Theoretical Basis of Banking Operation

Balancing profitability with liquidity management

The distinguishable feature of the banks compared to other profit making business (financial as well as manufacturing) is the degree to which they have to balance the principle of profit maximization with certain other principle.In India ,banks are required to modify their performance in profit making if that clashes their obligation in areas like social welfare ,social justice ,and promotional of regional balance in development.In any case,compared to other business concerned ,banks have to much more attention to balancing profitability with liquidity .

Management of Reserves

The banks are expected to hold voluntarily a part of their deposits in the form of ready cash which is known as the cash reserve ;and the ratio of cash reserve to deposit is called reserve ratio.Central bank of each country is empowered to prescribe the reserve ratio that all bank must maintained.since banks are required to maintain a fraction of deposit liabilities as reserve ,the modern banking system is also known as fractional reserve banking.for example ,in India the require reserve ratio is 4% from Jan 2013,as per RBI. like wise China 18.5 %, Russia 4%, South Africa 2.5 % while Australia,Sweden some country have none.

Creation of Credit 

Another distinguishable feature of banks is that while other financial institution can only transfer funds ,banks transfer as well as creates the credit or money. Every loan given by the banks create a deposit or credit or money.This has given concept of credit multiplier or money multiplier .Thus banks adds to money supply in the economy.

Credit or money Multiplier =1/R,  where R is reserve ration.

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