Commercial Bank Definition
Commercial Banks are profit-seeking financial institutions that take deposits from customers at a lower rate of interest and make business loans at a higher interest rate. In addition, they also sell various investment products and banking services that augment their profits. Examples include Citibank, Standard Chartered, ICICI, SBI, and HSBC.
How Does a Commercial Bank Earn Money
Let’s take the example of a commercial bank.
The rate of interest charged to a customer is higher than what depositors are paid by the banks. For example, consider a customer purchasing a CD with 5 years of maturity for $10,000 at an annual interest rate of 2%.
Another customer gets a term loan repayable within 5 years for $10,000 at an annual interest rate of 5%. The bank pays the depositor $1,000 over five years. It receives $2,500 over five years from the loan holder. The net interest income of $1,500 difference represents revenue for the bank. In addition to the interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. , they charge their customers fees for mortgages and other banking services. Also, when a loan is sanctioned, a fee is charged in addition to interest charges.
For example, the Origination fee on a mortgage loan is charged between 0.5% and 1% of the loan amount. If a customer receives a $100,000 mortgage loan, the bank earns $1,000 with a 1% origination fee over the life of the loan.
Functions of Commercial Bank
There are two types of functions – Primary Function and Secondary Functions.
#1 – Primary Functions
- Acceptance of deposit
- Providing loans and advances
- Credit creation
#2 – Secondary Functions
- Acts as an agent
- 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. facility
- Discounting bill of exchange
- Provides locker facility
- Issues traveler cheque
Products and Services
Commercial banks mainly offer loan facilities and accept deposits also. But in addition to that are saving accounts, merchant services, commercial loans, global trade services, treasury services, lending services, and other corporate-oriented products.
It offers loans for the industry like a large industrial corporation, syndicated loans, leasing, foreign trade financing, bills of exchangeBills Of ExchangeBills of exchange are negotiable instruments that contain an order to pay a certain amount to a particular person within a stipulated period of time. The bill of exchange is issued by the creditor to the debtor when the debtor owes money for goods or services.: deposit account services, loan services, and other possible services they offered.
Current or chequing accounts, term deposits, consumer loanConsumer LoanA consumer loan is a type of credit given to a consumer to finance specified set of expenditures. The borrower must pledge a specific asset as collateral for the loan, or it may be unsecured depending on the loan's monetary value. and mortgages, credit and debit cards, cash managementCash ManagementCash Management refers to the appropriate collection, handling, & disbursement of cash for ensuring financial stability & avoiding insolvency risk. services, corporate loans, trade finance, financial market products, online banking;
A certain minimum percentage of all deposit claims are legally required to be kept as liquid cash. This is called the reserve ratioReserve RatioThe reserve ratio is the minimum percentage of the amount defined by the central bank to park aside by every commercial bank. The Central Bank can change this ratio depending upon the economic environment. . It is 10% in the united states. Hence for every $100 deposit made in banks, a minimum $10 must be retained by the bank, and only the remaining must be invested or advanced as a loan.
Tier 1 capital measures a bank’s financial performance. It is used when a bank has to absorb losses without reducing operating capital. Under Basel III, the minimum tier 1 capital ratio is 10.5%, which is calculated by dividing the bank’s tier 1 capital by its total risk-based assets.
AAA bank has a tier 1 capital of $150 bn and risk-weighted assetsRisk-weighted AssetsRisk-weighted asset refers to the minimum amount that a bank or any other financial institution must maintain to avoid insolvency or bankruptcy risk. The risk associated with each bank asset is analyzed individually to figure out the total capital requirement. worth $1000 bn. The bank’s tier 1 capital ratio Tier 1 Capital RatioTier 1 Capital Ratio is the ratio of Tier 1 capital (capital that is available for banks on a going concern basis) as a proportion of the bank’s risk-weighted assets. Tier 1 capital includes the bank’s shareholder’s equity, retained earnings, accumulated other comprehensive income, and contingently convertible and perpetual debt instruments of the bank. is $150 bn / $1000 bn =15 %, which satisfies the Basel III requirements.
Tier 2 capitalTier 2 CapitalTier 2 capital, also known as supplementary capital, is the second layer of bank capital requirements. It consists of hybrid instruments, general provisions and revaluation reserves. Uneasy to liquidate; Tier 2 capital is considered less secure. consists of unsecured subordinated debt and its surplus with the maturity of lower than five years fewer investments in non-consolidated financial institutions. The total regulatory capital comprises tier 1 and tier 2 capital.
In 2019, under Basel III, the minimum total capital ratio was 12.9%.(minimum tier 2 capital ratio is 2% and 10.9% for the tier 1 capital ratio). For example, AAA bank reported tier 2 capital of $30 billion. Its tier 2 capital ratio for the quarter was $30 billion / $1 trillion = 3%.
The following are the roles –
- Implementation of monetary policy
- Encouragement of good or fair class of industries
- Regional growth
- Encourage industrial growth
- The gratification of socio-economic intention
- Increase the rate of fund formation
- Provision of finance and credit
- Support to rural areas
- Developing entrepreneurship
- Help customers
Commercial Banking vs. Retail Banking
The main difference between a commercial and retail bank is that commercial bank does not do transactions directly with consumers they firstly concerned with collecting deposits and then lending to business but the retail bank does transactions directly with consumers.
The commercial bank provides banking products and services to the corporation, any institutes, or sometimes the government. In comparison, retail bankingRetail BankingRetail banking or personal banking refers to the financial services offered by the financial institutions exclusively to the individual clients. The consumer banking provides personal loan, savings account, debit cards, credit cards, locker, etc. offers banking products and services to individual customers.
Points to Note
Most of the commercial banks today operate exclusively online, wherein every transaction is carried out electronically without the need to visit the branch office of any bank.
These “virtual” banks are able to increase their operating profit marginOperating Profit MarginOperating Profit Margin is the profitability ratio which is used to determine the percentage of the profit which the company generates from its operations before deducting the taxes and the interest and is calculated by dividing the operating profit of the company by its net sales. as they usually have lower service and, in turn, have the ability to pay a higher interest rate to depositors. They do not have to maintain physical branches, and hence all the ancillary charges such as rent, property taxes, and utilities will not be incurred.
Now a days few commercial banks include investment banking as one of the divisions. Example Citibank and JPMorgan Chase. But there are banks such as ally, which still operate only on the commercial aspect of the business.
Following are the items where commercial banks need to continuously innovate to survive:
- Digital Experiences, Automation, Data Analytics.
- Payment Speed, Quicker Response to Market Changes, and the Promise of Artificial Intelligence
Banks are highly regulated, but still, they do get fail. When they fail, it becomes costly. In the modern-day, commercial banks are not just dealers but act as leaders in economic development.
This has been a guide to Commercial Bank and its definition. Here we discuss the functions of a commercial bank with examples, roles, and its differences with retail banking. You can learn more about accounting from the following articles –