Commercial Banks and NBFIs: Similarities and Difference

In this article we will discuss about the similarities and difference between commercial banks and NBFIs.

Similarities between Commercial Banks and NBFIs:

From a functional viewpoint the operations of commercial banks are similar to those of NBFIs on the following counts:

1. Like NBFIs, commercial banks acquire the primary securities of borrowers, loans and deposits, and in turn, they provide their own indirect securities and demand deposits to the lenders. Commercial banks resemble NBFIs in that both create secondary securities in their role as borrowers.

2. Commercial banks create demand deposits when they borrow from the central bank, and NBFIs create various forms of indirect debt when they borrow from commercial banks.

3. Both commercial banks and NBFIs act as intermediaries in bringing ultimate borrowers and ultimate lenders together and facilitate the transfer of currency balances from non-financial lenders to non-financial borrowers for the purpose of earning profits.

4. Both commercial banks and NBFIs provide liquid funds. The bank deposits and other assets of commercial banks and the assets provided by NBFIs are liquid assets. Of course, the degree of liquidity varies in accordance with the nature and the activity of the concerned financial intermediaries.

5. Both banks and NBFIs are important creators of loanable funds. The commercial banks by net creation of money and the NBFIs by mobilising existing money balance in exchange for their own newly issued financial liabilities.

Difference between Commercial Banks and NBFIs?

Commercial banks are different from NBFIs in the following respects:

1. Credit Creation:

Prof. J. Tobin has shown that the existence of NBFIs significantly modifies the conventional view of commercial banks as creators of money because they can directly issue their own new liabilities to acquire other assets. On the other hand, NBFIs do not create money.

Like all other financial intermediaries (FIs), commercial banks lend to borrowers only currency deposited with them and make profit by charging borrowers a high rate than they pay to lenders. But both differ in the effects of their operations so far as secondary securities are concerned.

The two main financial assets that serve as money are currency, known as high powered money, and demand deposits of commercial banks. Demand deposits are the secondary securities issued by commercial banks which are substitutes for currency.

They represent a promise to pay currency on demand and are transferred direct by cheque without encashment in settlement of debt. Banks offer convenient safe-keeping, book-keeping and a large number of other services to depositors that are not available by holding currency.

Consequently, depositors who lend their currency to commercial banks receive in return a secondary security that itself serves as a medium of payment. Loans made or deposits created by any bank through the issue of cheques will ultimately be deposited by the borrowers or by other persons to whom they made cheque payments in the commercial banking system. Thus cheques help in creating credit by the bank credit multiplier.

Money lent by an individual bank is retained as cash reserve by the banking system minus only a small leakage in money used by the borrower. The bank credit multiplier implies that banks if uncontrolled would have an unlimited power to expand deposits, since the latter are determined only by the amount of primary securities that the banking system purchases.

“Bank money, once created in the process of bank lending, lives on as a virtually permanent part of the money supply. Thus, banks do manufacture money; and once manufactured, it is relatively immortal.” It is in this sense that commercial banks are unique among FIs in their ability to create money. But in the case of NBFIs, the amount of primary securities they can buy is limited by the amount of indirect securities they can sell to lenders.

Since they do not possess the bank credit multiplier power of commercial banks, they perform the brokerage function of simply transferring to borrowers the funds entrusted to them by lenders. Moreover, government regulations prevent NBFIs from offering chequing facilities on their liabilities and convertibility into currency on demand.

But a number of secondary securities, such as commercial bank time and demand deposits and deposits in some thrift institutions while directly not transferable by cheque can be turned into cash quickly, easily, conveniently and without cost. Therefore, they are a close substitute of money than other assets, are called near money assets.

Thus NBFIs can create liquidity and not money. Since the majority of NBFIs are small, the banking system multiplier does not operate fully in their case because of the leakages to banks of the money lent. Suppose a small non-banking financial institution lends and issues a cheque on its bank as payment.

This will lead to a drain on its resources unless an equal amount is re-deposited by some other borrower. In the case of small NBFIs, the redeposit ratio is low which makes it difficult for them to continue in business unless they have sufficient assets. But a commercial bank faces no problem of this type and can create money as well as liquidity to meet its lending requirements.

