Commericial Banks and Investment Banks – AQA Spec

The difference between a Commercial Bank and Investment Bank

Commercial Bank

• Manages deposits, cheques and saving accounts for different individuals / firms
• Using the money saved with them, they can make loans

Investment Bank

• Facilitates the trade of investments such as bonds and stocks
• Investment banks tend to have a higher risk tolerance due to their business models and the fact that government regulation is weaker in this industry

The main functions of a Commercial Bank

Provide Loans

Commercial Banks generate a lot of income through the interest earnt from providing loans

They can also use deposited funds as loans to create credit

Secured loans are issued to individuals against one of their assets – in order to protect the bank’s funds in the scenario of the loan not being repaid

Cash Credit loans are based on approved securities and loans – money can be withdrawn several times through a year

Loans on demand are when the entire amount of the loan is paid directly into the borrower’s account and therefore incurs interest expenses immediately

Short term loans are usually against a security and tend to be for personal reasons or for working capital

Accept Deposits

Commercial banks accumulate savings – which are deposits from the public

Banks provide different accounts to meet the varying needs of their depositors

Demand deposits allow for the immediate withdrawal or making of deposits

Fixed deposits have high interest rates as they can store money for a longer time and they know deposits are unlikely to be withdrawn until after a while

Saving deposits are usually from those who withdraw money frequently, hence have lower interest rates

Overdraft

These have high interest rates and there is a limit on how much can be borrowed

People tend to use the overdraft facility when the current account has no deposits

Investment of funds

The bank can generate returns when funds are invested into government bonds or treasury bills

Agency Functions

They have many different functions, representing their consumers:

• collect cheques and dividends
• pay and accept bills
• deposit interest and income tax
• buy and sell securities
• arrange transfers of money

The structure of a commercial bank’s balance sheet

What is a balance sheet?

A balance sheet shows the value of a company’s assets, equity, and liabilities throughout a period of time

The values are stated at the end of the accounting period – i.e end of the annum or end of a quarter

What is an asset?

An asset is something which is owned and can be tangible or intangible – it can be sold for value.

Current assets are ones which more liquid than non-current assets

Examples of assets include: cash, bills, investments

What is a liability?

A liability is a claim on assets and therefore is money owned to a third party. It can be used to buy assets which can then be used to generate income

What is equity?

Equity refers to the amount which is left over once assets have been sold and liabilities have been paid

The objectives of a commercial bank

Profitability

Banks need to generate profits so they can pay their depositors

If banks hold a larger proportion of their funds in cash, their profitability becomes limited

Liquidity

Liquidity refers to how quickly and easy assets can be converted into cash

In order for banks to be profitable, they must have cash and liquid assets – cash is the most liquid asset

If banks prioritise liquidity, their profitability will be low – hence they need to establish a balance

Banks are likely to keep fewer liquid assets if they can borrow easily and cheaply

Security

There are risks and uncertainties regarding how much cash banks can get and whether loans will be repaid or not

A bank may struggle to create more credit as they can only hold their safest assets due to a high proportion of liabilities that it must hold

As a result, the banks profit is low and it may lose their customers