Commercial Banks: Functions, Funding, and Capital Use
Commercial Banks (CBs) are pivotal financial institutions that serve as intermediaries by mobilizing capital from depositors and lending it to businesses and consumers. They perform essential functions like savings mobilization, credit provision, payment processing, and investment banking, ensuring liquidity and facilitating economic growth within the financial market structure.
Key Takeaways
CBs mobilize capital through deposits and various short-term and long-term borrowing methods.
Core functions include providing credit, managing payments, and offering investment and insurance services.
Capital deployment focuses primarily on loans (business, consumer, real estate) and securities investments.
Banks manage liquidity by balancing required reserves with income-generating loan and investment activities.
What are the primary functions performed by Commercial Banks?
Commercial banks serve as the backbone of the financial system by performing diverse functions essential for economic activity and stability. Their primary role involves financial intermediation, where they mobilize savings and channel funds into productive investments and consumption. Beyond lending and deposit-taking, CBs facilitate global commerce through payment systems, manage liquidity for businesses, and offer specialized services like insurance, brokerage, and investment banking to meet complex client needs, thereby supporting overall economic development and stability.
- Savings mobilization: Actively mobilizing idle capital sources from individuals and institutions.
- Credit provision: Supplying necessary capital for production, business expansion, and consumer spending.
- Payment execution: Facilitating collections and disbursements efficiently through customer accounts.
- Cash management: Offering safekeeping, collection, disbursement, and automatic investment services.
- Insurance services: Providing both life and non-life insurance products to clients.
- Brokerage activities: Engaging in investment and trading of securities, foreign currency, and real estate.
- Guarantee services: Offering financial guarantees backed by the bank's established reputation.
- Investment banking: Providing consulting, securities underwriting, M&A advisory, and corporate restructuring support.
How do Commercial Banks secure their necessary operating funds?
Commercial banks rely on a diversified capital structure, primarily sourcing funds through customer deposits, which form the largest and most stable base. They supplement this with borrowed funds, typically short-term instruments used to manage immediate liquidity needs and regulatory reserve requirements, such as interbank loans and repurchase agreements. Furthermore, long-term stability is ensured through the issuance of bonds and the maintenance of owner’s equity, which adheres to Central Bank regulations regarding charter capital and capital adequacy ratios (CAR). This balanced approach ensures both operational flexibility and regulatory compliance.
- Deposit Accounts: Includes transaction deposits (used for payments, check issuance possible, low or no interest), savings deposits (interest-bearing, typically no check issuance, no minimum balance required), and time deposits (requiring a specific amount and duration, subject to penalties for early withdrawal, and sometimes negotiable).
- Borrowed Funds: Utilized for short-term liquidity management, encompassing interbank borrowing (used to adjust short-term capital imbalances, featuring short maturities of 1-7 days, with interest rates increasing based on risk), Central Bank borrowing (primarily via the discount window to resolve temporary capital shortages), and Repurchase Agreements (selling securities with a commitment to repurchase, resulting in lower interest rates than interbank loans due to collateral).
- Long-Term Funds: Secured through the issuance of bonds to finance fixed assets, purchased by households and financial organizations, and bank capital (owner's equity) generated from stock issuance and retained earnings, which must comply with Central Bank regulations on charter capital and the Capital Adequacy Ratio (CAR).
Where do Commercial Banks strategically deploy their mobilized capital?
Commercial banks strategically deploy their capital to maximize returns while maintaining adequate liquidity and managing risk. The largest portion of funds is allocated to lending activities, which generate the primary income stream, covering diverse sectors from corporate working capital and fixed asset financing to consumer installment loans and long-term real estate mortgages. Remaining funds are held as cash reserves—both mandatory and voluntary liquidity buffers—and invested in high-quality, marketable securities like government and corporate bonds to ensure safety and secondary income generation, balancing profitability with safety and regulatory requirements.
- Cash Holdings: Comprises mandatory reserves stipulated by the Central Bank and voluntary liquidity reserves, which do not generate income. These funds are strategically allocated between vault cash (for customer transactions) and deposits held at the Central Bank (for required reserves).
- Lending Activities: The core income generator, covering diverse loan types: Business Loans (including working capital, long-term term loans for fixed assets, direct lease loans, informal credit lines, and revolving credit facilities); Loan Participations (where multiple banks co-lend large amounts); Leveraged Buyouts (LBOs), which finance company acquisitions using debt; Consumer Loans (such as installment loans for vehicles or shopping, and credit card facilities); and Real Estate Loans (long-term mortgages, typically 15-30 years for housing, and commercial property financing).
- Securities Investment: Strategic deployment into marketable, high-quality assets for safety and secondary income, including Treasury and Agency Securities (government bonds), Corporate Bonds, and Mortgage-Backed Securities (MBS).
- Other Operations: Includes selling funds on the interbank market (lending to other banks), engaging in Repurchase Agreements (acting as the lender), and investing in necessary fixed assets such as headquarters, equipment, and essential technology software.
Frequently Asked Questions
What is the primary difference between transaction deposits and time deposits?
Transaction deposits are highly liquid, used for immediate payments, and often bear low or no interest, allowing check issuance. Time deposits require funds to be held for a fixed period, pay higher interest, and penalize early withdrawal.
How do Commercial Banks use borrowed funds like interbank loans?
Borrowed funds, such as interbank loans and repos, are primarily used to quickly adjust short-term capital imbalances and meet temporary liquidity shortages or mandatory reserve requirements. Repos are often collateralized, offering lower interest rates.
What are the main categories of assets where a Commercial Bank deploys its capital?
A Commercial Bank deploys capital into three main categories: cash reserves (mandatory and liquidity buffers), various types of loans (the primary income source), and investments in marketable securities like government and corporate bonds.
