10.1 - Commercial and Investment Banking Flashcards
1. What are the functions of a commercial bank?
Commercial banks serve multiple functions, including providing a safe place for individuals and firms to deposit their money and earn a rate of return through interest rates. They use funds from savers and money gained from the money markets to provide loans to individuals and firms who need financing for various purposes such as buying houses or cars. Commercial banks also act as financial intermediaries, facilitating the movement of funds between 3rd party lenders and borrowers through bank accounts. Additionally, they offer financial services advice such as insurance, mortgage, and investment advice to their customers.
- How do commercial banks generate profits?
Commercial banks generate profits through the interest rate spread. They offer a lower interest rate to savers who deposit their money in the bank and charge a higher interest rate to borrowers who take out loans. The difference between these rates acts as the bank’s profit margin. Additionally, commercial banks may charge fees for financial services advice they provide to their customers.
- How do commercial banks facilitate payments?
Commercial banks enable payments to take place between individuals and firms. They act as intermediaries by moving funds from third-party lenders to borrowers through an individual’s bank account. This allows individuals to make payments to a given firm using their bank account.
- What are the functions of an investment bank?
Investment banks have various functions, including engaging in proprietary trading, which involves using their own funds to invest in financial assets for higher returns than market interest rates. They also participate in market making, where they hold a large quantity and variety of financial assets to facilitate buying and selling whenever demanded. Investment banks can organize and advise on mergers and acquisitions on behalf of a client (firm), providing guidance on deal structure, regulatory hurdles, due diligence, timing, paperwork, and media publicity. Moreover, they can assist clients in raising funds through new issues such as shares or bonds, by contacting prospective buyers, creating and marketing the products.
- What is the practice of underwriting in investment banking?
Underwriting refers to a practice in investment banking where an investment bank buys up all the shares or bonds issued by a client in need of urgent finance. The investment bank charges a percentage fee on top of the purchase, ensuring that the client receives the necessary funds. This practice provides a guarantee to the client that their shares or bonds will be sold, even if market demand is low at that time.
evaluation: How has deregulation affected the structure of commercial and investment banks?
Deregulation of financial markets since the 1970s has allowed commercial and investment banks to operate under the same business name. This has resulted in banks like Barclays having both an investment banking division and a commercial banking arm. While this has promoted rapid growth in the investment banking industry, allowing for riskier but more lucrative activities, it has increased systemic risk in the economy. The collapse of one firm in the financial industry can have a ripple effect, leading to further banking collapses and potentially the meltdown of the entire industry. As a result, purely specialized investment banks have become rare, with most banks integrating commercial and investment banking to benefit from stable funds from commerical banking to engage in high-risk activities in investment banking.
- How does the traditional profit-making model of commercial banks work?
The traditional profit-making model of commercial banks involves accepting savings from individuals and keeping a fraction of these savings as reserves within the bank or in their bank account at the Bank of England. The remaining portion can be used to issue loans to borrowers who need funds for spending. The profit for the commercial bank is derived from the difference between the interest rate offered to savers and the interest rate charged to borrowers. This model relies on the circulation of money, where once the loaned money is spent, it eventually returns to the commercial bank in the form of savings, allowing the process to repeat.
- What is the money multiplier?
The money multiplier is a concept used to estimate how much the money supply will increase based on the initial savings deposit. It is calculated using the formula 1/𝑟, where 𝑟 represents the percentage requirement of savings that must be held as reserves. The money multiplier provides a figure that, when multiplied by the initial savings deposit, indicates the potential increase in the money supply resulting from the lending and spending activities of commercial banks.
