Commercial bank: a firm that accepts deposits, lends money and provides payment services for profit.
Financial intermediary: an institution that channels funds from savers to borrowers.
Interest margin: the gap between the interest a bank charges borrowers and the interest it pays depositors.
What Commercial Banks Do
- A commercial bank accepts deposits, makes loans and runs the payment system for households and firms.
- It acts as a financial intermediary, channelling savers' deposits to borrowers.
- Its profit comes mainly from the interest margin, charging borrowers more than it pays depositors.
- In doing so it must balance three competing objectives: liquidity, security and profitability.
- Banks turn deposits into loans as intermediaries.
- Profit comes from lending at a higher rate than is paid on deposits.
- No bank can maximise liquidity, security and profitability at once.
Providing Deposit Accounts
Demand deposit account: a current account whose funds can be withdrawn on demand and used for payments.
Savings account: an account holding funds for longer and paying interest, with access sometimes restricted.
- A current account lets a household receive £2,000 wages and pay bills instantly, so it is liquid but pays little interest.
- A savings account holds funds longer and pays interest, say 4% a year, in return for less easy access.
- Deposits are liabilities of the bank, because it owes that money back to customers.
- Offering both lets a bank attract cheap, stable funds it can then lend at a higher rate.
Lending Money
Overdraft: a facility to borrow up to an agreed limit on a current account, repayable flexibly.
Loan: a fixed sum advanced by a bank, repaid with interest over an agreed period.
- An overdraft suits short-term needs, since interest is charged only on the amount actually used.
- A loan suits larger, planned spending, say £10,000 for a van, repaid in fixed instalments.
- Loans are assets of the bank, because borrowers owe it the money plus interest.
- Lending is the main income source but carries default risk, so banks screen borrowers carefully.
What a Bank Holds
- A bank holds cash and central-bank reserves so it can always meet withdrawals.
- It holds securities such as government bonds and Treasury bills, which are fairly liquid and earn a return.
- It holds loans to customers and deposits with the central bank or other banks.
- It also holds equity (capital) and can help firms raise equity finance by issuing shares.
- A bank's assets range from very liquid cash to less-liquid loans.
- More liquid assets are safer but earn less.
- The chosen asset mix reflects the bank's balance of objectives.
Reserve Ratio and Capital Ratio
Reserve ratio: the proportion of deposits a bank holds as liquid reserves rather than lending out.
Capital ratio: the ratio of a bank's capital to its risk-weighted assets, showing its buffer against losses.
- Suppose a bank holds £10m of reserves against £100m of deposits.
- So 10% of deposits stay liquid to meet withdrawals, leaving 90% to lend for profit.
- A higher reserve ratio raises liquidity and security, but leaves less to lend, so profit falls.
- The capital ratio instead measures solvency, the buffer that absorbs losses on assets.
- A higher capital ratio lets a bank survive bad debts, so it is more secure.
- Regulators set minimum ratios, for example under Basel rules, to keep the banking system stable.
Liquidity, Security, Profitability
Liquidity: holding enough readily spendable assets to meet withdrawals on demand.
Security: limiting risk by lending prudently and holding safe assets.
Profitability: earning a return, mainly by lending at higher interest than is paid on deposits.
- The most profitable assets, such as long-term loans, are the least liquid and least secure.
- Holding more cash raises liquidity and security but sacrifices interest income, so profit falls.
- So a bank trades off liquidity and security against profitability and cannot maximise all three.
- It depends on conditions: in a downturn banks favour liquidity and security; in a boom they chase profit.
- Distinguish deposit accounts, lending and the bank's asset holdings.
- Define the reserve ratio and the capital ratio precisely and keep them apart.
- Explain why liquidity, security and profitability conflict, using an example.
- Do not confuse the reserve ratio (liquidity) with the capital ratio (a loss-absorbing buffer).
- Do not assume a bank can maximise liquidity, security and profitability at once.
- What is the difference between a demand deposit account and a savings account?
- How does an overdraft differ from a loan?
- What is the reserve ratio?
- What is the capital ratio?
- Why do the objectives of liquidity, security and profitability conflict?
