The commercial bank is the financial institution performs diverse types of functions. It satisfies the financial needs of sectors such as agriculture, industry, trade, communication, etc. That means they play a very significant role in a process of economic social needs. The functions performed by banks are changing according to change in time and recently they are becoming customer centric and widening their functions. Generally, the functions of commercial banks are divided into two categories viz. primary functions and the secondary functions. Also learned, Explain Primary and Secondary Functions of Commercial Banks!
Learn, Explain Primary and Secondary Functions of Commercial Banks!
The two most distinctive features of a commercial bank are borrowing and lending, i.e., acceptance of deposits and lending of money to projects to earn Interest (profit). In short, banks borrow to lend. The rate of interest offered by the banks to depositors is called the borrowing rate while the rate at which banks lend out is called lending rate.
The difference between the rates is called ‘spread’ which is appropriated by the banks. Mind, all financial institutions are not commercial banks because only those which perform dual functions of (i) accepting deposits and (ii) giving loans are termed as commercial banks. For example, post offices are not the bank because they do not give loans. Functions of commercial banks are classified into two main categories: (A) Primary functions, and (B) Secondary functions.
Let us know about each of them:
(A) Primary Functions:
The Following primary functions below are:
1. It accepts deposits:
A commercial bank accepts deposits in the form of current, savings and fixed deposits. It collects the surplus balances of the Individuals, firms, and finances the temporary needs of commercial transactions. The first task is, therefore, the collection of the savings of the public. The bank does this by accepting deposits from its customers. Deposits are the lifeline of banks.
Deposits are of three types as under:
(i) Current account deposits:
Such deposits are payable on demand and are, therefore, called demand deposits. These can be withdrawn by the depositors any number of times depending upon the balance in the account. The bank does not pay any Interest on these deposits but provides cheque facilities.
These accounts are generally maintained by businessmen and Industrialists who receive and make business payments of large amounts through cheques.
(ii) Fixed deposits (Time deposits):
Fixed deposits have a fixed period of maturity and are referred to as time deposits. These are deposits for a fixed term, i.e., the period of time ranging from a few days to a few years. These are neither payable on demand nor they enjoy cheque facilities.
They can be withdrawn only after the maturity of the specified fixed period. They carry a higher rate of interest. They are not treated as a part of the money supply Recurring deposit in which a regular deposit of an agreed sum is made is also a variant of fixed deposits.
(iii) Savings account deposits:
These are deposits whose main objective is to save. The savings account is most suitable for individual households. They combine the features of both current account and fixed deposits. They are payable on demand and also withdrawable by cheque.
But the bank gives this facility with some restrictions, e.g., a bank may allow four or five cheques in a month. Interest paid on savings account deposits in lesser than that of fixed deposit.
Difference between demand deposits and time (term) deposits:
Two traditional forms of deposits are demand deposit and term (or time) deposit:
- Deposits which can be withdrawn on demand by depositors are called demand deposits, e.g., current account deposits are called demand deposits because they are payable on demand but saving account deposits do not qualify because of certain conditions on withdrawal. No interest is paid on them. Term deposits, also called time deposits, are deposits which are payable only after the expiry of the specified period.
- Demand deposits do not carry interest whereas time deposits carry a fixed rate of interest.
- Demand deposits are highly liquid whereas time deposits are less liquid,
- Demand deposits are chequable deposits whereas time deposits are not.
2. It gives loans and advances:
The second major function of a commercial bank is to give loans and advances particularly to businessmen and entrepreneurs and thereby earn interest. This is, in fact, the main source of income of the bank. A bank keeps a certain portion of the deposits with itself as the reserve and gives (lends) the balance to the borrowers as loans and advances in the form of cash credit, demand loans, short-run loans, overdraft as explained under.
(i) Cash Credit:
An eligible borrower has first sanctioned a credit limit and within that limit, he is allowed to withdraw a certain amount on a given security. The withdrawing power depends upon the borrower’s current assets, the stock statement of which is submitted by him to the bank as the basis of security. Interest is charged by the bank on the drawn or utilized the portion of credit (loan).
(ii) Demand Loans:
A loan which can be recalled on demand is called demand loan. There is no stated maturity. The entire loan amount is paid in lump sum by crediting it to the loan account of the borrower. Those like security brokers whose credit needs fluctuate generally, take such loans on personal security and financial assets.
(iii) Short-term Loans:
Short-term loans are given against some security as personal loans to finance working capital or as priority sector advances. The entire amount is repaid either in one installment or in a number of installments over the period of the loan.
Commercial banks invest their surplus fund in 3 types of securities:
(i) Government securities, (ii) Other approved securities and (iii) Other securities. Banks earn interest on these securities.
