4.2 Commercial Banks And Investment Banks

Question 1

Commercial bank definition

Answer 1

A bank that accepts deposits from and lends money to customers, usually for personal and business loans

Question 2

What are the functions of a commercial bank?

Answer 2

• accept deposits/savings
• to lend
• to act as financial intermediaries
• providing an efficient means of payment (through card and cheque settlement)

Question 3

What does act as a financial intermediaries mean?

Answer 3

Bringing together savers and borrowers

Question 4

Investment bank definition

Answer 4

A bank that provides financial services to other businesses such as arranging share or bond issues

Question 5

What does issues mean in terms of economics?

Answer 5

The giving out of something, in terms of financial markets = the giving out of bonds or shares

DO NOT GET CONFUSED WITH AN ISSUE (something bad happening!)

Question 6

Functions of a investment bank

Answer 6

• propriety capital
• market making = create a place for buying and selling of financial assets, sometimes on behalf of buyers or sellers = a service
• mergers and acquisitions
• new issues

Question 7

What is propriety capital?

Answer 7

Where the investment bank uses any of its capital (money) to invest any financial asset that will create even more profit for the firm

Question 8

What are mergers and acquisitions in a investment bank?

Answer 8

Investment banks give advice on when to take over a business, how to do it, regulation and paperwork = a service

Question 9

What is the function of new issues in a investment bank?

Answer 9

They help firms issue bonds and shares and give advice to them + find people who would want to buy them + advertise them

Question 10

What is systemic risk?

Answer 10

Where banks have both an investment side and a commercial side. So that if one side of the bank fails (more likely investment banking) it will also bring down the other side = higher systemic risk

Question 11

What is a balance sheet?

Answer 11

Is a financial record of all the assets and liabilities of a commercial bank at any given point in time

Question 12

What must a balance sheet always do?

Answer 12

Be balanced. Assets = Liabilities

Question 13

What is an asset?

Answer 13

Anything of value that an individual, firm or government owns

Question 14

What are liabilities?

Answer 14

Anything an individual, firm or government owes to other individuals or groups

Question 15

What are advances?

Answer 15

Loans made by banks to customers

Question 16

What is the interbank market?

Answer 16

Interbank market is the market where banks can borrow and loan money from each other - short-term needs

Question 17

What are the objectives of a commercial bank?

Answer 17

• profit = make money for its shareholders by charging interest
• liquidity = need to have sufficient notes and coins to meet the needs of their customers withdrawing money
• security = is to manage risk and avoid insolvency

Question 18

How can commercial banks be profitable?

Answer 18

• borrowing short-term (low interest) in the money markets but lending long-term (high interest) in the capital markets = good profit margins
• taking risks = offering loans to people who are high risk = charge higher interest. Offer loans that are not backed-up by anything = if the loans go bad the bank doesn’t get anything= can charge a higher interest

Question 19

Why is profit maximisation of commercial banks dangerous?

Answer 19

• the risk of bank failure is much higher
• if bank fails can lead to systemic risk as banks are interdependent
• bank bailouts = more tax or revenue not spent on other areas of the economy

Question 20

What are the two ways banks can fail?

Answer 20

• a liquidity crisis = there are not enough short-term liquid assets that the commercial bank has to meet its short-term liabilities = bank run
• insolvent = don’t have enough capital to offset any losses in asset value - if loans go bad = liabilities are greater than assets

Question 21

Fractional banking definition

Answer 21

The ability of a bank to hold a fraction of their customers deposit at any time, allowing for some liquidity and the rest can be lent out to borrowers