How Do Commercial Banks Work, and Why Do They Matter?

Commercial banks are the backbone of the banking system in most developed economies. They provide a range of services to businesses and individuals, including deposit-taking, lending, and money transmission. They play a crucial role in the economy by channeling savings into investment and facilitating trade.

In this article, we will look at how commercial banks work and why they are important. We will also discuss some of the challenges they face and how they are adapting to the changing landscape.

When is a Bank a Commercial Bank?

A commercial bank is a financial institution that accepts deposits, offers checking services, gives out loans, and offers financial products like certificates of deposit and savings accounts.

Commercial banks make money by earning interest from loans. They play a huge role in the growth of the economy as they provide short- and long-term financing.

How Commercial Banks Work

Commercial banks are an important part of the financial system in most developed countries. How do commercial banks work? In simple terms, commercial banks take deposits from customers and use those deposits to make loans. The loans are then used by businesses and households to finance a variety of activities, such as investment, consumption, and housing.

The interest rates that commercial banks charge on loans are determined by several factors, including the level of inflation, the demand for loans, and the supply of funds available to the bank. In general, commercial banks tend to charge higher interest rates when inflation is high and loan demand is strong. In Kenya, commercial banks are regulated by the Central Bank.

Most commercial banks have their branches located in buildings, but they have also embraced technology. They offer online banking which allows their customers to transact online.

What are the Functions of a Commercial Bank?

Commercial banks are important for the economy because they provide the necessary capital for businesses to grow and expand. They also play a vital role in providing financial stability by ensuring that the banking system is sound.

There are a variety of services that commercial banks offer. They offer primary and secondary functions. Here are the primary functions of commercial banks.

Accepting deposits

Customers can deposit money into their accounts at a commercial bank. The bank then uses this money to give loans and invest in other financial products. Deposits can be classified into

Current deposits

These deposits are also known as demand deposits. They are used to paying other people and don’t pay any interest to them.

Fixed deposit accounts( Term Deposits)

Fixed deposit accounts offer customers interest on money deposited in an account for a fixed period. The money deposited into a fixed deposit gives the customer interest over time.

Savings deposits

These are deposits for saving purposes and they earn interest.

Give personal and business loans.

Commercial banks provide the personal loans and capital that businesses need to grow and expand. This financing can be in the form of loans, lines of credit, or other types of financing. Commercial banks offer secured and unsecured loans.

Guaranteeing safe deposits

Commercial banks guarantee that the money you will deposit is safe. Deposits taking commercial banks are insured, meaning that in case of collapse, your money will be safe.

Secondary Functions

Commercial banks offer the following secondary functions.

Offer basic investment products.

Most commercial banks offer basic investment products, such as savings accounts, certificates of deposit (CDs), and money market accounts. These products are safe, liquid, and FDIC-insured. But they offer very little in terms of yield and growth potential.

For investors looking for more than just safety and liquidity, there are a few other options available in a commercial bank. These include online banks, credit unions, and brokerage firms. Online banks tend to offer higher yields on savings accounts and CDs, while credit unions and brokerage firms offer a wider variety of investment products, such as stocks, bonds, and mutual funds.

Offer safe lockers.

Commercial banks offer safe lockers for customers who want to store their valuables.

Overdraft facility

This facility allows customers to overdraw their current account up to a certain limit. Overdraft facilities are extended to customers who are trustworthy and reliable.

Discounting bills of exchange

Discounting bills of exchange allows the holder to discount them with a bank before they mature. The bank subtracts a fee and returns the remaining amounts to the holder.

Foreign exchange

Commercial banks provide foreign exchange to individuals and organizations, especially for the import and export of goods.

They act as agents.

Commercial banks act as agents for their clients, helping them to buy and sell stocks, bonds, and other securities.

Categories of Secured and Unsecured Loans Provided by Commercial Banks

There are many different types of loans that commercial banks can provide to businesses. They can be broadly classified into two main categories: secured and unsecured loans.

A secured loan is backed by collateral. This could be a property, a vehicle, or some other asset that the lender can claim if the borrower defaults on the loan. Unsecured loans, on the other hand, are not backed by any collateral. These are typically more difficult to obtain and usually carry higher interest rates.

Different businesses will have different needs, so it’s important to understand the different types of loans that are available. Here is a quick overview of the main types of secured and unsecured loans that commercial banks can provide.

Secured Loans

  • Home equity loans
  • cash credit
  • personal loans
  • Auto loans
  • Mortgage loan facilities
  • Business loans
  • Bank overdraft facility
  • Lease finance
  • Bank Guarantee

Significance of Commercial Banks

Commercial banks play a significant role in the economy by providing a variety of services to businesses and individuals. Banks allow businesses to finance their operations and expand their businesses. They also offer loans to individuals for various purposes, such as buying a home or car. In addition, banks provide a safe place for people to save their money.

Commercial banks are regulated by the government to ensure that they operate safely and soundly. They must maintain a certain level of capital, which is money that the bank has available to lend out or use to cover losses.

The significance of commercial banks lies in their ability to provide financing to businesses and individuals and to help promote economic growth.

