What is Business Banking?
Business banking is specialized division of bank or financial institution that deals only with businesses and corporate clients and offer products like business loan, assets management, electronic transfer of funds which are specifically designed to meet their needs. Banks have major focus in this area as it is major source of profit for them, generally interest rates and fees charged are higher for corporate client compared to retail clients.
Types of Facilities / Services Provided by a Business Bank
Financial InstitutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more like Wells Fargo or Barclays bank sign agreement with corporations, which allow companies to use various facilities and services of a bank at fixed service costs. Facilities like short to the long term loans and services like a letter of creditLetter Of CreditA Letter of Credit (LC) is issued by a buyer’s bank to ensure timely, full payment to the seller. If the buyers default, the bank pays the sellers on their behalf.read more are provided, which ensures the smooth functioning of a business.
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Source: Business Banking (wallstreetmojo.com)
#1 – Overdraft Facility
When companies have more cash requirements then the available balance in companies’ current accounts, then companies generally avails overdraft facilities from banks for which banks charge rate of interest. Overdrafts are often used as an alternative source of funding for unexpected expenditures. OverdraftOverdraftOverdraft is a banking facility that offers short-term credit to the account holders by allowing them to withdraw money from their savings or current account even if their account balance is or below zero. Its authorized limit differs from customer to customer.read more is a very common source of funding for small and medium enterprises.
Important characteristic
- Overdraft facility is available as short-term financing and useful for companies that have fluctuating finance requirements or have a seasonal business cycleBusiness CycleThe business cycle refers to the alternating phases of economic growth and decline.read more.
- An overdraft facility can be used with or without taking pre-approval from a lender. Generally, a Pre-approved facility carries a lower rate of interest as compared to without approval.
- Sometimes large overdraft facilities can be secured against company assets, which bring down the Interest rate as the risk to the lender will be lower.
- Interest paid is tax-deductible, and the balance of overdraft is not included in the calculation of the company’s business financial.
Example
Suppose a small retail firm based out of New York has emergency cash requirements to pay off suppliers, then the firm has the option to take a secured overdraft facility against its fixed deposit with a bank. Since overdraft is secured against a fixed deposit, it will carry a lower Interest rate, and the firm can pay off overdraft principle and interest upon cash receivables.
#2 – Bank Loan or Term Loan
When companies want to go for business expansion, like the purchase of new property, plant or machinery, then companies generally prefer to go for a bank loan that has a fixed tenor with a fixed or variable rate of interest. Through the bank, the loan companies can expand their business without taking a big hit on an available cash reserve.
Important Characteristic
- Bank loans are the best source of funding for medium and long term business needs.
- The interest rate can be fixed or variable rate. Variable-rate is based on LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more (London Interbank Offered Rate).
- Based on the company’s revenue generation capability and future cash flow, loan amount, repayment schedules, loan tenor will be decided.
- If the loan is secured against the company’s assets, then generally, Interest rates will be lower, but in any case, the business fails to repay, then the lender has the right to seize the assets and recover the loan amount.
- The default of loan payment can lead to an increase in the Interest rate for future loans and legal proceedings against the company.
#3 – Letter of Credit
A letter of credit or LC’s is generally used in international tradesInternational TradesThe trading or exchange of products and/or services across international borders is referred to as international trade. It frequently includes other risk factors such as exchange rate, government policies, economy, laws of the other nation, judicial system, and financial markets that impact trade between the two.read more. Letter of the credit agreement state that, in any case, if the Importer (or buyer) not able to make the payment, then the issuer of LC, i.e., bank, will make full or remaining payment to the exporter (or seller) on behalf of the buyer.
Types of Letter of Credits
- Standby Letter of Credit: In this type of LC’s, the bank pays the amount only when the applicant of LCLCThe full form of LC is a Letter of credit. A letter of credit is a document issued by the buyer's bank, known as the issuing bank, that guarantees that the buyer will pay the correct amount to the seller on time, and that if the buyer fails to pay the amount to the seller, the bank is liable to pay the outstanding dues to the seller on behalf of the buyer.read more is not able to make payment.
- Traveler’s Letter of Credit: This type of LC’s is useful for the traveler, in which issuing bank honor payment requests made at the foreign country banks.
- Revolving Letter of Credit: This type of LC allows any number of payments within a certain limit for a specific time period.
- Confirmed Letter of Credit: Two banks are Involved (Issuing bank and confirming bank); if the issuing bank or holder of LC’s unable to make a payment, then confirming the bank ensures payment to the seller.
Important Characteristic
- When the reliability of an Individual buyer cannot be determined by a seller from another country, then letter credit from the buyer side plays an important role in completing the trade.
- Bank takes credit risk based on the buyer’s creditworthiness and takes service cost for issuing a letter of credit. Charges will be higher if credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more is higher.
- Aspects such as distance, differing laws in each country, and difficulty in knowing the opposite party personally make a letter of credit even more important.
- A letter of credit helps in better payment terms and timely shipments of goods for both buyers and sellers.
Example
Suppose a furniture company Ladder Inc. based in the United States, wants to export $100,000 of furniture to a company ABC based in Kenya, but Ladder Inc. is concerned about Kenyan companies’ ability to pay them.
To address this, Company ABC gets a letter of credit from its bank, Bank of Kenya, indicating that Company ABC will make good on the $100,000 payment in, say, 60 days, or Bank of Kenya will pay the bill itself. Bank of Kenya then sends the letter of credit to Company Ladder Inc., which then agrees to ship the furniture.
After the shipment goes out, Company Ladder Inc. then asks for its $100,000 by presenting a written draft (also called a bill of exchange) to Bank of Kenya.
#4 – Treasury and Cash Management Services
Banks provide Treasury management services to cooperates like a collection of payments. Disbursements, trading, and Investment in bonds, foreign exchange. Banks has a special department devoted to treasury management and provide these services at a fixed costFixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more.
Important Functions
- Effective Treasury management helps in the smooth functioning of business and gain lender and stakeholder confidence.
- The main purpose of Treasury management is to ensure a firm’s liquidity position is stable.
- Treasury management helps the company mitigate various operational and financial risksFinancial RisksFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more.
Example
Suppose a company belonging to an export business that has a regular requirement of foreign currencies; then company can request for bank’s treasury service to get the best foreign exchange rate.
Conclusion
In Business banking main goal is to provide the best cooperate banking solution to companies using Innovative technologies, which will ensure the smooth functioning of businesses and will create a loyal Institutional client base for future growth.
Recommended Articles
This has been a guide to Business Banking and its definition. Here we discuss the 4 types of facilities provided by Business banking, including its Characteristics and examples. You can learn more about financing from the following articles –
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