Functions of Banking

Functions of Banking

Private sector banks play a significant role in the financial system. They intermediate between all sectors of the economy together with other financial institutions, with some banks providing the payment system we use. Banks are the only intermediaries that come in between all ultimate borrowers and lenders as well as other non-bank financial institutions. They are the most regulated and supervised financial institutions. All banks provide crucial functions and their very survival is essential in any economy.

What is a Bank

A bank is a lawful organisation which takes deposits that can be withdrawn on demand as well as provide loans to individuals or businesses that may need them. They also provide useful services such as bills collection and safekeeping of valuables. There are different types of banks which operate to meet the needs of individuals, businesses and government institutions. These banks can be differentiated by their functions. They include central banks, commercial, agricultural or cooperative, savings and development banks to name a few. The primary function of a bank is taking deposits and granting loans and advances. When required by individuals, businesses and government, banks create money with the assistance of the central bank. In addition to this, the broad functions of banks are discussed below.

Facilitation of funds Flow

The major function of banks, like any other financial intermediary, is to facilitate the flow of funds from surplus economic units to deficit economic units. Without this function the savings of ultimate lenders would not be available to borrowers. This is done through mobilising deposits and savings from the public. Depending on the type, some deposits earn interest. If the interest offered by a bank is high enough deposits and savings with the bank will increase. From these savings and deposits, the bank can grant loans and advances to individuals or businesses in need of funds. Consumer finance can be provided in the form mortgages and loans to purchase consumer goods such as televisions and cars. Plus, student loans can be given at reasonable interest rates.

Money Creation

Also called the credit and loan function, money creation is another bank function. In addition to the facilitation of funds, banks have the unique ability to create money through making new loans, but this is done under the reserve bank’s guidance. Money creation by banks is done through the accounting they use when loans are made. For every new loan granted, the bank creates new money. For example, when a bank gives out a new loan to an individual it does not give the person the amount in cash, it simply credits the borrower with the amount on his/her account, thus creating new money.

Payment System

An essential function of banks is the provision of a payment system. The banking sector provides mechanisms for the payment of anything that can be purchased, be it food, essential services and financial securities. Furthermore, a bank acts as an agent for its customers through investing on behalf of them and facilitating periodic payments. Other banks offer portfolio management for their clients. Also, banks facilitate the transfer of money from one bank to another through cheques, pay orders or demand drafts. Their financial assets serve as a means of payment. Some of the financial assets that are accepted as means of payments include:

  • Bank Notes and coins (issued by the central bank)
  • Bank Deposits
  • Cheques
  • Credit, debit and smart cards
  • Electronic funds transfer (EFT) facilities

Liquidity

Another function of banks is to enhance liquidity in the financial market. Enhanced liquidity is created for the depositors of the bank. Banks purchase less or non-marketable primary securities and offer liquid investments to their borrowers. Further, banks take on price risk by offering products that have little or zero risk. Their portfolios include non-marketable loans, bonds and share investments that carry price risk or market risk but offer products with minimum risk such as fixed deposits.

Economies of Scale

Because banks operate at a large-scale, achieving economies of scale is another bank function, through low transaction costs and search costs. The largest benefit of financial institutions including banks is low transaction costs. The banking system through the use of sophisticated technology provides an efficient payment service such as cheque clearing and electronic payments.  Such services are expensive if done by individuals in the financial market. Similarly, the research or search costs incurred by banks are low. Banks like every other financial intermediary can assess the credibility of a potential borrower to the benefit of the lender (the depositor) at low costs since they have the resources to carry out such at a reasonably low price.

Monetary Policy Function

Banks are instruments of money creation as well as the mechanism for the implementation of monetary policy. This is an essential function of banks. Through many ways, monetary authorities are able to influence the interest rates charged by banks and in turn affect consumption and Investment. With the result affecting a country’s gross domestic product.

Other Functions of Banks

The functions of banks mentioned above are not exhaustive, banks perform many other functions and some of them are summarised below;

  • Providing letters of credit and travellers’ cheques. (Banks issue drafts for transferring money from one place to another, in the case of import trade, travellers’ cheques are issued)
  • Other agency functions (Banks can act as trustees, executors, advisors and administrators on behalf of their clients, they also act as representatives of their clients when dealing with other banks or institutions)
  • Undertaking custody of valuables by providing safe deposit vaults and lockers for important documents and valuables such as gold ornaments.
  • Providing customers with facilities for foreign exchange (Commercial banks are allowed to deal with foreign exchange)
  • Underwriting of Shares (Some banks underwrite shares and debentures)
  • Banks can act as a guarantee on behalf of its customers for the payments of goods and machinery.
  • Project Reports (Collecting and suppling business information on behalf of its clients)
  • Periodic Collections (Banks can collect salaries, pensions and dividends on behalf of its clients)
  • Social Welfare programmes (Some banks participate in community projects or sponsor sports clubs)

 

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