AHSEC - Class 12: Banking Notes | Employment of Funds for Feb' 2022 - 23 Exam

Short Questions and Answers (1/2 Marks each)

1. What do you mean by employment of funds by a bank?                          2000

Ans: Use of funds collected by a banking institution in various types of assets such as loans and advances to customer, investment in securities and deposit with central & other banksetc with a view to earn profit to run the business is called employment of funds.

2. What is earning and non-earning assets?

Ans: Earning Assets are those which earn money for banks such as Cash Balance with central and other banks, money at call and short notice, investments, loans and advances.

Assets of a bank which do not make any contributions to the earning capacity of a bank is called non-earning assets. For example: cash in hand, non banking assets and fixed asset of the bank such as building, furniture etc.

3. Write the full form of SLR and CRR.

Ans: Statutory Liquidity Ratio and Cash Reserve Ratio

4. Give the meaning of Cash Reserve Ratio.                                        2013, 2020

Ans: All the banks operating in a country, beside, cash in hand must maintain statutory cash reserve in the Reserve Bank of India against their time and Demand liabilities which is called cash reserve ratio. The Cash Reserve Ratio (CRR) refers to the portion of total deposits of a commercial bank which it has to keep with the RBI in the form of cash reserves. Present CRR is 4%.

5. Give the meaning of Statutory Liquidity Ratio.                             2006, 08, 11, 14, 16

Ans: Statutory Liquidity ratio of the total deposits of a bank which it has to maintain with itself in the form of liquid funds like government securities and cash in hand at any given conditions and point of time. Present SLR is 19.25%.

6. What do you mean liquidity of asset?              

Ans: Liquidity of assets means ability to convert the asset into cash within a short period of time and without any loss in its value. 

7. The provision relating to maintenance of cash reserve ratio by banks is contained in:  Ans: RBI Act.

8. A transferable letter of credit cannot be transferred more than once. Ans: True

9. What are various modes of creating charge?

Ans: Lien, Pledge, Mortgage, Assignment and Hypothecation.

10. What is lien?

Ans: Lien is the right of the lender or creditor to retain the possession of the property given as security by the borrower or debtor until the debt is satisfied.

11. What is pledge?

Ans: Pledge is the delivery of goods as security for payment of a debt by the borrower or debtor known as pledger to the lender or creditor known as pledgee.

12. Define Mortgage.                                     2012

Ans: A mortgage is the transfer of an interest in specific immovable property for the purpose of securing the payment of money advanced or to be advanced by way of loan. This type of loan is long term in nature. If the borrower fails to repay the loan with interest amount, then the banker has the right to recover the loan amount by disposing the property mortgaged.

13. What is assignment?

Ans: Assignment is a process in which an existing or future right over property or money is transferred by one person to another person. This is applicable in case of fixed deposit in a bank, interest of a partner in dissolved firm etc.

14. What is the meaning of Hypothecation?                       1999, 09, 11, 13, 2018

Ans: Hypothecation is mode of creating a charge against a movable property for payment of a debt without transferring the possession of the property. The goods remain at the disposal and in the godown of the borrower. The bank is given access to goods whenever it so desires. The instrument which creates such charge is called the ‘letter of hypothecation’ which is handed over by the borrower to the creditor. This document empowers the banker to take possession of the property whenever he wishes to do so and sell the property if required to clear the dues.

15. Define bearer bonds and gilt-edged securities.

Ans: Bearer bonds are debt instruments which are issued by government or corporation without the name of the holder of the bond.

Government securities or instruments issued by the government and blue chip companies to borrow money are called gilt-edged securities. For example, TBs, Commercial Papers etc.

16. Write a short note of Traveler’s Letter of Credit.

Ans: Traveler’s letters of Credit are issued by the banks for the convenience of the travelers. The travelers are saved from the risk of traveling with heavy cash with them. The facility of such letter of credit can be available both for traveling in or outsides the country.

17. Write short note on Commercial Letter of Credit.

Ans: Commercial Letter of Credit is used of financing foreign trade. Commercial Letter of Credit is used by different banks in different countries in different languages.

