Private Banks:

Principles of Activity and Functions

Anar Mammadov, PhD (Econ)

 Definition

 A private bank is authorized by law to receive money

from businesses and individuals and lend money
 Private banks are open to public and serve individuals,
institutions, and businesses
 A private bank is almost certainly the type of bank you
think of when you think about a bank because it is the
type of bank that most people regularly use
 Four Principles of Private Banking
1. Private banks can execute payments in favour of other banks if the balances on
their correspondent accounts permit

2. Full economic independency refers to full economic liability for the results of
their activity. They are also free in attracting resources: have freedom of choosing
the customers and borrowers, of managing revenue after tax repayment. Banks
are liable for their debts to the full extent of their capital, assets, and property. All
risks related to its operations are taken by bank

3. All bank-customer relationships are market-based: a bank focuses not on

nationwide interests but on maximisation of revenue, minimisation of risks and
maintaining liquidity

4. Indirect economic methods – the government establishes rules of play for banks
but cannot give them direct orders
 Major Functions
• Receive deposits – take money in from individuals and businesses
• Lend money
• Disburse payments – make payments upon the direction of its depositors, such
as honouring a check
• Collections – a bank will act as your agent to collect funds from another bank
payable to you, such as when someone pays you by check drawn on an account
from another bank
• Invest funds in securities
• Safeguard money – banks are considered a safe place to store your wealth
• Maintain and service savings and checking accounts of its depositors
• Maintain custodial accounts – accounts controlled by one person but for the
benefit of another person, such as a trust account
Primary and Secondary Functions
of Private Banks
 Primary Functions:
1. Accepting Deposits
2. Issuing Loans
3. Money Remittances
Cont.
 Secondary Functions:
1. Overdraft Facility
2. Discounting Bills of Exchange
3. Investment of Funds
4. Agency Functions
5. General Utility Functions
6. Miscellaneous Functions
 Accepting Deposits
 The most important function of private banks

 Deposits are accepted in several forms according to requirements of

different sections of the society

Example: low income group people deposit their savings in small amounts for
the security and savings income purposes. On the other hand, traders and
businessmen deposit their savings in the banks for the convenience of payment

By keeping the needs and interests of various sections of society, banks

formulate various deposit schemes
Cont.

 Generally, there are three types of deposits:

 Demand deposits
 Fixed deposits
 Saving deposits
 Current (Demand, On-Call) Deposits
 The depositors may withdraw and deposit money whenever
they desire. Since banks always have to keep such
deposited amount in cash, they charge very low interest
 Call deposits are highly useful for traders and large
businesses because they make and accept payments many
times intraday
Demand (call) deposits may be withdrawn by depositors any
time they want
Fixed (Time) Deposits

 These are deposited for a definite period of time (generally

not less than one year)
 These are long term deposits and cannot be withdrawn
before the expiration
 They generally carry a higher rate of interest because banks
might use these deposits for a stipulated definite time without
having the fear of being withdrawn
Saving Deposits
 Money (up to a certain limit) may be deposited and
withdrawn once or twice a week. Rate of interest on these
is very low
 Main objective is to mobilise small savings
 These are generally done by salaried people and those
who have fixed and less income
Note: Banks often restrict the number of withdrawals from savings
account (for example, no more than twice a year), or set limits on the
partial withdrawal limits and the minimum balance on the account.
Advance notice is required!
Issue of Loans

Banks charge borrowers interest and this represent the

main source of their income
Banks give loans not only on the basis of the deposits of
the public, but also on the basis of depositing the money
in the accounts of borrowers
In other words, they create loans out of deposits and deposits
out of loans. This is called credit creation by banks
Issue of Loans
❑ Contemporary banks issue mostly secured loans
❑ At the time of issue, appropriate security (collateral)
should be provided
❑ Generally, the value of security/collateral is equal to the
loan amount
In Azerbaijan, collateral should not be less than 150%
of the requested loan amount
The purpose is to recover the loan money by selling the security in the
event of non-refund of the loan
Cont.
❑ At times, banks may give loans based on personal
security
❑ Such loans are called unsecured loans

 Generally, Azerbaijani banking legislation prohibits

advancing unsecured loans
 They might be granted only in individual cases
Cash Credit
❑ Using this credit scheme, banks advance loans to its
customers based on bonds, inventories and other
approved securities
❑ Under this scheme, banks enter into an agreement
with customers who make withdrawals many times
during a year
❑ Under this set up, banks open accounts of their
customers and deposit there the loan money. With this
type of loan, credit is created
 Cont.
 Demand loans
Such loans can be recalled on demand by banks. The entire loan
amount is paid in lump sum by crediting the borrower’s loan account,
and entire loan becomes chargeable to interest with immediate effect

 Short-term loan
These loans may be given as personal ones to finance working capital
or as priority sector advances. These are made against some security
and entire loan amount is transferred to the borrower’s loan account
 8 differences between Business Loans and
Lines of Credit

The first building block for managing a business is capital

Two popular options for businesses are loans and lines of
credit
Which is best for you?
Cont.

