Primary Concepts of Banking Questions and Answers [With PDF]

Almost everyone uses a bank: to keep savings safe, to send money, to take a loan or to run a business. But what exactly is a bank, what does it do, and how do different kinds of banks differ? This chapter covers the meaning, history, functions and types of banks, unit and branch banking, specialized banks, and why banks are called the lifeblood of the economy. Here are 30 important questions with clear answers and tables, ready for exams, vivas and job interviews.

This is Chapter 1 of our Banking course. Continue with Central Bank afterwards.

Meaning, History and Functions of a Bank

Q1. What is a bank?

A bank is a financial intermediary that accepts deposits from the public, lends money and provides a range of other financial services. It collects money from savers at a low rate of interest (or profit) and lends it to borrowers at a higher rate. The difference between the two is the bank’s main income, and what is left after expenses is its profit.

Banks now do much more than take deposits and lend. They also earn service charges for managing accounts and commissions for issuing pay orders, bank drafts, debit and credit cards and providing online banking.

Q2. What is banking?

Banking is the business of accepting deposits from the public for the purpose of lending or investing. Deposits are repayable on demand or after a fixed time, and can be withdrawn by cheque, draft, order or other means. In general, everything a bank does is called banking. It also includes accepting current, savings and term deposits, paying cheques, granting loans, discounting bills and helping customers transfer money.

Q3. Who is a banker?

A banker is a person or organization engaged in the banking business, or a person in charge of running a bank on behalf of its owners. Most banks today are run as companies, so the chairman, directors, managing director, managers and officers who take part in managing the bank are all called bankers.

Q4. What is the brief history of banking?

Q5. What are the features of a bank?

• Intermediary: it stands between savers and borrowers.
• Dealer in money and credit: it deals in money and loans, not in goods.
• Large-scale operation: it serves a large number of customers.
• Financially solvent: it must be able to pay its depositors.
• Symbol of safety and confidence: people trust it with their savings.
• Capital formation: it turns small savings into large funds for investment.
• Prime mover of the economy: it finances industry, trade and farming.
• Service-oriented: it offers many services.
• Maintains secrecy: it keeps customers’ accounts confidential.

Q6. What are the functions of a bank?

Q7. How does a bank earn money?

Mainly through the interest spread, the gap between the interest it earns on loans and the interest it pays on deposits. Example: a bank pays depositors 5% and lends at 10%. On 1,000,000 lent, the spread is 5%, or 50,000 a year, before expenses. It also earns fees and commissions from services.

Q8. What is the importance of banks in a country’s economic development?

• They create a medium of exchange.
• They collect savings and form capital.
• They supply capital and increase investment.
• They support domestic and international trade.
• They help industrial and agricultural development.
• They create employment.
• They increase government revenue.
• They handle foreign exchange.

Q9. How are banks classified?

Unit, Branch, Chain and Group Banking

Q10. What is a unit bank?

A unit bank is an independent bank that does all its business from a single office, with no branches. All employees work in the same place, and the managers take decisions there. Because its work is limited to one area, it is also called local banking. Unit banking was once common in the United States, where laws limited branching, although those limits were largely removed in the 1990s.

Q11. What are the features of unit banking?

• Management is centralized in one office.
• There is no branch office.
• It serves a limited area.
• Its functions are limited.
• Decisions are made in one place.
• It is small in scale.

Q12. What are the advantages of unit banking?

• The owner-manager gives close attention.
• Quick decisions.
• Lower operating costs.
• Direct relationship between the employer and employees.
• A warm, personal relationship with customers.
• It can meet the special needs of its local area.

Q13. What are the limitations of unit banking?

• Money transfer to other places is difficult.
• It cannot raise a large amount of capital.
• It is hard to attract efficient managers.
• Risk is concentrated in one area and cannot be spread.
• Funds cannot move to where they are needed.
• It can have liquidity problems.
• Staff have fewer chances for promotion, so motivation is lower.

Q14. What is a branch bank?

A bank that operates many branches under the same name, in the country and sometimes abroad, all controlled by a central head office. It is also called the British banking system, because it began and grew in the United Kingdom.

Q15. What are the features of branch banking?

• It has many branches.
• It is controlled by a head office.
• It works closely with the central bank.
• Staff are managed centrally.
• It operates on a large scale.

Q16. What are the advantages of branch banking, and why is it popular?

• It operates on a large scale and can raise huge capital.
• Funds can move from branches with surplus to branches that need them.
• Risk is spread across many places.
• Liquidity is better.
• It can attract efficient management.
• Money transfers between places are easy.
• Its branches act as publicity.

