2.4.2 Commercial Banks and Investment Banks

The Difference Between Commercial and Investment Banks

Commercial Bank: A bank that accepts deposits from households and firms, makes loans to them, and provides a payments system. Also known as a retail bank or high street bank.

Investment Bank: A bank that does not take deposits from the general public, but instead provides services to firms, governments and institutional investors, such as raising finance, advising on takeovers and trading securities.

Comparison

The Main Functions of a Commercial Bank

Accepting Deposits

Banks provide households and firms with a safe place to store money and earn interest on it. Deposits are held in sight accounts, which can be withdrawn on demand, or time accounts, which require notice of withdrawal and pay a higher rate of interest.

Lending

Banks advance funds through overdrafts, personal loans, mortgages and business loans. Lending is the bank's principal source of income and the main way in which savings are channelled into consumption and investment.

Providing a Payments Mechanism

Banks allow money to be transferred between accounts using debit cards, direct debits, standing orders and bank transfers. Money can therefore perform its function as a medium of exchange without cash changing hands.

The Structure of a Commercial Bank's Balance Sheet

Balance Sheet: A statement of a bank's assets and liabilities at a particular point in time.

Liabilities are what the bank owes to others; assets are what the bank owns or is owed by others. The two sides must always balance:

Assets are conventionally listed in descending order of liquidity. As you move down the list, assets become harder to turn into cash quickly but earn a higher rate of return. This ordering is what makes the bank's objectives conflict.

The Objectives of a Commercial Bank

A commercial bank pursues three objectives simultaneously: liquidity, profitability and security.

Liquidity

Liquidity: The ease with which an asset can be converted into cash without loss of value.

A bank must hold enough liquid assets to meet depositors' withdrawals on demand. Because deposits are repayable immediately while loans are not, a bank that runs short of liquid assets cannot pay its customers, even if its loan book is perfectly sound. Liquidity is therefore about survival and is managed through the bank's liquidity ratio - the proportion of assets held in liquid form.

Profitability

Profitability: The objective of maximising the return earned on the bank's assets for its shareholders.

Banks are private sector firms owned by shareholders, so they aim to maximise profit. Profit comes mainly from the interest rate spread, so it is increased by holding a larger proportion of assets as loans and long-term investments rather than as cash.

Security

Security: The objective of minimising the risk of losses from bad debts and risky investments.

A bank pursues security by lending only to creditworthy borrowers, diversifying its lending across different sectors and regions, requiring collateral, and holding sufficient capital to absorb losses. A bank whose losses exceed its capital becomes insolvent.

Conflicts Between Commercial Bank Objectives

The three objectives cannot all be met in full at the same time. The bank must choose a position on its balance sheet that represents a compromise between them.

Liquidity vs Profitability

This is the central conflict. The most liquid assets are the least profitable, because cash and reserves at the central bank earn little or no interest. The most profitable assets, such as long-term mortgages, are the least liquid.

• Holding a high proportion of liquid assets makes the bank safe but sacrifices interest income, reducing profit and shareholder returns.
• Holding a low proportion raises profit, but the bank may be unable to meet withdrawals. If depositors lose confidence, a bank run can force an otherwise solvent bank to fail.

Profitability vs Security

Higher returns are only available on riskier assets. A bank can raise profit by lending to borrowers with weaker credit histories or at higher loan-to-value ratios, and by charging them higher interest rates - but this increases the risk of bad debts. If defaults rise sharply, the losses can exceed the bank's capital.

How Banks Create Credit

Credit Creation: The process by which commercial banks make loans that create new bank deposits, thereby increasing the money supply.

Banks do not simply pass on money that savers have deposited. When a bank grants a loan it credits the borrower's account with a new deposit. That deposit is new money that did not exist before, so the act of lending itself expands broad money.

Fractional Reserve Banking

Credit creation is possible because of fractional reserve banking. Only a small fraction of depositors withdraw their money at any one time, and most payments are settled by transfers between accounts rather than in cash. A bank therefore needs to hold only a fraction of its deposits as liquid reserves and can lend out the rest.

The Process

1. A bank receives an initial deposit and retains only a fraction of it as liquid reserves, in line with its desired liquidity ratio.
2. It lends the remainder to a borrower by crediting the borrower's account, creating a new deposit.
3. The borrower spends the money, and the recipient pays it into their own bank account.
4. That bank now holds a new deposit, retains a fraction as reserves and lends the rest out again.
5. The process repeats. Total deposits across the banking system end up a multiple of the original deposit, with each successive round smaller than the last.

Each new loan appears on the balance sheet as an asset and each new deposit as a liability, so the balance sheet expands on both sides and still balances. The smaller the fraction held as reserves, the more credit can be created - and the less liquid the banking system becomes.

Why Credit Creation Matters

Bank lending is the principal source of new broad money in a modern economy, which gives credit creation significant macroeconomic effects:

• Rising credit finances consumption and investment, increasing aggregate demand, output and employment.
• Excessive credit growth can push aggregate demand beyond productive capacity, causing demand-pull inflation and fuelling asset price bubbles in housing and shares.
• When banks contract lending to rebuild liquidity, aggregate demand falls and a recession is deepened.