Select your language

Suggested languages for you:
Log In Start studying!
StudySmarter - The all-in-one study app.
4.8 • +11k Ratings
More than 3 Million Downloads
Free
|
|

All-in-one learning app

  • Flashcards
  • NotesNotes
  • ExplanationsExplanations
  • Study Planner
  • Textbook solutions
Start studying

Banks

Save Save
Print Print
Edit Edit
Sign up to use all features for free. Sign up now
Banks

Imagine a world without banks. Where would you borrow money? Would you be able to save as much as you need and when you need it? What risks would you face?

This explanation will help you understand the banking system and the purpose of banks in your economic life. You will also learn about the different types of banks and alternative forms of financial institutions and finally understand certain terms you come across every day.

The economic importance of banks

Banks have a very important role in an economy as they provide both individuals and companies with a range of financial services. Routine banking activities such as deposits or withdrawals may be carried out using a range of account types, such as checking or savings accounts.

But in addition, banks provide personal and business borrowers access to credit. Deposits made by individuals are used to lend long-term debt, such as credit cards and mortgages.

A bank’s ultimate purpose, like that of every other company, is to maximise its profit. Banks achieve this by charging borrowers higher interest rates on loans and other debt compared to the interest paid on deposits.

Shareholders of a bank that pays 2% interest on deposits and 6% on loans make a 4% gross profit for the company.

Banking is very important for the UK economy. It’s a sector that expands beyond the UK borders. Three UK based banks - HSBC, Barclays and Lloyds Banking group- are not only the largest but also rank among the top ten banks in Europe in terms of market capitalisation. The leading three banks have a market capitalisation of approximately $30 billion while the largest among these is HSBC with a market share of over $107 billion.

A bank is a financial institution that is involved in borrowing and lending money.

Functions of banks

There are multiple functions of banks. The most important ones include:

  • Safety deposits: banks are a relatively secure place to deposit money and safeguard assets while earning some interest on these deposits.
  • Interest on deposits: commercial banks pay interest on deposits that differ based on the type of account. For current accounts, this rate may be significantly lower compared to savings accounts. During inflation, interest rates are very important for maintaining the real value of your savings. For example, a 4% inflation rate will decrease the value of you savings. However, if banks are paying an interest rate of 6% then the real value of your savings will increase.
  • Loans: lending money is an important source of banks’ profit. Banks use the deposits to lend money to worthy individuals and businesses for investment or expansion. For example, if a bank pays 4% on deposits but lends money at 8%, the difference makes up the profit for the bank. Banks need to keep sufficient liquidity to meet the demands of the customers to withdraw their money.
  • Credit creation: banks can regulate money supply or create credit with the deposits of the customers by advancing them as loans while adhering to some regulatory requirements.
  • Other services: banks also provide miscellaneous services to customers: ATMs, advice on financial matters, international money transfers, and a range of other services, insurance and safety lockers for keeping tangible assets such as jewellery, important documents, etc.

Types of banks

There are two main types of banks: commercial and investment banks. One of the main differences between the two is that commercial banks take deposits from their customers, whereas investment banks do not take deposits. Investment banks’ main role is to help companies and governments to gather funds by issuing securities.

Commercial banks

Commercial banks or high street banks are financial institutions that cater to individuals and businesses and offer services such as accepting deposits, loans, checking accounts, and other basic banking services.

A few examples of commercial banks in the UK are Barclays, HSBC, and Lloyds bank.

Commercial banks have multiple networks of branches mostly located in prime locations such as a city’s high street or near shopping centres. However, with the development of electronic banking, these banks now operate mostly online.

These types of banks play an important role in the economy. They provide funding for individuals and enterprises in case one wants to buy a house or expand a company. This then leads to an increase in transactions in the economy which contributes to economic growth.

Government agencies and central banks closely monitor commercial banks’ activities. If large commercial banks were to go bankrupt, it would trigger a severe economic crisis.

Keep in mind that these banks hold the majority of your savings and if not managed properly, you could end up losing your entire wealth.

To learn more about the different functions of a commercial bank check our explanation on Commercial Banks.

Investment banks

As we said before, investment banks serve different roles than commercial banks. One of the main roles of an investment bank is to intermediate sophisticated transactions for large companies or governments.

When Apple first went public in 1980, it hired Morgan Stanley, a global investment bank, to help them with their initial public offering (IPO).

Other roles investment banks play also include mergers and acquisitions, offering advice to their clients such as pension funds. Some of the largest and most well-known investment banks are Goldman Sachs, JP Morgan Chase, and Citigroup.

Many of these banks also offer storefront community banking and have divisions that cater to the investment needs of high-net-worth individuals.

The main difference between an investment bank and a commercial bank is that investment banks do not take deposits. Investment banks either advise clients or help them accumulate funds through issuing securities.

As many banks are engaged in both commercial and investment banking activities, this may increase the systemic risk in the financial system.

