An institution that provides its customers with services like accepting deposits, providing loans, and making investments, with the objective of earning profits is known as a Commercial Bank. The two main characteristics of commercial banks are lending and borrowing. They make money from a variety of fees and by earning interest income from loans. For this, the bank charges interest on lending and borrowing. The two main types of rates are the Borrowing Rate and Lending Rate. The rate offered by commercial banks to depositors for depositing money is called the borrowing rate. The rate charged by commercial banks for lending money to investors is known as the lending rate. The difference between the borrowing rate and the lending rate is known as Spread. It is the profit earned by commercial banks.
Commercial Banks are important for an economy because they create capital, credit, and liquidity in the market. Commercial banks have traditionally been located in physical locations, but nowadays a number of banks also operate online.
Table of Content
Functions of Commercial Bank
Commercial Banks perform various functions which can be categorised into two broad categories; viz., Primary Functions and Secondary Functions.
A. Primary Functions
Accepting Deposits and Advancing of Loans are the two primary functions performed by commercial banks.
1. Accepting Deposits
One of the most essential functions of commercial banks is accepting deposits. Commercial banks accept deposits from their customers in different forms based on the requirements of different sections of society. The main types of deposits include:
- Demand Deposits or Current Account Deposits: The deposits which are repayable on demand by the banks are known as demand deposits or current account deposits. In general, these kinds of deposits are maintained by businessmen to make transactions with these deposits. One can get the amount deposited as demand deposits by a cheque without any restriction. Besides, commercial banks do not pay any interest to the depositors on these accounts; instead, they charge some amount as a service charge for running these accounts.
- Fixed Deposits or Time Deposits: The deposits in which the depositor, deposits money with the bank for a fixed time period are known as fixed deposits or time deposits. These deposits do not enjoy a cheque facility and carry a high interest rate.
- Saving Deposits: The deposits, which include combined features of demand deposits and fixed deposits are known as saving deposits. The depositors have the cheque facility to withdraw money from their accounts, but there are some restrictions on the number and amount of withdrawals. The restrictions are imposed to discourage the frequent use of saving deposits. Besides, the interest rate on saving deposits is less than the interest rate on fixed deposits.
2. Advancing of Loans
The banks are not allowed to keep the amount deposited with them, idle. Therefore, commercial banks have to keep some amount of the total deposits as cash reserves and lend the rest of the balance to needy borrowers and charge interest from them. The interest received by commercial banks from advancing loans is the main source of their income. Some of the different types of loans and advances made by commercial banks are:
- Cash Credit: The loan given to the borrowers against their current assets like stocks, bonds, shares, etc., is known as cash credit. For this, a credit limit is sanctioned to the borrower, and money is credited to this account. The borrower can now withdraw any amount at any time within his credit limit. Interest is charged from the borrower on the amount actually withdrawn by him.
- Demand Loans: The loans given by the banks which they can recall at any time on demand are known as demand loans. The entire amount of the demand loan is credited to the borrower’s account, and interest is charged on that amount.
- Short-term Loans: Personal loans given to borrowers against some collateral security are known as short-term loans. The amount taken as a loan is credited to the account of the borrower, and he can withdraw that money from his account. Interest is charged on the entire sum of the loan granted.
B. Secondary Functions
Besides primary functions, commercial banks also perform some secondary functions.
1. Overdraft Facility
A facility that allows the customer to overdraw from the amount of his current account upto an agreed limit is known as an overdraft facility. In general, an overdraft facility is given to respectable and reliable customers for a short period. Besides, the customers have to pay interest on the amount overdrawn by them.
2. Discounting Bills of Exchange
A facility in which the holder of a bill of exchange, before its maturity date can get the bill discounted with the bank. The bank pays the amount to the holder after deducting some amount as commission. Now, on the date of maturity, the party which has accepted the bill pays back the money to the bank.
3. Agency Functions
There are some agency functions performed by commercial banks for which they charge some commission from their clients. Some of these functions are:
- Transfer of Funds: With the help of instruments like mail transfers, demand drafts, etc., commercial banks provide their customers with the facility of easy and economical remittance of funds from one place to another.
- Collection and Payment of Various Items: Commercial banks provide their customers with the service of collecting bills, interest, subscriptions, rents, and other periodical receipts on their behalf. They also make payments for insurance premiums, taxes, etc., on their customer’s standing instructions.
- Purchase and Sale of Foreign Exchange: The central bank gives authority to commercial banks to deal in foreign exchange. Commercial banks, on the behalf of their customers, buy and sell foreign exchange and also helps in promoting international trade.
- Purchase and Sale of the Securities: Commercial banks on behalf of their customers, purchase and sell government securities and stocks and shares of private companies.
- Income Tax Consultancy: Commercial banks provide advice to their customers related to income tax. They also help them in the preparation of their income tax returns.
- Trustee and Executor: Commercial banks play the role of a trustee and preserve the will of their customers and as an executor, execute the will after their death.
- Letters of Reference: Commercial banks provide information about the economic position of their customers to the traders and vice-versa.
4. General Utility Functions
Some of the general utility functions performed by commercial banks are:
- Locker Facility: Commercial banks provide their customers with the facility of lockers or safety vaults so they can keep their valuable things in safe custody.
- Traveller’s Cheques: To avoid the risk of taking cash on their journey, commercial banks provide their customers with the facility of traveller’s cheques.
- Letter of Credit: Sometimes people need to show their creditworthiness for various reasons. Commercial banks certify the creditworthiness of their customers whenever required.
- Underwriting Securities: Commercial banks also performs the function of underwriting securities. And as the public has full faith in the bank’s creditworthiness, they do not hesitate in purchasing the securities which are underwritten by banks.
- Collection of Statistics: Commercial banks advice their customers on financial matters by collecting and publishing statistics related to commerce, trade, and industry.
It can be said that the commercial banks receive deposits from the public and use them in giving loans to the public. However, sometimes the loans offered by the commercial banks are more than the deposits received by them. This function performed by commercial banks is known as Money Creation or Credit Creation.
Importance of Commercial Banks
Commercial banks play a crucial role in the economic development of a country. The banks help in the acceleration of a country’s economic growth in the following ways:
1. Help Consumers: Commercial banks help consumers in purchasing durable consumer goods like Air Conditioners, Refrigerators, T.V., etc., which are out of their paying capacity limit, by advancing credit to them. By doing so, commercial banks create demand for these consumer goods.
2. Provision of Finance and Credit: Commercial banks play an essential role as a source of finance and credit for industry and trade. These banks not only perform activities that are confined to domestic trade and commerce but are also extended to foreign trade.
3. Accelerating the Rate of Capital Formation: Commercial banks encourage people’s habit of thrifting and mobilise their savings which are then allocated effectively among the ultimate users of funds; i.e., the investors for productive investment. Therefore, savings made by people result in capital formation forming the basis of economic development.
4. Promoting Balanced Regional Development: Commercial banks play an essential role by providing credit facilities to rural people by opening up their branches in backward areas. These banks use the funds collected in the developed regions to channelise investment in the under developed regions of the country. By doing so, commercial banks bring out more balanced regional development.
5. Developing Entrepreneurship: Commercial banks promote entrepreneurship by way of underwriting shares of new and existing companies and also, grant assistance for the promotion of new ventures or for financing promotional activities. These banks provide finance to the loss-making/sick industries to make them viable units.