Category : Banking
Credit Functions of 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. All financial institutions are not commercial banks but 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 bank because they do not give loans. Functions of commercial banks are classified into two main categories - (A) Primary functions and (B) Secondary functions.
(A) PRIMARY FUNCTIONS:
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 These can be withdrawn by the depositors any number of times depending upon the balance in the account.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., 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They can be withdrawn only after the maturity of the specified fixed period.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.
(iii) 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 withdrawable 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 is 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:
(i) 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.
(ii) Demand deposits do not -carry interest whereas time deposits carry a fixed rate of interest.
(iii) Demand deposits are highly liquid whereas time deposits are less liquid.
(iv) Demand deposits are chequable deposits whereas time deposits are not.
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.
(i) 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 utilised 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. For example, 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 instalment or in a number of instalments over the period of 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 primary (major) functions, commercial banks perform the following secondary functions also.
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 discounting process of a commercial bank. 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.
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 more amount than the balance amount in his account. In other words, depositor of a current account makes arrangement with the bank that in case a cheque has been drawn by it which is not covered by the deposit, then the bank should grant overdraft and honour the cheque. The security for overdraft is generally financial assets like shares, debentures, life insurance policies of the account holder, etc.
Difference between Overdraft facility and Loan:
(i) Overdraft is made without security in current account but loans are given against security.
(ii) In case of loan, the borrower has to pay interest on full amount sanctioned but in case of overdraft, the borrower is given the facility of borrowing only as much as he requires.
(iii) The borrower of loan pays Interest on amount outstanding against him whereas customer of overdraft pays interest on the daily balance.
The bank acts as an agent of its customers and gets commission for performing agency functions as under:
(i) Transfer of funds:
It provides facility for cheap and easy remittance of funds from place-to-place through demand drafts, mail transfers, telegraphic transfers, etc.
(ii) Collection of funds:
It collects funds through cheques, bills, bundles and demand drafts on behalf of its customers.
(iii) Payments of various items:
It makes payment of taxes. Insurance premiums, bills, etc. as per the directions of its customers.
(iv) Purchase and sale of shares and securities:
It buys and sells and keeps in safe custody securities and shares on behalf of its customers.
(v) Collection of dividends, interest on shares and debentures is made on behalf of its customers.
(iv) Acts as Trustee and Executor of property of its customers on advice of customers.
(vii) Letters of References:
It gives information about economic position of its customers to traders and provides similar information about other traders to its customers.
The banks provide many general utility services; some of which are as under:
(i) Traveller's cheques - The banks issue travellers cheques and gift cheques.
(ii) Locker facility. The customers can keep their ornaments and important documents in lockers for safe custody.
(iii) Underwriting securities issued by government, public or private bodies.
(iv) Purchase and sale of foreign exchange (currency).
A merchant bank is a company that deals mostly in international finance, business loans for companies and underwriting. These banks are experts in international trade, which makes them specialists in dealing with multinational corporations. A merchant bank may perform some of the same services as an investment bank, but it does not provide regular banking services to the general public. It is a combination of Banking and consultancy services. It provides consultancy to its clients for financial, marketing, managerial and legal matters. Consultancy means to provide advice, guidance and service for a fee. It helps a businessman to start a business. It helps to raise (collect) finance. It helps to expand and modernize the business. It helps in restructuring of a business. It helps to revive sick business units. It also helps companies to register, buy and sell shares at the stock exchange.
Differences between Investment Banks and Merchant Banks
A merchant bank typically works with companies that may not be large enough to raise funds from the public through an initial public offering (IPO), and these banks use more creative forms of financing. Merchant banks help corporations issue securities through private placements, which require less regulatory disclosure and are sold to sophisticated investors.
Investment banks, on the other hand, underwrite and sell securities to the general public through IPOs. The bank's clients are large corporations that are willing to invest the time and expense necessary to register securities for sale to the public. Investment banks also provide advice to companies regarding potential mergers and acquisitions, and provide investment research to clients. Both investment banks and merchant banks strive to build relationships with corporations so that the institution can provide a variety of services.
Regardless of how a company sells securities, there are some minimum disclosure requirements to inform investors. Both IPOs and private placements require a company audit by an outside CPA firm, which provides an opinion on the financial statements. The audited financial statements must include several years of historic financial data, along with footnote disclosures. All of this information is provided to inform the potential investor about the risks and potential rewards of buying the securities.
Credit (Money) Creation by Commercial Banks
RBI produces money while commercial banks increase the supply of money by creating credit which is also treated as money creation. Commercial banks create credit in the form of secondary deposits.
Cheques and their Types
A cheque is an agreement between two individuals or organizations to make a payment. In simple words. Cheque is an order to a bank to pay a stated sum from the drawer's account, written on a specially printed form. Cheque is used to make safe and convenient payment. It is less risky and the danger of loss is minimized.
A person writing the cheque and having a transaction banking account where their money is held is a drawer. The drawer writes the various details including the monetary amount, date, and a payee on the cheque, and signs it, ordering their bank, known as the Drawee, to pay that person or company the amount of money stated.
Bearer Cheque refers to a cheque that is payable to whoever presents it rather than to a designated payee.
When a cheque is not crossed, it is known as an "Open Cheque" or an "Uncrossed Cheque". The payment of such a cheque can be obtained at the counter of the bank.
Crossing of cheque means drawing two parallel lines on the face of the cheque. A crossed cheque cannot be encashed at the cash counter of a bank but it can only be credited to the payee's account.
If a cheque bears a date earlier than the date on which it is presented to the bank, it is called as "anti-dated cheque". Such a cheque is valid up to three months from the date of the cheque.
If a cheque bears a date which is yet to come (future date) then it is known as post-dated cheque. A post-dated cheque cannot be honoured earlier than the date on the cheque.
If a cheque is presented for payment after three months from the date of the cheque, it is called stale cheque. A stale cheque is not honoured by the bank.
Demand Draft is a kind of pre-paid negotiable instrument that is used to direct payments from one bank to another bank or one of its own branches to pay a certain sum to the specified party.
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