A
financial institution is an
institution that provides financial (intermediaries) services for its clients
or members. These financial institutions are highly regulated by government
bodies. A working employee will get his income first and then he/she start
spending it. Whereas a business needs to spend at first, then only they
will start getting their income. Without income we cannot spend, so the
businessmen should bring the required amount of money which is called the initial capital investment. The
capital may also be known as Loan capital or risk capital. The risk
capital is raised by the sale of shares in the ownership of a company.
Whenever the business need more than the initial capital they should borrow
money to bridge the gap between the expenditure and their income.
This is the loan capital. Firms borrow money from a variety of financial
institutions. Borrowing money has a cost. Interest rate is the cost of borrowing money. There are many
reasons for charging this interest. 1) People who lend the money
lose the opportunity to use money. 2) Lending money is a risk because there is
a possibility of non-repayment. 3) Money loses its value over
time.
There
are many financial institutions operate in an economy which include both money
market and capital market. Money
market refers to short and medium term finance and capital market refers to long term
finance. They are central bank, commercial bank (retail bank), merchant
bank and overseas bank.
Firms
need finance for short term, medium term and long term purposes. The
short term and medium term finance were provided by commercial banks. Commercial banks are financial
institutions. Their functions are
1) safeguard customers money – by accepting deposits, 2) supplying cash
to customers by lending, and 3) other functions such as
safeguarding valuables, night safe facility etc.
Banks
safeguard customer’s money by current deposit or a deposit account or
both. In current account the customers can deposit and withdraw money at
any time without notice. So it sometimes called sight deposit. A cheque book is given to withdraw the
money.
Deposit
accounts are used to save money for a period of time and a notice of withdrawal
has to be given, so this is sometimes called as time deposit. Banks offer a higher rate of interest to encourage
savings.
Banks
customers may request to convert the deposit back into cash at any time, so
bankers must ensure that they have enough money to pay. On an average, only
one-tenth of the deposit would be withdrawn at a time. Meanwhile, others also
make deposits. Thus the remaining cash would be kept idle. Banks can lend
this money to their customers. This process is known as credit creation.
Banks
lend money to their customers using different methods such as loans,
overdrafts. Bank loan is a
more formal method of borrowing, whereas overdraft is an informal way of borrowing. In overdraft banks allow the
account holder to withdraw or appropriate an amount more than the deposit in
the bank. In both the bank consider the creditworthiness of the customer that is, borrower’s ability to
pay back the money.
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