Commercial and Investment banks

Question 1

What do commercial banks do?

Answer 1

• They manage deposits, cheques and savings accounts for individuals and firms
• They can make loans using the money saved with them

Question 2

What do investment banks do?

Answer 2

They facilitate the trade of stocks, bonds and other forms of investment

Question 3

Why do investment banks have a higher risk tolerance?

Answer 3

• Because government regulation is weaker in the investment bank industry, and this combined with their business model
• For example proprietary trading (which involves a bank buying and selling shares using its own money)
• Although they engage in very high risk activities, they could potentially be very profitable

Question 4

Give examples of commercial banks

Answer 4

• HSBC
• Barclays
• Lloyds
• NatWest
• Santander

Question 5

Give examples of investment banks

Answer 5

• Goldman Sachs
• JP Morgan
• Morgan Stanley

Question 6

Give 4 functions of a commercial bank

Answer 6

• Accept savings
• Lend to individuals and firms
• Act as financial intermediaries (i.e. move funds from lenders to borrowers)
• Provide financial services advice

Question 7

How/why do commercial banks accept savings?

Answer 7

• By allowing individuals to open up savings accounts
• To keep their money safe and to provide a rate of return on money assets in the form of an interest rate

Question 8

How/why do commercial banks lend to individuals and firms?

Answer 8

• As profitable organisations, commercial banks will use funds from savers and funds gained from the money markets to lend to individuals and firms
• Individuals who need loans to buy houses, cars etc and firms who need loans to finance investment expenditure can receive such finance from a commercial bank
• Savings put into a commercial bank can be used to offer loans

Question 9

How do commercial banks act as financial intermediaries?

Answer 9

• They can move funds from (3rd party) lenders to borrowers through an individual’s bank account
• They can also allow for payments to take place between an individual with a bank account and a given firm

Question 10

Why do commercial banks provide financial services advice?

Answer 10

• They provide financial services advice to its customers in the form of insurance, mortgage and investment advice for example
• Individuals can, at a fee, receive guidance on where best to save their money, how to budget sustainably and also how to achieve the best mortgage deal
• Firms can also gain advice on credit worthiness and safer strategies for future growth

Question 11

How do commercial banks make profit?

Answer 11

• By providing and earning interest from loans such as mortgages, business loans, and personal loans
• Customer deposits (money held in a bank account) provide banks with the capital to make these loans
• In a nutshell, they ensure they charge a higher rate of interest on loans than they pay on deposits

Question 12

Give 4 functions of an investment bank

Answer 12

• Proprietary (prop) trading
• Market making
• Merges & acquisitions (M&A)
• New issues

Question 13

What is prop trading?

Answer 13

• This is when banks use their own funds to invest in financial assets for a better rate of return (i.e. to make profit)
• This can be done by buying shares, bonds and financial market derivatives that they think will rise significantly in value before selling them on to make significant profit
• i.e. it involves a bank buying and selling shares using its own money to make profit

Question 14

What is market making?

Answer 14

• The majority of investment banking activity is focussed in market making
• This is the practise of holding a large quantity and variety of financial assets to be able to buy and sell whenever demanded, in this sense making a market for that asset
• Whenever a client wants to sell a bond, they know an investment bank will buy it up
• Furthermore if an investor wants to buy a bond, they know an investment bank will sell to them

Question 15

How do investment banks make profit from market making?

Answer 15

• They profit from this activity by capturing the spread, which is the difference between the price at which they buy a security and the price at which they sell it
• For example, if an investment bank buys a stock at $10 per share and sells it at $10.05 per share, they capture a spread of $0.05
• By executing a large number of trades and capturing small spreads on each trade, investment banks can accumulate significant profits over time

Question 16

What is M&A?

Answer 16

• Investment banks offer services to facilitate mergers and acquisitions for their clients (firms)
• Merger: When two companies join together to form a single entity
• Acquisition: When one company takes over another company.
• The firm (predator) , looking to merge with or takeover a rival firm (the target) can seek advice from an investment bank regarding this move
• For example, how to structure the deal, the best timing of the deal, dealing with necessary paperwork, dealing with publicity and the media
• These services are provided for a fee

Question 17

What is new issues?

Answer 17

Financial securities (such as stocks/bonds) that are being offered to the public for the first time

Question 18

How can an investmet bank engage in new issues on behalf of a client who needs to raise funds?

Answer 18

• For example a firm may be issuing shares or bonds but wants help and advice from an investment bank to ensure that these products are actually sold
• In which case investment banks can contact prospective buyers, create the products and market the shares/bonds all for a fee

Question 19

What is underwriting?

Answer 19

• If nobody wants to buy the new issues, shares or bonds that firms are offering, investment banks can buy them all up, charging a percentage fee on top of whatever that value is, making huge sums of money
• This occurs when firms are in need of urgent finance through the sale of shares

Question 20

When were financial markets deregulated?

