Financial markets: Investment and commercial banks

What is a commercial bank?

Banks that provide retail banking services to household and business customers

What is an investment bank?

A bank that specialise in services for companies and high net worth investors related to capital markets

How do investment banks make profit?

• Underwriting securities offerings - purchase securities from issuer at discounted price then sell to public at a higher price

• Mergers and Acquisitions - advisory services to companies involved in M&A and charge fees for

• Trading and sales

What are private banks?

Banks that provide wealth management services to high net worth individuals

What are building societies and their main assets and liabilities?

These are owned by their members/customers not shareholders

Assets: Loans and advances to customers

Liabilities: Shares (customer deposits), debt securities

What are the main objectives of commercial banks?

Generating profit while managing liquidity and security

How do commercial banks make profit?

Charging a higher interest rate on loans/assets than it pays back on deposits or other liabilities

Borrowing short term and lending long term

Taking more risk

What are the main functions of a commercial bank?

• Accepting deposits

• Providing loans

• Payment services

• Safekeeping of valuables

• Currency exchange

What is the balance sheet of a commercial bank before lending

Assets: Currency, reserves, loans and advances, investments

Liabilities: Deposits, borrowing, capital (reserves and shareholder funds )

Why is a loan an asset

It represents a legal right to receive future payment from the borrower - owned by the bank

Why are deposits a liability

They are a record of how much the bank owes its customers

What is the balance sheet of a commercial bank after lending?

Assets: New loans, currency, reserves, loans and advances, investments

Liabilities: New deposits, deposits, capital

What is credit

A financial agreement allowing someone to borrow money now with a promise to repay it later

What is the availability of credit

Amount of money someone can still borrow/spend on a line of credit

What is a credit rate

The cost of borrowing money determined by someone’s reliability to repay debt

How does high availability of credit affect aggregate demand

• Lower borrowing costs. So loans are cheaper

• Increased spending power

• Businesses can expand operations

• Inflated asset prices = more wealth

How do commercial banks create credit?

• Agreeing loans to businesses and households - when banks make a loan or business take out a loan, it credits their bank account with a deposit the size of the loan

• Fractional reserve system - Required to hold only a fraction of their deposits as cash/liquid reserves and can lend out the rest

• Money multiplier - When banks lends out a portion of funds deposited with them, these funds are deposited to other banks

How can a commercial bank fail

• A liquidity crisis leading to a bank run

• Lack of capital leading to insolvency

Explain how a liquidity crisis can make a bank fail

If the bank does not have enough short term assets (like cash) to cover its short term liabilities (like deposits) it might not meet immediate demand. They may need to sell long term assets and borrow at high interest rates

What is a bank run

When too many depositors want their money back at once which can lead to bank failure

How can a lack of capital cause a bank to fail

They can’t offset any losses in asset values. Liabilities are greater than assets.

What is systemic risk

When one bank failure causes a ripple effect for other banks, e.g. if the bank that failed owed another bank money that they now can’t pay

What are the consequences of bank failure

• Systemic risk

• Recession

• Lost jobs, output and income

• Bank bailouts