Banking regulations in the UK

The central bank of the United Kingdom is deeply concerned with maintaining a sound and stable financial system. Besides ensuring that individuals' savings are protected, their goal is to also create an efficient and trust-based financial system.

Imagine not being able to withdraw funds from your checking accounts due to credit card payments being declined as a result of the bank’s bankruptcy.

One of the main goals of banking regulation is to prevent banks from taking huge risks. Reserve requirements and limits on the investment a bank may undertake are some examples. Banks must retain a minimum proportion of their deposits in reserves to support depositor requests for withdrawals.

The difference between a bank’s assets and liabilities, known as bank capital, is also another tool that financial regulators use to keep banks in check. To avoid bankruptcy, a bank has to have a positive net value; otherwise, it would be unable to pay the depositors back. Banks are required by law to maintain a certain level of net worth in order to safeguard their customers and other creditors.

One of the main regulatory bodies in the UK is the Financial Conduct Authority (FCA). It ensures that financial institutions in the UK comply with rules and regulations that create an efficient financial ecosystem.

To learn more about how banks are regulated check our explanation on the Regulation of Financial System.

Profitability, liquidity and risk in banks

Liquidity is the ability of banks to turn reserve assets into cash. Liabilities are payable on demand, and to maintain profitability banks must have cash and liquid assets. However, banks are often met with the problem of either maintaining liquidity or focusing on making profits. This is because higher liquidity yields lesser profits. Hence, it is important to strike a balance between the two objectives.

Assets in commercial banks are liquid to different extents. Cash is the most liquid asset, followed by deposits. Loans and long term bonds are the least liquid assets. If banks can borrow easily and cheaply, they are likely to keep fewer liquid assets. The more expensive and difficult it is to get a loan, the more liquid assets are likely to be kept.

Banks need to maintain profitability to pay their depositors interest on their money, wages, and to keep working capital for the bank. Holding funds in cash means profitability is limited. However, banks usually must prioritise liquidity and safety over profits, and it is considered a supplement for the survival of the bank.

Banks - Key takeaways

  • A bank is a financial institution that is involved in borrowing and lending money.
  • Banks play a critical role in the economy by providing both individuals and companies with a range of important financial services.
  • Government agencies and central banks closely monitor commercial banks' activities due to the important role they play in an economy.
  • There are two main types of banks: commercial and investment banks.
  • Commercial banks or high street banks are financial institutions that cater to individuals and businesses and offer services such as accepting deposits, loans, checking accounts, and other basic banking services.
  • One of the main roles of an investment bank is to intermediate sophisticated transactions for large companies or governments.
  • One of the main goals of banking regulation is to prevent banks from taking huge risks.
  • Liquidity is the ability of banks to turn reserve assets into cash. Banks need to maintain profitability to pay their depositors interest on their money, wages and keep working capital for the bank.

Frequently Asked Questions about Banks

  • Keep money safe for customers.
  • Offer customers interest on deposits, helping to protect against money-losing value against inflation.
  • Lending money to firms, customers, and homebuyers.
  • Offering financial advice and related financial services, such as insurance.

There are three types of banks in any economy.

  • Central bank
  • Commercial banks
  • Investment banks

Commercial banks are important to the economy because they create capital, credit, and maintain liquidity in the market. They ensure liquidity by taking their customers' deposits and lending them out to others, thus creating credit which leads to an increase in production, employment, and consumer spending, thereby boosting economic growth. 

Commercial banks are heavily regulated by the central bank. For instance, central banks impose reserve requirements on commercial banks. This means that banks are required to reserve a certain percentage of their deposits at the central bank as a cushion in case the general public needs to withdraw a large number of funds. 

Private equity is composed of funds and investors that directly invest in private companies, or engage in buyouts of public companies.

Banks create credit through the process of taking deposits and advancing loans. They maintain a certain percentage of reserves as security for heavy demand for liquid cash. The remaining of this reserve is advanced out for lending to the general public. 


This is based on the creation ability of one bank. In the real world, multiple banks create credit based on the initial deposit and initial reserves and through the same principle are able to expand the credit limit and thereby create extra deposits in the economy.

Banks are characterised by balancing liquidity, profitability, and risk. Liquidity refers to the reserves a bank needs to maintain in terms of liquid cash to fulfill heavy loan demands. Profitability is when this liquid reserve is advanced for loans and the interest charged can be treated as profits for the bank. 


It is important to balance the liquidity and profitability aspect of the bank in order to survive, especially with risks of advancing loans involving defaulters that could affect the balance sheet for the banks. 


Banks face risks and uncertainties about how much cash they can get and whether loans will be repaid or not. Banks, therefore, have to try and maintain the safety of their assets. 

Final Banks Quiz

Question

Define what a bank is.

