Essay: What are Commercial Banks?

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  • What are Commercial Banks?
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Commercial bank is defined as an authorized financial institution by the law whereby they receive money from individual and businesses as well as lending money to them. Commercial banks are open to the public and serve individuals, institutions as well as businesses (, undated). In a more detailed explanation, commercial banks is a financial institution which provides services including accepting deposits, giving business loans and auto loans, mortgage lending, as well as basic investment products such as saving accounts and certificates of deposit (Investopedia, undated).

2.0 Functions of Commercial Banks

Commercial bank has two main characteristics which are borrowing and lending. For an instance, acceptance of deposits and lending of money to projects to earn interest as profit. In brief, commercial banks borrow to lend. The interest rate which offered by the commercial banks to their depositors is called as the borrowing rate while the rate which commercial banks lend out is called as lending rate. “Spread” refers to the difference between the rates and is appropriated by the commercial banks. Keep in mind that not necessary all financial institutions are commercial banks as only those which perform dual functions of accepting deposits and giving loans are termed as commercial banks. For an instance, post offices are not termed as a bank as they do not give loans. The functions of commercial banks are categorized in to two categories which are:-

a) Primary Functions

b) Secondary Functions

2.1 Primary Functions

i) Accepting Deposits

The primary function of commercial banks is accepting deposits and it is the basis of its existence. A bank could not perform any other functions without accepting deposits. Commercial banks attracts deposits in order to make loans and investments. This is where people deposit their money in banks because of safety and at the same time to earn interest. A commercial banks accept various types of deposits from individual, institutions, and businesses. There are few different types of deposit accounts offered by the banks to cater the need of various depositors (Gazu Lakhotia, undated). Below are the few types of deposits:-

• Saving Deposits

The main objective of saving accounts is to encourage the habit of savings among people. This type of account is most suitable for individual households. Saving deposits combine the features of both current and fixed deposits (J. Singh, undated). Saving accounts only allowed to withdrawn for a specified number of times in a week. However, the deposits can be made any number of times. On such deposits, the rate of interest is very less( Gazu Lakhotia, undated).

• Fixed Deposits

Fixed deposits is where the depositors deposit a lump sum of money for a definite period of time. The period of time refers to not less than one year, therefore it is called as long term deposits. These type of deposits could not be withdrawn before the expiry of the stipulated time, therefore it is called as time deposits (K. Upadhyaya, undated). Besides that, these type of deposits are repayable on the expiry of the stated period. Furthermore, the rate of interest on such deposits is higher compared to other deposits.

• Current Deposits

Current deposits are payable on demand, therefore it is called demand deposits. Money can be withdrawn by the depositors as often as they want depending on the balance in such account. There is no interest allowed on such deposits, however the banks provides cheque facilities (J. Singh, undated). Besides that, overdraft facility is provided as well. Current accounts are generally maintained by businessmen who receive and make business payments of large amounts via cheques. A fee known as “bank charges” or incidental charges” is charged in order to maintain the current deposits (Gazu Lakhotia, undated).

ii) Advancing of Loans

Refer as one of the important function of a commercial bank. This is where the commercial banks giving loans and advances to businessmen and entrepreneurs, thus earning interest. The banks keep a portion of the deposits to itself as reserve and lending the balance to the borrowers as loans and advance. Commercial banks grant loans in the forms of cash credit, demand loans, short-term loans etc.

• Cash Credit

Refer as a loan which given to an eligible borrower against his/her current assets such as bonds, shares, stocks etc. A credit limit is sanctioned and the amount is credited to his/her account. The borrower is allowed to withdraw any amount within the credit limit and interest is charged upon the amount withdrawn.

• Demand Loans

Demand loans refer to those loans which can be recalled on demand is called demand loan. There is no maturity stated. This is where the loan is paid in a lump sum by crediting it to the borrower’s loan account and the interest is payable on the entire loan.

• Short-term Loans

Refer to a loan which given against some security as personal loans to finance working capital or as priority sector advances. The entire loan is repaid either by one installment or few numbers of installments over the period of loan (J. Singh, undated).

iii) Credit Creation

Credit creation is considered as important function of the commercial banks. This is where when the bank sanctioning a loan to a borrower, the bank do not provide cash, instead the bank opens a deposit account from where the borrower could withdraw (Gaurav Akrani, 2010).

2.2 Secondary Functions

Besides performing primary functions, each commercial bank has to perform several secondary functions too. This consists many agency functions or general utility functions. The secondary functions is divided into:-

i) agency functions

ii) general utility functions

i) Agency Functions

• to collect and clear cheques, dividends and interest warrant

• to make payment of rent, insurance premium etc

• to deal in foreign exchange transactions

• to purchase and sell securities

• to act as trusty, attorney, correspondent and executor

• to accept tax proceeds and tax returns

ii) General Utility Functions

• to provide safety locker facility to customers

• to provide money transfer facility

• to issue traveler’s cheque

• to act as referees

• to accept various bills for payment such as phone bills, water bills etc

• to provide merchant banking facility

• to provide various cards such as credit cards, debit cards etc

3.0 Islamic Banking

In Malaysia, Islamic banking as well known, it is consistent with the Shariah principles and guided by the Islamic economics. Under the Shariah principles, there are several common shariah contract which are Prohibition of Interest (Riba), Profit Sharing (Mudharabah), Safekeeping (Wadiah), Joint Venture (Musharakha), Cost Plus ( Murabahab), Leasing (Ijarah) and others (, 2009).

3.1 Prohibition of Interest (Riba)

The prohibition of payment or acceptance of the fixed interest on the basis of the Islamic doctrine, money is only a medium of communication, the value of a thing is defined which itself has no value, and therefore should not be allowed to increase more money, through fixed interest payments, simply put in the bank or lend to others. A person’s efforts, initiative, and adventure are more important than the use of financial money (, 2010).

3.2 Profit Sharing (Mudharabah)

Mudharabah is a profit sha
rring arrangement between two parties which is an investor and the entrepreneur. The investor will provide money and get a return of funds base on the contribution rate that has been agreed earlier. The principle of Mudharabah can be applied to Islamic banking operations in 2 ways: between a bank (as the entrepreneur) and the capital provider, and between a bank (as capital provider) and the entrepreneur. Losses suffered shall be borne by the capital provider (, 2009).

3.3 Safekeeping (Wadiah)

Wadiah means custody or safekeeping. In the Wadiah arrangement, customer deposit cash or other asset in the bank for safekeeping. The bank guarantees the security of the item (, 2009).

3.4 Joint Venture (Musharakha)

In the commercial and trade environment, musyarakah refer to the partnership or joint venture business to make profits. According to the agreed proportion of the amount invested by the partners, they share the profit may not be the same. If resulting in loss will be shared on the basis of the proportion of investment by each partner (, 2009).

3.5 Cost Plus ( Murabahab)

In Murabahab, it is a contract sale between the bank and its customer for the sale of goods at a price which includes a profit margin agreed by both parties. However, in Murabahab, the seller must let the buyer know the actual cost of the asset and profit margin of the sale agreement (, 2009).

3.6 Leasing (Ijarah)

It means to employ the services of a person on wages. Another type of Ijarah relates to pay rent for the use of an asset or property (, 2009).

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