Commercial Banks
Commercial banks are financial institutions that accept deposits, provide checking account services, make various loans, and offer basic financial products such as certificates of deposit (CDs) and savings accounts to individuals and small businesses. Most people conduct their banking at a commercial bank. Mortgages, auto loans, business loans, and personal loans are among the loans that commercial banks provide and earn interest from. These loans are made possible by the deposits of customers. Commercial banks provide short term loans in the form of Bank Credit.
A commercial bank provides basic banking products and services to individuals, small to medium-sized businesses, and the general public. A number of services are available, such as checking and savings accounts, loans, and mortgages, as well as basic investments such as CDs, as well as safe deposit boxes. Service charges and fees are how banks make money. There are different fees associated with different products, including account fees (monthly maintenance charges, minimum balance fees, overdraft fees, and NSF fees), safe deposit box fees, and late fees. The interest on loan products is often accompanied by fees.
The banks earn money from interest they earn on money they lend out to other clients as well. Customers deposit money into their accounts for them to lend. Banks, on the other hand, pay a lower rate of interest on money they borrow than they charge on money they lend. An example would be that a bank offers savings account customers an annual interest rate of 0.25%, but mortgage clients pay 4.75%. Traditionally, commercial banks are located in buildings where customers use teller windows and automated teller machines (ATMs) for their routine banking needs. In the era of internet technology, most banks now allow their customers to do most of the same services online that they can do in person, such as money transfers, deposits, and bill payments.
History of Commercial Banks
Banking gets its name from the Italian word bank, which means desk or bench. During the Italian Renaissance, Florentine bankers used a desk covered with a green tablecloth to conduct their transactions on. However, there are evidences of banking activity dating back to ancient times.
Commercial Bank was established in 1924 by local businessmen in Oglethorpe County to serve the financial needs of residents and businesses in the area. The Commercial Bank’s commitment to serving the communities it serves has not changed since 1924. The Commercial Bank is one of the only locally owned and operated community banks in the Athens area, making it uniquely suited to offer customers common sense solutions.
Functions of Commercial Banks
The functions of commercial banks are broader in scope, size, and magnitude. The functions of commercial bank is divided into two parts i.e. Primary Functions and Secondary Functions.
a. Primary Functions of Commercial Banks
Commercial banks have to perform primary functions of accepting deposits, providing loan, and funds involvement in earnings assets to balance the portfolios of assets management. The primary functions of commercial banks are as follows:
- Accepting Deposits: Generally, commercial banks accept savings, fixed, and current deposits from their customers.
- Fixed Deposits: A predetermined period of lock-in applies to fixed deposits. As fixed deposits are deposited for a specific period of time, they are also known as time deposits.
- Saving Deposits: A customer can credit funds to their accounts through a savings deposit up to a certain limit. Deposits of this type are preferred by individuals with fixed incomes, who use them to create savings over time.
- Current Deposits: The current deposit allows account holders the flexibility of depositing and withdrawing money as needed. Individuals and businesses may also be able to overdraft their current accounts until a predetermined limit.
- Credit Creation: Commercial banks are unique in their ability to create credit. The bank creates a line of credit and transfers the loan to the business or commercial entity all at one time instead of offering liquid cash.
Explain the process of credit creation by Commercial Banks
A commercial bank creates credit by advancing loans and buying securities. They lend money to individuals and businesses by accepting deposits from the public. Commercial banks, however, are not peZrmitted to use all public deposits in order to lend. For serving the cash requirements of depositors, banks are required to hold a certain amount as reserves. Commercial banks can lend the remainder of public deposits after keeping the required reserves.
- Providing Loans: A commercial bank’s main function is to extend credit to organizations and individuals, and earn interest on the loans. Banks usually hold a small reserve for their expenses, while offering the rest to customers as various types of short- and long-term credit.
b. Secondary Functions of Commercial Banks
Besides the primary functions of accepting deposits and lending money, banks perform a number of other functions which are called secondary functions. The secondary functions of commercial bank are as follows:
- Providing locker facilities: A commercial bank offers lockers to customers who want to store valuables safely. If kept at home, there is the risk of theft or loss. Locker facilities eliminate these risks.
