Commercial Bank Questions and Answers [With PDF]

When you open a savings account, take a loan or send money to a relative, you are almost certainly dealing with a commercial bank. It is the bank that ordinary people and businesses use every day. This chapter covers what commercial banks do, the principles they follow (liquidity, solvency, safety and profitability), where their money comes from and goes, how a loan creates a deposit, and why they are called the lifeblood of the economy. Here are 25 important questions with clear answers, tables and worked examples, ready for exams, vivas and job interviews.

This is Chapter 3 of our Banking course. It follows Central Bank and comes before Bank Account.

Meaning, Objectives and Functions

Q1. What is a commercial bank?

A commercial bank is a bank that accepts deposits from the public, makes loans and provides a range of banking services to its customers in order to earn a profit.

Q2. What are the objectives of commercial banks?

• To earn profit, which is the primary objective.
• To provide cheques, drafts and bills of exchange as convenient ways of making payments.
• To collect the savings of the public and help form capital.
• To protect depositors’ money.
• To follow the central bank’s regulations and cooperate with its credit policy.
• To help the economy grow by financing industry, trade and agriculture.

Q3. What are the features of a commercial bank?

• Profit motive: it is run to earn a profit.
• Collects savings and lends: it accepts deposits and gives loans, mostly short-term.
• Creates a medium of exchange: its cheques and deposits work as money.
• Branch banking: it works through many branches.
• Service-oriented: it offers many services to its customers.

Q4. What are the functions of commercial banks?

Q5. What is the importance of a commercial bank?

• It collects savings and creates capital.
• It provides loans and investment funds.
• It creates a convenient medium of exchange.
• It expands domestic trade.
• It helps international trade.
• It acts as an agent for customers.
• It creates employment.
• It helps transfer money safely.

Q6. What is the role of a commercial bank in the economic development of a country?

• It forms capital by collecting small savings.
• It provides short, medium and long-term loans for business expansion.
• It issues cheques, drafts and bills of exchange as a medium of exchange.
• It expands trade by keeping money safe, transferring it, and helping sell shares and debentures.
• It helps international trade through letters of credit, foreign exchange and payments.
• It supports price and economic stability by following the central bank’s directions.
• It creates jobs through its branch network.
• It helps carry out the government’s fiscal and monetary policy.

Principles of a Commercial Bank

Q7. What are the principles of a commercial bank?

• Liquidity
• Solvency
• Safety
• Profitability
• Savings (deposit collection)
• Loan and investment
• Efficiency
• Service
• Confidentiality (secrecy)
• Technological development
• Goodwill

Q8. What is the liquidity principle?

Liquidity is the ability to pay customers’ deposits when they ask for them. The liquidity principle means a bank keeps enough liquid assets, such as cash and balances with the central bank, to pay cheques and withdrawals on demand.

Q9. Why is the liquidity principle so important?

The main source of a commercial bank’s funds is demand deposits, which customers can withdraw at any time. If the bank cannot repay on demand, its reputation is badly damaged and depositors lose trust. A rush of withdrawals (a bank run) may follow. So a bank must always follow a liquidity policy.

Q10. What is the profitability principle?

The principle of earning as much profit as possible by lending or investing in safe and profitable sectors, while still keeping enough liquidity. A bank faces a trade-off: cash earns nothing but is perfectly liquid, while loans earn interest but are harder to turn into cash. The bank balances the two.

Q11. What is the confidentiality principle?

The principle that a bank must keep its customers’ account information private and take all technical and personal steps so that nobody except the customer, or an authorized person or authority, can obtain it.

Q12. What is the principle of goodwill?

Creating and keeping a good name by giving honest, skilled and prompt service. Goodwill attracts customers and deposits, which helps the bank grow.

Q13. What is the solvency principle?

Solvency is the ability to pay all of the bank’s liabilities from its assets. A bank is solvent when its assets are worth more than its liabilities. If the value of its assets falls below its liabilities, it is insolvent, and depositors’ money is at risk.

Example: A bank has assets of 100 million and liabilities (mainly deposits) of 90 million. Its net worth is 10 million, so it is solvent. If bad loans reduce its assets to 85 million, its net worth is -5 million, and it is insolvent. To stay solvent, a bank must hold enough capital and avoid risky lending.

