Credit Function of Banks

The credit department’s main function is to lend money and has a major role in the banking system.

To provide credit or loans, banks require deposits. Banks have deposits in two ways:

  • when customers deposit money with any commercial bank
  • when banks advance loans, discount bills, provide overdraft facilities, and make investments through bonds and securities.

The first types of demand deposits are called “primary deposits”. Banks play a passive role in opening them. The second types of demand deposits are called “derivative deposits”.

Commercial banks are profit seeking institutions. So when they find that a large volume of
cash received through primary deposits lies idle because all such demand deposits are not withdrawn at the same time by their customers, they use these resources for advancing loans or for making investments in securities, shares, etc., thereby earning a high rate of interest.

Now “primary deposits” is a simple term i.e. when customers deposit money.

But what is “derivative deposits” and why they are called deposits?
The derivative deposits or credit is done by the banks by

  • lending – when any person asks for a loan from bank, whether it be personal, educational, creditbusiness, etc.
  • term loans – a term loan is a monetary loan that is repaid in regular payments over a set period of time and they usually have unfixed interest rate.
  • providing overdraft facility – it is when you withdraw more funds than you actually have in your current accounts.
  • cash credit – it is also same as overdraft, but sometimes the meaning can vary in the form that they are offered for businesses than individuals.
  • bill discounting – Bills discounted are the bills which are purchased after discounting money. For e.g. A person buys a product from the market, and promises to pay the money at some later time. The shopkeeper will give a bill to the customer. Now if the shopkeeper wants the money before that time, he can go to bank with the bill. Now bank will not give the entire money written on the bill to the shopkeeper, but it will deduct some money (known as bill discounting) from the bill and lent the remaining to the shopkeeper. Now when the shopkeeper receives the money from his customer, he can pay back to bank. The bank deducts the money or discounts the bill in order to keep the discounted money with it as interest.

Now why they are called deposits?
When a customer asks for a loan from a bank, bank does not give the money to the customer; instead it opens an account and transfers the loan amount to that account. Now whenever the customer needs money, payment is made through cheques. So as loan as the loan is due, a deposit of that amount remains outstanding in the books of the bank. Thus every loan creates a deposit.