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05/10/2016

CommercialBanks:ItsFunctionsandTypesExplained!

EconomicsDiscussion

CommercialBanks:
ItsFunctionsand
TypesExplained!
ArticleSharedbyNitisha

Commercialbanksarethemostimportant
componentsofthewholebankingsystem.
Acommercialbankisaprofitbasedfinancial
institutionthatgrantsloans,acceptsdeposits,
andoffersotherfinancialservices,suchas
overdraftfacilitiesandelectronictransferof
funds.
AccordingtoCulbertson,

CommercialBanksaretheinstitutions
thatmakeshortmakeshorttermbans
tobusinessandintheprocesscreate
money.

Inotherwords,commercialbanksarefinancial
institutionsthatacceptdemanddepositsfrom
thegeneralpublic,transferfundsfromthebank
toanother,andearnprofit.
ADVERTISEMENTS:

Commercialbanksplayasignificantrolein
fulfillingtheshorttermandmediumterm
financialrequirementsofindustries.Theydo
notprovide,longtermcredit,sothatliquidity
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CommercialBanks:ItsFunctionsandTypesExplained!

ofassetsshouldbemaintained.Thefundsof
commercialbanksbelongtothegeneralpublic
andarewithdrawnatashortnoticetherefore,
commercialbankspreferstoprovidecreditfora
shortperiodoftimebackedbytangibleand
easilymarketablesecurities.Commercialbanks,
whileprovidingloanstobusinesses,consider
variousfactors,suchasnatureandsizeof
business,financialstatusandprofitabilityofthe
business,anditsabilitytorepayloans.
Commercialbanksareofthreetypes,
whichareasfollows:
(a)PublicSectorBanks:
Refertoatypeofcommercialbanksthatare
nationalizedbythegovernmentofacountry.In
publicsectorbanks,themajorstakeisheldby
thegovernment.InIndia,publicsectorbanks
operateundertheguidelinesofReserveBankof
India(RBI),whichisthecentralbank.Someof
theIndianpublicsectorbanksareStateBankof
India(SBI),CorporationBank,BankofBaroda,
DenaBank,andPunjabNationalBank.
ADVERTISEMENTS:

(b)PrivateSectorBanks:
Refertoakindofcommercialbanksinwhich
majorpartofsharecapitalisheldbyprivate
businessesandindividuals.Thesebanksare
registeredascompanieswithlimitedliability.
SomeoftheIndianprivatesectorbanksare
VysyaBank,IndustrialCreditandInvestment
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CorporationofIndia(ICICI)Bank,andHousing
DevelopmentFinanceCorporation(HDFC)
Bank.
(c)ForeignBanks:
Refertocommercialbanksthatare
headquarteredinaforeigncountry,butoperate
branchesindifferentcountries.Someofthe
foreignbanksoperatinginIndiaareHongKong
andShanghaiBankingCorporation(HSBC),
Citibank,AmericanExpressBank,Standard&
CharteredBank,andGrindlaysBank.InIndia,
sincefinancialreformsof1991,thereisarapid
increaseinthenumberofforeignbanks.
Commercialbanksmarksignificantimportance
intheeconomicdevelopmentofacountryas
wellasservingthefinancialrequirementsofthe
generalpublic.
ADVERTISEMENTS:

FunctionsofCommercialBanks:
Commercialbanksareinstitutionsthatconduct
businessforprofitmotivebyacceptingpublic
depositsforvariousinvestmentpurposes.
Thefunctionsofcommercialbanksare
broadlyclassifiedintoprimaryfunctions
andsecondaryfunctions,whichare
showninFigure1:

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Thefunctionsofcommercialbanks(as
showninFigure1)arediscussedas
follows:
ADVERTISEMENTS:

(a)PrimaryFunctions:
Refertothebasicfunctionsof
commercialbanksthatincludethe
following:
(i)AcceptingDeposits:
Impliesthatcommercialbanksaremainly
dependentonpublicdeposits.
Therearetwotypesofdeposits,which
arediscussedasfollows:
(1)DemandDeposits:
Refertokindofdepositsthatcanbeeasily
withdrawnbyindividualswithoutanyprior
noticetothebank.Inotherwords,theowners
ofthesedepositsareallowedtowithdraw
moneyanytimebysimplywritingacheck.These
depositsarethepartofmoneysupplyasthey
areusedasameansforthepaymentofgoods
andservicesaswellasdebts.Receivingthese
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depositsisthemainfunctionofcommercial
banks.
(2)TimeDeposits:
Refertodepositsthatareforcertainperiodof
time.Bankspayhigherinterestonrime
deposits.Thesedepositscanbewithdrawnonly
afteraspecifictimeperiodiscompletedby
providingawrittennoticetothebank.

