2. Primary Functions of Banks

The primary functions of banks are the core activities that define what it means to be a bank. These are the essential banking operations without which an institution would not be considered a bank. Broadly, the primary functions of a commercial bank are: 1. Accepting Deposits, and 2. Granting Loans and Advances.

Through these two functions, banks serve as intermediaries between depositors and borrowers. The primary functions generate the main source of income for banks (through interest spreads) and distinguish banks from other financial entities. Below is a closer look at each primary function:

Accepting Deposits

This is the foundational function of any bank. Banks accept money from the public who have surplus funds, providing them a safe custody of their money. People deposit money for different reasons – for saving, for earning interest, or for convenience of transactions.

Banks offer various types of deposit accounts to cater to the needs of different customers:

• Savings Deposits: These accounts are for general public (individuals, households) to encourage a savings habit. Banks usually pay interest on savings deposits (at a modest rate) and allow easy withdrawals, although there may be some limits on number of withdrawals. Savings accounts provide both security and liquidity (easy access) for the depositor’s funds.
• Current Deposits: These are primarily for businesses and traders who need frequent and large transactions. Current accounts offer high liquidity with no limits on withdrawals or deposits. Generally, no interest is paid on current account balances (or very minimal), and in fact banks may charge service fees because they must ensure high liquidity. Many current accounts come with facilities like overdraft (allowing the account holder to withdraw more than the balance up to a limit).
• Fixed Deposits (Term Deposits): These involve depositing money for a fixed period (say 6 months, 1 year, 5 years, etc.). In return, banks offer a higher rate of interest compared to savings accounts. However, the money cannot be withdrawn until the end of the term without a penalty. Fixed deposits are meant for those who want to earn a higher interest and do not need immediate access to that chunk of money.
• Recurring Deposits: In a recurring deposit, a customer deposits a fixed amount every month for a predetermined period. It helps in building savings through regular contributions, and at the end of the period, the customer gets the accumulated amount plus interest. It’s like a fixed deposit, but built with monthly savings – often used by salaried individuals to achieve a savings goal.

By accepting deposits in these forms, banks mobilize the idle funds from the public. Instead of cash sitting unused with individuals, it gets pooled into the banking system. Banks assure safety for the depositors’ money (through regulated operations and deposit insurance up to a limit) and provide interest income. Importantly, deposits form the basis for banks to carry out their second primary function – lending.

Granting Loans and Advances

The flip side of accepting deposits is that banks use these funds to provide loans and advances to those who need money. Lending is the primary income-generating activity for banks. After setting aside a portion of deposits as required reserves (to meet daily withdrawals and regulatory requirements like CRR/SLR), banks lend out the rest to earn interest.

Banks extend credit to various borrowers – individuals (for personal, housing, education loans, etc.), businesses (for working capital, expansion projects), and even governments (by investing in government bonds or providing short-term advances). There are different forms of loans and advances, for example:

• Term Loans: A loan given for a fixed term or period. This could be a home loan (often 10-20 years), a vehicle loan (3-7 years), or a personal loan/education loan (maybe a few years) etc. The borrower usually repays these in installments (EMIs) over the term.
• Overdrafts: An overdraft facility is offered usually on current accounts, allowing customers (often businesses) to withdraw more money than they have in their account up to a certain limit. It’s a short-term credit to cover cash flow gaps. Interest is charged only on the amount overdrawn and for the time it is used.
• Cash Credit: This is a short-term source of finance for businesses where the bank sanctions a credit limit against security (like inventory, receivables). The borrower can draw funds as needed up to that limit, and interest is charged on the amount actually utilized. Cash credit is commonly used by businesses to finance working capital needs.
• Advances & Bills Discounting: Banks also advance money by discounting trade bills or promissory notes. For instance, if a seller has sold goods on credit and holds a bill of exchange (to be paid by the buyer at a later date), the bank can pay the seller immediately (discounting the bill by some interest/fee) and then collect the full amount from the buyer at maturity. This provides immediate funds to the seller and the bank earns a fee/interest.

Lending is crucial because it injects funds into productive use – people can buy homes or cars, students can pay for education, businesses can invest and grow, etc. For the economy, this means increased investment, consumption, and job creation. For the bank, loans are assets that earn interest. Typically, the interest rate on loans is higher than the interest rate paid on deposits. The difference (called the interest spread or margin) is how banks make a profit and cover their costs of operations. For example, if a bank pays 4% on savings deposits but charges 9% on a loan, the spread of 5% (minus operating expenses and any credit losses) contributes to the bank’s earnings.

Additionally, when banks grant loans, they are essentially creating credit. Money lent often gets deposited into the banking system again (by the recipients of those funds), which enables further deposits and lending rounds – a multiplier effect. This credit creation ability of banks means they play a direct role in expanding the money supply in an economy, which must be managed carefully under central bank regulations to avoid inflation or excesses.