Welcome! Previously in our Economics class, we looked at the introductory aspect of this lesson which we titled ” Financial Institutions“. And now, we want to look at one of these financial institutions known as Commercial Banks.

Lesson Note

Subject: Economics

Topic: Financial Institutions

Subtopic: Commercial Banks

Learning Objectives: By the end of the lesson, the learners should be able to:

  1. Define the term commercial banks
  2. State the characteristics of commercial banks;
  3. State the functions of commercial banks;
  4. Mention the credit facilities provided by commercial banks;
  5. Identify the factors that could limit commercial banks from creating credit facilities.

Discussions

Commercial bank is a kind of bank that specialises in rendering services such as accepting deposits and other valuables, creating business loans and other investment products for the sole aim of making profit. Commercial banks can be own by public or private sector.

Characteristics Of Commercial Banks

i. Commercial bank is a limited liability company.
ii. The motive of its establishment is profit making.
iii. They are members of the money market.
iv. Commercial banks are incorporated.
v. They accept deposits and other valuables.

Functions of Commercial Banks

1. Acceptance if deposit: Commercial banks accept deposits from the public for safe keeping. This is the oldest function of commercial banks, which helps in taking care of people’s money. Money can be kept in current, fixed and savings account.
2. Lending of money: This is perhaps the most profitable function of commercial banks. Deposits from different customers are pooled together and given out as loans and overdrafts with interest to people and firms for profitable investment.
3. Agent of payment: Commercial banks can act as an agent of payment on behalf of their customers. They encourage and permit customers to have current accounts in which they can withdraw by cheque without notice. Money can also be transferred from one account to another, e.g, credit transfer.
4. Safe keeping of valuables: One of the functions of commercial banks is to keep customers’ valuables such as jewellery, certificates, will, etc.
5. Discounting of bills: Creditors can be paid by the bank immediately by discounting bill of exchange for their customers. This enables the creditors to be paid instantly, and the debtor is allowed a period of credit.
6. Issuance of bank statement: At regular intervals, the banks will prepare and send bank statements to their customers to show their transactions with them.
7. Foreign exchange transaction: Commercial banks make foreign currency available to their customers. They particulate im foreign exchange market and help in solving any problem relating to foreign exchange.
Roles of Commercial Banks I international trade
i. Provision of documentary credits: Commercial banks provide commercial credit facilities to exporters, which help them in payment for goods.
ii. Minimising of default in payment: Commercial banks guarantee payments for goods bought in order to ensure that default in payment is reduced. They help in confirming letters of credit.
iii. Discounting of documentary credit: Commercial banks can provide credit to facilitate foreign trade by discounting documentary credit. This will ensure that sellers are paid at once.
iv. Act as referees to customers: Commercial Banks act as referees to exporters by providing information to foreign businessmen about their credit worthiness.
v. Foreign exchange transaction: They help to arrange for the purchase and sales of foreign currencies, which are used to finance export and import trade.
vi. Issuance of travellers cheque: Commercial banks facilitate international trade by issuing travellers cheque to businessmen travelling abroad.

Credit Facilities Provided by Commercial Banks

Banks can act as agent of lending by means of loans, overdraft and discounting bill of exchange. Commercial banks act as agent of lending through the following ways:
i. Loan: Through loan, money is lent out to customers at an agreed rate of interest for a specific period of time. In this case, the borrower’s current account will be credited by the amount of the loan. At the same time, a loan account for the amount will be opened. The customer will pay interest on the full amount he has borrowed.
ii. Overdraft: Overdraft is a method of credit facility in which a customer is allowed or permitted to draw a cheque more than the amount of money in his account. Lets take for for example, Mr. Komolafe has #20,000 in his account and he was granted permission to withdraw #30,000. The #10,000 difference is the overdraft. The customer pays Interest on the overdraft. This type of credit facility can only be enjoyed by a current account holder.

Differences between loan and overdraft

1. Loan requires collateral security while Overdraft collateral security may not be required.

2. Loan attracts lower rate of interest whereas overdraft attracts higher rate of interest.

3.In overdraft, the money is repaid at a fixed time meanwhile in loan, there is gradual deduction from the customer’s account.

