The Banking systems and ultimately the banking industry operates on various factors and elements.
However there are five certain and very basic ‘principles’ – if you will – which are the five pillars on which the system of banking is built and which is instrumental in keep it going and viable.
The importance of these five pillars or principles can be understood from the view that, if any one of the pillars falls – the system crumbles.
People who have excess or extra money which they are not spending immediately need someplace safe to keep that money. They have no immediate use of that money, and hence would like to ‘deposit’ it somewhere; somewhere they know their money will be safe and they can easily get it back when required.
People who need extra money than what they have in hand, say for business purpose, of for sending their child to college, or for sudden medical purpose, or for building an extra room in their house – where will they get the extra money?
Will they go and ask everybody in the neighbourhood as to who is willing to give them some cash?!
Thus, Banks play the role of ‘financial intermediaries’ – they mobilize funds from the people who have idle funds (depositors) and give them to the people who are in the need of funds (loan takers).
Everyone saves…well almost everyone…and after PM NaMo’s Jan Dhan Yojana…everyone will save eventually in a bank!
And everyone takes a loan – at least once in a lifetime!
Imagine a scenario where there were no Banks – where would you keep the money? – Where would you go for a loan?
Hence, the role of the Banks as financial intermediaries is a very basic and a very important role.
Banks are not NPOs – Not for Profit Organisations. Banks are very much a commercial organization – with aim to earn profit.
Even though banks have been established to do ‘good’ for the people, it needs to make profits and the more – the better! Here’s why!
Customers need bank statements/locker services/AC Banks/ATMs/Branches in every nook and crony of the city and in every city of the country – then there are employees, their salaries and retirement benefits and pensions! How to meet these vast expenses?
A Bank will not survive if it didn’t earn any income for paying off the above mentioned expenses.
By charging interests on loans/charges for banking services banks earn their income – this is their primary source of income which is used to meet its expenses and plan expansions.
Thus earning profits is very essential for a bank to be able to continue its operations.
Because you know:
a. it’ll be kept safe.
b. you’ll be given some return on it by the Bank.
c. you can get it all back whenever you want it.
Even though you have kept your money in the bank, you know it is still yours and you have full right to demand it back when you want – this is the trust you have on your bank that it is taking care of your money.
If institutions like Banks did not invoke such feeling of trust from the people would they even exist? No! NO organization can ever survive if there is trust deficit!
All those scams we hear of – financial scams that is – always end up exposed and their head scammer in jail. Why? Because one fine day their façade falls – people lose their trust on such ‘investment routes’ and other businesses operating on the same line bear the brunt too.
Thus building and up keeping of the trust factor is very essential in banking business – it a very important pillar – if this pillar develops even a very thin crack – the whole structure is definitely collapsing!
You ask what in the world is ‘liquidity’?
I say, it is the ability of the bank to give loans, to be able to give you the money when you go for cash withdrawals in ATMs and to make you happy with the big amount on maturity of FDs!
What is the one common thing in all the intelligent non-sense I just spewed? – CASH.
Immediate availability of cash – to pay off short term obligations – is liquidity.
Imagine going to your local trusty bank to withdraw some money for Diwali shopping and the person at the counter saying they don’t have cash to give you your money! Oh no – now that’s a dud cracker!
Thus a bank always needs to have cash with them and cash is the most liquid item – it is cash after all! – followed by T-bills of short periods/accounts of a bank with RBI or other banks/debtors/Bills Receivable etc.
Please note land and building or even machineries, cars etc., are not liquid assets, because they cannot be easily converted to cash.
Thus the items which can be easily converted into cash are known as cash equivalents; thus cash and cash equivalents are the backbone of a company’s ‘liquidity’ status.
A Bank always compulsorily needs to have enough liquid assets to meet any demand liability that may arise at any moment. A bank’s business, its trust factor, and its survival will get very badly affected if it weren’t able to meet customer’s demand liabilities.
To ensure Banks always remain in comfortably ‘liquid’, RBI has prescribed compulsory CRR and SLR and LAF (Liquidity Adjustment Facility – for day to day mismatches of liquidity)!
So, now you know why the CRR and SLR! To safeguard the customers interest!
What is long term in any business? I would say staying alive from business point of view is the most important long term object of any business entity!
And to remain functioning and viable in the future, solvency is essential. Long term debts can be many kinds – such as repayment on debentures/bonds/shares issued, employees’ pensions and retirement funds, any legal suit which may/may not result in the bank paying etc.
Long term funds also mean huge outlay or expenditure – sometimes it may even lead to bankruptcy. Imagine – a bank going bankrupt! The horror!
Thus when an entity goes insolvent it enters bankruptcy; however, an entity that lacks liquidity can also be forced to enter bankruptcy even if it is solvent – no money – means bankruptcy.
Thus liquidity and solvency are two very important financial parameters which are important for the functioning of a bank.
I hope the five pillars of intermediation, trust, profitability, liquidity and solvency, which holds up the entire structure of banking, is clear to you.
That rounds up our discussion for today.
Good day and keep the feedbacks coming!
However there are five certain and very basic ‘principles’ – if you will – which are the five pillars on which the system of banking is built and which is instrumental in keep it going and viable.
