2.4.2a Commercial and investment banks: functions (A-level only)
A Commercial Bank Takes Deposits, Lends and Balances Liquidity, Profitability and Security
Definition
Commercial bank: a financial institution that accepts deposits from and makes loans to households and firms and provides payment services, with the aim of making a profit.
- A commercial bank accepts deposits, lends and provides payment services.
- It differs from an investment bank, which mainly trades securities and advises firms.
- Many large banks are universal banks that carry out both commercial and investment banking, which can increase systemic risk if losses on trading threaten ordinary deposits.
- Its three objectives are liquidity, profitability and security.
- These objectives conflict and cannot all be maximised at once.
Note
- Liquid assets are safe but earn little.
- Profitable loans are less liquid and more risky.
- So a bank must trade off liquidity against profitability.
A Commercial Bank Accepts Deposits, Lends and Provides Payment Services
- It accepts deposits from savers.
- It lends to households and firms.
- It provides payment and other services.
- It earns profit mainly from the margin between lending and deposit rates.
Example
- A high street bank takes deposits and makes mortgage loans.
- It keeps some funds as reserves to meet withdrawals.
- It lends the rest to earn interest.
The Balance Sheet Sets Assets Against Deposit Liabilities
- Assets include reserves, loans and other holdings.
- Liabilities include the deposits the bank owes.
- The reserve ratio is the share of deposits held as reserves.
- The capital ratio measures the buffer that absorbs losses.
Example
- Worked example: suppose a bank holds £1,000m of customer deposits, which are a liability because it owes the money back.
- It keeps £100m as cash reserves and lends out £900m, so its reserve ratio is 1001,000=10%\dfrac{100}{1{,}000} = 10\%1,000100=10%.
- On the balance sheet, assets are £100m\pounds 100\text{m}£100m reserves plus £900m\pounds 900\text{m}£900m loans =£1,000m= \pounds 1{,}000\text{m}=£1,000m, which equals liabilities of £1,000m deposits, so the two sides always balance.
Case study
- Holding more reserves raises liquidity but lowers profit.
- Lending more raises profit but leaves the bank less liquid.
- A larger capital ratio makes the bank safer in a downturn.
A Bank Cannot Maximise Liquidity, Profitability and Security at Once
- Holding liquid, safe assets sacrifices profit.
- Chasing profit through lending sacrifices liquidity and security.
- So the bank must strike a balance between the three.
- No bank can maximise all three objectives together.
Stress the Trade-Off Between the Objectives
Exam technique
- List the functions, then the three objectives.
- Explain why liquidity and profitability conflict.
- Refer to the reserve and capital ratios on the balance sheet.
Common Mistake
- Do not assume a bank can maximise profitability and liquidity at the same time.
- The objectives conflict and must be traded off.
Self review
- Name the functions of a commercial bank.
- How does it differ from an investment bank?
- What are the main items on its balance sheet?
- What is the reserve ratio?
- Why do the objectives conflict?
2.4.2b Bank objectives and credit creation (A-level only)
A Commercial Bank Balances Liquidity, Profitability and Security, and These Conflict
Definition
Credit creation: the process by which commercial banks make loans and thereby create new deposits, expanding the money supply by more than the original cash deposit.
- A commercial bank pursues three objectives: liquidity, profitability and security.
- Liquidity means holding enough readily available funds to meet withdrawals.
- Profitability means earning a return, mainly by lending at higher rates than it pays depositors.
- Security means keeping assets safe by limiting risky lending.
Note
- Liquid assets are safe but earn little.
- Profitable loans are less liquid and carry more risk.
- So the three objectives conflict and cannot all be maximised at once.
The Three Objectives Pull Against One Another
- Holding liquid, low-risk assets sacrifices profit.
- Lending more to raise profit reduces both liquidity and security.
- A bank must balance the three rather than maximise any one.
- This trade-off shapes every lending decision.
Example
- Keeping large cash reserves is safe and liquid but earns almost nothing.
- A long-term loan is profitable but ties up funds and risks default.
- Banks hold a mix of assets to balance the three objectives.
Banks Create Credit by Lending Out a Fraction of Each Deposit
- Credit creation is how banks turn deposits into a larger stock of money.
- Banks keep only a fraction of deposits as reserves and lend the rest.
- The money lent is re-deposited and lent again across the system.
- So an initial deposit multiplies into a larger expansion of deposits.
Note
- The credit multiplier is 1reserve ratio\dfrac{1}{\text{reserve ratio}}reserve ratio1.
- A smaller reserve ratio gives a larger multiplier.
- It is the banking system, not one bank, that multiplies deposits.
Lending Is Re-Deposited and Lent Again Through the System
- A bank receives a deposit and keeps part as reserves.
- It lends the rest, which is spent and re-deposited elsewhere.
- The next bank keeps a fraction and lends again.
- Each round adds less, and the total settles at a multiple of the first deposit.
Example
- Worked example: with a 10% reserve ratio, a new £1,000 deposit lets the first bank keep £100 and lend £900.
- That £900 is spent and re-deposited, so the next bank keeps £90 and lends £810; the round after keeps £81 and lends £729, and so on.
- The deposits (1,000+900+810+729+…1{,}000 + 900 + 810 + 729 + \dots1,000+900+810+729+…) sum to £10,000, matching the multiplier of 10.1=10\dfrac{1}{0.1} = 100.11=10.
- So the initial £1,000 of cash supports £10,000 of deposits, of which £9,000 is new credit created by the banking system.
Example
- With a reserve ratio of 10 per cent, the multiplier is 10.1=10\dfrac{1}{0.1} = 100.11=10.
- An initial £1,000 deposit can support up to £10,000 of deposits.
- A reserve ratio of 20 per cent would give a multiplier of only 10.2=5\dfrac{1}{0.2} = 50.21=5.
Reserve Requirements, Loan Demand and Caution Limit Credit Creation
- A higher reserve requirement lowers the multiplier.
- Weak demand for loans limits how much is borrowed.
- A cautious bank may choose not to lend fully.
- So the full multiplier is a maximum, not a guarantee.
Case study
- Quantitative easing adds reserves to encourage more lending.
- After 2008, cautious banks and weak demand held credit creation back.
- So extra reserves did not multiply into lending as much as expected.
The Multiple Appears Across the System, Not in One Bank
- A single bank can lend only a little more than its spare reserves.
- The multiple appears only across the whole banking system.
- Each bank passes lending on to the next as new deposits.
- So credit creation is a system-wide result.
Show the Working
Exam technique
- Compute the multiplier as 1reserve ratio\dfrac{1}{\text{reserve ratio}}reserve ratio1.
- Multiply the initial deposit by the multiplier for the total.
- State the limits set by demand and the willingness to lend.
Common Mistake
- Do not think a single bank can lend a multiple of its deposits.
- The multiple arises across the whole banking system.
Self review
- What are the three objectives of a commercial bank?
- Why do liquidity, profitability and security conflict?
- What is credit creation, and what is the credit multiplier formula?
- Name two limits to credit creation.
- Why can one bank not lend a multiple of its deposits?
