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Commercial Banks

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Economics

Is your local bank a commercial bank? Most probably yes. Commercial banks are one of the most important types of financial institutions in an economy. They are the main source of funding for individuals looking to buy a house or entrepreneurs looking to establish a startup. They also help individuals save for their retirement while protecting their wealth against inflation. Read to find out how commercial banks work and why they are so important for an economy.

Commercial banks: definition

Commercial banks work by accepting deposits from customers and using those deposits to make loans. Banks get their money from customer deposits, which allows them to then offer these as loans. They make a profit on the interest they charge for mortgages, vehicle loans, company loans, and personal loans. Customers with checking or savings accounts will also receive interest on their deposits.

Commercial banks often provide other services such as financial advice or basic investment services.

The functions of commercial banks

Commercial banks' primary function is to serve the financial needs of their customers. The main functions of a commercial bank include:

  • Ensuring that the money of its customers is safe.
  • Providing consumers interest on their deposits to hedge against inflation.
  • Offering loans to individuals, businesses, and homeowners.
  • Providing financial advice to relevant parties and other financial services such as insurance.

Guaranteeing safe deposits

Depositing money at a bank is generally considered a safe practice. Keeping all of your money in cash beneath your mattress is both inconvenient and risky. It was common practice in medieval times for citizens to pay the Knights Templar (or other early banks) to keep their money and possessions secure.

Putting your money in a bank helps you keep your mind at ease as you don't have to worry about whether someone will end up stealing all your savings. The Bank of England serves as a lender of last resort for commercial banks in the United Kingdom. In case anything happens, the Bank of England would step in and guarantee you get your money back.

Commercial Banks Commercial Bank functions StudySmarterA picture of the Bank of England from around 1865–95, Wikimedia Commons.

Providing interest on deposits

Deposits in commercial banks are rewarded with interest. Savings accounts may earn substantial interest rates whereas current accounts earn just a tiny fraction of that. Interest earned on deposits is significant at times of inflation to keep the actual worth of your money intact. However, this depends entirely on the rate of interest you earn on your saving deposits and the inflation rate.

If you are earning an interest of 3% in your earnings and inflation increases to 4%, then you would be losing money in real terms. If instead, you receive an interest of 5% on your deposit, then you would have the real value of your savings increase. In times of stable inflation, many consumers use their savings accounts to earn money.

Offering loans

Loans are one of the main sources of income for commercial banks. They use a portion of the deposits made by other individuals to offer loans to other customers and businesses. However, for them to maximise their profits, they need to charge higher interest on loans than the interest they pay on deposits.

Commercial banking becomes more profitable when banks lend money to businesses and individuals and there’s a wide difference between the interest charges on loans and deposits. The main thing a bank has to worry about is making sure it has enough cash on hand to accommodate client withdrawal requests.

Other financial services

There are other financial services that a commercial bank offers such as enabling clients to access cash in a matter of seconds by just going to an ATM. They also allow and facilitate international payments to pay for goods and services you might want to receive from other countries. They can also offer financial advice for your retirement fund or any other financial matter you might need advice on.

The balance sheet of commercial banks

The balance sheet of a commercial bank provides an overall overview of how well the bank is operating. At the end of the year, a balance sheet reveals the company’s assets and liabilities as of a certain date.

In a balance sheet, assets and liabilities are displayed on the left-hand side and right-hand side, respectively. Same as a company’s balance sheet, the total asset and liabilities of a commercial bank must balance. All commercial banks are required to disclose their balance sheets once a year.

The assets of commercial banks

A commercial bank generates revenue and profit through its assets. One of the first things you'll find on a commercial bank's balance sheet is cash in liquid form. This cash is a portion of deposits banks are required to keep in case a customer wants to withdraw their funds from the bank. They do not generate profit for the bank.

Other items that can be found on the asset's side of a commercial bank's balance sheet include receivables, which are deposits that the commercial bank makes at a central bank through which it generates profit.

Commercial banks also have loans made to other clients in their balance sheet as well as inventory, land, and building that the bank owns. These are the main items that can be found under the asset's side of a commercial bank's balance sheet.

However, there are many other types of assets that you can find on a commercial bank's balance sheet, including investments made in government securities, company shares, or corporate bonds.

Liabilities of a commercial bank

Liabilities are those items that the bank owes to other parties.

Deposits and borrowings from other institutions are examples of liabilities for a bank. You can think of liabilities of a commercial bank as things that provide funding for the bank.

One of the main and first items that can be found on the liabilities side is the bank's share capital. These is money owed to the bank's shareholders. Another very important item that you will always find on a bank's balance sheet is checkable deposits. These include the deposits of the bank's customers. The checkable deposits provide the bank with liability as the bank has to pay interest on those deposits.

There are other items that are included in a bank's liabilities such as borrowings from other banks, salaries paid to employees, rent, etc. Basically, you can think of liabilities as anything that the bank owes to someone.

Benefits of commercial banks

Commercial banks provide many benefits for their customers. Commercial banks offer loans and other financial products for people who need money for a large purchase or to start their own business.

Banks also offer checking and savings accounts, which may come with added bonuses and utilities that help people save and spend their money more wisely. For example, some commercial banks offer introductory CDs that pay higher rates of interest than regular CDs. They also offer safe deposit boxes at their branches, which can be used to store important documents and valuables in a secure location.