The importance of these five pillars or principles can be understood from the view that, if any one of the pillars falls – the system crumbles.
Principle 1: Intermediation
The essence of banking – to intermediate between the people who have funds and the people who need funds.People who have excess or extra money which they are not spending immediately need someplace safe to keep that money. They have no immediate use of that money, and hence would like to ‘deposit’ it somewhere; somewhere they know their money will be safe and they can easily get it back when required.
People who need extra money than what they have in hand, say for business purpose, of for sending their child to college, or for sudden medical purpose, or for building an extra room in their house – where will they get the extra money?
Will they go and ask everybody in the neighbourhood as to who is willing to give them some cash?!
Thus, Banks play the role of ‘financial intermediaries’ – they mobilize funds from the people who have idle funds (depositors) and give them to the people who are in the need of funds (loan takers).
Everyone saves…well almost everyone…and after PM NaMo’s Jan Dhan Yojana…everyone will save eventually in a bank!
And everyone takes a loan – at least once in a lifetime!
Imagine a scenario where there were no Banks – where would you keep the money? – Where would you go for a loan?
Hence, the role of the Banks as financial intermediaries is a very basic and a very important role.
Principle 2: Profitability
Banks are not NPOs – Not for Profit Organisations. Banks are very much a commercial organization – with aim to earn profit.
Even though banks have been established to do ‘good’ for the people, it needs to make profits and the more – the better! Here’s why!
Customers need bank statements/locker services/AC Banks/ATMs/Branches in every nook and crony of the city and in every city of the country – then there are employees, their salaries and retirement benefits and pensions! How to meet these vast expenses?
A Bank will not survive if it didn’t earn any income for paying off the above mentioned expenses.
By charging interests on loans/charges for banking services banks earn their income – this is their primary source of income which is used to meet its expenses and plan expansions.
Thus earning profits is very essential for a bank to be able to continue its operations.
Principle 3: Trust
Why would you deposit your hard earned money in a bank?Because you know:
a. it’ll be kept safe.
b. you’ll be given some return on it by the Bank.
c. you can get it all back whenever you want it.
Even though you have kept your money in the bank, you know it is still yours and you have full right to demand it back when you want – this is the trust you have on your bank that it is taking care of your money.
If institutions like Banks did not invoke such feeling of trust from the people would they even exist? No! NO organization can ever survive if there is trust deficit!
All those scams we hear of – financial scams that is – always end up exposed and their head scammer in jail. Why? Because one fine day their façade falls – people lose their trust on such ‘investment routes’ and other businesses operating on the same line bear the brunt too.
Thus building and up keeping of the trust factor is very essential in banking business – it a very important pillar – if this pillar develops even a very thin crack – the whole structure is definitely collapsing!
Principle 4: Liquidity
This, my friends is my personal favorite pillar – liquidity.You ask what in the world is ‘liquidity’?
I say, it is the ability of the bank to give loans, to be able to give you the money when you go for cash withdrawals in ATMs and to make you happy with the big amount on maturity of FDs!
What is the one common thing in all the intelligent non-sense I just spewed? – CASH.
Immediate availability of cash – to pay off short term obligations – is liquidity.
Imagine going to your local trusty bank to withdraw some money for Diwali shopping and the person at the counter saying they don’t have cash to give you your money! Oh no – now that’s a dud cracker!
Thus a bank always needs to have cash with them and cash is the most liquid item – it is cash after all! – followed by T-bills of short periods/accounts of a bank with RBI or other banks/debtors/Bills Receivable etc.
Please note land and building or even machineries, cars etc., are not liquid assets, because they cannot be easily converted to cash.
Thus the items which can be easily converted into cash are known as cash equivalents; thus cash and cash equivalents are the backbone of a company’s ‘liquidity’ status.
A Bank always compulsorily needs to have enough liquid assets to meet any demand liability that may arise at any moment. A bank’s business, its trust factor, and its survival will get very badly affected if it weren’t able to meet customer’s demand liabilities.
To ensure Banks always remain in comfortably ‘liquid’, RBI has prescribed compulsory CRR and SLR and LAF (Liquidity Adjustment Facility – for day to day mismatches of liquidity)!
So, now you know why the CRR and SLR! To safeguard the customers interest!
Principle 5: Solvency
Where liquidity was the ability to meet short term obligations, ‘Solvency’ is the ability to meet long term obligations.What is long term in any business? I would say staying alive from business point of view is the most important long term object of any business entity!
And to remain functioning and viable in the future, solvency is essential. Long term debts can be many kinds – such as repayment on debentures/bonds/shares issued, employees’ pensions and retirement funds, any legal suit which may/may not result in the bank paying etc.
Long term funds also mean huge outlay or expenditure – sometimes it may even lead to bankruptcy. Imagine – a bank going bankrupt! The horror!
Thus when an entity goes insolvent it enters bankruptcy; however, an entity that lacks liquidity can also be forced to enter bankruptcy even if it is solvent – no money – means bankruptcy.
Thus liquidity and solvency are two very important financial parameters which are important for the functioning of a bank.
I hope the five pillars of intermediation, trust, profitability, liquidity and solvency, which holds up the entire structure of banking, is clear to you.
That rounds up our discussion for today.
Good day and keep the feedbacks coming!
