Section III : Unit 15 - Banks

Banking :

Banking assists in borrowing, lending and carrying out a range of financial activities to make more
efficient use of resources and encourage economic growth.

Commercial Banks :

Commercial / joint stock / retail / high street banks are private sector banks that aim to make a
profit by providing a range of banking services. They have limited liability.

The Main Functions Of Commercial Banks :

• Accept Deposits : This enables customers to keep their money in a safe place. Deposits can be
made in a current/demand account. This gives people easy & immediate access to money but
interest usually isn’t paid on money held in such accounts. Customers mainly use this account to
receive & make payments. Another type of account is a deposit/time account. These accounts
are used for saving and interest is paid on the money held. Before withdrawing money from such
accounts a notice has to be given.
• To Lend : Two ways of borrowing from a bank ——> Overdraft (This enables customers to
spend more than what is available in his/her account, up to an agreed limit. Interest is charged, it
is relatively expensive and is used to cover short term gaps between expenses & income.) Loan
(Interest is charged but the rate of interest is lower than overdraft’s. Loans are taken for a
particular purpose for a certain period of time. Customers are asked to provide collateral for
security reasons.)
Lenders ——> Banks ——> Borrowers

• Enable Customers To Receive & Make Payments : Banks act as agents for payments &
provide money transmission services. This can be done through cheques,standing orders,direct
debits,debit/credit cards and online banking.

Other Functions Of Commercial Banks :

- Most commercial banks now provide travellers cheques and change foreign currency.
- Customers can leave important documents such as : house deeds with the bank.
- They help with the administration of customers’ wills.
- Provide advice regarding financial matters such as : purchase & sale of shares, completion of
tax forms etc.
- Many banks sell insurance and offer a variety of savings accounts.
- Some offer mortgage loans so that customers can purchase houses.
The Aims Of Commercial Banks :

• Make A Profit For Its Shareholders : This is done through giving loans. If a bank does not have
liquidity then it may fail to meet customers’ requests of withdrawing money from their accounts.
Hence, banks need to have liquid assets aka items that can be turned into cash quickly ; without
incurring loss. Banks earn most of their interest through giving long term loans but if they tie up
all their money in this, they may fail to pay out cash to customers requesting it. Therefore, they
have to balance profitability & liquidity by having some illiquid assets earning high interest and
some liquid assets earning low/no interest.
Banking and Islam :

In many Muslim countries, commercial banks aren’t allowed to charge interest on loans as it is
considered to be a sin in Islam. Muslim banks often provide finance for firms by lending to them in
return for a share of profit. European commercial banks opening branches in Muslim countries
usually employ Islamic sharia scholars and experts who can issue religious laws (fatwas) that
approve financial products such as loans. E.g : The German bank “Deutshe” is a major
shareholder in the Dar Al Istithmar sharia consultancy, which launched the world’s first dedicated
training programme to create financially qualified Islamic scholars.

Other Banks :

• Investment/Merchant Banks : They act as bankers to large firms. They accept deposits from
them and lend to them. They manage issues regarding new shares as well as buy & sell other
financial securities along with shares for their customers. They also give advice on mergers &
takeovers.
• Savings Banks : Their aim is to encourage savings. They especially encourage those that have
low incomes. They make it easy to withdraw cash. A large proportion of the money lent by them
goes to the government.

Central Banks :

A central bank is a government owned bank which provides banking services to the government
and commercial banks. E.g : The Federal Reserve Bank Of The LISA (The Fed), The European
Central Bank (ECB) and The Bank Of England.

The Functions Of A Central Bank :

• Act as a banker to the government : Tax revenue is paid into the government’s account at the
central bank as well as payment for goods and services purchased by the government is done.
• Operates as a banker to the commercial banks : Enables commercial banks to settle debts
between themselves and the central bank as well as draw out cash if their own customers are
taking more cash from their branches than usual.
• Act as a lender of last resort : Lends to banks that are temporarily short of cash.
• Manages national debt : The national debt is the total amount the government owes. The
central bank borrows on behalf of the government by issuing government securities such as :
bonds, pays interest on them and makes repayment when they’re due.
• Holds the country’s reserves of foreign currency & gold : To influence the exchange rate.
• Issues bank notes : They print notes and destroy those that are no longer suitable for
circulation. Also authorise the minting of coins.
• Implements the government’s monetary policy : Their main aim is to maintain price stability.
They control the money supply and change rate of interest charged on loans. They
increase/decrease money supply based on the government’s instructions. In some countries, the
government changes the interest rate whereas in others, central banks do.
• Controls the banking system : They regulate and supervise the banking system.
• Represents the government : At meetings with other central banks or international
organisations such as : the World Bank or the IMF.

Independence Of Central Banks :

A number of governments have given their central banks the authority to decide the rate of interest.
For instance, The Bank of England is instructed to use the interest rate to achieve an inflation
target of 2%. If inflation rises more than 2%, it will increase the interest rate and vice versa.
Allowing central banks to decide the interest rate is beneficial as unlike the government, they’re
unlikely to want to lower the rate of interest to gain public support. It also provides the bank with
knowledge regarding the appropriate interest rate to set.