Show answer

Answer

A business that makes its profit by paying interest to people who keep money there and charging a higher rate of interest to borrowers who borrow money from the bank.

Show question

Question

What are the two types of banks?

Show answer

Answer

Commercial and investment banks.

Show question

Question

What are bank reserves?

Show answer

Answer

Money and liquid assets (such as securities that can be sold quickly) held by banks in order to meet withdrawals by customers

Show question

Question

What do you understand by private equity?

Show answer

Answer

Investments in private companies, buyouts of private shares for the purpose of funding new technology, make acquisitions, expand working capital, adn to bolster and solidify a balance sheet.

Show question

Question

Name some of the functions of banks.

Show answer

Answer

Safety deposits

Interest on deposits

Loans

Credit creation

Other services such as financial advice or enabling monetary transactions

Show question

Question

Why are banking regulations important for an economy?

Show answer

Answer

Because if banks get involved into too much risk it might trigger economic crisis.

Show question

Question

Name the most important financial regulator in the UK.

Show answer

Answer

One of the main regulatory body in the UK is the Financial Conduct Authority (FCA). It ensures that financial institutions in the UK comply with rules and regulations that create an efficient financial ecosystem.

Show question

Question

What's one of the main banking regulations?

Show answer

Answer

Banks have to keep a certain portion of their deposits in their reserves.

Show question

Question

Banks have a very important role in an economy as they provide both individuals and companies with a range of ___________

Show answer

Answer

 financial services

Show question

Question

Banks provide personal and business borrowers access to ___________


Show answer

Answer

credit

Show question

Question

A bank’s ultimate purpose, like that of every other company, is to maximise its ___________.

Show answer

Answer

profit

Show question

Question

Shareholders of a bank that pays 2% interest on deposits and 6% on loans make a ___________ gross profit for the company.

Show answer

Answer

4%

Show question

Question

A bank is a financial institution that is involved in ___________ money.


Show answer

Answer

borrowing and lending 

Show question

Question

The function of the bank that involves depositing money and safeguarding assets is called ___________

Show answer

Answer

Safety deposits

Show question

Question

Banks can regulate money supply or create credit with the deposits of the customers.

Show answer

Answer

True

Show question

Question

Banks use the ___________ to lend money to worthy individuals and businesses for investment or expansion.

Show answer

Answer

deposits

Show question

Question

The two main types of banks are commercial banks and ___________


Show answer

Answer

investment banks

Show question

Question

Who can monitor the activity of commercial banks?

Show answer

Answer

Government agencies and central banks

Show question

Question

If large commercial banks were to go bankrupt, it would trigger a severe economic crisis.

Show answer

Answer

True

Show question

Question

One of the main roles of ___________ is to intermediate sophisticated transactions for large companies or governments. 

Show answer

Answer

investment bank

Show question

Question

One of the main goals of banking regulation is to prevent banks from taking huge risks. 

Show answer

Answer

True

Show question

Question

Reserve requirements and limits on the investment a bank can prevent banks from ___________

Show answer

Answer

taking huge risks

Show question

Question

Banks must retain a minimum proportion of their deposits in reserves to support depositor requests for withdrawals. These are called ___________

Show answer

Answer

Reserve requirements

Show question

Question

The difference between a bank’s assets and liabilities is called ___________

Show answer

Answer

bank capital

Show question

Question

___________ is the ability of banks to turn reserve assets into cash. 


Show answer

Answer

Liquidity

Show question

Question

Cash is the most liquid asset. 




Show answer

Answer

True

Show question

Question

Loans and long term bonds are ___________ liquid assets.


Show answer

Answer

the least

Show question

Question

Banks need to maintain ___________ to pay their depositors interest on their money.

Show answer

Answer

profitability

Show question

Question

banks usually must prioritise liquidity and safety over profits.

Show answer

Answer

True

Show question

Question

The main difference between an investment bank and a commercial bank is that investment banks ___________

Show answer

Answer

do not take deposits. 

Show question

60%

of the users don't pass the Banks quiz! Will you pass the quiz?

Start Quiz

Discover the right content for your subjects

No need to cheat if you have everything you need to succeed! Packed into one app!

Study Plan

Be perfectly prepared on time with an individual plan.

Quizzes

Test your knowledge with gamified quizzes.

Flashcards

Create and find flashcards in record time.

Notes

Create beautiful notes faster than ever before.

Study Sets

Have all your study materials in one place.

Documents

Upload unlimited documents and save them online.

Study Analytics

Identify your study strength and weaknesses.

Weekly Goals

Set individual study goals and earn points reaching them.

Smart Reminders

Stop procrastinating with our study reminders.

Rewards

Earn points, unlock badges and level up while studying.

Magic Marker

Create flashcards in notes completely automatically.

Smart Formatting

Create the most beautiful study materials using our templates.

Just Signed up?

Yes
No, I'll do it now

Sign up to highlight and take notes. It’s 100% free.