Explain the functions of commercial bank

A commercial bank is a financial institution which performs the functions of accepting deposits from the general public and giving loans for investment with the aim of earning profit.

The banks which perform all kinds of banking business and generally finance trade and commerce are called commercial banks.

Commercial Banks are the oldest and fastest growing banks in India. They are also most important depositories of public savings and the most important depositories banking in India is a unique system in world. In fact, commercial banks, as their name suggests, axe profit-seeking institutions, i.e., they do banking business to earn profit. They generally finance trade and commerce with short-term loans. They charge high rate of interest from the borrowers but pay much less rate of Interest to their depositors with the result that the difference between the two rates of interest becomes the main source of profit of the banks. Most of the Indian joint stock Banks are Commercial Banks such as Punjab National Bank, Allahabad Bank, Canara Bank, Andhra Bank, Bank of Baroda, etc.

Functions of Commercial Bank

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) Providing loans are termed as commercial banks. For example post offices are not bank because they do not give loans. Functions of commercial banks are classified in to two main categories — (A) Primary functions and Secondary functions.

Primary Function

Accepting Deposit
Providing Loan
Creation of Credit

Secondary Function

Bill Discounting
Overdraft Facility
Agency Functions

Primary Function

Accepting Deposit

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:

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.
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., 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 higher rate of interest. They are not treated as a part of money supply Recurring deposit in which a regular deposit of an agreed sum is made is also a variant of fixed deposits.
Savings account deposits:
These are deposits whose main objective is to save. 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 withdraw able by cheque. But 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.

Providing Loan

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 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.

Cash Credit:
An eligible borrower is 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 portion of credit (loan).
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.
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 instalment or in a number of instalments over the period of loan.

Creation of Credit

Creation of credit is one of the most important functions of commercial banks. It is one of the most important functions of commercial banks. It is said that every loan creates a deposit. A cheque book is given to the borrowers with the right to draw cheques up to the full amount of the loan. The bank is able to lend money and charges interest without parting with cash. Thus, bank creates a deposit, it creates a credit for the borrower. In all a very small cash reserve is kept by the bank to meet the obligations arising out of such transactions and credit aggregated to a very big amount. However ,there are limitations on the powers of these banks to create credit.

Secondary Function

Apart from the above-mentioned two primary (major) functions, commercial banks perform the following secondary functions also.

Bill Discounting or Bill of Exchange

Bill Discounting is another way of lending money. The commercial bank purchase these bills through brokers and discount them directly for the traders. These bills provide a very liquid assets. The banks immediately pay cash for the bills after deducting the discount and wait for all the bill to mature when they get back its full value. This is regarded as the best investment by the bank because it is liquid, lucrative and safe.

Alternatively, a bill of exchange is a document acknowledging an 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 specified period, the bank will get payment from A.

Overdraft facility:

An overdraft is an advance given by allowing a customer keeping 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 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 honors the cheque. The security for overdraft is generally financial assets like shares, debentures, life insurance policies of the account holder, etc.