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Chapter 3
Commercial Banking

Department of Accounting and Finance,

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Commercial Banks
 A banker or bank is a financial institution that acts as a
payment agent for customers, and borrows and lends money.
The first modern bank was founded in Italy at Genoa in 1406;
its name was "Banco di San Giorgio" (Bank of St. George).

 Banks act as payment agents by conducting checking or current

accounts for customers, paying cheques drawn by customers on
the bank, and collecting cheques deposited to customers' current
accounts..
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Commercial Banks
 Banks borrow money by accepting funds deposited on current
account, accepting term deposits and by issuing debt securities
such as banknotes and bonds. Banks lend money by making
advances to customers on current account, by making
installment loans, and by investing in marketable debt securities
 Banks provide almost all payment services, and a bank account
is considered indispensable by most businesses,
individuals ,and governments.
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Functions of Commercial Banks

Commercial Banks

Primary Agency General

Functions Functions Functions
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Primary Functions
1. RECEIVING DEPOSITS
Commercial banks receive deposits from the people who have
surplus money and willing to deposit with banks for the purpose of
safety and interest etc.

To meet the needs of people the banks offer following deposit

schemes:
 Current Account
 Saving Account
 Fixed Deposit (Term Deposits)
 Foreign Currency Accounts
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Primary Functions

2. ADVANCING LOANS
Commercial bank lend the money collected from the
people under different accounts, to the borrowers.
The bank provide loans in the following shapes.
• Cash credit
• Over draft
• Call loans
• Discounting of bills
• Investment loans
» Short-term loans
» Medium-term loans
» Long-term loans
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Functions of Commercial Banks

 Agency Functions
• Collection & Payment Services
• Purchase & Sale Service
• Execution of Standing Instructions
• Collection of Dividends and Interest on Securities
• Transfer of Funds
• Bank as Guarantor
• Income Tax Facility
• Collection of Zakat
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Functions of Commercial Banks

 General Utility Functions

• Issuance of Letter of Credit
• Discounting of Bills
• Issuance of Traveler’s Cheques
• Lockers Facility
• Foreign Exchange Transactions
• Act as an under writer
• Compile Statistics
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The role of Commercial Banks in the Economic
Growth & development of a country

 Mobility of savings The banks by launching a vigorous campaign

both in the villages and cities can mobilize the idle savings and
can increase the investment rate in all sectors which leads to
economic growth of a country.
 Capital formation
• Generation of savings
• Mobilization of savings
 Credit creation
 Agricultural development
 Industrial development
 Employment
 Trade expansion
 Help to government
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The role of Commercial Banks in the Economic
Growth & development of a country

 Help to central bank

 Promotion of savings
 Income distribution :Commercial banks borrow from the people of the
higher-income group and lend it to the people of the lower income group.
 Poverty alleviation :Commercial bank help the poor people by lending
money so as to improve their standard of life
 Creation and distributors of money: They purchases securities and
allow money to play an active role in the economy.
 Influencing economic activity: Commercial banks influence economic
activity in two ways. First by lowering the interest rate. Secondly , by making
the capital available to the investors.
 Export promotion cell: To boost up exports, banks have established
export promotion cells to provide information and guidance to exporters.
Through this, export volume increases, which fetches more foreign exchange.
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Bank Sources of Funds
 Deposit Accounts
• Transaction deposits
• Savings deposits
• Time deposits
• Money market deposit accounts
 Borrowed Funds
• Federal funds purchased (borrowed)
• Borrowing from the central bank
• Repurchase agreements
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Bank Sources of Funds

 Long term sources of funds

• Bonds issued by the bank
• Bank capital
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Sources of Funds: Deposit Accounts

 Transaction deposits
• Demand deposit account
» Require a small minimum balance and pays no interest
• Negotiable order of withdrawal
» Provide checking services as well as interest services

 Saving deposits
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Sources of Funds: Deposit Accounts

 Time deposits
» Deposits that cannot be withdrawn until a specified maturity
date
• Certificates of deposits (Retail CDs)
» Requires a minimum amount of funds to be deposited for a
specified period of time
» Annualized interest rates offered on CDs vary among banks,
and even among maturity types at single bank
» Some FIs have begun to offer CDs with a callable features
» No organized secondary market
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Sources of Funds: Deposit Accounts

• Negotiable Certificates of Deposits
» Some large banks offer to companies
» Similar to retail CDs
» Secondary market does exist
» The level of large time deposits is much more volatile than that of
small time deposits
 Money Market Deposit Accounts
• Different from conventional time deposits in that they do not
specify a maturity
• More liquid than retail CDs from the depositor’s point of view
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Sources of Funds: Borrowed funds

 Federal funds purchased (Borrowed)

• This allows depository institutions to accommodate the short
term liquidity needs of other financial institutions federal funds
purchased represent a liability to the borrowing bank and an
asset to the lending bank sells them

• Loans in the federal funds market are typically for one to seven
days.

• A bank may act as a lender of federal funds on one day and as

borrower shortly thereafter, as its funds balance changes every
day.
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Sources of Funds: Borrowed funds

• Interest rates charged in the federal funds market is called

federal fund rate
• If many banks have excess funds and few banks are short of
funds, the federal funds rate will be low.

 Borrowing from the central bank

• Central bank also provide short term loans to banks (as well as
to some other depository institutions)
• This is called borrowing at discount window.
• Interest rate charged on these loans is known as discount rate.
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Sources of Funds: Borrowed funds

 Banks rely on the central bank’s fund market for normal short term financing, and use
of discount window as a last resort.

 Loans from the discount window are short term , commonly from one day to a few
weeks.

