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.
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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.
A picture of the Bank of England from around 1865–95
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.
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