- Dealing in foreign exchange: Foreign exchange is provided by commercial banks to individuals and organizations exporting or importing goods. These transactions can only be carried out by banks that have a foreign exchange license.
- Exchange of Securities: A commercial bank’s other function is to trade bonds and securities. Financial institutions allow customers to buy and sell units through themselves, which is more convenient than alternative methods.
- Discounting Bills of Exchange: In today’s day and age, the main function of a commercial bank is to discount business bills. The discounting of bills is considered a profitable investment by banks. Payment of bills is not considered a risky venture during its payment as it is considered to be a negotiable instrument. Financial institutions also do not become involved in litigation.
Role of Commercial Banks in Economic Development
An important part of the economy is the commercial banking sector. Furthermore, they create liquidity and capital in the market, in addition to providing consumers with an essential service. Customers deposit funds in their accounts, and then they lend them out.
This ensures liquidity. As a result of these activities, commercial banks create credit that leads to an increase in production, employment, and consumer spending, thereby boosting the economy.
Therefore, commercial banks are heavily regulated by a central bank in their country or region. A central bank may, for instance, require banks to maintain sufficient reserves. The central bank holds some of banks’ consumer deposits as a cushion in case the general public withdraws funds in a rush. Read More…..
Types of Commercial Banks
There are three types of commercial bank. They are; Public sectors banks, Private sectors banks, and foreign banks.
- Public Sector Banks: An institution that has been nationalized by the government is a public sector bank. The government is the major stakeholder. These banks are usually part of the central bank of a country.
- Private Sector Banks: A private bank is one whose major shareholders are individuals and businesses. These banks are limited liability companies.
- Foreign Banks: Banks with branches in different parts of the world and headquarters in a foreign country are called foreign banks. Foreign banks play a significant role in helping a country’s economy flourish, in addition to serving its people’s financial needs.
Loans offered by Commercial Banks
The types of loan offered by commercial banks are as follows:
- Bank Loan
In banking, a loan is an amount of money offered by a bank to a borrower at a set interest rate for a set period of time. The bank must obtain several important documents from a client in order to verify that the borrower can repay the loan. If the borrower does not pay back the loan, the bank will not grant the loan.
Corporate clients may need to provide copies of their ID, proof of income, and audited financial statements. If the customer defaults on the loan, the bank can sell the collateral to recover the money. Collateral may include equipment, machinery, real estate property, inventory, documents of ownership, etc.
- Cash Credit
A cash credit is an agreement between the bank and a client which allows the client to withdraw money beyond his or her account limit. A cash credit is usually offered for a year, but it can extend up to three years in special circumstances. In addition to the loan amount, a cheque can be issued to the borrower to withdraw it from their current account. Interest is based on the amount of money withdrawn as well as the length of time for which it was withdrawn.
- Bank Overdraft
A bank overdraft is a type of credit that allows current account holders to overdraw their account up to a certain limit. Overdrafts don’t require any written documentation, and clients use them for urgent needs. Banks charge interest on the amount overdraft that the account has been overdrawn by, not on the full amount of the overdraft.
- Discounted Bills of Exchange
Bills of exchange are discounted by banks by providing money instantly to the holders. After deducting an interest rate for the loan period, the bank deposits the money into the account of the holder. The bank receives its payment when the bill of exchange matures from the banker of the bill holder.
Risks in Commercial Banks
Banks face a number of risks, including credit, operational, market, and liquidity risks. Banks can improve profits by reducing losses on loans and investments through prudent risk management. In order to decrease risks, diversify assets, use prudent underwriting practices, and improve operating systems. Some of the risks faced by commercial bank are as follows:
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Operational Risk
A risk of loss resulting from errors, interruptions, or damages caused by people, systems, or processes is an operational risk. Operations with low operational risk are retail banking and asset management, and those with higher operational risk are sales, trading, and investment management. In addition to internal fraud and mistakes during transactions, human error can result in losses. One example is when a teller accidentally hands over an extra $50 bill to a customer. In a larger scale, fraud can be committed by breaching a bank’s cybersecurity.
