Commercial Banks: Functions, Accounts, and Credit Facilities

In this post, we are going to talk about commercial banks and look into several of their functions, among many other things, like the types of accounts and credit facilities offered by commercial banks. But first things first, it is important that we understand what a bank is and, of course, what its functions are.

What is a bank?

A bank is a financial institution that provides various financial services, such as storing money, lending funds, issuing loans, facilitating payments, and offering investment opportunities to individuals and businesses.

A bank is a dedicated institution designed primarily for the secure storage of various assets, including money, valuable goods, and essential documents such as wills and deeds.

Banks, in their capacity as custodians, ensure the safety and security of individuals’ and businesses’ money, valuable possessions, and crucial legal documents. Beyond safekeeping, banks offer a multitude of financial services, including lending funds, facilitating transactions, managing investments, and providing various banking products.

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Commercial Banks

Commercial banks are a specific category of financial institutions established primarily to store and lend money to individuals, businesses, or government entities. These banks are owned by individuals, organisations, or even the government and operate with the primary objective of generating profits.

Characteristics of Commercial Banks

1. Deposit and Lending: Commercial banks accept deposits from customers. They safeguard the funds while also lending money to borrowers in need of financial assistance. Apart from money, they also handle other valuable securities.
2. Profit Motive: Unlike other types of banks, commercial banks function with a profit-centric approach. The primary objective behind the establishment of commercial banks is profit generation. They aim to generate revenue through interest on loans, fees, and various financial services.
3. Limited Liability Companies: Commercial banks operate as limited liability entities. This means that the liability of the owners or shareholders is restricted to their investment in the bank. Their personal assets are protected from the bank’s liabilities.
4. Diverse Ownership: Commercial banks are established and owned by individuals, organisations, or government entities. The ownership structure can range from privately held businesses to publicly traded corporations or even government-backed institutions.
5. Broad Clientele: These banks conduct transactions and provide financial services to a wide range of entities, including governments, private individuals, and organisations. They cater to the financial needs of various sectors by offering services such as deposit accounts, loans, investment opportunities, and other banking products.

Functions of Commercial Banks

1. Acceptance of Deposits: Commercial banks serve as custodians of funds. They allow individuals and entities to deposit their money into various types of accounts, such as savings, current, or fixed deposit accounts. They also guarantee the safety and liquidity of these funds.
2. Lending of Money: They play a crucial role in the economy by extending loans and credit facilities to individuals, businesses, and other institutions. By lending people money, they stimulate economic activity and support financial growth.
3. Agents of Payment: Commercial banks facilitate transactions through various payment mechanisms, such as checks, debit cards, credit cards, and electronic transfers, to enable smooth and secure financial transactions between parties.
4. Agency Services: Besides handling money, commercial banks often act as agents for their customers, offering services like collecting checks, making payments on behalf of customers, and executing financial transactions as instructed by their clients.
5. Issuing Bank Drafts: They issue bank drafts, a payment method similar to cheques. This allows individuals to make payments securely, especially for transactions involving large sums or international payments.
6. Acting as Referees: Commercial banks often act as intermediaries in business transactions. They verify and authenticate the financial standing or credibility of parties involved in a bid to ensure trust and reliability in various financial dealings.
7. Issuing Travellers’ Cheques: These banks provide travellers’ cheques, a secure and convenient way for individuals to carry funds while travelling. These cheques are pre-paid and can be replaced if lost or stolen. They are a safe alternative to cash.
8. Discounting Bills of Exchange: Commercial banks engage in the practice of discounting bills of exchange. They offer immediate cash payment to the holder of the bill at a discounted rate. This allows the holder to access funds before the bill’s maturity.
9. Foreign Exchange Solutions: They assist in managing foreign exchange transactions. They provide services related to currency conversion and facilitate international trade.
10. Credit Transfer Services: Commercial banks offer credit transfer services that enable the transfer of funds from one account to another, either domestically or internationally. These services facilitate efficient and secure fund transfers between accounts.
11. Providing Financial Advice: Commercial banks offer advisory services to their customers. They provide guidance on financial matters such as investment options, financial planning, and other banking-related queries to help customers make informed decisions.
12. Safe Custody Services: In addition to money and securities, commercial banks often offer safe-custody services for other valuable items. They provide secure storage facilities for items like jewellery, important documents, and other high-value possessions.
13. Employment Opportunities: Banks create employment opportunities by hiring staff across various departments, including banking operations, customer service, finance, and management. Thus, they contribute to job creation and economic development.
14. Involvement in Agriculture: Some commercial banks engage in financing agricultural activities by providing loans, credit facilities, and other financial services tailored to support farmers, agricultural businesses, and related sectors.