Long Answer Type Questions (Marks: 3/5/8 Marks each)

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Also Read:

1. HS 12 Banking Chapter wise Notes

2. AHSEC Class 12 Banking Question Papers From 2012 Till Date

3. AHSEC Class 12 Banking Solved Question Papers From 2012 Till Date

4. Banking Chapter wise MCQs

5. Class 12 Banking Important Questions and Question Bank

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Q.1. What is liquidity (2018) and liquid assets? Discuss the different forms of liquid assets.       2017

Ans. Liquidity means the ability of the bank to give cash on demand. Generally, the business of the bank depends upon the confidence of depositors on the bank and the depositors feel confident only when they are sure that they can withdraw their money any time. Therefore, every bank must keep the adequate amount of liquid assets.

Liquidity depends on the availability of liquid assets. Liquid assets are those assets which can be easily converted into cash without loss the money and time. More the liquid assets, greater will be the liquidity and vice versa. The liquid assets of a bank are composed of the following:

a)      Cash in hand: Cash is the most liquid asset and is considered as the first line of defense. Every bank keeps certain amount of cash in order to meet the cash requirements of its depositors.

b)      Statutory cash balances with the Reserve Bank: Commercial banks have to maintain statutory cash reserve in the Reserve Bank of India against their time and Demand liabilities which is called cash reserve ratio. The Cash Reserve Ratio (CRR) refers to the portion of total deposits of a commercial bank which it has to keep with the RBI in the form of cash reserves. Present CRR is 4%.

c)       Balances with other banks: Besides The bank keep cash deposited with other banks in current account besides the central bank of the country. This money can be withdrawn by the banks as and when the need arises. These deposit either carry no interest or interest at a very nominal rate.

d)      Money at call and short notice: This refers to loans which are recoverable by the bank on demand or at a very short notice. The loans are for a maximum period ranging from, 1 day to 14 days. Such loans are earning as well as highly liquid assets which can be converted into cash quickly and without loss.

e)      Investment: Banks also invest greater part of their resources in different kinds of shares, stocks and securities. Securities include securities of the central and state government, treasury bills and bonds etc which can be easily converted into cash without the loss of money and time.

Q.2. Explain the significance of Liquidity. What are the factors affecting quantum of cash balance of banks? 2012, 2017

Ans: Significance of liquidity: The term liquidity has special significance in banking business. The deposits accepted by a bank are largely payable on demand. In other words, the depositor has the right to withdraw money as and when they needs. The banker must pay his depositors on demand. In case a bank fails to pay cash on demand to the depositors on account of shortages of liquid cash, it may lose the trust and confidence of the public which will ultimately result in the closure of the bank. Thus, the banker must safeguard his position by maintaining sufficient liquid assets with him to meet the demand of the depositors for cash.

Factors determining the cash balances: The following factors help the banks to decide the quantum of cash balances to be maintained:

1)      Banking habit: Banking habits play a significant role in determining the cash balances of a bank. Banking habits refers to the utilisation of banking services by the public. If the people have e-banking habits then the use of cash in transaction is reduced and the banks need to keep lesser amount of liquid cash.

2)      Structure of banking: The banking structure of the country also influence the liquidity requirements of the bank. In a branch banking system, the banks can function with less cash reserves because in case of emergency cash can be transferred from one branch to another. Whereas in unit banking system higher cash reserve is required.

3)      Nature of bank accounts: The nature of deposit accounts viz. savings, current or fixed accounts affect the amount of cash balance to be kept by the banks. In case of fixed deposit account holders, the bank can manage with less cash balance as against current account where it must keep larger cash balance.

4)      Type of depositors: The type of depositors is another determinant of cash balance of the banks. If the majority of the depositors of the bank are business firms, corporations, schools, college etc. the bank will have to maintain high liquidity because of unpredictable. On the other hand, if the deposits are mostly by individual customers and are of personal nature, the bank can operate with less liquid cash.

5)      Nature of advances: The nature of advances of bank i.e. loans, cash credit, overdraft and purchasing and discounting of bills also affect the size of the cash balances of the bank.

6)      Seasonal requirements: The banks have to take into consideration the seasonal requirements of credit from the customers. It is an established fact that during busy seasons e.g. festivals, sowing, harvesting seasons, there is increased demand for credit. Hence, the banks should keep large amount of cash.

7)      Nature of business condition: The prevailing business condition in the country has its influence on the cash balances of a bank. When the condition is good, there is greater demand for cash. On the other hand, when the business is dull there is less borrowing from the banks.