Answer 20

• 1970s
• Since deregulation of financial markets in the 1970s, commercial and investment banks can operate under the same business name, for example Barclays has both an investment banking division and a commercial banking arm

Question 21

What are the benefits of commercial and investment banks operating under the same business name?

Answer 21

• This has allowed for the rapid growth of the investment banking industry, therefore a reduction in unemployment, thus contributing to economic growth
• The safe and stable funds made in the commercial banking part of the business can be used in riskier but more lucrative investment banking activities, therefore huge profits can be made in a short period of time

Question 22

What is meant by systemic risk in the context of financial markets?

Answer 22

Where the collapse of one firm in the financial industry can ripple through the industry leading to further banking collapses and eventually a meltdown of the entire financial industry

Question 23

What is a evaluative/ con of commercial and investment banks operating under the same business name?

Answer 23

It increases systemic risk in the economy

Question 24

What is a balance sheet?

Answer 24

A financial record of all the assets, liabilities and capital (shareholder’s equity which is the amount that the owners of a company have invested in their business.) at any given point in time

Question 25

What are assets?

Answer 25

Anything of value that a commercial bank OWNS

Question 26

What are liabilities? Give examples

Answer 26

Anything that a commercial banks OWES

Question 27

What is the equation to calculate assets?

Answer 27

assets = liabilities + capital

Question 28

What assets will be on a commercial banks balance sheet (in order of most liquidity to least liquidity)

Answer 28

1. Cash
2. Reserves of BoE
3. Money at call at short notice
4. Short term investments
5. Long term investments
6. Advances ( e.g. issuing morgages or loans)
7. Fixed assets (machinery, property)

Question 29

What liabilities will be on a commercial banks balance sheet (in order of most liquidity to least liquidity)

Answer 29

1. Deposits (they’re owed to individual savers, they do not belong to a commercial bank)
2. Short-term borrowing (e.g. borrowing from money markets)
3. Long-term borrowing (e.g. bonds the bank has issued)
4. Capital - Shareholder’s fund, retained profit (reserves)

Question 30

What are the three objectives of a commercial bank?

Answer 30

1. Profitability
2. Liquidity
3. Security

Question 31

Why is profitability an objective for commercial banks?

Answer 31

To satisfy shareholders and gain promotions in the bank

Question 32

Who are shareholders?

Answer 32

• They’re the owners of a commercial bank
• They seek dividends (usually from profits) as a reward for their investment into the business

Question 33

What is the best way for commercial banks to make profit?

Answer 33

Borrow short term at low interest rates and lend long term at much higher interest rates, therefore the profit margin will be the greatest

Question 34

Give an example of short term and long term borrowing

Answer 34

• Short term borrowing = money markets
• Long term lending = mortgages and business loans (greater risk involved –> higher interest rate –> charged over a long period of time)

Question 35

Evaluate profitability as an objective for commercial banks

Answer 35

• The search for profit is extremely dangerous
• Excessive risks can be taken to maximise profits
• It increases the chances of both insolvency and a liquidity crisis
• Thus bank failure

Question 36

What is liquidity?

Answer 36

E.g.
* Holding more cash
* Holding more reserves (extra money)

Question 37

Why is liquidity an objective for commercial banks?

Answer 37

It avoids a bank run

This is when a large number of people withdraw their money from a bank due to fears of insolvency

Question 38

Evaluate liquidity as an objective for commercial banks

Answer 38

They are not as profitable

Therefore conflict between the two objectives (profitability and liquidity) of a commercial bank

Question 39

What is security?

Answer 39

Managing risk to avoid insolvency

Question 40

Why is security an objective for commercial banks?

Answer 40

To avoid insolvency in the drive for profitability

Question 41

Give an example of security

Answer 41

Issuing more loans to safer borrowers

Question 41

Evaluate security as an objective for commercial banks

Answer 41

• It involves sacrificing profit
• As high interest rates are not always charged on such loans
• Therefore conflict between the two objectives (profitability and security) of a commercial bank

Question 42

Give a conclusion for the objectives of a commercial bank

Answer 42

• It is clear that profit is the primary objective of commercial banks
• But bank failure and excessive risk (putting all your eggs in one basket) must be prevented
• Therefore must be a focus on liquidity and security

Question 43

What can be held to prevent conflict between the commercial bank objectives?

Answer 43

• Holding a balanced portfolio of assets is important
• Although some profit will be sacrificed due to liquidity and security reasons
• This is in the long term interest of managers in the bank and shareholders who own the bank

Question 44

How do commmercial banks create credit?

Answer 44

1. Fractional Reserve System: Banks use a system where they only keep a small portion of the money people deposit with them, and they lend out the rest
2. Money Multiplier Effect: When banks lend out money, that money gets deposited in other banks, who then also lend it out. This keeps happening, creating more money in the economy
3. Credit Creation Process: When banks give out loans, they’re essentially creating new money because those loans become deposits in the bank
4. This boosts the economy by increasing the total amount of money circulating, which helps contribute to economic activity