Primary Functions of Banks: Banks play a vital role in modern commerce and are crucial to the economic development of nations worldwide. They perform two primary functions, functions of money, which are as follows:
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Accepting Deposits
The primary function of a commercial bank is to attract deposits from the public. Individuals with excess income and savings prefer depositing their funds in banks. These deposits can be of various types and typically accrue interest. As a result, both the deposited amounts and the interest earned on them contribute to the growth of deposits held by the bank. Higher interest rates often incentivize the public to deposit more of their funds in the bank. Additionally, there is a sense of security associated with keeping money in a bank.
Banks are often referred to as custodians of public funds. While they primarily accept deposits for safekeeping, they also utilize these funds to earn interest from borrowers. A portion of this interest is shared with the depositors. The specific interest rate is influenced by the duration for which the depositor chooses to keep their money with the bank and the flexibility of withdrawal. In general, a longer tenure and more lenient withdrawal restrictions result in higher interest rates, while shorter tenures and stricter withdrawal terms lead to lower interest rates.
Providing Loans and Advances
The second pivotal function of a commercial bank is to offer loans and advances. Banks receive deposits from the public for safekeeping and pay them interest. Subsequently, they extend these funds as loans to earn interest. In essence, banks serve as intermediaries connecting those with surplus funds to lend and those in need of funds for conducting various business transactions. The margin between the interest paid on deposits and charged on loans is commonly referred to as the “spread.”
Loans and advances are extended to both the general public and the business community at interest rates higher than those offered on different deposit accounts. The interest rate applied to loans and advances varies based on factors like the loan’s purpose, its duration, and the repayment method. Loans typically have specific timeframes, with commercial banks usually providing short-term loans. However, they may also grant term loans, which are loans with durations exceeding one year. A loan may be issued in a lump sum or in installments and is often secured against certain assets, with repayment taking place in installments, although lump-sum repayment is also possible. Primary Functions of Banks
Overdraft Facility
Another method of providing loans or accommodations is through overdrafts. To avail this, the borrower must hold an account with the bank. An overdraft allows the account holder to withdraw an amount exceeding their account balance, up to the limit approved as a loan. The excess amount drawn is treated as a used loan, and interest is charged accordingly in their accounts. Additionally, the overdraft can be used to pay rent, installments, and premium subscriptions based on the customer’s standing instructions.
Cash Credit
A loan account is established, enabling the borrower to withdraw money up to the approved amount. In this scenario, a promissory note or some tangible security is taken by the bank. Interest is charged on the portion of the loan that is utilized. However, a minimum interest guarantee is usually applicable, and the borrower is expected to repay the loan on demand. Importantly, the borrower does not need to have an account with the bank. This method is popular in India.
The distinction between overdraft and cash credit is subtle, primarily related to account operations. Cash credit involves a specific sanctioned limit, which is typically a percentage of the value of commodities or debts pledged by the account holder with the bank. Overdrafts, conversely, are granted against various securities, including financial instruments such as shares, mutual fund units, LIC policy surrender value, debentures, and even the perceived “worth” of an individual. These are known as clean overdrafts. functions of money
Bill Purchasing and Discounting
Bill discounting represents another form of bank credit. In this case, the bank may purchase inland and foreign bills at a discounted value before they are due for payment by the debtor-drawer. Typically, these discounted values are slightly lower than the face values of the bills. Banker’s discount is typically calculated as the interest on the full bill amount for the remaining bill duration. Banks retain the right to debit customers’ accounts in the event that bills are ultimately not honored or get dishonored. functions of money
Bills come into the possession of the bank after endorsement. Bill discounting by banks provides immediate financing to goods sellers, facilitating their ongoing business operations. Banks can usually discount only genuine commercial bills, specifically those drawn against the sale of goods on credit. Accommodation bills, on the other hand, are not eligible for discounting by banks.
Loans and Advances
This category encompasses both demand and term loans, covering direct loans and advances extended to all kinds of customers, predominantly to entrepreneurs and investors. These loans may be secured against personal assets or movable and immovable goods. The loan amount is made available either in cash or credited to the customer’s account, which they can withdraw at their discretion. Interest is charged on the full loan amount, regardless of whether the customer withdraws the money from their account. Primary Functions of Banks, functions of money
Short-term loans are granted to meet working capital needs, while long-term loans are extended to support capital expenditures. In the past, the RBI used to regulate the interest on loans. Currently, banks have the autonomy to determine interest rates themselves. However, each bank is required to establish a minimum rate, known as the Prime Lending Rate (PLR). functions of money
Primary Functions of Banks (FAQ)
Banks benefit from accepting deposits by using the deposited funds to lend to borrowers at higher interest rates. The difference between the interest paid on deposits and the interest earned on loans is a source of revenue for banks.
Banks offer various types of loans and advances, including overdrafts, cash credits, term loans, and the purchasing and discounting of bills. These loans cater to different financial needs, whether for working capital, capital expenditure, or short-term financing.
Banks are often referred to as custodians of public money because they provide a secure place for individuals to deposit their savings. However, the role of custodianship also involves earning interest on these deposits and sharing a portion of it with depositors.
Overdrafts and cash credits are both methods of providing loans to bank customers. The key distinction lies in the securities they accept. Overdrafts are often granted against various securities, including financial instruments, while cash credits are typically secured against tangible assets or assets that can be easily converted into cash.