8)      Existence of clearing house arrangements: Cash balance of a bank also depends upon the availability of clearing house facilities. Clearing house settles inter-bank claims. If there is a clearing house, inter-bank claims can be easily settled and the banks need not keep large cash balances.

Q.3. Discuss briefly about the different types of Loans and advances granted by a commercial bank.  11, 14, 16

Ans: Different types of loans and advances granted by a commercial bank are discussed below:

(i)      Cash Credit (2020): Cash Credit is a type of advance wherein a banker permits his customer to borrow money upto a particular limit by a bond of credit with one or more securities. The advantage associated with this system is that a customer can withdrawn money as and when required. The bank will charge interest only on the actual amount withdrawn by the customer. Many industrial concerns and business houses borrow money in this form.

(ii)    Overdraft (2014): An overdraft is an arrangement by which the customer is allowed to overdraw from his account. It is granted against some collateral securities. The facility to overdraw is allowed through current account only. Interest is charged on the exact amount of overdrawn subject to the payment of minimum amount by way of interest.

(iii)   Loan: Loan is an advance in lump sum amount the whole of which is withdrawn and is supported to be rapid generally wholly at one time. It is made with or without security. It is given for a fixed period at in agreed rate of interest. Repayments may be made in installments or at the expiry of a certain period.

(iv)  Discounting of Bills of Exchange: The bank also gives advances to their customers by discounting their bills. The net amount after deducting the amount of discount is credited to the account of customer. The bank may discount the bills with or without any security from the debtor in addition to the personal security of one or more person already liable on the bill. Advantages of discounting of bills are given below:

1)      Certainty of payment of the advance to the banker.

2)      Definite period of time of payment of the advance.

3)      The banker can obtain refinance facility from other financial institutions.

Q.4. Distinguish between loans, cash credit and overdraft.                         2017

Ans: Difference between Loan, Cash Credit and Overdraft:

Q.5. Discuss the lending principles followed by commercial banks while granting loans to customer.  12, 13, 15, 18, 19

Ans: The principles of sound lending by commercial banks are:

1)      Safety of principal: The most important rule for lending/granting loans is the safety of funds. This is so because the banks earn income through these loans and advances. In case the bank does not get back the loans granted by it, it might fail. A bank cannot and must not sacrifice the safety of its funds to get higher rate of interest. Banks must ensure the creditworthiness of the borrower before lending.

2)      Marketability or liquidity: The second important principle of granting loan is liquidity. Liquidity means possibility of converting loans and advances into cash without loss of time and money. Banks are essentially dealers in short term funds and therefore, they lend money mainly for short term period. The banker should see that the borrower is able to repay the loan on demand or within a short notice.

3)      Return or Profitability: Return or profitability is another important principle. The funds of the bank should be invested in securities to earn highest return, so that it may pay a reasonable rate of interest to its customers on their deposits, reasonably good salaries to its employees and a good return to its shareholders. However, a bank should not sacrifice either safety or liquidity to earn a high rate of interest.

4)      Purpose of the loan: Before granting loans, the banker should examine the purpose for which the loan is demanded. If the loan is granted for productive purpose, thereby the borrower will make much profit and he will be able to pay back the loan. In no case, loan is granted for unproductive purpose.

5)      Diversification: ‘One should not put all his eggs in one basket’ is an old proverb which very clearly explains this principle. A bank should not invest all its funds in one industry. In case that industry fails, the banker will not be able to recover his loans. Hence, the bank may also fail. According to the principle of diversification, the bank should diversify its investments in different industries and should give loans to different borrowers in one industry. It is less probable that all the borrowers and industries will fail at one and the same time.

6)      Security: A banker should grant secured loans only. In case the borrower fails to return the loan, the banker may recover his loan after realizing from the sale of security. In case of unsecured loans, the chances of bad debts will be very high. Security conditions are different in different banks.

7)      Margin Money: The banker must properly value the security against which loan is granted. There must be sufficient margin between the amount of the loan and the value of the security. If adequate margin is not maintained, the loan might be unsecured in case the borrower fails to pays the principle and the amount of the interest.

