Commercial Bank

Published Apr 6, 2024

Definition of Commercial Bank

A commercial bank is a type of financial institution that provides various banking services to businesses and individuals. These services include accepting deposits, making business loans, and offering investment products. Essentially, commercial banks function by accepting deposits from the public and utilizing those funds to offer loans to businesses and individuals, thereby generating profit through the difference in interest rates charged on loans and paid on deposits.

Example

Consider a scenario where a small business needs funding to expand its operations. The business owner approaches XYZ Commercial Bank to apply for a loan. The bank assesses the business’s financial health and decides to grant a loan on the basis of its creditworthiness. The interest rate the bank charges on this loan is higher than the interest rate it pays to its depositors. This difference in interest rates allows the bank to cover its costs and make a profit.

At the same time, individuals and other businesses deposit money into their accounts with XYZ Commercial Bank, earning interest on their balances. The bank uses these deposits to fund the loan to the small business, among other investments and loans, thus facilitating the flow of money within the economy.

Why Commercial Banks Matter

Commercial banks play a critical role in the financial system and the economy at large. They serve as intermediaries between savers and borrowers, thereby enabling the efficient allocation of resources and liquidity within the economy. By providing a safe place for individuals and businesses to deposit their money, they help to encourage saving. Through the loan products they offer, commercial banks enable businesses to grow and individuals to purchase homes and cars or to finance education, which in turn contributes to economic development and growth.

Moreover, commercial banks offer various other services, including financial advice, wealth management, and safe deposit boxes, adding value for their customers and aiding in the overall functioning of the economy. Their role in processing payments and facilitating international trade through letters of credit and foreign exchange services is also vital.

Frequently Asked Questions (FAQ)

How do commercial banks create money?

Commercial banks create money through the lending process. When a bank grants a loan, it does not give out existing money but creates a deposit in the borrower’s account, effectively creating new money. This process is subject to regulatory requirements like maintaining reserve ratios to ensure banks have enough liquidity to meet their obligations.

What is the difference between commercial banks and central banks?

Commercial banks are private entities whose main goals include profit-making, accepting deposits, and providing loans to the public and businesses. In contrast, central banks are government institutions that manage the country’s currency, money supply, and interest rates. Central banks also serve as a bank for commercial banks and the government, but they do not deal with the public directly.

How do commercial banks manage risks?

Commercial banks manage risks through various strategies, including diversifying their loan portfolios, setting aside provisions for bad debts, and meticulously assessing the creditworthiness of borrowers. They also use hedging and insurance to manage risks associated with changes in interest rates, foreign exchange rates, and other market variables. Additionally, banks are subject to regulatory oversight, which includes requirements for capital adequacy and liquidity, further ensuring their stability and the safety of the banking system.

What role do commercial banks play in monetary policy implementation?

Commercial banks play a crucial role in the implementation of monetary policy. Central banks use tools like reserve requirements, open market operations, and the discount rate to influence the amount of money that commercial banks can lend. Changes in these policy tools can affect the interest rates charged on loans and paid on deposits, influencing borrowing and spending in the economy. Through these mechanisms, commercial banks act as conduits through which monetary policy affects economic activity and inflation.