(B) Secondary Functions:
Apart from the above-mentioned two primaries (major) functions, commercial banks perform the following secondary functions also.
3. Discounting bills of exchange or bundles:
A bill of exchange represents a promise to pay a fixed amount of money at a specific point of time in future. It can also be encashed earlier through the discounting process of a commercial bank. Alternatively, a bill of exchange is a document acknowledging the amount of money owed in consideration of goods received. It is a paper asset signed by the debtor and the creditor for a fixed amount payable on a fixed date. It works like this.
Suppose, A buys goods from B, he may not pay B immediately but instead give B a bill of exchange stating the amount of money owed and the time when A will settle the debt. Suppose, B wants the money immediately, he will present the bill of exchange (Hundi) to the bank for discounting. The bank will deduct the commission and pay to B the present value of the bill. When the bill matures after the specified period, the bank will get payment from A.
4. Overdraft facility:
An overdraft is an advance given by allowing a customer keeping the current account to overdraw his current account up to an agreed limit. It is a facility to a depositor for overdrawing the amount than the balance amount in his account.
In other words, depositors of current account make the arrangement with the banks that in case a cheque has been drawn by them which are not covered by the deposit, then the bank should grant overdraft and honor the cheque. The security for the overdraft is generally financial assets like shares, debentures, life insurance policies of the account holder, etc.
Difference between Overdraft facility and Loan:
- Overdraft is made without security in current account but loans are given against security.
- In the case of the loan, the borrower has to pay interest on full amount sanctioned but in the case of an overdraft, the borrower is given the facility of borrowing only as much as he requires.
- Whereas the borrower of loan pays Interest on the amount outstanding against him but the customer of overdraft pays interest on the daily balance.
5. Agency functions of the bank:
The bank acts as an agent of its customers and gets the commission for performing agency functions as under:
- Transfer of funds: It provides a facility for cheap and easy remittance of funds from place-to-place through demand drafts, mail transfers, telegraphic transfers, etc.
- Collection of funds: It collects funds through cheques, bills, bundles and demand drafts on behalf of its customers.
- Payments of various items: It makes payment of taxes. Insurance premium, bills, etc. as per the directions of its customers.
- Purchase and sale of shares and securities: It buys sells and keeps in safe custody securities and shares on behalf of its customers.
- Collection of dividends, interest on shares and debentures is made on behalf of its customers.
- Acts as Trustee and Executor of the property of its customers on the advice of its customers.
- Letters of References: It gives information about the economic position of its customers to traders and provides similar information about other traders to its customers.
6. Performing general utility services:
The banks provide many general utility services, some of which are as under:
- Traveler’s cheques. The banks issue traveler’s cheques and gift cheques.
- Locker facility. The customers can keep their ornaments and important documents in lockers for safe custody.
- Underwriting securities issued by the government, public or private bodies.
- Purchase and sale of foreign exchange (currency).
Primary Functions of Commercial Banks:
Commercial Banks performs various primary functions some of them are given below
- Accepting Deposits: Commercial bank accepts various types of deposits from the public especially from its clients. It includes saving account deposits, recurring account deposits, fixed deposits, etc. These deposits are payable after a certain time period.
- Making Advances: The commercial banks provide loans and advances of various forms. It includes an overdraft facility, cash credit, bill discounting, etc. They also give demand and demand and term loans to all types of clients against proper security.
- Credit creation: It is the most significant function of commercial banks. While sanctioning a loan to a customer, a bank does not provide cash to the borrower Instead it opens a deposit account from where the borrower can withdraw. In other words, while sanctioning a loan a bank automatically creates deposits. This is known as a credit creation from the commercial bank.
Secondary Functions of Commercial Banks:
Along with the primary functions each commercial bank has to perform several secondary functions too. It includes many agency functions or general utility functions.
The secondary functions of commercial banks can be divided into agency functions and utility functions.
Agency Functions: Various agency functions of commercial banks are.
- To collect and clear cheque, dividends and interest warrant.
- To make payment of rent, insurance premium, etc.
- To deal in foreign exchange transactions.
- To purchase and sell securities.
- To act as trustee, attorney, correspondent, and executor.
- To accept tax proceeds and tax returns.
General Utility Functions: The general utility functions of the commercial banks include.
- To provide a safety locker facility to customers.
- To provide money transfer facility.
- To issue a traveler’s cheque.
- To act as referees.
- To accept various bills for payment e.g phone bills, gas bills, water bills, etc.
- To provide merchant banking facility.
- To provide various cards such as credit cards, debit cards, Smart cards, etc.