Commercial & Investment Banks (AQA A Level Economics)

• Commercial banks (also known as retail or high-street banks) are financial institutions that make profits by selling banking services to their customers
• • They serve the general public, both personal consumers and businesses
     

• Investment banks are global banks that assist in raising finance for companies, financial institutions, governments, and organisations

The Characteristics of Commercial & Investment Banks 

Characteristic	Commercial Banks	Investment Banks
Services offered	Provide loans to individual consumers and businesses  Eg. mortgages Provide safekeeping and returns for deposits / savings	They issue shares and bonds Provide advisory services for companies undergoing mergers or acquisitions Financial advisory services to businesses
Examples	Barclays HSBC Deutsche Bank in Germany	J.P. Morgan Morgan Stanley Citigroup
Branch network	Extensive networks of branch banks in high streets and shopping centres Numerous large commercial banks have opted to close a number of their physical branch locations due to rise of online banking	Not dependent on branch networks; global presence Historically, investment banks were situated within the square mile of the City of London

• A commercial banks balance sheet shows its assets and liabilities

• Assets are resources owned by a bank, e.g. cash, stock
  • It also includes money and assets owed to the bank, eg. investment bonds, commercial and treasury bills, advances

• Liabilities are the amount owed by the bank and are a source of finance for the bank
  • Eg. share capital or reserves, bonds the bank issued, deposits from savers

Balance Sheet for a Commercial Bank 

Asset	£bn	Liabilities	£bn
Liquid assets	50	Capital	20
Investment	40	Long-term borrowing	10
Advances	110	Deposits	170
Total assets	200	Total liabilities	200

Source: AQA
 

• It is called a balance sheet because the total assets (£200bn) should always equal total liabilities (£200bn)
• The income earned from a bank's liabilities is used to finance / purchase assets

• Commercial banks face a challenge in trying to balance their objectives of:
  • Liquidity
  • Security
  • Profitability

Liquidity

• Banks want enough cash on hand that they can always meet withdrawal requests from their customers
• This liquidity helps their customers not lose faith in the bank and prevents a run on the bank

Security

• Banks need to ensure that any money they lend out is likely to be repaid
• This means that the loan is secure
• Banks will generally look for security from the borrower on larger loans, such as mortgages

Profitability

• Banks also want to be able to earn as much interest on their loans as possible
• Higher interest rates are usually charged on more risky loans
• The bank has to balance their desire for profitability with their desired level of security

• The process of creating credit by commercial banks, also known as fractional reserve banking, involves a cycle of lending and deposit creation

Diagram: Creation of Credit by Banks 

An initial deposit of $100 is multiplied as successive rounds of borrowing and deposits occur in the banking system

The Money Creation Process (Fractional Banking)

1. Initial Deposit

• A customer deposits $100 into a commercial bank 

2. Reserve Requirement

• Banks are required by the Central Bank to hold a certain percentage of their deposits as reserves so as to meet the demands of customers who want a portion of their money back
• In this example, the reserve requirement is 20%, so $20 must be retaine

3. Lending and Loan Creation

• Banks keeps a fraction of the deposit (20%) and lend out the remainder to borrowers

4. Deposit Expansion

• The loaned amount is then received by the borrower, who deposit the funds into their own bank account
• These new deposits can be used by the other bank as the basis for creating further loans
• The cycle continues as banks retain a portion of the new deposits as reserves and lend out the rest, leading to further loan creation, deposit expansion, and potential new rounds of lending

5. Money Supply Expansion

• Through this process, new loans and subsequent deposit creation increase the overall money supply in the economy
• The original deposit has effectively multiplied into multiple deposits across the banking system