considerably reduced whereas in under developed economics, without a developed banking culture cash transactions still dominate hence the use of cheque is not commonly practiced. In such conditions banks are forced to maintain large liquid reserves.
3. The size of the liquid reserve will depends upon the number and magnitude of monetary transaction in the country such as peak or festive seasons when banks are called upon to finance a large number of transactions hence they will have to keep a large percentage of cash.
4. The nature of business conditions in essence inflation deflation or depression influences the amount of liquidity in the banking system. During inflationary periods, a small percentage of cash is sufficient to support large deposits while during depression with general pessimism pervading the whole place, businessmen do not easily borrow and thus their cash reserve to reduce the possibilities of a run on banks.
5. The structure of the banking system can influence the amount of liquid maintained. Under a breach banking system, cash reserves can be centralized in the head office and branches can manage with smaller proportion of cash reserves. In the unit banking system, every bank is an independent unit and thus keeps a higher degree of liquidity.
6. Finally where the money on Investment Policy is marketed, it is well organised by it, it will then be easy for banks to buy and sell securities easily. In such a case, a commercial bank can afford to have a large percentage of government securities in its portfolio and a low liquidity ratio.

The liquidity of commercial banks can be increased or decreased by the banks themselves, the general monetary authorities and the general public. The general public can do this through their desire to hold more or less cash or through their preference for cash or government securities. The central bank who constitute the monetary authorities of a country can alter bank liquidity by changing the supply of cash at the ratios as well as the liquidity ratio. The banks themselves may prefer to maintain a higher or lower degree of liquidity depending on the nature of business.

Commercial Banks Creation Of Credit

Creation of credit is one of the most important and significant functions of a modern bank. Let us examine this significant function by first acquainting ourselves with the concept and control of banks over deposits. Bank deposits are of two major types, current or demand deposits used mostly by industrialist, merchant and other business and individuals to settle debts.

The current deposit can also be referred to as cash deposit or chequing deposit because it involves the extensive use of cheques. The other type of bank deposit is the saving deposits which are usually left with banks as a form of saving or investments since they are not meant for current transactions, the savings deposit earn interest from the banks. Savings deposit have also a variant known as fixed deposits. These are deposit of money, which can be withdrawn only after a given period of time.

Generally it is easy to understand the motives why people keep their fund with the banks. Money kept in the bank for the sake of convenience and to meet excess of payments over receipts. Current deposits are useful for meeting payments immediately while savings deposits are kept to settle debts in future. It is the customer who decides which of the deposit accounts he or she wishes to lodge his or her money including matters concerning the varying of such accounts.

Primary And Derivative Deposits (Investment Policy)

Primary deposit refers to those deposit created when people lodge their cash with the banking system in form of say demand deposit s. Thus one form of money (cash with the public) changes into another form of money (bank money). As we said the initiative for creating these deposits is usually token by the customers and the deposit are known as primary deposit.

Primary deposits bring cash to the banking system. Using this cash, the banking system buys assets from the market (in essence, bills, bonds, debentures etc) or it lends to business men and industrialists. Note then, that whenever a banks buys assets from the market or advances loans to prospective borrowers, it does not give cash to them but creates demand deposits in their name. These deposit so created, are referred to as secondary or derivative for creating these deposit comes from the banking system.

In the balance sheet, the bank are anxious to show that their position is very sound. The soundness of a bank whether it is properly run or not will be clearly reflected in the distribution of the banks fund on different types of assets. Hence a good banker is one who follows a wise investment policy, in essence a policy which will bring in maximum profits for the shareholders and yet provide maximum security to the depositors.

Questions 

Question 1 – How do banks monetize debts?

Question 2 – Evaluate branches of the commercial bank system with specific from the page branch banking, making reference its merit

Question 3 – access the merit and demerit of branch banking from the page branch banking