8)      National policies: Banks have certain social responsibilities towards society also. The banks have to take into account the economic and social priorities of the country beside safety, liquidity and profitability. While formulating the lending policy, the banks are guided by the government policies in relation to disbursal of credit. Thus, national interest and policies are influence the lending decisions of banks.

In conclusion, it may be said that due consideration of all the principles are necessary, while evaluating a loan proposal. 

Q.6. What do you mean by investments? Mention the principles of sound investment. 2003, 05, 08, 2014, 2016, 2017

Ans: Investment: The term investment means employment of funds to buy an asset. Here investment means employment of funds by the banks to buy securities from the market. The securities which are purchased by the banker from the market include:

a)      Government securities: These are the securities which are issued by the governments to raise funds. These securities are the safest of all securities because these are guaranteed by the government. Government securities may be of three types: (i) Stock, (ii) Bearer bonds and (iii) Promissory notes.

b)      Semi-government securities: These are the securities which are issued by semi-govt. organisations like Municipal Corporations, Port Trusts, State Financial Institutions etc and these securities include debentures or bonds.

c)       Industrial securities: There are the securities which are issued by industrial or business concerns. Bank invests a small percentage of its funds in the shares and debentures issued by these industrial concerns.

Besides these securities, banks also invest in fixed deposits, units and capital of various financial institutions. However, amongst all these, a marked preference of the banker is noted in favour of government and semi-government securities. Investment by banks in these securities constitutes the “third line of defense” of the banks.

Principles of Sound Investment

Banks should follow some basic principles at the time of investing funds. This ensures efficient and long term working of the banks. Some of the basic principles of sound investments are as follows:

1)      Safety of principal: The most important rule for investment of funds is the safety of funds. A banker deals in borrowed funds and therefore his main consideration is safety of principal invested in securities. Banks must ensure the solvency and sound financial position of the companies in which investments is made. The government and semi-government securities are the safest securities because they are guaranteed by the government.

2)      Marketability or liquidity: The second important principle of sound investments is liquidity. Liquidity means possibility of converting investments into cash without loss of time and money. Thus, the banker should see that the security in which he invests his funds possesses a ready market i.e. they can be sold in the market without loss of time and money.

3)      Return or Profitability: Return or profitability is another important principle. The funds of the bank should be invested in securities to earn highest return, so that it may pay a reasonable rate of interest to its customers on their deposits, reasonably good salaries to its employees and a good return to its shareholders. However, a bank should not sacrifice either safety or liquidity to earn a high rate of interest.

4)      Price stability: The price of security selected by the banker should remain stable. The safety of investments depends on the stability in the prices of securities. Banker is not a speculator and hence his object of buying security should not be to gain on wide fluctuations in prices of the securities and should prefer those securities whose prices remain fairly stable over a period of time. The Prices of government securities remain stable and do not fluctuate. .

5)      Diversification of Investment: One should not put all his eggs in one basket’ is an old proverb which very clearly explains this principle. A bank should not invest all its funds in one particular industry or security or company. In case that industry or company fails, the banker will not be able to recover his funds. Hence, the bank may also fail. So, the bank should diversify its investments in different industries and should invest in variety of companies with sound financial record.

6)      Refinance: To ensure the liquidity of his investments the banker has to see that the security is eligible to obtain refinance from the Central Bank and other refinancing institutions.

7)      Duration: In addition to the above factor, a banker also considers the duration and denomination of security and its future earnings prospects.

                In conclusion, it may be said that for a banker the government and semi-government securities are most ideal for investment of funds. Government securities with virtually no risks, have a ready market, are eligible for refinance and bring reasonably good return.

Q.7. What do you mean by Letter of Credit? Mention the various parties of a letter of credit.    2020

Ans: A Letter of Credit is an assurance document issued by the bank of the importer in favour of the exporter specifying that the bills of exchange drawn by the exporter on the importer will be met upto a specified amount in case the importer fails to honour his commitment. Letter of credit is mainly used as a means to make payment in international trade. In actual practice, a letter of credit means, “a document issued by a banker authorizing the banker to whom it is addressed to honour the bills of the person named therein to the extent of certain amount.”

The various parties of a letter of credit are:

a)      The Buyer/Importer: The buyer who is the importer applies to the bank for a letter of credit.

b)      The Beneficiary: The seller, who is exporter, is the beneficiary of the letter of credit.

c)       Issuing Bank: The bank which issues the letter of credit at the request of the buyer is the issuing bank.

d)      Paying Bank: The paying bank is the bank on which the bill or draft is drawn.

