EEEC

2.4 Commercial Bank and their functions

Meaning:

A commercial bank is an institution that operates for profit.

It accepts deposits from the general public and extends
loans to the households, the firms and the Government. The
essential characteristics of commercial banking include

(1) Acceptance of deposits from the public.

(2) For the purpose of lending or investment.

(3) Withdrawal by means of an instrument whether a

cheque, draft, order, etc.

Definition:

According to Cairns Cross, “A bank is an institution

which deals in money and credit.”

According to Sayers, “Banks are institutions whose debts

are usually referred to as ‘bank deposits’ and commonly
accepted in final settlement of other people debts.”

FUNCTIONS OF COMMERCIAL BANKS

Modern commercial banks perform a variety of functions

and help the industrialists, businessmen and traders. They
keep the wheels of commerce, trade and industry always
revolving. Modern commercial banks perform mainly two
types of functions i.e., primary or banking functions and
secondary or subsidiary functions.

Functions of commercial bank

(A) Primary Functions:

The primary functions of a bank are also known as banking

functions.

They are the main functions of a bank. They are as follows –

(I) Accepting Deposits: Accepting Deposits from the

public is the most important function of a modern
commercial bank offering various types of deposit accounts;
banks mobilize the savings of the community. People who
have surplus money deposit it with a bank for safety. The
commercial banks protect the deposits and give interest on
such deposits. There are four types of accounts:
(a) Saving Deposits Accounts: It is a deposit account
which is operated by individuals for the purpose of saving a
part of their income. Its main objective is to promote
savings. It encourages saving habits among the salary
earners and others. There is no restriction on the number
and amount of deposits. But withdrawals are subject to
certain restrictions. Banks pay a certain percentage of
interest on this deposit. At present it is 4 % p.a. The money
can be withdrawn either by cheque or withdrawal slip.

(b) Fixed Deposits Accounts: Fixed deposits are kept in a

bank for fixed period varying from 30 days to several years.
A certain sum of money is deposited for a fixed period. A
higher rate of interest is paid. The rate may vary from bank-
to-bank Withdrawals are not allowed before the maturity of
period. In case of emergency, if the depositor wants to
withdraw money before the maturity date, he will have to
lose some interest. The depositor is given a fixed deposit
receipt which he has to produce at the time of maturity. The
deposit can be renewed for further period. Fixed deposit
account is also known as time deposit.
(c) Current Deposits Accounts: These accounts are also
known as demand deposits because the amount can be
withdrawn on demand. This type of account is opened by
businessmen who have a number of regular transactions
with the bank, both deposits and withdrawals. There, is no
restriction on the number and amount of deposits. There
are also no restrictions on the withdrawals. Bank does not
pay any rate of interest on such accounts. The bank
provides overdraft facility to current account
holder. Bank’s charge incidental commissions on
such accounts. It facilitates the industrial progress.

(d) Recurring Deposits Account: Under this account,

regular income earners deposit a certain amount of money
at regular intervals for a certain period of time. For
example, an individual can deposit, say Rs 500 every month
for a certain period say, 2 years. Its main objective is to
develop regular savings habits among the public. The
period of deposit is minimum 6 months and maximum 10
years. The rate of interest is higher. At the end of the
maturity period, the account holder can get substantial
amount, which can be utilized for the purchase of consumer
durables or some other investment such as land,
machinery, etc.

(II) Granting Advances (Loans):

The second important function of a commercial bank is to

extend loans and advances. The money which is received
by banks by way of deposits is utilized for granting loans
and advances to worthy borrowers. The profit earning
capacity of a bank mainly depends upon the performance of
the function. This function is also important in the context of
economic development in general and development of
trade, industry and commerce.
(a) Overdraft Facility: An overdraft facility is granted by
the bank only to those persons who have their current
accounts in the bank. To meet the temporary needs of the
customer, the bank may permit the customer to overdraw
the amount from the bank in excess of his balance. The
bank may grant such advance on the personal security. The
interest is charged only on the actual amount used. The
overdraft is granted only occasionally and for short periods.
A certain amount is sanctioned as overdrafts which can be
withdrawn within a certain period of time say three months
or so. It is sanctioned to traders, partnership firms and joint
stock companies. The overdraft facility can be renewed
from time to time.

