Ans: 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.