8. What the various types of letter of credit?                     2020

Ans: Various types of letter of credit are: 

(A) Traveler’s Letter Credit.

a)      Circular Note.

b)      Circular Cheque.

c)       Traveler’s Cheques.

(B) Commercial Letter of Credit.

a)      Documentary and clean letter of credit.

b)      Revocable and irrecoverable Letter of Credit.

c)       Fixed and revolving Letter of Credit.

d)      Confirmed and Unconfirmed Letter of Credit.

e)      Red clause Letter of Credit.

f)       Transferable and Non-transferable letter of credit.

g)      With and Without Resource Letter of credit.

Q.9. Mention the nature and importance of letter of credit (L/C).

Ans: Characteristics of letter of credit:

a)      It is issued by banks only.

b)      It is issue for a specific period of time and for a specific amount.

c)       There are four parties in a letter of credit viz, the importer, issuing bank, paying bank and the beneficiary.

d)      It is not affected by exchange rate fluctuations.

Importance of letter of credit: It is beneficial to the seller as well as buyer. Advantages of letter of credit are stated below:

a)      It ensures the beneficiary about the certainty of payment.

b)      It avoids the risk of dishonour of bill.

c)       It is not affected by exchange rate fluctuations.

d)      It makes possible immediate negotiation of the bill.

e)      It enables the importer to get banker’s credit to import goods.

Precautions to be taken while issuing letter of credit:

a)      The banker should ascertain the creditworthiness of the importer.

b)      The banker should examine the validity of the import license.

c)       The banker should examine the documents attached by the beneficiary.

Q.10. Write a brief note on Cash Balance, Cash Credit and Cash Reserve.     2012, 2014, 2016

Ans: Cash Balances: Cash balances are the most liquid assets of a bank.  A cash balance refers to the following: 

a)      Cash held by the bank itself.

b)      Cash with the Central Bank and

c)       Cash with other banks in current account.

These cash balances are called the ‘first line of defense’ of the bank as they defend the solvency, reputation and goodwill of the bank. In technical language it is known as ‘vault cash’. With the help of these cash balances the bank can meet the demand of the customers immediately to customer’s satisfaction. But deciding the amount of cash in hand is a complex task. Cash in hand is an idle asset and does not earn any income for the bank, but at the same time it is very important for the banker to pay back his depositors’ money.

In case of excess cash balances, the bank will lose interest on the excess portion of the cash balances, while in case of deficit balances, the banker may find himself in an embarrassing position. Hence, it is important that the banks keep an optimum level of cash balances-neither excess nor deficit. The banker has to follow the legal requirements and is to be guided by the conventions followed by the banking community in this regard.

Cash Credit (2016): Cash Credit is a type of advance wherein a banker permits his customer to borrow money upto a particular limit by a bond of credit with one or more securities. The advantage associated with this system is that a customer can withdrawn money as and when required. The bank will charge interest only on the actual amount withdrawn by the customer. Many industrial concerns and business houses borrow money in this form. Cash credit limits are fixed once a year. Hence it gives rise to the tendency of fixing a higher limit than the amount of funds required by the customer throughout the year. In times of credit shortage the customer may misutilise the normally unutilized credit gap.

Cash Reserve: All the banks operating in a country, beside, cash in hand also maintain certain cash with the Central Bank of the country. This is called cash reserve. In fact, maintenance of these cash reserves has been made compulsory by the Law and the Central Bank has been given the power to determine the percentage of cash to be kept as reserves. This is termed as cash reserve ratio. In case of emergency these cash reserve can be utilised by the banks to safeguard their liquidity position.

In India, under Sec 42(1) of the Reserve Bank of India Act, 1934, every scheduled bank is required to maintain with the Reserve Bank a minimum cash reserve as percentage of the time and demand liabilities of the banks in India. The rate varies between 3% and 20%. In practice the bank keep a higher percentage of cash reserve with the RBI then what the RBI prescribes at different times. The RBI pays interest on the cash reserve maintained in excess of the statutory minimum of 3% at a rate equivalent to the rate of interest payable by the banks in case of savings bank deposit accounts.

Difference between Cash Balance and Cash Reserve