 Banks that wish to borrow at that discount window must first obtain the central
bank’s approval.

 Discount window is mainly used to resolve a temporary shortage of funds.

 This is the source of funds for banks that experience unanticipated shortages of
reserves.
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Sources of Funds: Borrowed funds

 Repurchase Agreements
• REPO represents the sale of securities by one part to another with
an agreement to repurchase the securities at a specified date and
price.

• Banks often use a REPO as a source of funds when they expect to

need funds for just few days.

• The bank simply sells some of its government securities to a

corporation with a temporary excess of funds and buys those
securities back shortly thereafter.
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Sources of Funds: Borrowed funds

• The government securities involved in the REPO transaction serve as security

for the corporation providing funds to the bank.

• REPO transactions occur through a telecommunication network connecting

large banks, other corporations, government securities dealers, and federal
funds brokers.

• The federal funds brokers match up firms or dealer that need funds with those
that have excess funds.

• The yield on REPO agreements is slightly less than the federal funds rate at
any given point in time because the funds loaned out are backed by collateral.
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Sources of Funds: Borrowed funds
Long term Sources

 Bonds issued by the bank

• Fixed assets (land, building, etc.) of banks are usually
financed by the issuance of bonds
• Such bonds are purchased by the households and various
financial institutions.

 Bank capital
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Uses of Funds by Banks

 Cash
 Bank loans
 Investment in securities
 Federal funds sold (loaned out)
 Repurchase agreements
 Eurodollar loans
 Fixed assets
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Uses of Funds: Cash

 Cash
• Bank must hold some cash as reserves to meet the reserve
requirement enforced by the central bank

• Banks also hold cash to maintain some liquidity and

accommodate any withdrawal requests by depositors.

• Bank do not earn income from cash, they hold only as much
cash as is necessary to maintain a sufficient degree of liquidity.
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Uses of Funds: Bank Loans

 Bank loans
• Working Capital Loan ( self liquidating loan)
• Term loans
» Used primarily to finance the purchase of fixed assets
» Assets purchased with the borrowed funds may serve as partial
or full collateral on the loan
» Contains Protective agreements because of long term
• Direct lease loan
» Bank can purchase the asset and leasing them to the firm in need
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Uses of Funds: Bank Loans
 Bank loans
• Informal line of credit
» Which allow the business to borrow up to specified amount within
a specified period of time
» This useful for the firms that may experience a sudden need for
funds but do not know precisely when
» The interest rate charged on any borrowed funds is typically
adjustable in accordance with the prevailing market rates.
» Banks are not legally obligated to provide funds to the business, but
they usually honor the arrangement to avoid harming their
reputation
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Uses of Funds: Bank Loans
• Revolving credit line
» Which obligates the bank to offer up to some specified maximum
amount of funds over a specified period of time ( typically less
than five years)
» Bank charge a commitment fee on any unused funds
 Loan Participation
• Some large corporation wish to borrow a large amount of funds than
any individual bank is willing to provide.
• To accommodate a corporation, several banks may be willing to pool
their available funds in what is referred to as loan participation.
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Uses of funds by banks
 Most common form, one of the banks serves as the lead bank by arranging for the
documentation, disbursement, and payment structure of the loan.

 The main role of the other banks is to supply funds that are channeled to the
borrower by the lead bank.

 The borrower may not even realized that much of the funds have been provided by
other banks.

 As interest payments are received, the lead bank passes the payment on to the other
participants in proportion to the original loan amounts they provided.
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Uses of funds by banks

 The lead bank receive fees for servicing the loan in
addition to its share of interest payments.

 All participating banks are exposed to credit risk.

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Uses of funds by banks
 Loans supporting Leveraged buyouts
• Some commercial banks finance leveraged buyouts
• LBO financing is the relatively high loan rate that can be
charged.

 Collateral requirements on business loans

• Commercial banks are increasingly accepting intangible assets
(patents, brand name) as collateral for commercial loans.
• This is important to service oriented companies that do not have
tangible assets.
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Uses of funds by banks
 Types of consumer loans
• Installment loans
» Commercial banks provide installment loans to individuals
to finance purchase of cars and household products
» Periodic payments
» Credit cards
» Interest rate on credit card loans and personal loans ID
typically much higher than the cost of funds
• Real estate loans
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Investment in securities

 Bank purchase Treasury securities as well as

securities issued by agencies of the federal
government.

 Banks also purchase corporate bonds

 Risk and Returns

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Federal funds sold
 Some banks often lend funds to other banks in the federal funds market.

 The fund sold or lent out, will be returned at the time specified in the
loan agreement, with interest

 The loan period is typically very short, such as a day or few days

 If the transaction is executed by a broker, the borrowers cost on a federal

funds loan is slightly higher than the lender’s return, because the broker
matching up the two parties charges a transaction fee.
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Off-Balance sheet activities

 Loan commitment
 Standby letters of credit
 Forward contract
 Swap contracts
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Off-Balance sheet activities

 Loan commitment
• A loan commitment is an obligation by a bank to
provide a specified loan amount to particular firm
upon the firm’s request
• The interest rate and purpose of the loan may also
be specified
• The bank charges a fee for offering the commitment
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Off-Balance sheet activities
 Standby Letters of Credit
 Forward Contract
 Swap Contract
• Banks also serve as intermediaries for interest rate swaps,
where by two parties agree to periodically exchange interest
payments on a specified estimated amount of principal
• Bank receives a transaction fee for its services
• If it guarantees payments to both parties, it is exposed to the
possibility that one of the parties will default on its obligation.
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End of Chapter
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