(3)AdvancingLoans:
Referstooneoftheimportantfunctionsof
commercialbanks.Thepublicdepositsareused
bycommercialbanksforthepurposeof
grantingloanstoindividualsandbusinesses.
Commercialbanksgrantloansintheformof
overdraft,cashcredit,anddiscountingbillsof
exchange.
(b)SecondaryFunctions:
Refertocrucialfunctionsofcommercialbanks.
Thesecondaryfunctionscanbeclassifiedunder
threeheads,namely,agencyfunctions,general
utilityfunctions,andotherfunctions.
Thesefunctionsareexplainedasfollows:
(1)AgencyFunctions:
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CommercialBanks:ItsFunctionsandTypesExplained!

Impliesthatcommercialbanksactas
agentsofcustomersbyperforming
variousfunctions,whichareasfollows:
(i)CollectingChecks:
Refertooneoftheimportantfunctionsof
commercialbanks.Thebankscollectchecksand
billsofexchangeonthebehalfoftheir
customersthroughclearinghousefacilities
providedbythecentralbank.
(ii)CollectingIncome:
Constituteanothermajorfunctionof
commercialbanks.Commercialbankscollect
dividends,pension,salaries,rents,andinterests
oninvestmentsonbehalfoftheircustomers.A
creditvoucherissenttocustomersfor
informationwhenanyincomeiscollectedbythe
bank.
(iii)PayingExpenses:
Impliesthatcommercialbanksmakethe
paymentsofvariousobligationsofcustomers,
suchastelephonebills,insurancepremium,
schoolfees,andrents.Similartocreditvoucher,
adebitvoucherissenttocustomersfor
informationwhenexpensesarepaidbythe
bank.
(2)GeneralUtilityFunctions:
Includethefollowingfunctions:

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(i)ProvidingLockerFacilities:
Impliesthatcommercialbanksprovidelocker
facilitiestoitscustomersforsafekeepingof
jewellery,shares,debentures,andother
valuableitems.Thisminimizestheriskofloss
duetotheftathomes.
(ii)IssuingTravelersChecks:
Impliesthatbanksissuetravelerschecksto
individualsfortravelingoutsidethecountry.
Travelerschecksarethesafeandeasywayto
protectmoneywhiletraveling.
(iii)DealinginForeignExchange:
Impliesthatcommercialbankshelpin
providingforeignexchangetobusinessmen
dealinginexportsandimports.However,
commercialbanksneedtotakethepermission
ofthecentralbankfordealinginforeign
exchange.
(iv)TransferringFunds:
Referstotransferringoffundsfromonebankto
another.Fundsaretransferredbymeansof
draft,telephonictransfer,andelectronic
transfer.
(3)OtherFunctions:
Includethefollowing:
(i)CreatingMoney:
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Referstooneoftheimportantfunctionsof
commercialbanksthathelpinincreasing
moneysupply.Forinstance,abanklendsRs.5
lakhtoanindividualandopensademand
depositinthenameofthatindividual.
BankmakesacreditentryofRs.5lakhinthat
account.Thisleadstocreationofdemand
depositsinthataccount.Thepointtobenoted
hereisthatthereisnopaymentincash.Thus,
withoutprintingadditionalmoney,thesupply
ofmoneyisincreased.
(ii)ElectronicBanking:
Includeservices,suchasdebitcards,
creditcards,andInternetbanking.

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TypesofCreditOfferedbyCommercial
Banks:
Acommercialbankoffersshorttermloansto
individualsandorganizationsintheformof
bankcredit,whichisasecuredloancarryinga
certainrateofinterest.
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Therearevarioustypesofbankcredit
providedbyacommercialbank,as
showninFigure2:

BankLoan:
Bankloanmaybedefinedastheamountof
moneygrantedbythebankataspecifiedrateof
interestforafixedperiodoftime.The
commercialbankneedstofollowcertain
guidelinestoextendbankloanstoaclient.For
examplethebankrequiresthecopyofidentity
andincomeproofsoftheclientandaguarantor
tosanctionbankloan.Thebanksgrantloanto
clientsagainstthesecurityofassetssothat,in
caseofdefault,theycanrecovertheloan
amount.Thesecuritiesusedagainstthebank
loanmaybetangibleorintangible,suchas
goodwill,assets,inventory,anddocumentsof
titleofgoods.
Theadvantagesofthebankloanareas
follows:
a.Grantsloanatlowrateofinterest
b.Involvesverysimpleprocessofloangranting
c.Requiresminimumdocumentandlegal
formalitiestopasstheloan
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d.Involvesgoodcustomerrelationship
management
e.Consumeslesstimebecauseofmodern
techniquesandcomputerization
f.Providesdoortodoorfacilities
Inadditiontoadvantages,thebankloan
suffersfromvariousimitations,which
areasfollows:
a.Imposesheavypenaltyandlegalactionin
caseofdefaultofloan
b.Chargeshighrateofinterest,ifthepartyfails
topaytheloanamountintheallottedtime
c.Addsextraburdenontheborrower,who
needstoincurcostinpreparinglegal
documentsforprocuringloans
d.Affectsthegoodwilloftheorganization,in
caseofdelayinpayment
CashCredit:
Cashcreditcanbedefinedasanarrangement
madebythebankfortheclientstowithdraw
cashexceedingtheiraccountlimit.Thecash
creditfacilityisgenerallysanctionedforone
yearbutitmayextenduptothreeyearsinsome
cases.Incaseofspecialrequestbytheclient,
thetimelimitcanbefurtherextendedbythe
bank.

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Theextensionoftheallottedtimedependson
theconsentofthebankandpastperformanceof
theclient.Therateofinterestchargedbythe
bankoncashcreditdependsonthetime
durationforwhichthecashhasbeenwithdrawn
andtheamountofcash.
Theadvantagesofthecashcreditareas
follows:
a.Involvesverylesstimeintheapprovalof
credit
b.Involvesflexibilityasthecashcreditcanbe
extendedformoretimetofulfilltheneedofthe
customers.
c.Helpsinfulfillingthecurrentliabilitiesofthe
organization
d.Chargesinterestonlyontheamount
withdrawnbythecustomer.Theintereston
cashcreditischargedonlyontheamountof
cashwithdrawnfromthebank,notonthetotal
amountofcreditsanctioned.
Thecashcreditisoneofthemostimportant
instrumentsofshorttermfinancingbutithas
somelimitations.
Theselimitationsarementionedinthe
followingpoints:
a.Requiresmoresecurityfortheapprovalof
cash

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b.Imposesveryhighrateofinterest
c.Dependsontheconsentofthebanktoextend
thecreditamountandthetimelimit
BankOverdraft:
Bankoverdraftisthequickestmeansofthe
shorttermfinancingprovidedbythebank.Itis
afacilityinwhichthebankallowsthecurrent
accountholderstooverdrawtheircurrent
accountsbyaspecifiedlimit.Theclients
generallyavailthebankoverdraftfacilityto
meeturgentandemergencyrequirements.Bank
overdraftisthemostpopularformofborrowing
anddonotrequireanywrittenformalities.The
bankchargesverylowrateofinterestonbank
overdraftuptoacertaintime.
Theadvantagesofthebankoverdraftare
asfollows:
a.Involvesnodocumentationfortheextension
ofoverdraftamount
b.Imposesnominalinterestontheoverdraft
amount
c.Chargesfeeonlyontheamountexceedingthe
accountlimit
Thedisadvantagesofthebankoverdraft
areasfollows:
a.Incurshighcostfortheclients,iftheyfailto
paytheamountofoverdraftforalongerperiod
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oftime
b.Hampersthereputationoftheorganization,
ifitfailstopaytheamountofoverdraftontime
c.Allowsthebanktodeductoverdraftamount
fromthecustomersaccountswithouttheir
permission
DiscountingofBill:
Discountingofbillisaprocessofsettlingthe
billofexchangebythebankatavaluelessthan
thefacevaluebeforematuritydate.According
toSec.126ofNegotiableInstruments,abillof
exchangeisanunconditionalorderinwriting
addressedbyonepersontoanother,signedby
thepersongivingit,requiringthepersonto
whomitisaddressedtopayondemandorat
fixedordeterminablefuturetimeasumcertain
inmoneytoorderortobearer.
Thefacilityofdiscountingofbillisusedbythe
organizationstomeettheirimmediateneedof
cashforsettlingdowncurrentliabilities.
Conditionslaiddownbythebankfor
discountingofbillareasfollows:
a.Mustbeintendedtospecificpurpose
b.Mustbeenclosedwiththesignatureofthe
twopersons(company,bankorreputedperson)
c.Mustbelessthanthefacevalue

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d.Mustbeproducedbeforethematurityperiod.
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