Because of these strengths, branch banks can offer better and wider services, including online banking, so branch banking is the most widely used system today.

Q17. What are the limitations of branch banking?

• Management is more complex.
• Decisions can be delayed because they need head office approval.
• Large banks may develop monopoly tendencies.
• High overhead expenses.
• Less personal contact between the bank and customers.

Q18. What is chain banking?

A system in which several independent banks, each with its own legal identity, are controlled by one person, family or group of individuals who own a majority of their shares. Unlike group banking, there is no holding company.

Q19. What is group banking?

A system in which a holding company controls several banks by owning a majority of their shares, or sets up several small banks of the same type, and runs them as one group. The controlling company is the holding company and the banks it controls are its subsidiaries.

Q20. What is the difference between unit banking and branch banking?

Specialized Banks

Q21. What is an investment bank?

A specialized bank whose job is to provide long-term capital to business firms. It helps companies raise money by issuing and selling (underwriting) shares and bonds, helps start new industries, and may also buy shares itself.

Q22. What is an agricultural bank?

A bank established to finance farmers and develop the country’s agriculture. It provides capital for buying machinery, fertilizer, seed and other needs, and often gives loans on easy terms.

Q23. What is a merchant bank?

A financial institution that combines international trade finance and investment banking. It issues letters of credit for customers, accepts bills raised by exporters, pays bills in international trade, buys goods or equipment from abroad and supplies them on lease or hire purchase, gives long-term loans and invests in joint ventures.

Q24. What is a consumer bank?

A specialized bank that helps people buy goods for personal use. It issues credit cards and finances consumer durables such as refrigerators, televisions and cars, which the buyer pays for in instalments.

Why Banks Matter

Q25. Why is a bank called the driving force and lifeblood of the economy?

Industry, trade and agriculture cannot function without money, credit and safe ways of making payments, and banks provide all three. Banks collect savings, lend them to businesses and individuals, create credit and provide the payment system. Just as blood carries nutrients around the body, banks carry money to where it can be used productively, so they are called the driving force and the lifeblood of a modern economy.

Q26. Why is a bank called a dealer in money and credit?

Because a bank’s business is borrowing and lending money. It borrows money from depositors at a lower cost and lends it to borrowers at a higher rate, and the difference is its profit. Money and credit are its stock-in-trade, just as goods are for a shopkeeper.

Q27. Why is a bank called a financial intermediary?

Because it stands between those who have surplus money (depositors) and those who need money (borrowers). A bank does not carry on business mainly with its own funds. It earns income by lending out the money of depositors. By bringing the two sides together, it lets savers earn a return and lets borrowers get funds they could not find alone.

Q28. Why is a bank called a symbol of trust?

People deposit their hard-earned savings only when they are sure of getting them back. Banks keep deposits safe, repay them on demand or when due, and keep customers’ affairs confidential, so they earn the public’s confidence. Without that trust, nobody would deposit money and banking could not work.

Q29. How do banks create a medium of exchange?

A medium of exchange is anything widely accepted as payment. The central bank issues notes and coins on behalf of the government. Commercial banks add to it by issuing cheques, pay orders, bank drafts, letters of credit and debit and credit cards. They also create money through credit creation: when a bank lends part of a deposit, the borrower’s spending ends up as new deposits in the banking system.

Example: Banks keep a 10% reserve. A new deposit of 1,000 lets a bank lend 900, which is deposited elsewhere, and 810 is lent from that, and so on. In total the system can support deposits of 1,000 x (1 / 0.10) = 10,000. The money multiplier is 1 / reserve ratio = 10.

Q30. Why are transactions with a scheduled bank considered better?

A scheduled bank is a bank that is included in the schedule (list) of the central bank. To be listed, a bank must meet minimum capital requirements and keep a required reserve with the central bank, and it follows the central bank’s rules and supervision. Because of this supervision, scheduled banks are considered safer, and the central bank can act as lender of last resort in a crisis, so depositors’ interests are better protected.

Quick Revision Points

• A bank accepts deposits and lends. Its main income is the interest spread.
• Unit bank: one office. Branch bank: many branches. Chain bank: independent banks controlled by one person or group. Group bank: controlled by a holding company.
• Specialized banks: investment, agricultural, merchant, consumer and others.
• Credit creation: money multiplier = 1 / reserve ratio.
• Scheduled banks are listed with the central bank and are supervised by it.

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