3.2.4.2 - Commercial and investment banks

Commercial and investment banking

Commercial banking provides everyday deposit, payment and lending services, while investment banking mainly supports financial transactions and capital-market finance.

A commercial bank accepts deposits, provides accounts and transfers payments, and lends to households and firms. A household can pay wages into an account, buy goods through bank transfers and obtain a mortgage. A firm can obtain working-capital finance before customers pay or borrow to buy machinery. Banks assess borrowers, monitor loans and offer services that reduce the information and transaction costs of arranging finance individually.

An investment bank helps businesses and governments issue securities, advises on transactions such as mergers, and may trade financial assets. It can help a company issue a bond rather than supply the same kind of household current account as a commercial bank. Detailed specialist investment-bank activities are outside this lesson's scope. Some banking groups undertake both kinds of business. Trading losses or wholesale funding problems in one part can damage confidence in the group, affecting deposits and credit elsewhere. Combining activities can diversify revenue, but may also increase interconnectedness and systemic risk: disruption spreading beyond one institution.

Other financial institutions exist, including insurers, pension funds and investment funds. They channel savings and hold financial claims; they are not all deposit-taking banks, and their detailed functions are not required here. The important distinction is the service and financial obligation involved, rather than assuming every organisation operating in a financial market creates bank deposits.

A bank balance sheet

A bank's balance sheet records what it owns or is owed, how it is funded, and the owners' loss-absorbing stake at a particular date.

Assets include reserves at the central bank, securities and loans owed to the bank. A customer loan is the bank's asset because the bank has a claim to repayment. Liabilities include customer deposits and borrowing from other institutions: the bank owes that money. Equity capital is the residual owners' stake, accumulated through shares and retained profits. It is not a separate pile of cash stored for emergencies.

These entries describe the same institution from two sides. Customer deposits are assets for customers but liabilities for the bank. Equity is shown separately from liabilities even though both fund assets. If a £5 million loan becomes worthless, asset value falls by £5 million and equity falls from £10 million to £5 million, assuming other entries do not change. The bank has suffered a loss; it has not necessarily lost £5 million of immediately available reserves at that moment. Conversely, a depositor withdrawing funds may create a liquidity need without first creating a loan loss. That distinction prepares the difference between liquidity and solvency.

Liquidity, profitability and security

A bank must earn a return while remaining able to make payments and withstand losses.

Liquidity is the ability to meet payments when due, using reserves or assets that can quickly be converted into payment funds without a large loss. Profitability involves revenues, such as loan interest and fees, exceeding funding and operating costs and losses. Security concerns preserving the value of assets and limiting the risk of default or other losses. No asset is perfectly secure under all conditions.