Commercial & Investment Banks (AQA A Level Economics)

The Distinction Between Commercial & Investment Banks

• 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 

The Structure of a Commercial Bank’s Balance Sheet

• 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 

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

Potential Conflicts Between Achieving Liquidity, Security & Profitability

• 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

How Banks Create Credit

• 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 

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