What is a Commercial Bank?

A commercial bank is a financial institution that grants loans, accepts deposits, and offers basic
financial products such as savings accounts and certificates of deposit to individuals and
businesses. It makes money primarily by providing different types of loans to customers and
charging interest.

The bank’s funds come from money deposited by the bank customers in saving accounts,
checking accounts, money market accounts, and certificates of deposit (CDs). The depositors
earn interest on their deposits with the bank. However, the interest paid to depositors is less than
the interest rate charged to borrowers. Some of the loans offered by a commercial bank include
motor vehicle loans, mortgages, business loans, and personal loans.

Functions of Commercial Banks

The basic role of a commercial bank is to provide financial services to the general public,
businesses, and companies. Banks also ensure economic stability and sustainable growth of a
country’s economy. A commercial bank performs the following functions:

1. Accepting Deposits
Accepting deposits is one of the oldest functions of a commercial bank. When banks started, they
charged a commission for keeping money on behalf of the public. With the changes in the
banking industry over the years and the profitability of the business, banks now pay a small
amount of interest to the depositors who keep money with them. However, depositors also incur
administrative fees to maintain their accounts.

Banks accept three types of deposits. The first one is the savings deposit for small savers who are
paid interest on their accounts. They can withdraw their money up to a limited amount by writing
a cheque. The second type of deposit is the current account for people in business who can
withdraw their money at any time without notice. Banks do not typically pay interest on deposits
held in current accounts. Instead, the account holders are charged a nominal fee for the services
rendered.

The last type of deposit is the term or fixed deposit. Customers who have money that they do not
need for the next six months or more can save in the fixed account. The rate of interest paid
increases with the length of the fixed deposit. Customers can only withdraw the money at the end
of the agreed period by writing to the bank.

 
2. Advancing Credit Facilities
Advancing loans is an essential function of banks since it accounts for the highest percentage of
revenue earned annually. Banks mostly offer short-term and medium-term loans from a
percentage of the cash deposits at a high interest rate. They do not provide long-term financing
due to the need to maintain liquidity of assets. Before advancing loans to customers, banks
consider the borrower’s financial status, business profitability, nature and size of the business,
and ability to repay the loan without default.

3. Credit Creation
While granting loans to customers, banks do not provide the loan in cash to the borrower.
Instead, the bank creates a deposit account from which the borrower can draw funds. This allows
the borrower to withdraw money by cheque according to his needs. By creating a demand
deposit in the borrower’s account without printing additional money, the bank increases the
amount of money in circulation.

4. Agency Functions
Commercial banks serve as agents of their customers by helping them in collecting and paying
cheques, dividends, interest warrants, and bills of exchange. Also, they pay insurance premiums,
utility bills, rent, and other charges on behalf of their clients.

Banks also trade shares, securities, and debentures, and they provide advisory services for
customers that want to buy or sell these investments. In property administration, commercial
banks act as trustees and executors of the estate on behalf of their customers. Banks charge a
nominal fee for the agency functions performed on behalf of their clients.

Other Functions
Apart from the above primary functions, banks also perform several other functions. They
provide foreign exchange to clients who are in the import and export business, by buying and
selling foreign currency. However, banks must get permission from the regulatory body, mainly
the central bank, before dealing with foreign exchange.

A commercial bank also acts as a custodian of precious stones and other valuables. They provide
customers with lockers where they can put their jewelry, precious metals, and crucial documents.
Such items are more secure when stored at the bank than keeping them at home where they may
be stolen or damaged.

 
Types of Loans Offered by Commercial Banks
There are several types of loans advanced by commercial banks to their clients. These loans
include:

1. Bank Loan
A bank loan is an amount of money offered by a bank to a borrower at a defined interest rate for
a fixed period. Before granting a bank loan to a client, a bank must obtain several important
documents to verify that the borrower will pay back the loan. These documents may include
copies of identity, proof of income, and audited financial statements in the case of corporate
clients. The loan is granted against collateral that, if the customer defaults, the bank can sell them
to recover the money. The collateral may be equipment, machinery, real estate property,
inventory, documents of ownership, and other items.

