Commercial Banks: Functions, Loans, and Risks

Commercial banks are crucial institutions in the financial landscape, serving individuals, businesses, and governments. Understanding their core functions, various types of loans, and inherent risks is essential for anyone studying economics or finance, especially students preparing for exams. This guide provides a comprehensive overview of commercial banks, their operations, and the principles governing their lending activities.

What are Commercial Banks and Their Core Functions?

A commercial bank is a legal entity, often established as a joint-stock company and licensed to receive deposits and make loans. Located in countries like the SR (Slovak Republic), their primary goal is to gain maximum profit or maximize the price of shares. They can be universal, specialized (like mortgage or investment banks), private, public (state-owned), or mixed ownership.

Commercial banks engage in three main types of activities:

1. Receiving Deposits: This is a passive operation where the bank acquires funds. A depositor puts money into the bank, making the bank a debtor. The bank is obligated to return the borrowed money with arranged interest, which represents a cost for the bank.
2. Making Loans: This is an active operation, providing temporary cash to clients for a certain refund – interest. The debtor has a liability to the bank and must pay off the debt with interest, which becomes revenue for the bank.
3. Other Activities: These include payment services, currency exchange, consulting, and securities trading.

Passive Operations: Acquiring Funds

Passive operations focus on acquiring sources for the bank's business activities. These sources are liabilities and fall into two categories:

• Own Sources (Own Capital): This includes capital from bank shareholders and profits from the bank's own business activities.
• Borrowed Capital (Loan Capital): Money acquired in various ways that the bank must return with arranged interest after a given period.

Types of Deposits in Commercial Banking

Deposits are a significant part of borrowed capital. They can be categorized as:

• Demand Deposits (Call Deposits/Vista Deposits): These are short-term deposits on clients' current accounts. Clients have free disposal of these funds, and their balance can change overnight, making them the least stable borrowed capital. Banks must maintain high reserves, leading to high administration costs and thus the lowest interest rates. We distinguish deposits from entrepreneurs (business accounts, with or without credit limits), individuals (personal accounts), government/local administration, and other banks.
• Savings Deposits: Typically money from natural persons deposited for longer periods, making them more stable borrowed capital with higher interest rates. Types include deposit accounts (often with a bankbook), asset saving accounts (for long-term securities investment), building society accounts (for building loans with state bonuses), and insurance savings accounts (savings combined with life insurance).
• Fixed-Term Deposits: Clients commit not to dispose of their deposited money for a specified period. Funds can be withdrawn at the arranged term, with an arranged notice period, or through a combination of both.
• Other Passive Sources: These include deposit slips, mortgage bonds, and bank bonds.

Active Operations: Understanding Commercial Bank Loans

Active operations utilize the acquired funds for business activities, resulting in changes to the bank's assets as it acts as a creditor. These typically involve providing various types of loans.

Key Principles of Granting Bank Loans

When providing loans, banks must adhere to several critical principles to manage risk and ensure repayment. Students often look for a "Commercial Banks: Functions, Loans, and Risks rozbor" of these principles:

1. Contractual Principle: Loans are granted solely based on a written credit contract regulated by the Commercial Code, detailing conditions, repayments, and sanctions.
2. Principle of Purpose: The bank studies the loan's purpose. Loans are often for a strictly specified purpose (purpose loan), stated in the contract. If no purpose is specified, it's a non-purpose loan.
3. Principle of Return: Banks face the risk of non-repayment. Therefore, they assess the borrower's reliability and solvency through financial management analysis.
4. Principle of Credit Securing: To reduce risk, banks secure loans. This can be through security with property (movable or immovable) or personal security (e.g., a guarantor).
5. Principle of Fixed Terms: Loans are categorized by their due periods:

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

6. Principle of Paid Interest: The debtor must pay interest, which is the price of the loan.

The Loan Granting Procedure

The process for obtaining a loan typically follows these steps:

• Entry interview
• Request for granting a loan
• Credit analysis
• Concluding a credit contract, loan drawing
• Checking credit conditions and loan contract

Annual Percentage Rate (APR): The True Cost of Credit

For students asking about "Commercial Banks: Functions, Loans, and Risks maturita" topics, the Annual Percentage Rate (APR) is a crucial indicator. It represents the most important measure of the price of credit. APR includes not only the interest rate but also other fees associated with the loan, making it a comprehensive indicator for comparing and selecting the most suitable loan.

Different Types of Bank Loans

Commercial banks offer a wide array of loans, categorized by term and purpose.