Through this method, hackers can steal customer information and money from banks, and blackmail institutions for more money. This causes banks to lose capital and customer trust. When a bank’s reputation is damaged, it may be more difficult to attract deposits or business in the future.
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Credit Risk
The biggest risk for banks is credit risk. Borrowers and counterparties fail to meet contractual obligations. For example, when borrowers fail to make their monthly loan payments. A default can occur on a mortgage, credit card, and fixed income security. Derivatives and guarantee agreements can also fail to meet their obligations. Due to the nature of their business model, banks cannot fully protect themselves from credit risk.
However, they can reduce their exposure in several ways. Diversification lowers banks’ exposure to deterioration in an industry or issuer because it is unpredictable. Thus, banks are less likely to be exposed to a category with large losses during a credit downturn. For example, they can lend money to people with good credit histories, transact with high-quality counterparties, or own collateral to guarantee loans.
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Market Risk
The majority of a bank’s market risk is derived from its activities in the capital markets. This is due to the unpredictable nature of equity markets, commodity prices, interest rates, and credit spreads. A bank is more at risk if it invests heavily in capital markets or engages in sales and trading. A bank may have investments in companies that produce commodities, which also affects commodity prices. The value of the company and the value of the investment change with the value of the commodity.
The price of commodities is affected by supply and demand shifts, which are often difficult to predict. In order to reduce market risk, it is important to diversify investments. In addition to hedging their investments with other, inversely related investments, banks can also reduce their investment.
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Liquidity Risk
Liquidity risk is the risk that a bank might be unable to meet its funding obligations if it is not able to access cash. Such obligations include allowing customers to withdraw their deposits. A lack of cash in a timely manner to customers can create a snowball effect. In the event that a bank delays cash to a few customers for a day, other depositors might rush to withdraw their deposits as they lose confidence in the institution.
Consequently, the bank’s ability to provide funds is further lowered, resulting in a bank run. Banks often face liquidity issues as a result of overreliance on short-term sources of funds, a balance sheet dominated by illiquid assets, and a loss of customer confidence. It is also possible to experience funding difficulties if asset-liability duration is not properly managed. A short-term debt problem occurs when a bank has too many short-term obligations and too few short-term assets.
Examples of Commercial Banks
The world’s largest financial institutions are commercial banks or have commercial banking operations, many of which are based in the United States. JPMorgan Chase’s commercial banking division, Chase Bank, is an example. Chase Bank is headquartered in New York City and reported $3.2 trillion in assets as of June 2021. With assets of over $2.35 trillion and 66 million customers including consumers and small and midsize businesses, Bank of America is the second-largest bank in the United States.
Commercial Banks MCQs
Commercial banks create money by way of
The Reserve Bank of India regulates the commercial banks in matters of:
a) liquidity of assets
b) branch expansion
c) merger of banks and winding-up of banks
d) All of the above options
References
Corporate Finance Institue. (n.d.). Retrieved from Corporate Finance Institue: https://corporatefinanceinstitute.com/resources/knowledge/finance/commercial-bank/
Kagan, J. (2021, October 6). Investopedia. Retrieved from Investopedia: https://www.investopedia.com/terms/c/commercialbank.asp
The Commercial Bank. (n.d.). Retrieved from The Commercial Bank: https://www.thecommercialbank.net/about-us/history#:~:text=The%20Commercial%20Bank%20was%20founded,we%20serve%20remains%20the%20same.
Vedantu. (n.d.). Retrieved from Vedantu: https://www.vedantu.com/commerce/functions-of-commercial-banks
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MBA,BBA.
I am Smirti Bam, an enthusiastic edu blogger with a passion for sharing insights into the dynamic world of business and management through this website.
I hold a MBA degree from Presidential Business School, Kathmandu, and a BBA degree with a specialization in Finance from Apex College,