How Do Commercial Banks Work and Why Do They Matter?

What is a Commercial Bank?

A commercial bank is a type of financial intermediary that offers a variety of services and products to businesses in order to help them with their liquidity needs. These banks also offer small to medium-sized enterprises and individuals basic banking services like loans and deposit accounts. Most people use commercial banks to handle their banking needs.

In simple terms, a commercial bank is a type of financial organisation that allows customers to deposit money and provides loans for profit-making investments and consumption. Public and private sector banks both fall under the category of commercial banks.

Institutions take and maintain deposits to generate fee income and serve as a low-cost funding source. Funds can help earn interest income through the establishment of credit and providing credit facilities. Commercial banks' two main sources of income-accepting deposits and issuing credit-serve a wide range of industries and clientele. Commercial banks play a key role in a nation's economy since they provide various businesses' short- and medium-term financing needs.

How do Commercial Banks work?

The general public, including individuals and small to medium-sized businesses, is provided with basic banking products and services by commercial banks. These services include checking and savings accounts, loans, mortgages, basic investment options like CDs (Certificates of Deposits), and other services like safe deposit boxes.

Banks make money from interest on loans they give to other clients. They also earn through service fees and other charges; these costs range from account fees, periodic maintenance fees, minimum balance charges, overdraft charges, safe deposit box charges, and other fees, depending on the products.

Banks profit from the interest earned on loans given to other consumers, and from regular deposits of customers, the banks get back the money they lent. However, the bank pays lower interest on money borrowed than it charges on money lent. For example, a bank might charge mortgage customers a yearly interest rate of 5% while offering savings account customers a yearly interest rate of 0.5%.

Commercial banks are usually located in buildings where customers go to perform normal banking transactions using ATMs and teller window services. However, due to technological advancements, most banks nowadays enable their customers to conduct the majority of their services online, like transfers, deposits, and bill payments.

Functions of Commercial Bank

Commercial bank functions are divided into two main categories, such as Primary and Secondary Functions. They are:

Primary Functions

The following are some of the primary functions that commercial banks perform:

• Deposit Acceptance: Savings, fixed, and current deposits are all accepted by commercial banks from their clients.
• Savings Deposits: Savings deposits allow customers to credit up to a specified amount of money to their accounts. People with a fixed salary/income prefer these deposits as they can accumulate money over time.
• Fixed Deposits: A defined lock-in period is included with fixed deposits. Since the money is deposited for a defined period, FD is also known as a time deposit.
• Current Deposits: Current deposits enable account holders to add and remove funds as needed. In some circumstances, individuals and corporations can receive overdrafts up to a predetermined amount through current accounts.
• Offering Loans: Providing loans to businesses and individuals and earning money from the interest generated are a few of the major functions of commercial banks. These banks typically provide their clients with a variety of short- and long-term credits while keeping a small reserve for operating costs.
• Credit Creation: It is one of the functions of commercial banks. Banks provide a credit line in place of providing liquid cash and disburse the loan to a company or other commercial entity all at once.

Secondary Functions

The following are some of the secondary functions that commercial banks perform:

• Locker Facilities: The offering of locker facilities is something commercial banks do for customers who desire a secure place to store their belongings, which eliminates the constant risk of theft or loss associated with storing items at home.
• Exchange of Securities: Another function that commercial banks perform is trading in bonds and other securities; customers can buy or sell the securities directly from the banking institution, which is more convenient than other options.
• Discounting Bills of Exchange: In modern times, a commercial bank's primary function is to discount bills issued by companies. Banks are thought to profit from their investments in bill discounting; bills generate a consistent flow of money while preventing potentially risky situations during payment, as they are considered negotiable instruments. Additionally, they don't subject the financial institution to any legal disputes.
• Bank as an Agent: Commercial Bank and its role also call for them to perform the duties of an agent by offering customers various financial services.
• Dealing in Foreign Exchange: Commercial banks assist in foreign exchange to organisations and individuals that export or import items abroad; however, such operations can only be carried out by a small number of banks that are permitted to deal in foreign exchange.

Importance of Commercial Banks

Commercial banks play an important role in the economy. They generate cash and liquidity in the market in addition to offering customers necessary services.

They maintain liquidity by taking the money their consumers deposit in their accounts and lending it to others. Commercial banks contribute to credit issuance, increasing output, employment, and consumer spending while promoting economic growth.

As a result, each country or region's central bank has stringent rules for commercial banks. For example, commercial banks are subject to reserve requirements set by central banks. As a safety measure in case there is a sudden surge of withdrawals by the general public, banks are therefore obligated to hold a specific portion of customer deposits at the central bank.

Commercial Banking vs Investment Banking

Commercial banking and investment banking share similarities but have quite different objectives. A commercial bank offers home, auto, and other types of personal loans, as well as finance for individuals and businesses. An investment bank, on the other hand, provides financial services to large corporations and institutional investors. The following are some other significant distinctions between these two types of banking:

Primary Services

Credit lines, credit cards, small- to medium-sized business loans, housing loans, auto loans, personal savings and checking accounts, and ATM services are some of the main services provided by commercial banks. Larger funding quantities are provided by investment banks for corporate financing and investing.

Regulations

Although both commercial and investment banks must abide by regulations, their services and the regulations that apply to them are considerably different. An investment bank, for instance, might not even take housing loan regulations into account because it does not offer home loans, but it may be governed by corporate lending requirements.

Size and Liquidity

However, almost all commercial and investment banks have considerable liquidity to provide their customers with lending, financing, and other services. Investment banks frequently require bigger funds for corporate funding and investing; these institutions frequently have a higher amount of money available in various forms.

Clientele

Small to medium-sized enterprises, as well as individuals, are generally served by commercial banks. In contrast, large corporations, high-net-worth individuals, investment businesses, and even governments can all be served by an investment bank. They serve as financial brokers, offering their clients underwriting services, merger and acquisition plans, corporate restructuring services, and brokerage services for many institutions and HNWIs (high-net-worth individuals).