Commercial Banks vs. Investment Banks

Both investment and a commercial bank provide financial services to their clients, but there are some key differences between the two.

Commercial banks are typically focused on deposits and loans, while investing banks are focused on underwriting and trading.

Commercial banks offer their services to the general public and businesses, while investing banks offer their services to large corporations and institutional investors.

Here are the main differences between these two financial institutions:

Investment BanksCommercial Banks
ClientsInvestors, large corporationsSmall and medium-sized businesses
Primary servicesAssist institutional investors and corporates with financial needs.Offers loans, mortgages, and deposits for small and medium-sized businesses.
Other servicesWealth and asset management, brokerages services, and advisory servicesMobile banking, credit cards.
ProfitEarn profit from servicesEarn profit from products and services.

Types of Commercial Banks

Commercial banks are grouped into scheduled and non-scheduled groups. Scheduled banks are further divided into private, public, and foreign banks.

Non scheduled banks

Non-scheduled banks don’t follow all the set banking regulations. They have a smaller cash reserve as compared to scheduled banks.

Scheduled banks.

These are banks that meet the criteria set by the regulating body. Such banks must maintain a certain amount of paid-up capital. Scheduled banks are either private, public, or foreign.

Private banks

Private banks are owned by individuals or businesses. The government has no role in such a bank other than requiring it to follow certain regulations. Private banks come up with their strategies for finance and customer service.

Public sector banks

Public-sector banks are part of the central banks, with the government as the main stakeholder.

Foreign banks

Foreign banks have locations worldwide. They have branches in different countries.

What Role Do Commercial Banks Play in the Economy?

Commercial banks play a crucial role in the economy. Here are some of the roles they play in the economy.

Capital formation

Banks mobilize the savings of people and make them available for projects. Through their branch network, they can accumulate money that can be used for productive purposes.

Credit creation

Commercial banks offer credit creation for development projects. This increases productivity, creates employment, and fosters development.

Leads to better utilization of resources.

Savings pooled by commercial banks can be utilized for large development projects, leading to better utilization of resources.

Finance Government

Commercial banks provide the government with long-term credit by investing in government securities such as bonds, treasury bills.

Money Multiplier

They provide consulting and advisory services to their customers. By providing the services, they help in wealth creation.

Examples of Commercial Banks in Kenya

  • UBA Kenya Bank Ltd.
  • The Co-operative Bank
  • Standard Chartered
  • Prime Bank
  • Paramount Bank
  • Oriental Commercial Bank Ltd.
  • NIC Bank
  • ABC Bank
  • National Bank
  • K-Rep Bank
  • Kenya Post Office Savings Bank
  • KCB Bank
  • Investments & Mortgages Bank Limited – I&M Bank
  • Imperial Bank Limited
  • Housing Finance
  • Guardian Bank Ltd.
  • Giro Commercial Bank Ltd
  • Fina Bank
  • Fidelity Bank
  • Equity Bank
  • Equatorial Commercial Bank Limited
  • Dyer & Blair Investment Bank
  • Dubai Bank Kenya Ltd
  • Dry Associates Limited
  • Development Bank Of Kenya Ltd
  • Co-operative Bank
  • Consolidated Bank
  • Commercial Bank of Africa
  • Citibank N A
  • Chase Bank
  • CFC Stanbic Bank Limited
  • Central Bank of Kenya
  • Bank Of Baroda (Kenya) Ltd.
  • Bank of Africa Kenya Ltd
  • Afrika Investment Bank
  • African Development Bank Group
  • African Banking Corporation

Challenges Commercial Banks Face

Increased competition

The commercial banking sector has undergone significant changes in recent years, driven by a combination of macroeconomic factors, technological advancement, and regulatory pressures. This has led to an increase in competition, and commercial banks are now under pressure to provide a more differentiated and personalized service to their customers.

Declining Interest rates

In addition, commercial banks are also facing several challenges arising from the current economic climate. These include declining interest rates that are pressuring margins and the need to manage costs to maintain profitability.

Geopolitical tension

Geopolitical tension impacts the global economy, which in turn piles pressure on commercial banks. Political tension results in reduced cash flow and affects the operation of banks.

Is My Money Safe In a Commercial Bank?

Are commercial banks reliable? Are my deposits safe? The banking system in Kenya, the United States, and the world over is one of the most regulated industries. Organizations such as the KDIC, the Federal Reserve, and the FDIC all work to ensure that banks are operating safely and soundly.

Banks are required to follow certain rules and regulations to ensure the safety of their deposits. For example, banks must keep a certain amount of cash on hand, as well as invest in high-quality, liquid assets. These requirements help protect depositors in the event of a bank failure.

In addition, the KDIC provides insurance for deposits, which covers any money you save in the event of a bank failure. So, while no investment is ever 100% safe, commercial banks are highly regulated.

In Conclusion

Commercial banks are an important part of the economy, providing essential services to businesses and individuals. They offer a wide range of products and services, from lending and deposits to foreign exchange and investment services. When choosing a commercial bank, it’s important to consider your specific needs and objectives. Speak to a financial advisor to learn more about which bank is right for you.

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