• One Time vs. Multiple Uses

• Payment Options

• The Difference in the “Whens”

• Closing Costs

• Monthly Payments

• Long-Term Debt and Short-Term Debt

• Monthly Costs
 One Time vs. Multiple Uses

• A line of credit can be used more than one time

• Business loans are used only once

 Payment Options

• With a line of credit, you only make payments on the amount

you have borrowed, so your payment is zero if your
balance is zero
• When you have a traditional business loan you borrow the
whole amount at once. This option sets you up with monthly
payments that begin right away
 The Difference in the “Whens”

• “When” you get a line of credit – this is something you acquire

before you need it. It is generally not for a specific purpose
• “When” you get a loan – this is for a specific purpose and is
only obtained when needed
 Closing Costs

• A line of credit can have minimal to no closing costs

• A traditional loan can have closing costs that range from 3-

7%, but there are exceptions to every rule
Monthly Payments
• Monthly payments are usually higher on traditional loans
than they are for lines of credit
• For example: a traditional loan for the amount of $75,000
would have a monthly payment of $600-1,000 more than if you
owed the same amount on a line of credit
Line of Credit Loan

Payments reflect only the amount of money you Payment on the full amount begins immediately,
have borrowed. If you have a zero balance, you whether you are using all the money or not
do not owe anything
Repayment terms and periods are customised Repayment terms and periods are fixed. You owe
for your business the same amount every month
Long-Term Debt and Short-Term Debt

• For short-term purposes such as making payroll, marketing

costs, or unexpected cash-flow issues, lines of credit are best.
Although this is great for surprises, be careful not to exhaust
your funds
• However, using your credit line for revenue-generating
activities (RGA) is an ideal use for these funds. You will be
able to justify new debt you have incurred because you have
achieved success by growing you company and generating
 Monthly Costs

• With a line of credit, you have greater flexibility in what you

pay on a monthly basis. You can draw only what you need,
and then pay it down to lower your balance back to zero
• With a traditional loan, you would have to pay off the entire
loan balance or refinance, which can carry additional costs
 Summary

• With changes in guidelines, products and lenders the world of

small business lending can be delicate
• Banks are approving less than 10% of small business loan
applications these days, and owners are looking for alternative
ways of funding their businesses in order to make them
successful
Cont.
 Overdraft
If there are no deposits in the current account, banks
may give loans up to a certain amount through overdrafts
For this, banks demand security and charge much
higher rate of interest
Discounting of Bills of Exchange

This is the most prevalent and important method of giving

loans to traders for short-term purposes
Under this system, banks give loans to traders and firms
by discounting their bills
In this way, businessmen get loans on the basis of their
bills of exchange before the time of their maturity
Investment of Funds

Banks invest their surplus funds in government securities.

These include those of central and state governments,
such as treasury bills, national savings certificate etc.
Other securities include securities of state-associated
bodies like electricity boards, housing boards, debentures
of Land Development Banks, shares of Regional Rural
banks etc.
Agency Functions

Banks also perform certain agency functions for their

customers (in the form of agents and representatives of
their customers)
Customers give their consent for performing such
functions. For these services, banks charge some
commission from their clients
The important functions of these types are as follows:

(i) Banks collect cheques, drafts, bills of exchange and dividends of shares
for their customers
(ii) Banks make payment for their clients and at times accept the bills of
exchange: of their customers for which payment is made at the fixed time
(iii) Banks pay insurance premium of their customers. Besides this, they also
deposit loan installments, income-tax, interest etc. as per directions
(iv) Banks buy and sell securities, shares and bonds on behalf of their
customers
(v) Banks arrange to send money from one place to another for the
convenience of their customers
Cont.
(vi) Banks provide Income Tax Consultancy
They even prepare their income tax returns
(vii) Banks function as Trustee and Executor
Private banks preserve the wills of their customers as trustees and
execute them after their death as executors
(viii) Banks provide Letters of Reference
They provide traders with information about economic position of their
customers and similar information about other traders to their customers
 General Utility Functions
Banks render some general utility services like:
(i) Locker Facility:
❑ facility of safety vaults / lockers to keep valuable articles of customers in safe custody
(ii) Traveller’s Cheques:
❑ Commercial banks issue traveller’s cheques to their customers to avoid risk of taking cash
during their journey
(iii) Letter of Credit:
❑ They also issue L/Cs to their customers to certify their creditworthiness
(iv) Underwriting Securities:
❑ Banks also undertake the task of underwriting securities. As public has full faith in the
creditworthiness of banks, public do not hesitate in buying securities underwritten by banks
(v) Collection of Statistics:
❑ Banks collect and publish statistics relating to trade, commerce and industry. Hence, they
advice customers on financial matters. Banks receive deposits from public and use these
deposits
 Miscellaneous Functions
Banks perform many other functions of general utility which are as follows:
(i) make arrangement of lockers for the safe custody of valuable assets of their
customers such as gold, silver, legal documents etc.
(ii) give reference for their customers
(iii) collect necessary and useful statistics relating to trade and industry
(iv) buy and sell FX to facilitate foreign trade
(v) advise their clients relating to investment decisions
(vi) underwrite shares and bonds
(vii) issue letters of credit
(viii) during natural disasters, mobilize funds and donations
(ix) provide loans for consumer durables like car, air-conditioner, fridge etc.