Commercial banks also offer basic investment services such as certificates of deposits (CDs) and mutual funds, which can allow people to invest without having to do so on their own. With the help of a financial advisor at the bank, this service can give you peace of mind knowing your investments are managed by professionals.

Examples of commercial banks

Commercial banks and banks with commercial banking activities are some of the biggest financial institutions in the world. Many of these institutions are located in the United Kingdom.

Examples of the largest commercial banks in the UK include HSBC, Barclays, Lloyds Banking group, and NatWest groups. All these banks manage trillions of British pounds. They maximise profits by paying low interest on deposits and charging higher interest on loans.

Commercial Banks - Key takeaways

  • Commercial banks work by accepting deposits from customers and using those deposits to make loans.
  • Banks get their money from customer deposits, which allows them to then offer these as loans.
  • They make a profit on the interest they charge for mortgages, vehicle loans, company loans, and personal loans.
  • The main functions of a commercial bank include: - Ensuring that the money of its customers is kept safe. - Providing consumers interest on their deposits to hedge against inflation. - Offering loans to individuals, businesses, and homeowners. - Providing financial advice to relevant parties and other financial services such as insurance.
  • The balance sheet of a commercial bank is comprised of various assets and liabilities.
  • Commercial banks offer loans and other financial products, which can be beneficial for people who need money for a large purchase or to start their own business.

Commercial Banks

Banks get their money from customer deposits, which allows them to then offer these as loans. They make a profit on the interest they charge for mortgages, vehicle loans, company loans, and personal loans.

  • Guaranteeing safe deposits.
  • Providing interest on deposits.
  • Offering loans.
  • Other financial services.

Providing financing to businesses and individuals which enables them to perform activities such as opening up a startup or buying a house.

Commercial banks play an important role in an economy as they are the main source of funding for individuals looking to buy a house or entrepreneurs looking to establish a startup. They also help individuals save for their retirement while protecting their wealth against inflation. 

The difference between commercial banking and retail banking is that retail banking is a division that is concerned with retail customers.

Final Commercial Banks Quiz

Question

What are commercial banks?

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Answer

Commercial banks are one of the most important types of financial institutions in an economy. They work by accepting deposits from customers and using those deposits to make loans.

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How do commercial banks get their money?

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Commercial banks get their money from customer deposits.

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How do commercial banks make profit?

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Banks make profits buy providing lower interest rates on deposits and charging higher interest rate on loans.

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What are the main functions of commercial banks?

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  • Guaranteeing safe deposits.
  • Providing interest on deposits.
  • Offering loans.
  • Other financial services.

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Why deposits on commercial banks are considered to be safe?

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Answer

The central bank of a country serves as a lender of last resort for commercial banks. In case, anything would happen the Bank of England would step in and guarantee you get your money back.

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Why is interest earned on deposits important during times of inflation?

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To keep the actual worth of your money intact.

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When does commercial banking become more profitable?

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Commercial banking becomes more profitable when banks lend money to businesses and individuals and there’s a wide difference between the interest charges on loans and deposits.

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Mention some of the other financial services a commercial bank offers.

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-Enabling clients to access cash in a matter of seconds, by just going to an ATM. 

-Allowing and facilitating international payments to pay for goods and services you might want to receive from other countries. 

-Offer financial advice for your retirement fund or any other financial matter you might need advice on.

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What is a balance sheet of a commercial bank?

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Answer

The balance sheet of a commercial bank provides an overall overview of how well the bank is operating.

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What does a balance sheet of a commercial bank contain?

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Assets and liabilities.

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How are assets and liabilities displayed on a commercial bank's balance sheet?

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In a balance sheet, assets and liabilities are displayed on the right-hand side and left-hand side, respectively.

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What are the assets of a commercial bank?

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A commercial bank generates revenue and profit through its assets.

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What are liabilities for a commercial bank?

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Liabilities are those items that the bank owes to other parties.

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Why are commercial banks required to keep a portion of their customer deposits?

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To ensure that the bank has enough money in case a client wants to withdraw their funds.

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What's one of the most important liabilities on a bank's balance sheet?

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Interested owed to customer deposits.

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Mention some examples of the largest commercial banks in the UK.

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HSBC, Barclays, Lloyds Banking group, and NatWest groups.

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What role do commercial banks play in the economy?

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Answer

Providing financing to businesses and individuals which enables them to perform activities such as opening up a startup or buying a house.

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Serving the financial needs of their customers is commercial banks' ___________.

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primary function

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When depositing money in commercial banks, you are rewarded with ___________

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interest

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What happens when you earn an interest of 3% in your earnings and inflation increases to 4%?

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You would be losing money in real terms

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___________ of a commercial bank provides an overall overview of how well the bank is operating. 

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The balance sheet 

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Liabilities are those items that the bank ___________

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owes to other parties. 

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One of the main and first items that can be found on the liabilities side is  ___________

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the bank's share capital.

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HSBC, Barclays, Lloyds Banking group, and NatWest groups are examples of ___________

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commercial banks

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Banks make a profit on the interest they charge for mortgages, vehicle loans, company loans, and personal loans.

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True

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Banks maximise profits by paying ___________ interest on deposits and charging ___________ interest on loans. 

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low, higher

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