Q14. What is the savings principle?

The policy of raising funds by attracting customers through different accounts, deposit schemes and other plans.

Q15. What is the safety principle?

The strategy of protecting customers’ deposits and the bank’s assets from theft, fraud and loss, and of keeping lending and investment as free of risk as possible. Banks take collateral for loans, check borrowers’ credit, and spread loans over many borrowers.

Funds, Income and Expenditure

Q16. What are the sources of funds of a commercial bank?

Q17. What are the sources of income of a commercial bank?

• Interest on loans (the main source)
• Returns on investments
• Discount on bills (interest taken in advance when buying a bill before it is due)
• Commission on bank drafts, traveller’s cheques and other services
• Locker rent
• Agency service fees
• Brokerage on buying and selling shares
• Profit from foreign exchange

Q18. What are the expenditures of a commercial bank?

• Interest paid to depositors.
• Interest paid to the central bank or other lenders on borrowed funds.
• Salaries and allowances of employees, directors and managers.
• Auditors’ fees.
• Legal costs of recovering unpaid loans.
• Rent of offices and storage.

Example of bank profit: A bank lends 1,000 million at 10% and earns 100 million. It pays 5% on 900 million of deposits, which is 45 million, and spends 30 million on salaries and rent. Profit before tax = 100 – 45 – 30 = 25 million.

Guarantees and Credit Creation

Q19. What is a bank guarantee?

A bank guarantee is a written promise from a bank to a third party (the beneficiary) that if the bank’s customer fails to pay a certain amount, or to fulfil an obligation, within a set time, the bank will pay. It lets customers do business that needs assurance of payment. Example: a contractor gets a guarantee so the project owner knows he will be paid compensation if the contractor fails to complete the work.

Q20. How does a loan create a deposit?

When a bank grants a loan, it usually does not hand over cash. It credits the amount to the borrower’s account. That entry is itself a new deposit, and the borrower can spend it by cheque or transfer. When the money is spent, it ends up as a deposit in another bank. So lending creates deposits.

Q21. What is credit (deposit) creation, and how does it work?

Credit creation is the process by which commercial banks, by lending, increase the total amount of deposits (money) in the banking system, based on a primary deposit.

Example: Banks must keep a 10% reserve. Someone deposits 1,000 (a primary deposit). Bank A keeps 100 and lends 900. That 900 is deposited in Bank B, which keeps 90 and lends 810. Bank C then receives 810 and so on. The total deposits that the original 1,000 can support is 1,000 / 0.10 = 10,000. The money multiplier is 1 / reserve ratio = 10.

Q22. What are the limitations on credit creation?

• The cash reserve ratio and other reserve rules set by the central bank. A higher CRR reduces credit creation.
• The amount of primary deposits.
• Cash drain: if people hold more cash instead of depositing it, less money is available to lend.
• Lack of suitable borrowers or good security.
• The central bank’s credit policy and interest rates.
• Low public awareness and use of banks.

Why Commercial Banks Are Called …

Q23. Why is a commercial bank called a short-term loan dealer?

Because most of a commercial bank’s funds are deposits that customers can withdraw on demand, so the bank cannot safely lend them out for a long time. Most of its lending is therefore short-term, such as overdrafts and cash credit for working capital, although it also gives some medium and long-term loans.

Q24. Why is a commercial bank called the middleman of the money market?

The money market is where short-term funds are lent and borrowed. Commercial banks are the main institutions in it: they collect short-term funds from depositors and supply them to borrowers, so they stand between lenders and borrowers.

Q25. Why is a commercial bank called the lifeblood of the economy?

Commercial banks serve all kinds of people and businesses: they hold savings, give loans, make payments possible and create credit. Industry, trade and agriculture depend on these services, just as the body depends on blood. Without commercial banks, economic activity would slow down or stop.

Quick Revision Points

• A commercial bank accepts deposits and lends. Its main income is the gap between interest earned and interest paid.
• Principles: liquidity, solvency (assets above liabilities), safety and profitability.
• Liquidity and profitability pull against each other, so a bank balances them.
• A bank guarantee is a promise to pay a third party if the customer fails.
• Credit creation: money multiplier = 1 / reserve ratio.

Test yourself with the chapter quiz below, then continue to Bank Account.