There are probable contradictions between the objectives of liquidity, safety and profitability when linked to a commercial bank. Efforts have been made by economists to resolve these contradictions by laying down some theories from time to time.
In fact, these theories monitor the distribution of assets considering these objectives. These theories are referred to as the theories of liquidity management which will be discussed further in this chapter.
The commercial loan or the real bills doctrine theory states that a commercial bank should forward only short-term self-liquidating productive loans to business organizations. Loans meant to finance the production, and evolution of goods through the successive phases of production, storage, transportation, and distribution are considered as self-liquidating loans.
This theory also states that whenever commercial banks make short term self-liquidating productive loans, the central bank should lend to the banks on the security of such short-term loans. This principle assures that the appropriate degree of liquidity for each bank and appropriate money supply for the whole economy.
The central bank was expected to increase or erase bank reserves by rediscounting approved loans. When business started growing and the requirements of trade increased, banks were able to capture additional reserves by rediscounting bills with the central banks. When business went down and the requirements of trade declined, the volume of rediscounting of bills would fall, the supply of bank reserves and the amount of bank credit and money would also contract.
These short-term self-liquidating productive loans acquire three advantages. First, they acquire liquidity so they automatically liquidate themselves. Second, as they mature in the short run and are for productive ambitions, there is no risk of their running to bad debts. Third, such loans are high on productivity and earn income for the banks.
Despite the advantages, the commercial loan theory has certain defects. First, if a bank declines to grant loan until the old loan is repaid, the disheartened borrower will have to minimize production which will ultimately affect business activity. If all the banks pursue the same rule, this may result in reduction in the money supply and cost in the community. As a result, it makes it impossible for existing debtors to repay their loans in time.
Second, this theory believes that loans are self-liquidating under normal economic circumstances. If there is depression, production and trade deteriorate and the debtor fails to repay the debt at maturity.
Third, this theory disregards the fact that the liquidity of a bank relies on the salability of its liquid assets and not on real trade bills. It assures safety, liquidity and profitability. The bank need not depend on maturities in time of trouble.
Fourth, the general demerit of this theory is that no loan is self-liquidating. A loan given to a retailer is not self-liquidating if the items purchased are not sold to consumers and stay with the retailer. In simple words a loan to be successful engages a third party. In this case the consumers are the third party, besides the lender and the borrower.
This theory was proposed by H.G. Moulton who insisted that if the commercial banks continue a substantial amount of assets that can be moved to other banks for cash without any loss of material. In case of requirement, there is no need to depend on maturities.
This theory states that, for an asset to be perfectly shiftable, it must be directly transferable without any loss of capital loss when there is a need for liquidity. This is specifically used for short term market investments, like treasury bills and bills of exchange which can be directly sold whenever there is a need to raise funds by banks.
But in general circumstances when all banks require liquidity, the shiftability theory need all banks to acquire such assets which can be shifted on to the central bank which is the lender of the last resort.
The shiftability theory has positive elements of truth. Now banks obtain sound assets which can be shifted on to other banks. Shares and debentures of large enterprises are welcomed as liquid assets accompanied by treasury bills and bills of exchange. This has motivated term lending by banks.
Shiftability theory has its own demerits. Firstly, only shiftability of assets does not provide liquidity to the banking system. It completely relies on the economic conditions. Secondly, this theory neglects acute depression, the shares and debentures cannot be shifted to others by the banks. In such a situation, there are no buyers and all who possess them want to sell them. Third, a single bank may have shiftable assets in sufficient quantities but if it tries to sell them when there is a run on the bank, it may adversely affect the entire banking system. Fourth, if all the banks simultaneously start shifting their assets, it would have disastrous effects on both the lenders and the borrowers.
This theory was proposed by H.V. Prochanow in 1944 on the basis of the practice of extending term loans by the US commercial banks. This theory states that irrespective of the nature and feature of a borrower’s business, the bank plans the liquidation of the term-loan from the expected income of the borrower. A term-loan is for a period exceeding one year and extending to a period less than five years.
It is admitted against the hypothecation (pledge as security) of machinery, stock and even immovable property. The bank puts limitations on the financial activities of the borrower while lending this loan. While lending a loan, the bank considers security along with the anticipated earnings of the borrower. So a loan by the bank gets repaid by the future earnings of the borrower in installments, rather giving a lump sum at the maturity of the loan.
This theory dominates the commercial loan theory and the shiftability theory as it satisfies the three major objectives of liquidity, safety and profitability. Liquidity is settled to the bank when the borrower saves and repays the loan regularly after certain period of time in installments. It fulfills the safety principle as the bank permits a relying on good security as well as the ability of the borrower to repay the loan. The bank can use its excess reserves in lending term-loan and is convinced of a regular income. Lastly, the term-loan is highly profitable for the business community which collects funds for medium-terms.
The theory of anticipated income is not free from demerits. This theory is a method to examine a borrower’s creditworthiness. It gives the bank conditions for examining the potential of a borrower to favorably repay a loan on time. It also fails to meet emergency cash requirements.