Ways by which commercial banks create credit or money

Credit or money creation refers to the process where you commercial banks make it possible for more deposits to be made through loans or overdrafts. Bank lending in form of loan or overdraft increases the quality of money in circulation, which in turn increases the purchasing power of the people. This is because the bank credits the amount borrowed thereby creating new bank deposits. The total purchasing power increases by the amount loaned out. This is why it is said that bank lending creates credit or money.
Commercial banks can create money or credit in the following ways:
i. By granting loans to members of the public and charging Interest on them. By so doing more money is pumped into circulation and this increases the purchasing power of the people.
ii. By granting overdraft to customers having current account. This process of overdraft permits customers to draw money above the amount in their current account up to a certain limit and interest is charged on the overdraft. (An overdraft is defined as the excess amount which a customer is allowed to draw over the amount he has in his current account). Commercial banks use current account as the basis for creating credit or money.
iii. Commercial banks are required by law to keep certain percentage of their deposit with the central bank known as cash ratio or liquidity ratio or cash reserve. This is done in order to protect customers’ accounts and prevent bank crisis. When the percentage of the cash reserve is low, it will enable the commercial banks to give out loans and overdrafts thereby creating credit or money but when the percentage of cash reserve is high, commercial banks will find it difficult to lend out money.
iv. Commercial banks can create credit or money by purchasing treasury bills from the government and by discounting bills of exchange. It should be noted that for commercial banks to be able to create credit the following assumptions must be made:
a. That no single bank can create credit except all the banks or the banking system is involved.
b. That no excess reserve exists.
c. There must be no cash drain from the banks.
d. That the banks invest only in loans, overdrafts and purchase of treasury bills from government.
e. That there must be only one type of demand deposit.

Limitations to Credit Creation by Commercial Banks

1. Cash deposit ratio: The higher the legal reserve requirements, i.e. the higher the cash deposit ratio, the lower the ability of commercial banks to create money or credit.
2. Collateral security available: If collateral security is not available, banks will be scared of lending, hence the lower the volume of money created.
3. Central bank’s restrictions: Central bank’s action to restrict lending, e.g. open market operation, directives, etc can affect the ability of commercial banks to create money.
4. Amount of cash drain from the banking system: The more the amount of cash drain from the banking system, the less the amount of cash available with banks, e.g when people borrow money and spend it on consumption.
5. Interest rate charged: The higher the interest rate charged by commercial banks, the lower the rate at which customers will take loans and consistently the lower the ability to create money and vice versa.
6. Willingness of other banks to lend to the public: The higher the willingness of other banks to lend to the public, the greater the ability of commercial banks to create money.
Problems of Commercial Banks in Nigeria
i. Urban concentration: Majority of the commercial banks are located in urban centres thereby denying the rural areas banking services.
ii. Low savings: Majority of the populace are poor and this leads to their inability to save in commercial banks.
iii. Corruption: There is a high level if corruption in the banking industry as some bank managers and officials embezzle money and Grant unauthorised loans to friends and relatives because of their selfish interest.
iv. High level of Illiteracy: High level of Illiteracy among the people makes banking operations and services very difficult.
v. Government’s frequent interventions: Government’s frequent interventions in the operation of banks sometimes make things difficult for commercial banks to operate smoothly and efficiently.
vi. Low Patronage: Commercial banks are not patronised as it should be as a result of ignorance, poevrty and Illiteracy.
vii. High interest rates: The high interest rate charged by banks makes it difficult for prospective customers to take loans from the bank.
viii. Non-repayment of loans: Some customers who took loans from commercial banks may sometimes fail to repay the loans and this will lead to collapse and failure of those commercial banks.

Done Studying? See previous lessons in Economics

Take a quick test for this lesson

WAEC PAST QUESTIONS AND ANSWERS ON FINANCIAL INSTITUTIONS FROM 1998 TO DATE

1. Which of the following is a function of merchant banks A. acting as banker’s bank. B. Lending to the
commercial banks as a last resort. C. Controlling inflation in the economy. D. Underwriting and issuing
of shares.

2. Which of the following is an asset of a commercial bank A. Reserve funds. B. Shareholder’s capital. C. Customer’s deposits. D. Treasury bills.

3. Which of the following is the most liquid asset to a commercial bank A. Money at call and short notice.
B. Treasury Bills. C. Commercial Bills. D. Cash.

4. The drawer of a cheque is the A. person who is to be paid the sum of money as written on the cheque.
B. person who takes the cheque to the bank. C. bank on which the cheque is drawn. D. person who writes out the cheque.

5. The financial institution that specializes in risk spreading is called A. an investment bank. B. a development bank. C. an insurance company. D. the stock exchange.

