Chapter 15: Banks

Main types of Banks

• Commercial Banks
• Central Banks.

In exams, read carefully whether the question is talking about commercial banks or central banks.

Commercial Banks

Commercial banks are private sector banks which aim to make a profit by providing a range of banking services. 

They are also known as joint stock banks, retail or high street banks

• Commercial banks are banks that seek to make a profit. 
• Shareholders have limited liability ( the state of being legally responsible for something )
• They are in the private sector
• They are either public limited companies or private limited companies.
• They sell banking services.
• They are the banks we are most familiar with

Main Functions of commercial banks

1. Accept deposits

Deposits can be made into two types of banks accounts. Current accounts (a.k.a demand accounts) and deposit accounts (a.k.a time accounts)

In current accounts:

• There is easy and immediate access to money.
• However interest is not paid on such accounts
• Customers use these accounts to receive and make payments

In deposit accounts:

• A period of notice has to be given before money can be withdrawn. 
• Interest is paid on money held in such accounts
• Customers use such accounts as a way of saving.

2. Lend money 

Banks make most of their profit by charging higher interest from borrowers than that is paid on the money held within the banks. There are two main ways of doing this- Overdrafts and loans

In overdrafts

• A customer is allowed to spend more than what is in his or her account up to an agreed limit. 
• Interest is charged on the amount borrowed
• This is a relatively expensive way of borrowing money.
• Customers use it to cover short term gaps between expenses and income

In loans

• Taking a loan is for a particular purpose.
• Interest is charge on the full amount of the loan.
• The rate of interest for loans is likely to be lower than that of an overdraft.
• The customer may be asked to give some form of security- collateral
• This is to ensure that if the loan is not paid the collateral can be sold and the money can be recovered.
• Banks try to avoid this, by checking very carefully, whether the person seeking the loan would be able to repay it.

Lending and borrowing from banks means that they act as financial intermediaries. They accept deposits from those with more money than they want to spend and lend it to those with an immediate desire to spend more money than they have at hand. 

3. Enabling customers to receive and make payments

Banks act as agents for payments and provide money transmission services. There is now a range of ways in which people can receive money and make payments out of their accounts such as cheques, standing orders, direct debits, debit/credit cards and online banking.

4. Other Functions

1. Provide travellers with cheques
2. Change foreign currency 
3. Customers can leave important documents such as house deeds and small valuables with their banks.
4. Banks can also help with the administration of customers' wills
5. Provide advice and help with financial matters-
1. Such as completion of tax forms and the purchase and sale of shares. 
6. Sell insurance 
7. Offer a wide variety of savings accounts with a range of conditions and interest rates.
8. Offer mortgage loans as well

Aims of commercial banks

Making a profit for their shareholders

• The main way it does this is by giving out loans

Liquidity

• Banks have to ensure that they can meet their customers' requests to withdraw money from their accounts.
• To do this banks have to keep a certain amount of liquid assets - items that can be quickly turned into cash without incurring loss.
• Banks earn most of their interests by giving out long term loans
• However if they lend out all their money in these loans then they will not be able to pay money to the consumers who are requesting it.
• Thus, banks have to balance profitability and liquidity
• Having some assets that are earning profit while being illiquid and having others that are earning low or no interest but being liquid.

 Central Banks

Central Banks are government-owned banks which provide banking services to the government and commercial banks.

 For example: Federal Reserve Bank Of the USA, Europeen Central Bank and Bank Of England.

Functions of a Central Bank

1.     Acts as a banker to the government

o    Tax revenue is paid into the government's account at the central bank

o    Payments by the government are made out of the government's account at the central bank.

2.     Operates as a banker to the commercial banks

o    Holding accounts at the central banks allows the commercial banks to withdraw money from there if their own customers are taking out more money than usual.

3.     Acts as a lender of last resort

o    It will lend money to those banks that are temporarily out of cash.

4.     Manages the national debt 

o    National debt is the total amount of money that the government owes.

o    Over time government debt tends to build up. 

o    The central bank carries out borrowing on the government's behalf

§  It does this by issuing government securities such as issuing government bonds, paying interest on these and repaying them when they fall due

5.     Holds the country's reserves of foreign currency and gold

o    The central bank keeps foreign currency and gold to influence the exchange rate

6.     Issues bank notes

o    It is responsible for printing notes and destroying notes which are no longer available for circulation. It also authorises the minting of coins

7.     Implements the government's monetary policy

o    The policy is to keep the inflation low and steady.

§  This involves controlling the money supply 

§  Influencing interest rates through the economy (changing interest rates it charges on loans.)

§  In some cases central banks decide the interest rates.

§  In others, the government may decide the interest rates

8.     Controls the banking system

o    Regulate and supervise the banking system

9.     Represents the government

o    At meetings with other banks and international organisations such as the World Bank and international monetary fund.

Independance of Central Banks

 A lot of central banks have the authority to decide the rate of interest. The govt. still decides the aims of central banks and gives a target for inflation. Eg: The bank of England has been given an inflation target of 2%. If it thinks that the prices may rise by more than 2%, it will raise the rate of interest and vice versa                  

There are some advantages in allowing the central bank to make the rate of interest- it will not be tempted to lower the interest rate to win public support. Central banks also have extensive knowledge of the banking system and know the appropriate rate of interest to set.

Disadvantages?

Other Types of banks 

There are two other types of banks- investment banks and savings banks

Investment banks or merchant banks-

• These are banks that tend only to large firms. They accept deposits from them and lend money to them as well.
• They manage the issue of new shares and buy and sell shares and other financial securities on behalf of their own customers.
• They also give advice on, and help with mergers and takeovers.

Savings banks

• They try to encourage people with relatively low incomes to save,
• They make it easy to withdraw cash with few penalties
• A large proportion of the money lent by these banks goes to the govt.

Banking and Islam

In Muslim countries, commercial banks are not allowed to charge interest on bank loans. This is because Muslims regard charging of interest (usury) a sin.

So to tackle this problem- Muslim banks have provided finance to banks by lending to them in return for a share of profits.

Islamic sharia scholars are employed to issue religious edicts that approve financial products including loans.