Functions of Commercial Banks

Commercial banks are important pillars of the modern economy. They serve as the intermediaries for the financial system. The banks are “for profit” organizations and generate profit primarily through interest from loans and fees for services they provide to their customers. The banks receive money from individuals, businesses or government institutions for savings or checking accounts. They use these deposits and also the invested capital to grant loans or trade securities.  Though major function of the bank has been to generate profit through interest on loans, the banks have become sophisticated with improvements in technology, and are dealing in many derivative products. The major function of a commercial bank includes the following:

1. The banks receive deposits from individuals and institutions in the form of current accounts, savings accounts, money market accounts, and certificates of deposits.  Most of these deposits earn interest while current accounts usually don’t. The rate of return paid by banks varies with the restrictions on withdrawal from the accounts.
2. The banks earn money lent on interest to individuals and institutions for personal or business needs.
3. Businesses deposit their excess cash which banks invest in a variety of instruments to earn interest.  The banks also offer cash management through payment and collection services to maximize the interest on idle cash and to protect the customer against overdraft.
4. The banks act as financial intermediaries to facilitate international trade. They issue letters of credit for a fee to guarantee payments for the products imported into a country.  They also provide financing for manufacturing, packaging, and shipment for export goods as well receivables financing by discounting of bills until payments are received by the exporter. The promotion of import and export is critical for functioning of a national economy as the world is interdependent and no country can survive by only producing and consuming domestic goods.
5. In domestic trade, the banks provide guarantees against default by its corporate customers. In case of default, the bank will make the payment which turns into an interest bearing loan until it is paid off by the defaulting party. The banks also charge commission for making this guarantee.
6. With international trade spanning varying exchange and interest rates, comes the risk of rate fluctuations eating into or completely erasing the profits of a transaction.  Through financial derivatives, the banks offer risk mitigation against foreign exchange and interest rate fluctuations. These include various means of locking current rates or asking for payment at the prevailing rate at the time of payment.
7. The banks provide domestic and foreign currency remittance and exchange services and earn money on transaction fees as well as on differences between buying and selling rates.

Besides the above products, the banks might also issue debit and credit cards, travelers’ checks, and a variety of insurance products. Some banks also take on the role of check clearing houses which accept checks from a variety of sources and settle the net differences between banks. The modern banks have also evolved into security traders which include debt, equity, options and futures, and derivative products.  
In all traditional services, banks earn interest on money that is created out of thin air due to application of fractional reserve. They can lend money which is a multiple of the money they collect from their depositors.  With the advent of derivatives, they earn profits without involving money. A derivative contract is just an agreement between two parties based on various market conditions which results in payoffs at the end of the contract. These include interest rate and foreign exchange futures, options, swaps and many other esoteric variants. The capital is a notional amount on which the payments are based. Thus, it is possible for banks to earn tremendous amount of money that they do not even possess.