Commercial Banks and Banking Operations

Welcome to a comprehensive guide on Commercial Banks and Banking Operations, essential knowledge for any student diving into the world of finance. This article will break down what commercial banks are, their main activities, and the intricate operations that allow them to function, from lending money to managing deposits and navigating various risks. Understanding these concepts is crucial for students preparing for exams or simply seeking a clearer picture of the financial system.

What are Commercial Banks and Their Operations?

A commercial bank is a legal entity, typically headquartered in countries like the Slovak Republic, established as a joint-stock company. It operates under a license to perform two primary functions: receiving deposits and making loans. The main aim of a commercial bank is to achieve maximum profit or maximize the price of its shares. Banks can be categorized into various types:

• Universal banks: Offer a wide range of services.
• Specialized banks: Focus on specific areas, such as mortgage banks, investment banks, or municipal banks.
• Private banks: Owned by private entities.
• Public banks: Owned by the state.
• Mixed ownership banks: A combination of private and public ownership.

Main Activities of Commercial Banks: A Core Banking Operations Overview

Commercial banks engage in several key activities that form the backbone of their operations. These activities define how banks interact with clients and generate revenue.

1. Receiving Deposits

When a depositor places money in a bank, the bank effectively becomes a debtor. The deposits, along with any arranged interest, become liabilities for the bank. After a specified period, the bank must return the borrowed money and the agreed-upon interest to the depositor. For the bank, these interests represent a cost.

2. Making Loans

Making loans involves the temporary provision of cash to a client for a certain refund, known as interest. The debtor incurs a liability to the bank and is obliged to pay off the debt with the arranged interest. In this scenario, interest serves as revenue for the bank.

3. Other Banking Operations and Services

Beyond core deposit and lending functions, banks also offer a variety of other services:

• Provision of payment services
• Currency exchange activities
• Consulting services
• Securities trading

Passive Operations of Commercial Banks: Funding Strategies

Passive operations are fundamental to commercial banking operations as they focus on acquiring the sources a bank needs to conduct its business activities. These sources primarily consist of liabilities.

• Own sources (own capital): This includes capital from the bank's shareholders and funds generated from its own business activities.
• Borrowed capital (loan capital): Acquired through various means, this capital must be returned with arranged interest after a given period.

Types of Deposits for Banks

Deposits are a critical component of a bank's borrowed capital. They vary significantly in their stability and liquidity:

• Demand deposits (call deposits, vista deposits, money at call):

• Short-term deposits held by clients in their current accounts.

• Clients have free disposal of these funds, and balances can change overnight, making them the least stable form of borrowed capital.

• Banks must maintain high reserves due to the high liquidity risk.

• Administering current accounts is costly, leading to the lowest interest rates for clients.

• Types: Business accounts (with or without credit limit/overdraft), personal accounts, government/local administration deposits, interbank deposits.

• Savings deposits:

• Typically money deposited by natural persons for longer periods.

• More stable borrowed capital compared to demand deposits, often offering higher interest rates.

• Types: Deposit accounts (often with a bankbook), asset saving accounts (for long-term investment in securities), building society accounts (specialized institutions for housing savings with state bonuses), insurance savings accounts (combining savings with life insurance).

• Fixed term deposits:

• Clients commit not to dispose of their deposited money for a given period.

• Money can be withdrawn at the arranged term (e.g., after 1, 3, 6 months) or with an arranged notice period (e.g., 30 days in advance), or a combination of both.

Other Forms of Borrowed Capital

Beyond traditional deposits, banks also acquire funds through:

• Deposit slips
• Mortgage bonds (hypotekárne záložné listy)
• Bank bonds (bankové obligácie)

Active Operations of Commercial Banks: Lending and Investing

Active operations naturally follow passive operations, utilizing the funds acquired to generate assets and revenue. In these operations, the bank acts as a creditor.

Credit Operations: Principles of Lending

When providing loans, banks adhere to strict principles to manage risk and ensure profitability:

1. Contractual Principle: Loans are granted only via a written credit contract, regulated by commercial codes, detailing conditions, repayments, and sanctions.
2. Principle of Purpose: Banks often study the loan's purpose. Loans can be for a strictly specified purpose (purpose loan) or non-purpose loans if not specified.
3. Principle of Return: Banks assess the borrower's reliability and solvency through financial analysis to mitigate the risk of non-repayment.
4. Principle of Credit Securing: Banks reduce risk by securing loans through:

• Property security: Movable and immovable property.
• Personal security: A guarantor.

5. Principle of Fixed Terms: Loans are categorized by their maturity:

• Short-term: Due within 1 year.
• Medium-term: Maturing 1 - 5 years.
• Long-term: Due over 5 years.

6. Principle of Paid Interest: The debtor pays interest to the bank, which is the price of the loan.

Procedure for Granting a Loan

The process typically involves several stages:

1. Entry interview
2. Request for granting a loan
3. Credit analysis
4. Concluding a credit contract, loan drawing
5. Checking credit conditions and loan contract

Annual Percentage Rate (APR)

The APR is the most crucial indicator of the credit price. It represents the total cost the borrower must pay, including not only the interest rate but also other fees associated with the loan. It's a complex indicator vital for selecting the most suitable loan.