2. Cash Credit
Cash credit is an arrangement between the bank and a client, and it allows the client to withdraw
money beyond their account limit. The cash credit is advanced for a period of one year, but it
may extend to even three years in special circumstances. The amount is deposited in the current
account of the borrower and can be withdrawn through cheque. The interest charged on the cash
credit depends on the amount of money and duration for which the money has been withdrawn.

3. Bank Overdraft
A bank overdraft is a form of financing that allows the current account holders to overdraw their
account up to a specified limit. It does not require any written formalities and clients use the
overdraft to meet urgent needs. Interest is charged on the amount that the current account has
been overdrawn with and not the full amount of overdraft allowed by the bank.

4. Discounted Bills of Exchange

A bank discounts a bill of exchange by providing money immediately to the holder of the bill.
The bank deposits the money in the holder’s current account, after deducting an interest rate for
the loan period. Once the bill of exchange matures, the bank gets its payment from the banker of
the bill holder.

Regulation by Central Banks

Commercial banks are regulated by the central banks in their respective countries. Central banks
act as the supervisor of commercial banks, and they impose certain regulations to ensure banks
operate within the stipulated rules. For example, central banks make it mandatory for
commercial banks to maintain bank reserves with them. Some central banks set the minimum
bank reserves, and this requires banks to keep a particular percentage of their customer deposits
at the central bank. The reserves help to cushion banks against unexpected events like bank runs
and bankruptcy.

CENTRAL BANKING

A central bank plays an important role in monetary and banking system of a country. It issues
currency, regulates money supply, and controls different interest rates in a country. Apart from
this, the central bank controls and regulates the activities of all commercial banks in a country.

Some of the management experts have defined central bank in different ways, which are as
follows:
According to Samuelson, “Every Central Bank has one function. It operates to control economy,
supply of money and credit.”

According to Vera Smith, “The primary definition of Central Bank is the banking system in
which a single bank has either a complete or residuary monopoly of note issue.”

It is responsible for maintaining financial sovereignty and economic stability of a country,

especially in underdeveloped countries.

According to Kent, “Central Bank may be defined as an institution which is charged with the
responsibility of managing the expansion and contraction of the volume of money in the interest
of general public welfare.”

According to Bank of International Settlement, “A Central Bank is the bank in any country to
which has been entrusted the duty of regulating the volume of currency and credit in that
country.”

Bank of England was the world’s first effective central bank that was established in 1694. As per
the resolution passed in Brussels Financial Conference, 1920, all the countries should establish a
central bank for interest of world cooperation. Thus, since 1920, central banks are formed in
almost every country of the world. In India, RBI operates as a central bank.

Functions of Central Bank:

The central bank does not deal with the general public directly. It performs its functions with the
help of commercial banks. The central bank is accountable for protecting the financial stability
and economic development of a country.

Apart from this, the central bank also plays a significant part in avoiding the cyclical fluctuations
by controlling money supply in the market. As per the view of Hawtrey, a central bank should
primarily be the “lender of last resort.”

On the other hand, Kisch and Elkins believed that “the maintenance of the stability of the
monetary standard” as the essential function of central bank. The functions of central bank are
broadly divided into two parts, namely, traditional functions and developmental functions.

These functions are shown in Figure-4:

The different functions of a central bank (as discussed in Figure-4) are explained as
follows:
(a) Traditional Functions:
Refer to functions that are common to all central banks in the world.

The traditional functions of the central bank include the following:

(i) Bank of issue:
Possesses an exclusive right to issue notes (currency) in every country of the world. In the initial
years of banking, every bank enjoyed the right of issuing notes. However, this led to a number of
problems, such as notes were over-issued and the currency system became disorganized.
Therefore, the governments of different countries authorized central banks to issue notes. The
issue of notes by one bank has led to uniformity in note circulation and balance in money supply.

(ii) Government’s banker, agent, and advisor:

Implies that a central bank performs different functions for the government. As a banker, the
central bank performs banking functions for the government as commercial banks performs for
the public by accepting the government deposits and granting loans to the government. As an
agent, the central bank manages the public debt, undertakes the payment of interest on this debt,
and provides all other services related to the debt.

As an advisor, the central bank gives advice to the government regarding economic policy
matters, money market, capital market, and government loans. Apart from this, the central bank
formulates and implements fiscal and monetary policies to regulate the supply of money in the
market and control inflation.

