4.2.4.2 Commercial banks and investment banks

Question 1

What is a commercial bank?

Answer 1

• One that accepts deposits from and lends money to the general public, usually for personal and business loans (usually in form of bank overdrafts and mortgages for homebuyers)
• ‘High-street banks’

Question 2

What is an investment bank?

Answer 2

• Bank that provides financial services to other businesses, such as arranging share or debenture issues

Question 3

Main functions of investment banks

Answer 3

• Help companies raise finance by assisting with the issue of new capital
• Many will assist governments w/ share issues for the privatisation of state-owned enterprises (e.g. Royal Mail in 2013)
• Also buys and sells securities in the secondary capital market - to generate returns for the investment bank
• Buys and sells financial assets in the money and foreign exchange markets

Question 4

How do investment banks earn income?

Answer 4

• From charging a fee for the services of advertising and organising the raising of finance

Question 5

Dual role of banks

Answer 5

• May carry out both activities - some economists believe this contributed to the financial crisis of 2007-08
• Legislation to enforce separation not been passed - any bank performing dual roles must ‘ring-fence’ any commercial banking activities from their investment banking activities (i.e., any funds generated by customers’ deposits cannot be used for investment banking activities, such as buying and selling investments

Question 6

Functions of a commercial bank

Answer 6

• Key: Transferring funds from those w/ a surplus to those wishing to make use of money that they don’t have

1. Accepting deposits (from customers w/ surplus of money they wish to have securely and conveniently stored)
2. Lending to economic agents (individuals and firms wishing to borrow can arrange this from a commercial bank, which will offer a variety of lending instruments, e.g., loans, overdrafts, mortgages)
3. Providing an efficiency means of payments (setting debts w/ others far more convenient if using services of a commercial bank)

Question 7

Define balance sheet

Answer 7

• A financial statement showing the assets of an organisation alongside how those resources were financed (i.e., the liabilities of the organisation)
• Must always balance

Question 8

Assets

Answer 8

• Notes and coins - most liquid
• Balances held at the Bank of England
• Money at call and short notice - generally very liquid assets
• Bills (commercial and treasury) - generally very liquid
• Investments
• Advances
• Tangible non-current assets
• Loans

Question 9

Liabilities

Answer 9

• Share capital
• Reserves (e.g. retained profits)
• Long-term borrowing
• Short-term borrowing
• Deposits

Question 10

Define liquidity

Answer 10

Refers to how easily an asset can be converted into cash without any loss in value

Question 11

Objectives of a commercial bank

Answer 11

• Liquidity
• Profitability
• Security

Question 12

Objective of commercial banks: liquidity

Answer 12

• Banks have to manage assets carefully and ensure they have sufficient notes and coins to meet the needs of customers withdrawing cash
• Will have to borrow money (and pay interest) from financial markets if it has insufficient amounts to meet the requirements of its customers

Question 13

Objective of commercial banks: profitability

Answer 13

• Holding notes and coins doesn’t generate a return

- Make profit for their shareholders by lending out money to borrowers and charging interest on any money lent

Question 14

Objective of commercial banks: security

Answer 14

• Bank takes risk when lending money - the risk that the borrower will default (fail to repay)
• Normally, the interest on the riskiest types of loans is higher to compensate for the higher risk
• Therefore - greater profits can be made on riskier lending made by the bank

Question 15

Role on central bank to ensure commercial banks are secure

Answer 15

• Can act as a ‘lender of last resort’ to banks with a short-term liquidity shortage
• Doesn’t mean it will continually provide money for banks that make unwise loans - but will provide short-term finance for banks to provide liquidity when required

Question 16

Explain the profit-liquidity trade off

Answer 16

• Increased lending = increased profits - but customers less able to access deposits

Higher liquidity = higher profits by lending out on risky, long-term ventures (money tied up elsewhere just when the bank might need it)

Question 17

Banks know customers are unlikely to withdraw their full balances from accounts regularly.

Therefore…

Answer 17

• They can create credit by lending out some of their customers’ deposits to those wishing to borrow - enabling the bank to profit on any loans made
• If the money lent out is redeposited in the bank as a new customer deposit, it can be lent out yet again, thus creating even more credit

Question 18

Fractional banking

Answer 18

• Ability of banks to hold a fraction of their customers’ deposits at any time, thus allowing them to lend out money and earn interest
• To create credit

Question 19

What limits a banks ability to create credit?

Answer 19

• The extent to which the bank feels it must hold a portion of its customers’ deposits in liquid form
• If the proportion held is very small, it means any new deposits the bank receives can create large amounts of credit within the economy

If everyone wanted to withdraw deposits at the same time - bank in trouble (wouldn’t have notes and coins to meet customers’ demands) - may turn into a ‘run on the bank’
- Customers fear a bank likely to run out of money so demand all of their deposits back at once