6. The clearing house of all commercial banks in Nigeria is the A. General Post Office. B. Bank for Commerce at Industry. C. Nigerian Industrial Development Bank.
D. Central Bank.

7. In open market operations, what the Central Bank sells or buys are A. shares. B. debentures. C. securities.
D. equities.

8. Deposits held in a commercial bank are part of A. money supply. B. transfer payments. C. ordinary shares. D. treasury bills.

9. One profitable form of business undertaken by the commercial banks is A. the issuing of cheques. B. the
payment of standing order. C. lending money to borrowers. D. accepting cheques from customers.

10. Which of the following is not a function of the West African Development Bank A. Promotion of both private and public investments in member states.
B. Financing and executing projects in member states.
C. Promotion of social development of member states. D. harmonization of oil prices to the advantage of member states.

11. Time deposit has the same meaning as A. current account. B. demand deposit. C. deposit account.
D. bank deposit.

12. In order to develop the banking habit of rural dwellers, the traditional money lenders should be A. proscribed. B. legalized. C. subsidized. D. heavily taxed.

13. All rates of interest in a country are influenced by the A. bank rate. B. population growth rate. C. wage rate. D. mortgage rate.

14. The liquidity ratio of a commercial bank refers to the A. proportion of the bank’s total assets which should be held in cash and liquid form. B. total amount of cash for the bank’s treasury. C. total amount of cash for the bank in the central bank. D. proportion of the bank’s cash that should be on loan.

15. Open market operations are the processes by which
A. the Central Bank purchases and sells securities. B. commercial bankS purchase and sell securities.
C. business firms buy raw materials freely. D. households buy consumer goods openly.

16. Examples of joint stock banks are A. commercial banks. B. co-operative credit societies. C. central banks. D. development banks.

17. One major function of the central bank is to A. mint
money. B. hold demand deposits and honour cheques. C. act as a medium of exchange. D. control and regulate money supply.

18. The amount of money to be created by commercial banks is actually influenced by the A. legal reserve ratio. B. external reserve. C. external borrowing. D. availability of money and capital market.

19. A financial institution established for the purpose of providing specialized services like acceptance of bills of exchange and equipment leasing is known as A. merchant Bank. B. development Bank. C. central
Bank. D. insurance Company.

20. Which of the following is a liability of a commercial bank A. Deposits. B. Money at call. C. Loans to customers. D. Overdrafts.

21. Which of the following is a function of the Central Bank of Nigeria A. Serving as custodian of important valuables. B. Giving advice to customers. C. Serving as bankers’ bank. D. Creating credit.

22. Which of the following is specialized in lending money
for the purpose of developing real estate A. Merchant
banks. B. Mortgage banks. C. Discount houses. D. Commercial banks.

23. The marketing of government securities by the Central Bank is termed A. retail banking. B. open
market operations. C. selective credit control. D. credit
creation.

24. Which one of the following serves as a banker’s bank A. Commercial Bank. B. The Mortgage Bank.
C. The Central Bank. D. Development Bank.

25. Which of the following is a function of merchant banks A. Minting of coins. B. Preparation of government budget. C. Keeping watch on external reserves of the country. D. Acting as acceptance
houses.

26. Open Market Operation (OMO) means the A. provision of credit facilities by commercial banks.
B. provision of credit facilities by the mortgage banks. C. buying and selling of government securities
by the central bank. D. procedure for the establishment of commercial banks.

27. Commercial banks settle their inter-bank indebtedness through A. merchant banks. B. central bank. C. development banks. D. stock exchange.

28. Which of the following banks grant credit facilities to individuals wishing to build houses A. Central Bank of Nigeria. B. Nigerian Industrial Development Bank. C. Agricultural Credit Bank. D. Federal Mortgage Bank of Nigeria.

29. The primary objective of the Nigerian Industrial Development Bank (NIDB) is the provision of loans to A. farmers. B. manufacturers. C. estate agents. D. transporters.

30. The proportion of commercial bank’s total assets kept in the form of highly liquid assets is known as A. demand deposit. B. fixed deposit. C. cash ratio. D. moral suasion

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Take a quick test for this lesson

  1. What are commercial banks?
  2. State the characteristics of commercial banks.
  3. What functions do commercial banks perform?
  4. Mention and explain the credit facilities provided by commercial banks.
  5. Identify the differences between loan and overdraft.
  6. State the factors that could limit credit creation by commercial banks.

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