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Functions of a bank
Banks carry out a number of financial functions. They accept deposits on different types of interest-bearing and noninterest-bearing accounts, make different types of loans, work as agent of their clients, issue debit and credit cards and so on. The success and failure of banks depend on their ability to identify the financial services the public demands, produce those services efficiently and sell them at competitive price. Broadly, the functions performed by most of the banks for their customers are classified into three areas: payments, intermediation and other financial services. We discuss each of these functions in the following section.
1. Payment functions
You have to pay your water bill, electricity bill and telephone bills. Similarly, your friend, who lives in Kathmandu, has to pay you (living at Pokhara) Rs 10,000 by next week. You can pay your utility bills just clicking your laptop or through your smart phone. Your friend can pay you without visiting you in Pokhara just by depositing Rs 10,000 on your account at Pokhara branch of NIC Asia Ltd. These are the examples of settlement of financial transactions through modern banking services. So whenever we talk about payment, it refers to the means by which financial transactions are settled. Payment is one of the basic functions of banks. Payment systems involves the settlement of credit card transaction, electronic banking wire transfer and other aspects of the movement of the funds. In our example, internet banking system involves in the settling the utility bills and remitting the payment from one place to other.
Efficient payment system is important for social and economic stability. Banks play an important role in an efficient payment system. Inefficient payment system costs more to the society and economy. Checking account is one of the means for payment and at one time banks had the monopoly in checking account. But now almost all depository financial institutions can accept the deposits on checking accounts. In Nepal, current account and saving account are checking accounts commonly used as means of payments. Normally, in Nepal, corporate bodies use current account and individuals use saving account as means of payments.
Banks along with the central bank has an important role in settling financial transactions. Payment system is dividend into retail payment system and large amount payment system. Payment of utility bill, payment at service point, payment of salary and wages, and payment of a small amount of bills come under retail payment system. Banks may handle the large amount of payments made by business firms, government and non-government organizations at domestic as well as international level. Such payment system is known as large amount payment system.
Retail payment system extensively uses paper check. In addition to the paper checks, this system uses electronic means like debit card and credit cards. Debit and credit cards are very popular means of payment for shopping in the markets with developed financial system. But in Nepal, most consumers have yet to develop banking habits to pay off their bills through banks.
Electronic payment system is popular in large amount payment system. Fedwire, CHIP (the clearing house interbank payment system) and SWIFT (the society for worldwide interbank financial telecommunication) are used to make large amount of both domestic payments and foreign payments. In Nepal, SWIFT is commonly used to make large amount of both domestic and foreign payments.
2. Financial Intermediation
There are two types of economic units. One type of economic units has surplus of funds and another type of units has deficit of funds. In the absence of financial intermediation, deficit units directly borrow the funds from surplus units to meet their deficit of funds. But in the presence of financial intermediaries, surplus units deposit funds in financial intermediaries and financial intermediaries lend the money to deficit units. In other words, financial intermediaries borrow the funds from surplus units and deficit units borrow the fund from financial intermarries. This function of borrowing funds from surplus units by an intermediary and lending the funds to deficit units of economy is called financial intermediation.
Banks receive deposits from the savers and lend the same to the borrowers. Deposits are the liabilities and loans are the assets of banks. Thus, banks perform the function of financial intermediation by accepting deposits from savers (primarily from households) and lend funds to the borrowers (primarily to business firms). Thus, banks mainly perform two intermediation functions – deposit function and loan functions.
2.1 Deposit functions
Banks receive deposits indifferent types of accounts. Broadly, bank accounts are classified as demand deposit account, saving account and time deposit account. Business firms, government and non government offices deposit their money in demand deposit account for settling the transaction of their businesses. So, demand deposit account is known as transaction account also. Generally, banks provide the facility of this account to business firms, government and non government organizations for transaction purpose.
Small savers deposit their money in saving accounts. Interest is provided on saving accounts. They provide their customers the checking facility on this account with some restrictions on the withdrawals of deposits. Banks may put the ceiling on the amount and number of withdrawals in a day or week. Thus, this account has some features of both transaction account and time deposit account.
