The roles and types of commercial banks

Commercial banks play a central part in the economy by managing money flows and supporting various financial activities for individuals and businesses.

Core functions of commercial banks

• Accepting savings - Banks take deposits from customers, providing a safe place to store money while often paying interest.
• Acting as financial intermediaries - They channel funds from savers (lenders) to those who need money (borrowers), helping to match supply and demand for finance.
• Providing loans - Banks lend money to individuals and businesses for purposes such as buying homes, expanding operations, or investing in equipment.
• Facilitating payments - They enable transfers of money between different parties, including through cheques, electronic transfers, and card payments.

Additional services offered by commercial banks

• Insurance products to protect against risks like theft or accidents.
• Financial advice on topics such as investments, retirement planning, or debt management.

Divisions within commercial banking

• Retail banking - Focuses on individuals and small businesses, such as local shops or restaurants, offering services like personal accounts, small loans, and basic financial products.
• Wholesale banking - Caters to larger companies, handling bigger transactions, corporate loans, and complex financial needs.

How commercial banks support business growth

• Offering loans to fund expansion, new projects, or working capital.
• Providing expert financial advice to help businesses make informed decisions.
• Assisting with international trade through services like foreign exchange and letters of credit.

The functions of investment banks

Investment banks differ from commercial banks by focusing on capital markets and corporate finance rather than everyday deposits and loans.

Key roles of investment banks

• Arranging share and bond issues - They help firms raise capital by issuing new shares or bonds to investors.
• Advising on finance and corporate actions - Providing guidance on how to secure funding, as well as on mergers, acquisitions, or other strategic moves.
• Handling securities transactions - Buying and selling shares, bonds, or other securities on behalf of clients.
• Acting as market makers - For specific securities, they maintain a market by buying and selling them directly, allowing trades without relying on a stock exchange.

High-risk activities in investment banking

Investment banks often engage in proprietary trading, where the bank uses its own funds to buy and sell shares or other assets in pursuit of profits. This activity carries greater risk but offers potential for high rewards.

Risks of combining commercial and investment banking

Many large banks operate both commercial and investment divisions, which can create significant challenges for the financial system.

Systemic risks from combined operations

• Blending of activities - Major international banks often combine retail deposit-taking with high-risk investment activities, potentially exposing the entire institution to volatility.
• Use of customer deposits - Funds from commercial banking (like savers' deposits) may be used to finance investment banking, putting depositors' money at risk if investments fail.
• Potential for widespread collapse - This integration can lead to systemic risk, where problems in one area threaten the stability of an entire market or the global financial system.

Other financial institutions including pension funds and insurance firms

Beyond banks, various institutions provide essential financial services that support long-term investment and risk management in the economy.

Pension funds

Pension funds manage savings for retirement, pooling contributions from workers and employers. They invest these funds in assets like shares or property to grow the value over time. Upon retirement, the accumulated funds are paid out, often as regular income. Pension funds offer large-scale, long-term capital to companies, helping them expand or innovate.

Insurance firms

Insurance companies help manage uncertainty by offering protection against potential losses. They charge premiums to cover risks such as property damage, health issues, or business interruptions. This coverage is vital for the economy, as it allows businesses to trade confidently, knowing they can insure against events like customers failing to pay debts.

Hedge funds, private equity firms, and the shadow banking system

Certain financial entities operate with less oversight, providing alternative investment options but introducing additional risks to the system.

Hedge funds

Hedge funds pool money from multiple investors to seek high returns. They invest across diverse markets, using strategies like short-selling or derivatives. While aiming for strong profits, their light regulation can pose dangers to investors and the broader economy if strategies fail.

Private equity firms

Private equity firms focus on buying and improving businesses for profit. They invest directly in companies, often taking control to enhance performance before selling them at a higher value. This can help firms grow and succeed, but critics argue it sometimes involves asset-stripping (selling off valuable parts) or job cuts to maximise short-term gains.

The shadow banking system

The shadow banking system consists of unregulated financial activities and institutions that provide credit outside traditional banking. It includes entities like hedge funds and private equity firms, as well as unregulated operations by otherwise regulated banks.

Key characteristics:

• This system has expanded rapidly, supplying a growing share of credit to the economy.
• Risks arise from the lack of regulation, no access to emergency support (like that available to regular banks), and its vast but opaque size.
• These factors could contribute to financial crises if problems emerge.