2. Cash Reserve Requirements:

Commercial banks, like other FIs, have to earn a higher rate on their total assets than they pay on their total liabilities. They have to keep cash reserves. But cash reserves do not earn income. So banks wish to maintain their cash reserves as low as possible. But, unlike NBFIs, they are legally required to maintain a minimum cash reserve ratio (CRR).

This ratio is always more than what the banks would wish to maintain. As a result, banks do not normally hold cash reserves in excess of those legally required and invest all excess cash in earning assets. With a reduction of required cash reserve ratio, the volume of bank intermediation would expand, and vice versa.

As deposits are preferred to currency, an increase in the stock of high powered money results in an increase in the public’s demand for bank deposits. This leads to increase in deposits with the banking system. So long as the average cost of providing and servicing demand deposits is low relative to the interest rate earned on primary securities, banks have a profit incentive to lend all excess cash by buying securities and granting loans.

Consequently, the volume of bank intermediation expands. This process will continue until bank assets and deposits have risen to a level where the required cash reserves and actual reserves are equal.

It should, however, be noted that the foreign exchange liabilities of commercial banks are not required to meet cash reserve requirements. So this part of the bank business can be regarded like an NBFI. On the other hand, NBFIs are not subject to any such restrictions.

They are thus in an advantageous position over the banks. But this regulatory distinction between banks and NBFIs does not apply now in almost all the developed and developing countries of the world because reserve requirements have been enforced in one form or another on NBFIs with the exception of insurance companies, pension funds, and investment and unit trusts.

3. Portfolio Structure:

Commercial banks differ from NBFIs in their portfolio structure. Bank liabilities are very liquid. The liabilities of a bank are large in relation to its assets, because it holds a small proportion of its assets in cash. But its liabilities are payable on demand at a short notice. Many types of assets are available to a bank with varying degree of liquidity.

The most liquid is cash. The next most liquid assets are deposits with the central bank, treasury bills and other short-term bills issued by the centre and state governments and large firms, and call loans to other banks, firms, dealers and brokers in government securities.

The less liquid assets are the various types of loans to customers and investment in longer-term bonds and mortgages. Thus banks have a large and varied portfolio on the basis of which they create liquidity.

NBFIs also create liquidity but in the form of savings and time deposits which are not used as a means of payment. They are limited in the choice of their assets and are also prohibited from holding certain assets. Thus the size of their portfolio is very small as compared with banks.

They generally issue claims against themselves that are fixed in money terms and have maturities shorter than the direct securities they hold. They borrow for short period, and lend for long period. This is because of the small size of their portfolio and they hold less liquid assets than banks.

4. Risk:

Banks have to follow certain norms at the time of advancing loans. There are detailed appraisals of projects and hence delays in sanctioning loans. On the other hand, NBFIs do not enter into detailed appraisals of projects, they have to follow less stringent rules for advances. There are no time delays in granting loans. Thus NBFIs are able to take greater risk and lesser supervision as compared to banks.

5. Security:

NBFIs insist on greater security than banks before lending. Normally, it is in the form of shares and post-dated cheques. This is to ensure that if one project goes bad, they can recover from the others.

6. Recovery:

NBFIs are very innovative in their methods of recovery and calculation of interest rates. They combine a good security with other factors such as upfront fee, and higher lending rates. Consequently, their recovery rates are good and the percentage of bad debts to their assets is very low.

Banks, on the other hand have to follow specific norms in making loans. Their prime lending rates are much lower than the NBFIs. Since banks advance huge loans to corporates, the rate of default is very high in their case.

Conclusion:

The entire discussion can be summarised as follows:

(a) The distinction between commercial banks and NBFIs has been too sharply drawn. The differences are of degree rather than of kind,

(b) The differences which do exist have little intrinsically to do with the monetary nature of bank liabilities,

(c) The differences are more importantly related to the special reserve requirements. If NBFIs are subject to the same kind of regulations they would behave in much the same way.

(d) Commercial banks do not possess a ‘widow’s cruse’ which means that any expansion of assets will generate a corresponding expansion of deposit liabilities. Despite these differences, commercial banks are unique among financial intermediaries.