Essentials of a Sound Banking System

A bank plays a very critical role in the development of the economy of a country. A sound banking system ensures that the development is all-round. In this article, we will look at the essential features of a sound banking system.

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Essentials of a Sound Banking System

A sound banking system has four essential aspects – liquidity, expansion, investments and loan policies, and the human factor. Let’s look at these aspects in detail.

sound banking system

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Adequate Liquidity

A bank offers types of deposits to customers – demand deposit, time deposits, CASA deposit, and NRO.

Therefore, a bank needs to keep adequate cash in hand to meet the withdrawal requests of depositors. If it fails to do so, then the bank would be insolvent.

Further, bank failure affects depositors as well as other banks. One bank failing makes people lose their trust in the banking system and hence they tend to avoid depositing funds with the banks. Therefore, a bank must ensure that it has adequate liquidity at all times to ensure its safety.

Expansion of Banking

In any economy, it is important that banking services are spread across all sections of people. A sound banking system is present throughout the economy and offers funds for all productive activities in society.

In fact, the less-developed regions and segments of society must receive more banking facilities than the others. Therefore, the diffusion of banking services is essential.

Learn more about Types of Banking here in detail.

Investment and Loan Policies

A bank has dual goals – liquidity and profitability. Therefore, a sound banking system needs to have a sound investment policy to help the bank achieve these goals.

It is important to remember that if a bank’s loan and/or investments go wrong, then it can suffer losses or liquidity shortage.

Therefore, a prudent banker carefully determines the composition and character of its loans and advances in order to optimize the earning without putting its safety and solvency at risk.

Human Factor

As an industry, banking relies heavily on the quality of people working in it. Banking is a practical affair. Therefore, one cannot rigidly apply the laws of banking as it does not bear fruit.

Hence, a lot depends on the people working in the industry. Thus, a sound banking system depends more on the banking personnel than on the laws.

Solved Question

Q1. What are the four essential factors of a sound banking system?

Answer: The four essential factors are:

  • Adequate Liquidity – Banks must have adequate cash in hand to meet the withdrawal requests of depositors on a daily basis. Failing to do so can adversely affect the customers as well as other banks as people start losing their trust in the banking system.
  • Expansion of Banking – In an economy, banking services must spread across the different sections of the society. Further, the under-developed regions or segments of society must have greater access to banking services.
  • Investment and Loan Policies – It must have a sound investment policy to achieve the goals of profitability as well as liquidity.
  • Human Factor – A sound banking system depends more on the personnel working in it than the banking laws.
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