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MGT604 - Management of Financial Institutions - Lecture Handout 15

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A bank is a commercial or state institution that provides financial services, including issuing money in various forms, receiving deposits of money, lending money and processing transactions and the creating of credit

A commercial bank accepts deposits from customers and in turn makes loans, even in excess of the deposits; a process known as fractional-reserve banking. Some banks (called Banks of issue) issue banknotes as legal tender. A commercial bank is usually defined as an institution that both accepts deposits and makes loans; there are also financial institutions
that provide selected banking services without meeting the legal definition of a bank. Many banks offer ancillary financial services to make additional profit; for example, most banks also rent safe deposit boxes in their branches. Currently in most jurisdictions commercial banks are regulated & require permission to operate. Operational authority is granted by bank regulatory authorities who provide rights to conduct the most fundamental banking services such as accepting deposits and making loans.

Purpose of a bank:

Banks have influenced economies & politics for centuries. Historically, the primary purpose of a bank was to provide loans to trading companies. Banks provided funds to allow businesses to purchase inventory, and collected those funds back with interest when the goods were sold.

Commercial Lending:

For centuries, the banking industry only dealt with businesses, not consumers. Commercial lending today is a very intense activity, with banks carefully analyzing the financial condition of their business clients to determine the level of risk in each loan transaction.

Banking Services:

Banking services have expanded to include services directed at individuals, and risks in these much smaller transactions are pooled.

A Bank’s Profit

A bank generates a profit from the differential between the level of interest it pays for deposits and other sources of funds, and the level of interest it charges in its lending activities. This difference is referred to as the spread between the cost of funds and the loan interest rate. Historically, profitability from lending activities has been cyclic and dependent
on the needs and strengths of loan customers. In recent history, investors have demanded a more stable

revenue stream and banks have therefore placed more emphasis on transaction fees, primarily loan fees but also including service charges on array of deposit activities and ancillary services (international banking, foreign exchange, insurance, investments, wire transfers, etc.). However, lending activities still provide the bulk of a commercial bank's income.

The name bank derives from the Italian word banco "desk/bench", used during the Renaissance by Florentines bankers, who used to make their transactions above a desk covered by a green tablecloth.

However, there are traces of banking activity even in the Babylonian times, and indeed a book about the history of banking is named: Banking, from Babylon to Wall Street.

Services Typically Offered by Banks

Although the basic type of services offered by a bank depends upon the type of bank and the country, services provided usually include:

  1. Taking deposits from their customers and issuing current (Pak) or checking (US) accounts and savings accounts to individuals and businesses.
  2. Extending loans to individuals and businesses.
  3. Cashing cheque
  4. Facilitating money transactions such as wire transfers and cashier's checks
  5. Issuing credit cards, ATM cards, and debit cards
  6. Storing valuables, particularly in a safe deposit box
  7. Consumer & commercial financial advisory services
  8. Pension & retirement planning

Financial transactions can be performed through many different channels:

  1. A branch, banking centre or financial centre is a retail location where a bank or financial institution offers a wide array of face to face service to its customers.
  2. ATM is a computerized telecommunications device that provides a financial institution's customers a method of financial transactions in a public space without the need for a human clerk or bank teller
  3. Mail is part of the postal system which itself is a system wherein written documents typically enclosed in envelopes, and also small packages containing other matter, are delivered to destinations around the world
  4. Telephone banking is a service provided by a financial institution which allows its customers to perform transactions over the telephone.
  5. Online banking is a term used for performing transactions, payments etc. over the Internet through a bank, credit union or building society's secure website

Types of banks

Banks' activities can be divided into retail banking, dealing directly with individuals and small businesses; business banking, providing services to mid-market business; corporate banking, directed at large business entities; and investment banking, relating to activities on the financial markets.

Most banks are profit-making, private enterprises. However, some are owned by government, or are non-profits.

Central banks are non-commercial bodies or government agencies often charged with controlling interest rates and money supply across the whole economy. They generally provide liquidity to the banking system and act as Lender of last resort in event of a crisis.

  • Commercial bank: the term used for a normal bank to distinguish it from an investment bank. After the Great Depression, the U.S. Congress required that banks only engage in banking activities, whereas investment banks were limited to capital market activities. Since the two no longer have to be under separate ownership, some use the term "commercial bank" to refer to a bank or a division of a bank that mostly deals with deposits and loans from corporations or large businesses.
  • Community Banks: locally operated financial institutions that empower employees to make local decisions to serve their customers and the partners
  • Community development banks: regulated banks that provide financial services and credit to underserved markets or populations.
  • Postal savings banks: savings banks associated with national postal systems.
  • Private Banks: manage the assets of high net worth individuals.
  • Offshore Banks: banks located in jurisdictions with low taxation and regulation. Many offshore banks are essentially private banks.
  • Savings bank: in Europe, savings banks take their roots in the 19th or sometimes even 18th century. Their original objective was to provide easily accessible savings products to all strata of the population. In some countries, savings banks were created on public initiative, while in others socially committed individuals created foundations to put in place the necessary infrastructure. Nowadays, European savings banks have kept their focus on retail banking: payments, savings products, credits and insurances for individuals or small and medium-sized enterprises.
  • Apart from this retail focus, they also differ from commercial banks by their broadly decentralized distribution network, providing local and regional outreach and by their socially responsible approach to business and society.
  • Building societies and Lands-banks: conduct retail banking.
  • Ethical banks: banks that prioritize the transparency of all operations and make only what they consider to be socially-responsible investments.