Definition of a commercial bank
A commercial bank is a profit-oriented financial institution that grants loans and accepts money and other valuables for safekeeping.
Commercial banks are called high-street banks as they have a network of branches through which their services can be accessed by the public, i.e. individuals and businesses.
Functions of a commercial bank
The primary functions of the bank are accepting deposits and granting loans. It makes most of its earnings from interest on lending. The interest charged on loans is higher than the one paid on savings accounts. The difference between interest income (total interest on loans) and interest expense (total interest on deposits) is a major source of income for the bank.
The secondary functions include business advisory and agency services.
Deposits taking
It accepts deposits from individuals and businesses in three types of accounts: current accounts, savings accounts, and fixed deposit accounts.
A current account is a very active account with regular payments and withdrawals. The holder usually opens this account to meet current expenses. The account holder can request his/her deposit or withdraw it on demand, i.e., without giving prior notice to the bank. Current account entitles the holder to almost all banking facilities, e.g., certified cheques, overdrafts, etc. This account is also referred to as a demand deposit account or sight account.
A savings account is meant for saving but withdrawals can be made at any time. A fixed deposit account is for saving money for a specific period with a fixed interest rate agreed between the depositor and the bank. A fixed deposit requires notice before the money is withdrawn. Banks pay interest on savings and fixed deposit accounts. A fixed deposit account attracts a higher interest rate since the money is kept for a specific period without withdrawal.
Lending
Commercial banks lend to individuals and businesses through loans and overdrafts. Overdraft is a facility that allows an account holder to withdraw more than the balance in his/her account. This is usually arranged with the bank and interest is charged on the amount overdrawn.
A loan is a facility that is given for a specific time and purpose. The loans granted by commercial banks are mainly short-term to medium-term since most of their deposits are short-term and medium-term in nature. Interest is charged on the whole loan. The bank usually requires an asset to serve as security for the loan. This is known as collateral. The interest charged on a loan is lower than what is charged on an overdraft.
Agency services
Commercial banks perform some functions on behalf of their customers for a commission, e.g., fund transfers, payment of bills, collection of dividends or interests, etc.
Foreign exchange dealing
They are often authorised to buy and sell foreign currencies on behalf of their customers. They make foreign currencies available to customers who are involved in importation/exportation or settlement of foreign transactions, e.g., paying school fees abroad.
Purchase and sale of securities
They facilitate the purchase and sale of securities such as shares and bonds. They help sell new issues of shares by receiving the application money for new shares, as they have a widespread network and can reach a lot of people, even in remote parts of the country.
Advisory services
Commercial banks offer business advisory services to customers due to their experience in money management and finance.
Letters of credit
This is a means of guaranteeing payments to sellers on behalf of its customers involved in international trade. The bank agrees to pay the seller if the buyer (its customer) is unable to pay for the products purchased.
Safekeeping of valuables
It keeps valuable documents and belongings such as jewelry, insurance policies and certificates of occupancy. Deposit lockers are made available for rent; these lockers are kept securely by the bank with a key for access by the customer.
Commercial banks versus investment banks
Commercial banks offer services that are accessible to members of the public (individuals, big and small businesses). The services rendered include deposit-taking, lending and agency services. They have a branch network through which their services can be accessed. In addition, these banks are subjected to high and intensive regulation because their failure may lead to loss of confidence in the financial system and bank run. A bank run is a situation where people start withdrawing their money from banks which may eventually lead to their collapse.
Investment banks, on the other hand, target big businesses and high-networth individuals with their financial services such as issuance of securities, arranging finance, asset management, mergers and acquisitions, etc. They do not have many branches as their services are not targeted at the general public. They are also regulated but not as much as commercial banks.
Objectives of a commercial bank
A commercial bank has three major objectives, namely liquidity, security and profitability. These objectives do conflict but efforts are made to ensure there is a balance. Increased lending boosts profitability but may pose a risk to the bank, thereby limiting its ability to achieve liquidity and security. Regulators put measures in place to ensure that banks operate safely with adequate capital and liquidity. On the other hand, pursuing liquidity and security by restricting lending would reduce profitability. A less profitable bank will fail to attract investors and customers.
Liquidity
Banks must have enough liquid assets to meet up with unexpected demand for cash by depositors. Liquid assets are assets that can be easily converted into cash, e.g. cash and short-term securities. Cash is the most liquid asset. There is a percentage of total deposits that must be held in liquid assets. This is known as the bank reserve ratio. The reserve ratio is determined by the central bank.
Security
Banks must ensure they are protected against failure. They have to abide by regulations to ensure they do not cease operations abruptly. For example, they are required to keep part of their deposits with the central bank. This will limit their lending ability and profitability since they make profits from lending and offering other services to their customers.
Banks are subject to capital requirements to ensure they do not go under. The bank must have adequate capital to continue operations even if debtors default in repaying their loans. Undercapitalised banks are subject to sanctions or risk losing their licences.
Profitability
The owners of the bank (shareholders) receive part of the profit as compensation for investing in the bank. More loans have to be given out to earn more profits. But this must not be done in a way that jeopardises the other two objectives of liquidity and security. Too much lending can increase the risk of default which may cause financial distress for the bank.
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