Banks offer wide varieties of time deposit account. The interest rate varies according to the denomination and maturity of the deposit. In general, banks provide higher interest rate on time deposit with higher denomination and longer maturity period. Banks issue certificate of deposit (CD) of different denomination with different maturity period. But at present, banks in Nepal do not issue CD. Banks in Nepal offer different types of time/fixed deposit products to attract diverse customers. Bank deposits have high degree of liquidity, and have wide variety of denominations, interest rates and maturities. Due to these characteristics, deposits meet the needs of most savers better than bonds and stocks.
2.2 Loan functions
We discussed earlier that banks work as the intermediary between deficit units and surplus units of the economy. Surplus units deposit their money in banks in different accounts and deficit units take different types of loans from banks. In other words, banks design different types of products (deposits and loans) suitable to the needs of their customers. Historically, banks used short-term deposits to finance short-term commercial lending. This is the reason why banks are called commercial banks. But now-a-days provides wide variety of loans. Lending functions of banks is not limited to the short-term lending. They provide long-term loans to finance projects. The period of loan depends upon the nature of the projects. For examples, loan granted to finance hydro-power and other infrastructural projects may be for longer period, and loan for the projects having short gestation period may be for relatively short period.
In addition to the commercial loans, banks provide a variety of consumer loans. The consumer loans may be to finance consumption need, home appliances and other durables. Banks provide real estate and housing loan, and hire purchase loan and a number of different types of consumer loans.
Intermediation between depositors and borrowers has a vital role in the growth and stability of the economy. Economic growth of the country depends on the savings and effective allocation of the saving to the productive and profitable sector of the economy. Banks can encourage savings by designing and offering financial instruments that have desirable risk/return characteristics. Banks also have crucial role in channeling the funds to the productive and profitable sectors. They can discourage the loan requests for unproductive sectors and encourage the loans for productive sector.
3. Other Financial Sectors
In the addition to the payment functions and intermediation functions, banks provide different types of financial services. Off-balance sheet functions, insurance and securities related function, trust service functions, and agency functions are grouped as other functions of banks. We discuss these functions in brief in the following section.
3.1 Off-Balance Sheet Activities
The activities which are not recorded in the balance sheet but are considered contingent liabilities or assets of banks are called off-balance sheet activities. Banks perform many off-balance sheet activities such as providing the bank guarantee, issuing the letter of credit, issuing the standby credit agreement, signing the loan commitment agreement and foreign exchange rate contracts. All these activities are the examples of off-balance sheet activities of banks.
3.2 Insurance and Securities Related Activities
Banks and their affiliates may provide services related to life insurance policies and annuities to their clients. Similarly, they may provide different securities-related services. They can provide services of brokerage and dealers. In other words, they may, on behalf of their customers, buy and sell securities on commission basis. Similarly, they may buy the securities on their own account and sell them to their customers.
Banks offer merchant banking services to larger companies. In merchant banking services, banks help other firms to go public by purchasing the securities temporarily and selling to the ultimate investors. Process of temporary purchase and sell of securities is called underwriting functions. Thus banks help their corporate clients to raise capital required for launching new projects and expanding their businesses.
3.3 Trust Services
Banks are providing the trust services for many years. They manage the financial affairs and property of individuals and business firms and in return they charge the fee. Trust fee depends on the value of the property or amount of funds under management. Such property and fund management services are known trust services. Banks do not own the property and funds. So, the assets under trust agreement are not shown in their balance sheet. As a trustee, banks manage employee pension funds, profit-sharing programs and other securities related services and earn fee income. Banks also provide personal trust services to individuals. In personal trust services, banks, manage the funds and property of individuals. Banks act as trustee for wills, managing the property of decreased customers, and keeping valuable assets safe.
3.4 Agency Services
Banks as an agent provide different types of services to their customers. For examples, they may pay the bills for utilities and settle the accounts of their customers. they may collect various credit instruments such as checks, promissory notes, and bill of exchange on behalf of their customers. Similarly, banks may collect dividend on shares and interest on bonds and debenture, and credit to their customers’ accounts. And banks perform many other agency services for and on behalf of their customers.
