The main functions of commercial banks

Commercial banks, sometimes referred to as high street banks or retail banks, perform several essential roles in the economy.

Types of deposit accounts provided by commercial banks

Commercial banks offer accounts that allow customers to store and access their money securely:

• Demand deposit accounts - Also known as current accounts or sight accounts, these provide immediate access to funds and are primarily used for everyday transactions, such as receiving wages and making payments.
• Savings deposit accounts - These are designed mainly for building up savings over time, often offering interest on the balance to encourage long-term deposits.

Assets held by commercial banks

Banks maintain a range of assets to ensure stability and meet customer needs:

• Cash - Physical money held for immediate withdrawals.
• Government securities - Safe investments like bonds issued by the government.
• Equities - Shares in companies that can provide returns but carry more risk.

The reserve ratio in banking

The reserve ratio refers to the proportion of a bank's total deposits that it keeps as liquid assets, such as cash or easily convertible securities. This helps ensure the bank can handle customer withdrawals without issues.

How banks generate profits through lending

Commercial banks earn most of their profits by lending money to customers and charging interest. This lending takes different forms, each suited to specific needs.

Types of lending offered by commercial banks

• Overdrafts - These allow customers to withdraw more money than is available in their accounts, often to cover short-term gaps between income and spending. Interest is charged only on the amount overdrawn, making it flexible but potentially expensive.
• Loans - These are fixed amounts provided for a specific purpose and duration, such as buying equipment. Interest is charged on the entire loan amount from the start, regardless of how much is used, and rates are usually lower than those for overdrafts.

The key objectives of commercial banks

Commercial banks pursue three primary objectives to operate effectively and satisfy stakeholders, including shareholders and customers.

Main objectives pursued by banks

• Profitability - Banks aim to generate high returns for shareholders, primarily through interest on loans and investments.
• Liquidity - This involves holding sufficient liquid assets, like cash and short-term securities, to meet anticipated customer withdrawals and maintain smooth operations.
• Security - Banks focus on staying financially stable by building up capital reserves to cover potential losses from bad loans or failed investments, which helps build customer trust.

Conflicts between objectives and how banks balance them

The objectives of profitability, liquidity, and security often clash, requiring banks to make careful trade-offs to maintain overall stability.

Challenges in balancing bank objectives

• Trade-off between liquidity and profitability - Liquid assets like cash provide security but generate little or no income, while more profitable assets, such as long-term loans, are less liquid and harder to convert quickly.
• Security versus profitability - Investing in high-return but risky assets can boost profits but may threaten security if loans default; banks often set aside some profits as reserves to mitigate this.
• Impact of economic changes - Fluctuations in economic activity force banks to reassess their priorities, such as increasing liquid holdings during uncertain times or expanding lending when growth is strong.

Banks typically hold a combination of assets to address these conflicts. By adjusting this mix and monitoring the margin between interest earned and paid, banks adapt to changing conditions while aiming to meet all objectives.