Question

What main functions are performed in the economy by commercial banks?

Short answer

The main functions performed in the economy by commercial banks include: 1) Accepting deposits from the public through savings accounts, current accounts, or fixed deposits, thereby allowing individuals to save their surplus income and earn interest; 2) Granting loans and advances to individuals, businesses, and industries at a higher interest rate than they offer to depositors, with the difference in interest rates acting as their main source of income; 3) Providing overdraft facilities, allowing customers to withdraw more money than is present in their accounts and charging interest on the overdraft amount; 4) Offering agency services such as collection and payment of credit instruments, buying and selling securities on behalf of customers, and the collection of dividends and interest on stocks and debentures; 5) Delivering general utility services like locker facilities, issuing traveler's checks, fund transfers, and underwriting of shares, all of which contribute to national economic development.

Step-by-step solution

Accepting Deposits

The base function of commercial banks is to accept deposits from the public. This can be in the form of savings accounts, current accounts, or fixed deposits. By doing this, banks enable individuals to save their surplus income and earn interest on it.

Granting Loans and Advances

Commercial banks provide loans and advances out of the money received through deposits. They advance money to individuals, businesses, and industries at a higher rate of interest than they offer to depositors. The difference in interest rates constitutes the main source of their income.

Overdraft Facility

Overdraft is another type of loan facility offered by commercial banks to its customers. Customers can withdraw more money than what is actually present in their account. The excess amount is considered as loan, and interest is charged on the overdraft amount.

Agency Services

Commercial banks also offer agency services to their customers. This includes collection and payment of credit instruments like cheques, bills, and drafts, buying and selling securities on behalf of their customers, collection of dividends, interest on stocks and debentures, etc.

General Utility Services

Banks provide various general utility services such as providing locker facilities, issuing traveler's checks, providing transfer of funds, underwriting of shares, etc. These services not only meet the general needs of the customers, but also contribute significantly to the national economic development.

Key concepts

Accepting Deposits

In the world of banking, accepting deposits is the cornerstone upon which all other services rest. Commercial banks offer various deposit accounts, each catering to different customer needs. Savings accounts, for instance, encourage regular saving habits among individuals by providing a safe place to keep money and earn a modest interest rate. For those who handle daily transactions more frequently, current accounts are suitable as they typically do not bear interest but offer unlimited transactions and easy access to funds. Meanwhile, fixed deposits appeal to those looking for higher interest rates in exchange for leaving their money with the bank for a predetermined period. Collectively, these deposits form a substantial pool of resources that banks can use to extend various credit facilities to other clients.

By offering interest on deposits, banks incentivize customers to leave their money in the bank's hands. This interest acts as a reward for the depositors and is vital in building trust between customers and financial institutions. It is essential to understand the symbiotic relationship between depositors and banks: while customers seek a secure place to hold and grow their savings, banks need the collected funds to support their lending endeavors and thus generate profits.

Granting Loans

One of the primary functions of commercial banks is granting loans. This involves providing financial assistance to individuals, businesses, or government entities. Banks assess the creditworthiness of applicants before issuing loans to mitigate the risk of default. Interest rates on these loans are typically higher than the rates provided on deposits, which serves as the primary source of revenue for banks.

Loans come in various forms, such as mortgages for home buyers or business loans for companies looking to expand their operations. This function of banks is instrumental in propelling economic growth, as it gives borrowers the capital needed to make significant purchases, invest in developments, or cover operational costs. The careful assessment of loan applications, followed by prudent lending policies, ensures that banks maintain a healthy loan portfolio and contribute positively to their community's economic health.

Overdraft Facility

The overdraft facility is an important credit service provided by commercial banks. This facility allows customers to spend more than what is available in their account, up to a certain limit agreed upon with the bank. An overdraft is essentially a short-term loan, and the bank charges interest only on the overdrafted amount. This service is particularly valuable for businesses that experience seasonal fluctuations in cash flow or to individuals faced with sudden unexpected expenses.

An overdraft can also serve as a financial safety net, providing an additional layer of flexibility and security to account holders. However, it's crucial for customers to be aware of the interest rates and terms associated with overdrafts, as excessive use without proper management can lead to financial strain. Educating customers about proper overdraft usage and the importance of managing their accounts effectively helps ensure that this facility is a boon rather than a burden.

Agency Services

Commercial banks also function as agents for their customers, whereby they perform a set of agency services. These services simplify and manage various financial transactions, which may otherwise be time-consuming and complex for customers to handle independently.

One common agency service is the processing of payments and collections, such as handling the clearance of cheques, bills, and drafts. Additionally, banks operate in the investment realm, where they buy and sell securities on behalf of their account holders. Beyond transactional services, they also assist customers with the collection of dividends and interest on investments. These services, while contributing to customer convenience, also reinforce the relationship between banks and their clientele by positioning the bank as a trusted financial partner for various needs.

General Utility Services

Beyond traditional banking offerings, commercial banks provide wide-ranging general utility services that add convenience and function to everyday financial activities. For instance, banks offer safe deposit locker facilities where individuals can store valuable items securely. Similarly, services like the issuance of traveler's checks simplify the traveling experience by providing a safer alternative to carrying cash.

Furthermore, banks facilitate the smooth transfer of funds across geographical boundaries through wire transfers and electronic payments. Another important utility service is the underwriting of shares, wherein banks guarantee the sale of new stock issued by companies and manage the financial aspects of this process. These ancillary functions provided by banks help forge a deeper bond with their customers, catering to a comprehensive array of financial activities beyond the realm of ordinary banking services.