2.4.2 Commercial and Investment Banks — Practice Questions

Seven original multiple-choice questions on commercial and investment banks, written to the style and difficulty of AQA Paper 3 Section A.

7 questions AQA A-Level Multiple choice Model answers included

Not read the notes yet? Start with the 2.4.2 Commercial and Investment Banks revision notes.

1. 1. Which one of the following is a function of a commercial bank but not of an investment bank?

   Definition in context

   Select one answer

   A Accepting deposits from households.

   B Advising firms on mergers and takeovers.

   C Trading securities on its own account.

   D Underwriting new issues of shares.
   Show model answer

   Answer: A (Accepting deposits from households.). A commercial bank — the high street or retail bank — takes deposits from households and firms, lends to them, and runs the payments system. An investment bank takes no deposits from the general public; it funds itself on wholesale markets and from shareholders' capital.

   Why the other options are wrong

   • B — Advising on mergers and takeovers is a classic investment banking service, sold to large firms for a fee.
   • C — Trading securities on its own account is investment banking, and it is one reason those banks carry more risk.
   • D — Underwriting new share issues — guaranteeing that an issue sells — is investment banking work.

2. 2. Table 1 shows four items from a commercial bank's balance sheet.
   Using Table 1, the bank's total liabilities are

   Data interpretation

   Table 1: Selected balance sheet items

   Item	Amount
   Customer deposits	£420bn
   Loans and advances to customers	£380bn
   Cash and reserves at the central bank	£45bn
   Bonds issued by the bank	£30bn

   Select one answer

   A £420bn

   B £425bn

   C £450bn

   D £875bn
   Show model answer

   Answer: C (£450bn). Liabilities are what the bank owes to others. It owes customers their deposits back, and it owes investors the money raised through the bonds it has issued.
   £420bn + £30bn = £450bn.
   The other two items are assets: loans are owed to the bank, and cash and reserves are money it holds.

   Why the other options are wrong

   • A — £420bn is customer deposits alone. The bonds the bank has itself issued are borrowing too, so they are also a liability.
   • B — £425bn is loans plus cash and reserves — the two assets. This is the classic error of treating deposits as assets and loans as liabilities, which is exactly backwards.
   • D — £875bn adds all four items together. Assets and liabilities are the two sides of the balance sheet and are never summed.

3. 3. The three objectives a commercial bank pursues simultaneously are

   Definition in context

   Select one answer

   A Growth, market share and profitability.

   B Liquidity, profitability and security.

   C Liquidity, solvency and market share.

   D Profitability, growth and security.
   Show model answer

   Answer: B (Liquidity, profitability and security.). A commercial bank must hold enough liquid assets to meet withdrawals (liquidity), earn a return for its shareholders (profitability), and avoid losses from bad debts (security).
   The three pull against each other, which is why a bank's balance sheet is always a compromise rather than an optimum on any one measure.

   Why the other options are wrong

   • A — Market share is a general business aim, not one of the three objectives that structure a bank's balance sheet.
   • C — Solvency is the result of pursuing security successfully — a bank is insolvent when losses exceed capital — rather than one of the three objectives itself.
   • D — Growth again is a general aim. Liquidity is the objective missing here, and it is the one banks fail on first in a crisis.

4. 4. A commercial bank moves a large share of its assets out of central bank reserves and into long-term mortgage lending. The bank has become

   Applied reasoning

   Select one answer

   A Less liquid and less profitable.

   B Less liquid and more profitable.

   C More liquid and less profitable.

   D More liquid and more profitable.
   Show model answer

   Answer: B (Less liquid and more profitable.). This is the central conflict on a bank's balance sheet. Assets are listed in falling order of liquidity, and return rises as liquidity falls.
   Reserves at the central bank are perfectly liquid but earn almost nothing. Mortgages are the least liquid asset a bank holds and the most profitable. Shifting from one to the other therefore raises profit and reduces the bank's ability to meet withdrawals — less liquid, more profitable.
   A bank that pushes this too far can be perfectly solvent and still fail, if depositors ask for money it cannot raise quickly.

   Why the other options are wrong

   • A — Mortgages earn considerably more than reserves at the central bank, so profitability rises.
   • C — Long-term mortgages cannot be turned into cash quickly, so this move reduces liquidity rather than raising it.
   • D — Both halves are wrong. Liquidity and profitability move in opposite directions along the balance sheet, so no reshuffle raises both.

5. 5. A bank grants a customer a new loan of £10,000. The immediate effect on the money supply is that it

   Applied reasoning

   Select one answer

   A Falls by £10,000, because the bank's reserves fall.

   B Is unchanged, because the bank lends out an existing deposit.

   C Rises by £10,000, because a new deposit is created.

   D Rises by £10,000, because the central bank prints the money.
   Show model answer

   Answer: C (Rises by £10,000, because a new deposit is created.). The bank makes the loan by crediting the borrower's account. That deposit did not exist a moment earlier, and deposits are money — so the act of lending has itself increased broad money by £10,000.
   The balance sheet still balances: the loan is a new asset and the deposit a new liability, so both sides expand together.

   Why the other options are wrong

   • A — Nothing leaves the banking system. No cash has moved, and the bank's reserves are untouched by the act of crediting an account.
   • B — This is the most common misconception on the topic. Banks do not pass on money that savers have deposited — new lending creates new deposits.
   • D — The central bank is not involved. Commercial bank lending is the principal source of new broad money in a modern economy.

6. 6. A banking system operating with a liquidity ratio of 10% receives an initial new deposit of £2,000. Once the credit creation process is complete, the maximum total value of deposits in the system is

   Calculation

   Select one answer

   A £200

   B £1,800

   C £18,000

   D £20,000
   Show model answer

   Answer: D (£20,000). Each bank keeps a fraction of every deposit as reserves and lends the rest, which becomes a deposit at another bank, and so on. The rounds shrink but sum to a multiple of the original.
   Total deposits = initial deposit ÷ liquidity ratio = £2,000 ÷ 0.10 = £20,000.
   The smaller the fraction held in reserve, the more credit the system can create — and the less liquid it becomes.

   Why the other options are wrong

   • A — £200 is 10% of the initial deposit, which is the amount the first bank holds back as reserves rather than the deposits created.
   • B — £1,800 is the amount the first bank can lend from the initial deposit. That is only the first round of a process with many more.
   • C — £18,000 is the additional deposits created, £20,000 − £2,000. The question asks for total deposits, which includes the original £2,000.

7. 7. Banks are sometimes described as able to create credit without limit. The strongest objection is that credit creation is constrained by

   Applied reasoning

   Select one answer

   A Loan demand and banks' own caution.

   B The quantity of notes and coins in circulation.

   C The savings deposited by households.

   D The total value of shares issued by banks.
   Show model answer

   Answer: A (Loan demand and banks' own caution.). The ability to create credit is not the same as the willingness or the opportunity to use it. A bank cannot lend to borrowers who do not want to borrow, and in a downturn creditworthy demand for loans dries up.
   Banks also restrain themselves: they hold liquidity above the regulatory minimum because they fear withdrawals, and they tighten lending standards when they expect bad debts. In a recession both constraints bind at once, which is why cutting interest rates does not automatically produce more lending.

   Why the other options are wrong

   • B — Under fractional reserve banking most payments are settled by transfers between accounts, not in cash, so the stock of notes and coins is not the binding constraint.
   • C — This is the misconception the topic exists to correct. Banks do not lend out deposits — lending creates deposits.
   • D — Share capital determines a bank's ability to absorb losses, which regulators cap lending against. But it is not what limits credit creation in the sense described.