Functions of Commercial Banks (Cambridge (CIE) A Level Economics): Revision Note

What does a commercial bank do?

• A commercial bank is a financial institution that accepts deposits from individuals and businesses, provides loans and offers payment services, with the primary objective of generating profit

1. Providing deposit accounts

• Commercial banks offer two main types of deposit account, differentiated by how quickly funds can be accessed and the interest paid

• Deposits are the main source of funds that commercial banks use to lend - without deposits, there is no capacity to make loans

2. Lending money

• Commercial banks provide two main forms of lending

  • Overdrafts - short-term borrowing allowing account holders to withdraw more than their deposit balance, up to an agreed limit

    • Typically charged at high interest rates

    • Used for short-term cash flow needs

  • Loans - fixed-sum borrowing repaid over an agreed period, usually at lower interest rates than overdrafts

    • Includes mortgages (loans secured against property)

    • Used for larger purchases, business investment or long-term borrowing

  • Interest charged on loans is the main source of commercial bank profit

3. Holding or providing cash, securities, loans, deposits and equity

• A bank's balance sheet records its assets (what it owns or is owed) and its liabilities (what it owes to others), with the two sides always equal in total.

• The five balance sheet items are:

  • Cash - notes, coins and reserves held at the central bank; the most liquid asset

  • Securities - government bonds, treasury bills and similar financial instruments; liquid and low-risk

  • Loans - sums lent to customers (also called advances); typically the largest asset and main source of profit

  • Deposits - funds owed to customers holding accounts; the main liability

  • Equity - the bank's own capital (share capital and retained profits); also called capital

Example balance sheet

• Total assets always equal total liabilities - this accounting identity is where the balance sheet gets its name

• Liabilities are the sources of funds the bank uses to acquire its assets - deposits (plus borrowing and equity) are lent out as loans, held as cash, or invested in securities

• The composition of the balance sheet reflects the bank's choice between liquidity, security and profitability

4. Reserve ratio and capital ratio

• Two key ratios measure a commercial bank's financial safety

  • The reserve ratio is the proportion of a commercial bank's deposits held as liquid reserves (cash or deposits at the central bank) rather than lent out

    • A higher reserve ratio reduces lending capacity but increases the bank's ability to meet customer withdrawals

    • Central banks may set minimum reserve ratios to ensure banking system stability

    • Using the example above: £50bn cash against £180bn deposits gives a reserve ratio of approximately 28%

  • The capital ratio is the proportion of a commercial bank's equity capital to its total assets (or risk-weighted assets)

    • A higher capital ratio means the bank has a larger cushion to absorb losses before depositors are at risk

    • Internationally agreed minimum capital ratios (under the Basel framework) are designed to prevent banking crises

    • Using the example above: £20bn equity against £200bn total assets gives a capital ratio of 10%

Objectives of commercial banks

• Commercial banks must balance three competing objectives

• The fundamental trade-off is that more liquid and more secure assets generally generate less profit

  • A bank that prioritises profit by lending aggressively risks insolvency if loans default or depositors demand withdrawals

  • A bank that prioritises liquidity and security sacrifices returns to shareholders

• Reserve and capital ratios are regulatory tools that constrain banks' pursuit of profit to protect depositors and the wider financial system