(iii) Custodian of cash reserves of commercial banks:

Implies that the central bank takes care of the cash reserves of commercial banks. Commercial
banks are required to keep certain amount of public deposits as cash reserve, with the central
bank, and other part is kept with commercial banks themselves.

The percentage of cash reserves is deeded by the central bank! A certain part of these reserves is
kept with the central bank for the purpose of granting loans to commercial banks Therefore, the
central bank is also called banker’s bank.

(iv) Custodian of international currency:

Implies that the central bank maintains a minimum reserve of international currency. The main
aim of this reserve is to meet emergency requirements of foreign exchange and overcome
adverse requirements of deficit in balance of payments.

(v) Bank of rediscount:

Serve the cash requirements of individuals and businesses by rediscounting the bills of exchange
through commercial banks. This is an indirect way of lending money to commercial banks by the
central bank. Discounting a bill of exchange implies acquiring the bill by purchasing it for the
sum less than its face value.

Rediscounting implies discounting a bill of exchange that was previously discounted. When
owners of bill of exchange are in need of cash they approach the commercial bank to discount
these bills. If commercial banks are themselves in need of cash they approach the central bank to
rediscount the bills.

(vi) Lender of last resort:

Refer to the most crucial function of the central bank. The central bank also lends money to
commercial banks. Instead of rediscounting of bills, the central bank provides loans against
treasury bills, government securities, and bills of exchange.

(vii) Bank of central clearance, settlement, and transfer:

Implies that the central bank helps in settling mutual indebtness between commercial banks.
Depositors of banks give checks and demand drafts drawn on other banks. In such a case, it is
not possible for banks to approach each other for clearance, settlement, or transfer of deposits.

The central bank makes this process easy by setting a clearing house under it. The clearing house
acts as an institution where mutual indebtness between banks is settled. The representatives of
different banks meet in the clearing house to settle inter-bank payments. This helps the central
bank to know the liquidity state of the commercial banks.

(viii) Controller of Credit:

Implies that the central bank has power to regulate the credit creation by commercial banks. The
credit creation depends upon the amount of deposits, cash reserves, and rate of interest given by
commercial banks. All these are directly or indirectly controlled by the central bank. For
instance, the central bank can influence the deposits of commercial banks by performing open
market operations and making changes in CRR to control various economic conditions.

(b) Developmental Functions:

Refer to the functions that are related to the promotion of banking system and economic
development of the country. These are not compulsory functions of the central bank.

These are discussed as follows:

(i) Developing specialized financial institutions:
Refer to the primary functions of the central bank for the economic development of a country.
The central bank establishes institutions that serve credit requirements of the agriculture sector
and other rural businesses.

Some of these financial institutions include Industrial Development Bank of India (IDBI) and
National Bank for Agriculture and Rural Development (NABARD). These are called specialized
institutions as they serve the specific sectors of the economy.
(ii) Influencing money market and capital market:
Implies that central bank helps in controlling the financial markets Money market deals in short
term credit and capital market deals in long term credit. The central bank maintains the country’s
economic growth by controlling the activities of these markets.

(iii) Collecting statistical data:

Gathers and analyzes data related to banking, currency, and foreign exchange position of a
country. The data is quite helpful for researchers, policymakers, and economists. For instance,
the Reserve Bank of India publishes a magazine called Reserve Bank of India Bulletin, whose
data is useful for formulating different policies and making macro-level decisions.

Difference between Money Market and Capital

Market
A financial market is a place where buyers and seller come together to trade in financial assets
such as bonds, stocks, derivatives, currencies, and commodities. The main objective of a
financial market is to fix prices for global trade, increase capital, and transfer risk and liquidity.
Thought the financial market has various components, the two most important components are
the money market and capital market. In the money market, only short-term liquid financial
instruments are exchanged. Whereas, in the capital market only long term securities are dealt.
Capital Market plays a significant role in the growth of country’s economy as it provides a
platform for mobilizing the funds. Similarly, the money market holds a range of operational
characteristics. The article will explain what is the difference between money market and capital
market. 

What is the Money Market?