(b) Cash Credit: It is a short-term credit given by the bank

to any businessman to meet regular working capital needs.
The bank opens a separate account in respect of cash
credit. The borrower is allowed to draw from that account
upto a certain ‘limit against a bond signed by securities or
any other eligible securities. Interest is charged only on the
actual amount withdrawn by the customer. It can be availed
by current account holders as well as other businessmen.
Most industrial concerns and business houses borrow
money in this form.
(c) Loans: When a banker makes a lump-sum advance to
the customers, it is called 'loan'. Interest is charged on the
entire amount sanctioned irrespective of whether the
complete amount is used or not by the customer. Loans are
of various types i.e., Term loans, participation loans,
personal loans, call loans, collateral loans etc.
a) Call Loans or Money at call: are loans repayable at
short notice. They are called call loans, as they can be
called back at any time. These loans are given to for a
period of 7 to 15 days for investment in stock market. The
rate of interest is the lowest.

b) Short term Loans: are provided by commercial bank for

a period not more than two years. The rate of interest is
higher. They are given to businessmen to satisfy their
working capital requirement.

c) Medium term Loans: The loans are sanctioned for a

period of two to five years period. The rate of interest
charged for this type of loan is more than the short-
term loans. Such loans are useful to industries to
introduce innovations or for introduction of new method of
production.
d) Long term Loans: Loans which are sanctioned for five
years are known as long term loans. The rate of interest
charged is higher than other loans. Such loans help
businessmen to introduce permanent changes in the
methods of production.

Discounting Bills of exchange: Another important

function that the modern banks perform is the discounting
of bills of exchange. Advances are made by discounting the
bills of exchange. These advances are given for short
periods only. When the holder of the bill is not in a position
to wait till the maturity of the bill and requires the cash
urgently, he sells the bill of exchange to the bank. The bank
purchases the instrument at a discount. This type of
business is very common in advanced countries.

(B) Secondary Functions:

Secondary functions are also known as non-banking

functions or subsidiary functions or subsidiary functions.
They are classified into two main categories

(a) Agency functions (b) General utility Functions

(A) Agency Functions: Bank also act as agents for their

customers and in that capacity perform certain functions,
which are known as agency functions. For these services,
the bank charges certain commission from the customers.
Some of the agency functions are as follows:

1) Collection: The commercial banks collect cheque, bills,

draft interest, dividends on behalf of their customers and
credit them into their accounts. This service is provided
on the standing instructions from customers.

2) Payments: Banks also pay bills, insurance premium

interest, loan installments, electricity bills, telephone bills,
etc. on behalf of their customers as per their direction.

3) Purchase and Sale of Securities: Bank’s purchase or

sell shares, bonds and securities of private companies on
behalf of their clients.
4) Acts as Trustee: Banks acts as the trustee and the
executor of the wills of their customers after their death.

5) E-Banking (Electronic Banking): A customer can

operate his bank account through internet. Money can be
transferred from one place to another for their customers.
E-banking helps businessmen, traders, merchants in
transacting business.

6) Dematerialization Account (De-mat

Account): Some banks provide De-mat facility. De-mat
account is useful to investors who deal in shares. The
transactions related to buying and selling of shares are
recorded in a separate De-mat account. Periodically
statements regarding shares transactions are given to
each investor.

B) General Utility Functions:

1) Safe Deposit Vault (Lockers): This facility is available

to the general public to enable them to keep their
valuables and securities like ornaments, jewels,
documents, deeds, etc. There is a separate section in
banks where lockers are provided in various sizes on
payment of fixed rates.

2) Remittance of Funds: Banks remit money from one

place to another or even from one country to another.
Remittance of fund is done by telegraphic transfer, mail
transfer, demand draft, etc.

3) Letter of credit: Commercial banks also issue letters of

credit, to enable the traders to buy goods from foreign
countries on credit. Through this letter of credit, the bank
in one country authorizes another bank in foreign country
to honour the draft or cheque of the person named in the
document. The payment is limited to the amount shown in
the letter and the amount is chargeable to the bank which
issues the letter.

4) Referee: As a referee a bank authenticates the credit

worthiness of its customers. This enables the customers
 to run their business smoothly and also obtain goods and
services on credit.

5) Underwriter: Banks provide underwriting facility to the

joint stock companies especially new business enterprises
and also to the government in order to help them in
raising funds. It guarantees the purchase of certain
portion of shares if not sold in the market. Later they are
free to sell these shares in the market whenever they
want to do so. This is all done by the banks on a small
commission from the company.

6) Dealings in Foreign Exchange: By keeping separate

foreign exchange department, commercial banks offer
services for converting one currency into another.

7) ATM facility (Automated Teller machine): Now-a-

day banks also provide ATM facility to their customers.
As a result, they can withdraw money at any time of the
day, at their convenience, whenever they need it.

8) Collects statistics: The modern banks also collect

statistics about money, banking, trade, commerce and
publish them in form of pamphlets and handouts. This
helps their customers in acquiring knowledge about the
latest economic situation.

9) Travellers’ Cheques: Banks help customers by issuing

internal or international travellers’ cheques. When people
travel within the country or between countries traveller’s
cheques are used as most convenient method of carrying
funds.

MULTIPLE CREDIT CREATION (Credit creation by

banks)

The banks are monetary institutions capable of expanding

or contracting money through credit. In the words of
Sayers, "Banks are not merely purveyors of money
but also, in an important sense, manufacturers of
money".