Types of Bank Accounts

1. Savings Account: A savings account is the most prevalent form of banking for the low-income group who aim to cultivate a habit of saving. Operated through passbooks or online interfaces, this account incentivises individuals to deposit money and accrue interest on their savings. The focus is on encouraging financial discipline and fostering a habit of saving among account holders.
2. Current Account: A current account allows frequent withdrawals and unlimited transactions within a month. Operated using checks, a teller, or a paying-in book, this account provides flexibility for businesses and individuals to manage their day-to-day transactions. However, the account holder typically pays a commission or fee for the services provided by the bank.
3. Fixed Deposit Account: Also referred to as a time deposit, the fixed deposit account operates on the principle of depositing money for a predetermined duration. This account requires a specific notice period, typically between 7 to 14 days, before withdrawals can be made. The account holder receives a receipt or a deposit account passbook upon depositing the funds. The bank pays interest on these deposits, incentivising individuals to save for the specified period and rewarding them with interest earnings upon maturity.

Credit Facilities Offered by Commercial Banks

(a) Loan: Commercial banks provide loans. They offer a substantial sum of money to eligible customers or entities that meet specified criteria. The bank typically requires collateral security in the form of fixed assets from the borrower before granting the loan. Interest is charged on the loan amount, and borrowers repay the loan in installments according to the agreed terms.

(b) Overdraft: An overdraft facility allows bank customers to withdraw more money from their accounts than their current balance. It is a flexible credit arrangement where the bank permits account holders to overspend up to a certain limit. Interest is charged on the overdrawn amount. This provides customers with short-term financial flexibility within the approved limit.

Factors Considered by Bank Managers Before Granting Loans

1. Type of Account: Bank managers assess the type of account a customer operates. Different accounts have varying transaction patterns and financial behaviours. This influences the decision-making process for loan approvals.
2. Loan Amount: The amount requested by the customer is a critical factor. Bank managers evaluate the loan size in relation to the customer’s financial capacity and the bank’s risk tolerance.
3. Customer’s Financial History: Past financial dealings between the customer and the bank are carefully examined. A good history of prompt repayments and responsible financial behaviour enhances the likelihood of loan approval.
4. Purpose of the Loan: Bank managers scrutinise the intended use of the loan funds. Clear and justifiable reasons for borrowing are essential, as the purpose influences the risk assessment and viability of the loan.
5. Collateral Security: Bank managers evaluate the collateral offered by the borrower. Collateral serves as security for the loan and helps mitigate the bank’s risk. The type and value of collateral significantly influence loan approvals.
6. Repayment Period: The proposed duration for loan repayment is carefully assessed. Bank managers consider the feasibility of the repayment period based on the borrower’s financial situation and the nature of the loan.
7. Customer’s Referee: The credibility and reliability of the borrower’s referee or guarantor are taken into account. A trustworthy and creditworthy referee can positively impact the loan approval process.
8. Borrower’s Earning Capacity: Bank managers analyse the borrower’s earning potential and financial stability. The borrower’s income sources and stability contribute to assessing their ability to repay the loan.
9. Government Policy on Lending: Current government regulations and policies regarding lending practices impact a bank’s decision-making process. Banks adhere to regulatory guidelines, and government policies on lending influence the terms, rates, and overall approach to loan approvals.