Types of Loans: Exploring Various Credit Options

Commercial banks offer diverse loan products to meet various needs:

Long-Term Loans

1. Issuing Credit: The bank acts as an intermediary, issuing securities (bonds) for an entrepreneur that are then bought by other banks and the public. The bank also buys some of these securities itself, directly providing a loan.
2. Credit Note Loan: An entrepreneur takes a loan directly from the bank. A credit note, issued with the credit agreement, serves as evidence of the bank's receivable. It's not tradable, meaning the bank must wait until the due period for repayment.
3. Mortgage Loan: Secured by a lien (záložné právo) on real estate. Banks provide up to a maximum of 70% of the property's value for specific purposes, secured by domestic real estate (existing or planned). These loans have due periods of 4-30 years and are primarily financed through mortgage bonds.
4. Municipal Loan: Similar to mortgage loans but secured by a lien on real estate belonging to a municipality or district. Also provided for domestic real estate with due periods of 4-30 years, financed by selling municipal obligations by the mortgage bank.

Short-Term Loans

1. Bank Overdraft: Provided on a client's current account, acting as an immediate reserve. The overdraft account allows for both credit and debit balances. It's limited by arranged credit limits. Benefits for the client include immediate access, no need to apply for a new loan, and paying interest only on the debit sum. Disadvantages include a higher price of the loan.
2. Paper Credit: Involves promissory notes.

• Discount Loan (Eskontný úver): The bank buys a bill of exchange from a client before its due date at a reduced value (nominal value minus interest and commission). The bank becomes the new owner and claims repayment from the issuer. If the issuer defaults, the bank claims against the previous owner.
• Acceptance Loan (Akceptačný úver): The bank provides only its goodwill, accepting a promissory note and becoming the main debtor. Typically for VIP clients.
• Aval Credit (Ručiteľský úver): The bank guarantees to pay for the promissory debtor. Only for solvent VIP clients, with an aval commission as the price for the loan.

3. Lombard Loan: Secured by various forms of collateral, typically amounting to 60-90% of the pledge's value.

• Lombard loan for securities: Borrower receives money without selling securities, retaining ownership but unable to trade them.
• Lombard loan for receivables: Only for easily recoverable receivables.
• Lombard loan for goods: Risky for the bank due to potential market changes affecting goods value.
• Lombard loan for other types: Can be secured by precious metals, copyrights, life insurance, etc.

4. Consumer Credit: Provided to natural persons for purchasing consumer goods, services, or other consumer expenses.

Other Operations of Commercial Banks

Beyond core lending and deposit-taking, banks also:

• Provide payment and investment services.
• Trade securities and precious metal coins.
• Serve as an exchange office.
• Issue and administer payment instruments like cheques and cards.
• Provide financial leasing.

Understanding Bank Risks: A Key Element of Banking Operations

Every business activity carries risk, and commercial banks face two main types:

1. The activity results in a loss.
2. Invested funds are not returned within the agreed time or at all.

External Risks

These risks are independent of the bank's activities:

• Political risks: Instability in the country's political situation.
• Territorial risks: Related to political risk.
• Monetary risk: Inflation, currency depreciation.
• Interest rate risk: Changes in prevailing interest rates.
• Foreign exchange risk: Changes in foreign currency exchange rates.

Internal Risks

Banks can influence these risks through their decisions and activities:

• Credit risks: Solvency of clients.
• Risks of ownership interest: Poor investment decisions.
• Payment risks: Delays in payments.
• Liquidity risks: Bank's failure to meet obligations.
• Managerial risks: Mistakes by management.
• Technical and technological risks: Hardware/software failures or employee errors.

Electronic Banking: Modernizing Banking Operations

Electronic banking represents a modern, non-face-to-face form of communication with the bank, primarily via the internet using devices like PCs, laptops, cell phones, smartphones, and tablets. It offers significant advantages:

• Access to services 24/7.
• Convenience.
• Ability to perform both active and passive operations.
• Account control via mobile, internet, email, telephone, etc.
• Lower fees.

Electronic Banking Tools

• Home banking
• Internet banking
• Email banking
• SMS banking
• Mobile banking
• Telephone banking
• Payment cards: Means of non-cash payment or cash withdrawal. The bank owns the card, and the client is the holder.
• Debit card: Provides instant access to the client's own money in their account. Payments and withdrawals are limited by available funds and daily limits. May or may not have fees depending on the account type.
• Credit card: A type of bank loan with a credit limit and monthly payments. Often includes an interest-free period (30-50 days).

FAQ: Common Questions About Banking Operations and Commercial Banks

What is the main difference between active and passive operations in commercial banks?

Passive operations focus on how banks acquire funds (e.g., through deposits or issuing bonds), effectively creating the bank's liabilities. Active operations, in contrast, involve how banks use these acquired funds to generate assets and revenue, primarily through lending and investments.

How does a bank assess the risk of granting a loan?

A bank assesses loan risk through several principles, including the Principle of Return and the Principle of Credit Securing. This involves analyzing the client's financial management, assessing their reliability and solvency, and often requiring collateral (property or a guarantor) to reduce the bank's exposure to potential default.

What is the Annual Percentage Rate (APR) and why is it important?

The Annual Percentage Rate (APR) is the most important indicator of the true cost of a loan. It includes not only the stated interest rate but also other fees and charges associated with the loan. This makes it a comprehensive tool for borrowers to compare different loan offers and choose the most suitable one.

Can you explain the difference between a debit card and a credit card?

A debit card allows you to spend money directly from your own bank account; you can only spend what you have. A credit card, on the other hand, is a type of bank loan. It allows you to borrow money up to a certain credit limit from the bank, which you then repay over time, often with interest.