A random course of financial institutions, bill brokers, money dealers, banks, etc., wherein
dealing on short-term financial tools are being settled is referred to as Money Market. These
markets are also called a wholesale market.
In India, money markets serve an essential objective of providing liquid cash to borrowers and
fund providers for a small period of time, while keeping a balance between the supply and
demand short-term term funds. The important money market instruments in India today cover
call money, commercial papers, certificates of deposit, treasury bills, and forward rate
agreements. 
Money Market is a disorganised market, so the dealing is done off the public exchange market,
i.e. Over The Counter (OTC), within two bodies by using email, fax, online, and phones etc. It
supports the industries to accomplish their working capital demand by circulating short-term
funds in the economy

What is Capital Market?

A kind of financial market where the company or government securities are generated and
patronised for the intention of establishing long-term finance to coincide the capital necessary is
called as Capital Market. 
In this market, the buyers use funds for longer-term investment. The nature of the capital market
is risky markets, therefore, it is not used for short-term funds investment. Most of the investors
obtain the capital markets to preserve for education or retirement.

Top 10 Difference between Money Market and Capital Market

Basis Money Market Capital Market

Meaning A random course of financial A kind of financial market where the

institutions, bill brokers, money
dealers, banks, etc., wherein dealing
on short-term financial tools are being
settled is referred to as Money
Market.
company or government securities are
generated and patronised for the intention
of establishing long-term finance to coincide
the capital necessary is called as Capital
Market.

Nature of Informal Formal

Market

Financial Tools Commercial Papers, Treasury Bonds, Debentures, Shares, Asset

Certificate of Deposit, Bills, Trade Securitization, Retained Earnings, Euro
Credit, etc., Issues, etc.,
 Organizations Commercial bank, bill brokers, non- The stock exchange, Commercial banks,
financial institutions, the central bank, non-banking organisations like insurance
acceptance houses, and so on. companies etc.,

Risk Factor Low High

Liquidity High Low

Purpose To achieve short term credit To achieve long term credit requirements of
requirements of the trade. the trade.

Time Horizon Within a year More than a year

Merit Rises liquidity of capitals in the Mobilization of Economies in the market.

market.

Return on Less High

Investment

Features of Money Market

Few general money market features are: 
 It is fund-term market funds.
 It’s maturity period up to one year.
 It trades with assets that can be transformed into cash easily.
 All the transactions take place through phone, email, text, etc.
 Broker not required for the transaction 
 The components of a money market are the Commercial Banks, Non-banking financial
companies, and Central Bank etc. 

Features of Capital Market

Important features of the capital market are: 
 Unites entrepreneurial borrowers and savers 
 Deals long-term investments.
 Agents are required.
 It is controlled by government rules and regulations.
 Deals in both commercial and non-commercial securities.
  Foreign Investors.

5 Types of Money Market

Money market instruments have different securities, which can be utilised for short term
borrowings. Few different types of market money are:

 Call Money- It portrays a short term loan with maturities term starting from one day to
fourteen days and it can be repaid on demand. 
 Treasury Bill-
 It is the oldest and traditional money market instruments and practised across the globe.
The instrument is declared by the Government and does not have to pay any interest. This
is available at a discounted rate at the time of issue.

 Ready Forward Contract (Repo)-

The word repo is acquired from the phrase “repurchase agreement”. It is an agreement
that specifies the sale and purchase of an asset. In India,  this agreement is prepared
between different banks and sometimes between bank and RBI for short term loans. 

 Money Market Mutual Fund-

This is the alternative name for liquid funds, and are the lowest risk debt funds. 

 Interest Rate Swaps- This is the latest money market instruments in India. Here, two
parties sign an agreement, where one decides to pay a fixed rate of interest, and the
other pay a floating rate of interest.

Types of Capital Market

The Capital Market instrument involves both the auction market and dealer market. It is
classified into two sections: Primary Market and Secondary Market.

 Primary Market:
Here, fresh contracts are given to the people for the subscription purpose.

 Secondary Market:
The securities that have already been issued are exchanged among investors.

Money Market Examples

Because they are extremely liquid in nature, the money market recovery period is restricted to
one year. Few examples of Money Market are:
 Trade Credit
 Commercial Paper
 Certificate of Deposit
  Treasury Bills

Capital Market Examples

The capital market circulates the capital in the economy among the user and the suppliers of
money.
The maturity period more than one year or sometimes it is incurable (no maturity). 
 Stocks
 Bonds
 Debentures
 Euro issues