A bank can create money and multiply it too. It can convert

a deposit of Rs. 1000 into Rs. 10,000 and Rs. 10,000 into 1,
00,000. No wonder, it looks like a magic. The process by
which banks can multiply their deposits is called credit
creation.

Though every bank can create credit on its own, multiple

credit creation is possible when the entire banking system
is involved in the process of credit creation.

Assumptions: The process of credit creation can be

explained under the following assumptions:

(i) The bank should be prepared to lend on the basis of

reserves. The required reserves are kept on the basis cash
reserve ratio (CRR) fixed by the central bank. Let us
suppose the cash reserve ratio is 10 percent. The remaining
90 percent would go into the process of credit creation.

(ii) The public should be willing to deposit their money in

banks rather than hoarding.

(iii) There should be sufficient demand for bank loans.

(iv) People should accept the cheques in settlements of

debts in place of cash.

(v) There are several banks operating in the economy.

Primary Deposits and Derivative Deposits:

It is important to learn the concepts of primary deposit and

derivative deposit to understand the process of credit
creation. Primary deposits are the original deposits held by
people with the bank in the form of savings accounts,
current accounts, fixed deposits etc. Suppose if Mr. P
deposits Rs. 100 in his savings account, it becomes
a primary deposit.

A banker knows by his experience that all the depositors do

not withdraw all their deposits at the same time and diverts
the major part of deposits into credit creation after keeping
a part (say 10 percent) for meeting the requirements of
cash reserve ratio.

Every one creates a deposit. Suppose a bank grants a loan

of Rs. 90 to a borrower, he is supposed to maintain an
account in which the loan is credited. Thus, the loan
ultimately becomes a deposit. As this deposit is derived
from primary deposit, it is called derivative deposit or
secondary deposit. Thus, every loan creates a deposit.

Let us suppose bank X receives a primary deposit of Rs. 100

from a deposit holder. Bank X keeps cash reserves of 10
percent (i.e., Rs. 10) and lend the remaining amount Rs. 90
as a loan to Mr. A. Now the balance sheet of bank X appears
as follows:

Balance Sheet of Bank X

Amou Amou
nt nt
Liabilities Assets
Rs. Rs.
Deposits 100 Cash reserve 10
Loan to B 90
100 100

Under double entry system, the amount Rs. 100 appears on

both the sides. The deposit Rs. 100 is a liability to bank X
since it is obliged to return the same to the deposit.

At the same time the cash reserves and loan are treated as
assets of the bank and therefore they appear on the asset
side.

Let us suppose Mr. A uses the loan Rs. 90 to pay off his
creditor Mr. B by means of a cheque. Mr. B in turn deposits
the cheque in his bank Y. As a result Rs. 90 becomes
deposit for bank Y.

Bank Y will keep 10 percent of the deposit as cash reserves

and the remaining amount is granted as a loan to Mr. C.
Now the balance sheet of bank Y will appear as follows.

Balance Sheet of Bank Y

Amou Amou
nt nt
Liabilities Assets
Rs. Rs.
 Deposits 90 Cash reserve 09
Loan to C 81
90 90

Mr. C who receives a loan of Rs. 90 will issue a cheque of

Rs.90 to his creditor Mr. D. who in turn will deposit the
cheque in his bank Z. Bank Z will follow the same procedure
and expansion of credit will take place to extent of Rs.
72.90 by bank Z.

Now the balance sheet of bank Z will appear as follows:

Balance Sheet of Bank Z

Amou Amou
nt nt
Liabilities Assets
Rs. Rs.
Deposits 81 Cash reserve 8.10
Loan to C 72.90
81 81

The system of credit expansion continues in several banks

till the original deposit Rs. 100 gets exhausted. Thus, the
original deposit Rs.100 becomes additional deposits of Rs.
90,81,72.90,65.61 etc. If all these additional deposits are
added, it will lend to a total of Rs.1000. The final position
appears as follows:

The process of Multi Credit Expansion:

Cash
Primary Loans
Bank Reserve
Deposits
s
(Rs.) (Rs.)
(Rs.)
X 100 10 90
Y 90 9 81
Z 81 8.10 72.90
Total 271 27.10 243.90
Key Takeaways:
 A commercial bank is an institution that operates for
profit.
 It accepts deposits from the general public and extends
loans to the households, the firms and the Government.
 A bank is an institution which deals in money and credit
 Modern commercial banks perform a variety of functions
and help the industrialists, businessmen and traders
 Modern commercial banks perform mainly two types of
functions i.e. primary or banking functions and secondary or
subsidiary functions.
 The primary functions of a bank are also known as
banking functions. They are the main functions of a bank
 It is important to learn the concepts of primary deposit
and derivative deposit to understand the process of credit
creation.
 Primary deposits are the original deposits held by people
with the bank in the form of savings accounts, current
accounts, fixed deposits etc.