Long-Term Bank Loans

These loans typically have repayment periods extending beyond five years:

1. Issuing Credit: A bank acts as an intermediary, helping an entrepreneur issue securities (like bonds) that other banks and the public buy. The bank may also buy some securities itself, providing a direct loan.
2. Credit Note Loan: An entrepreneur takes a direct loan from the bank, evidenced by a credit note issued with the credit agreement. This note is not tradable, meaning the bank must wait until the due period for repayment.
3. Mortgage Loan: Secured by a lien on real estate, these loans are provided for specific purposes (e.g., buying a home) for up to 70% of the property's value. Due periods range from 4-30 years, financed mainly through mortgage bonds.
4. Municipal Loan: Secured by a lien on real estate belonging to a municipality or district, also for domestic real estate. Due periods are 4-30 years, financed by using and selling municipal obligations by the mortgage bank.

Short-Term Bank Loans

These loans are due within one year and provide immediate liquidity:

1. Bank Overdraft: Provided on a client's current account, it acts as an immediate reserve, allowing for a debit balance up to an arranged credit limit. Advantages include immediate access, no separate application, no security required, and interest paid only on the debit sum. Disadvantages include a higher price.
2. Paper Credit: Issued in the form of promissory notes.

• Discount Loan (Eskontný úver): The bank buys a bill of exchange from a client before its due date, reducing the nominal value by interest and commission. The bank becomes the new owner and seeks repayment from the issuer; if unsuccessful, it claims against the previous owner.
• Acceptance Loan (Akceptačný úver): The bank provides only its goodwill, accepting a promissory note and becoming the main debtor. This is typically for VIP clients.
• Aval Credit (Ručiteľský úver): The bank guarantees to pay for the promissory debtor, again, only for solvent VIP clients, with an aval commission as the price.

3. Lombard Loan: Secured by various assets, with amounts typically 60-90% of the pledge's value.

• Lombard loan for securities: Allows borrowers to receive money without selling securities, retaining ownership.
• 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 pledge precious metals, copyrights, life insurances, etc.

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

Understanding Commercial Bank Risks

Every business activity carries risk, and commercial banks face two main types of risks: losing money or not having invested funds returned within the agreed time or at all. Students searching for "Commercial Banks: Functions, Loans, and Risks shrnutí" often focus on these risks.

External Risks for Banks

These risks are independent of the bank's activities:

• Political Risks: Instability in the country's political situation.
• Territorial Risks: Related to political risk, often concerning specific regions.
• Monetary Risk: Inflation or currency depreciation.
• Interest Rate Risk: Changes in general interest rates.
• Foreign Exchange Risk: Changes in foreign currency exchange rates.

Internal Risks for Banks

These risks are influenced by the bank's own activities and decisions:

• Credit Risks: Pertaining to the solvency of clients and their ability to repay loans.
• Risks of Ownership Interest: Stemming from wrong investment decisions.
• Payment Risks: Delays in payments.
• Liquidity Risks: The bank's failure to meet its obligations due to insufficient liquid assets.
• Managerial Risks: Mistakes made by bank managers.
• Technical and Technological Risks: Hardware/software failures or employee errors.

Modern Banking: Electronic Banking and Payment Cards

Electronic banking represents a modern, non-face-to-face form of communication with the bank, primarily via the internet. It offers 24/7 access, convenience, and often lower fees. Users can manage accounts and perform active and passive operations through various tools:

• Home banking
• Internet banking
• E-mail banking
• SMS banking
• Mobile banking
• Telephone banking

Payment cards are essential tools for non-cash payments and ATM withdrawals. The bank owns the card, while the client is the holder.

• Debit Card: Provides instant access to the client's own money, linked directly to their account. Payments are limited by the available balance, and fees depend on the account type.
• Credit Card: A type of bank loan with a credit limit. It often includes an interest-free period (30-50 days) on purchases, requiring monthly payments.

Frequently Asked Questions (FAQ) about Commercial Banks

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

Passive operations, like receiving deposits, focus on acquiring funds where the bank acts as a debtor. Active operations, such as making loans, involve the bank using these acquired funds to conduct business, making the bank a creditor and leading to changes in its assets.

How does a bank secure a loan to reduce its risk?

Banks secure loans primarily through two methods: security with property (using movable or immovable assets as collateral) and personal security (involving a guarantor who agrees to repay the debt if the primary borrower defaults).

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

APR is the most important indicator of the total cost of credit. It includes not only the interest rate but also all other fees associated with the loan. For borrowers, it's crucial because it provides a comprehensive view of the loan's true price, enabling better comparison between different loan offers.

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

A debit card provides access to your own money directly from your linked bank account, so you can only spend what you have. A credit card, however, is a type of bank loan that allows you to borrow money up to a certain credit limit, which you then repay (often with interest) over time. Credit cards offer an interest-free period, while debit cards do not involve borrowing.

What are some common internal risks faced by commercial banks?

Internal risks, which a bank can influence, include credit risks (client's solvency), risks of ownership interest (poor investments), payment risks (delayed payments), liquidity risks (inability to meet obligations), managerial risks (management errors), and technical/technological risks (system failures or employee mistakes).