The roles of commercial and investment banks

Commercial and investment banks play distinct but sometimes overlapping roles in the financial system, supporting individuals, businesses, and the wider economy through various services.

Commercial banks

Commercial banks, such as TSB or NatWest, focus on everyday banking needs. They receive deposits from customers, providing a safe place to store money, and act as financial intermediaries by channelling funds from savers (lenders) to those who need money (borrowers).

Key functions of commercial banks:

• Providing loans - They offer lending to individuals and businesses for purposes like buying homes or expanding operations.
• Facilitating payments - They enable transfers of money between people or organisations, such as through cheques or electronic payments.

Commercial banks also deliver additional services, including insurance products and guidance on personal finances.

Divisions within commercial banking

Commercial banking is divided into two main categories to serve different customer groups:

• Retail banking - Targets individuals and small businesses with services like current accounts, savings options, and home loans. These are commonly known as high street banks due to their widespread branch presence.
• Wholesale banking - Handles the needs of larger corporations, such as managing substantial transactions or international dealings. Historically, the term 'commercial banking' sometimes referred specifically to this wholesale side.

Commercial banks support business expansion by supplying credit, offering expert advice, and aiding with global trade activities.

Investment banks

Investment banks differ from commercial banks as they do not accept customer deposits. Instead, they specialise in capital market activities.

Key functions of investment banks:

• Arranging share and bond issues - They help companies raise funds by organising the sale of securities like stocks or debt instruments.
• Providing advice - They offer guidance on securing finance, as well as on company mergers and takeovers.
• Trading securities - They purchase and sell assets such as shares and bonds for clients.
• Acting as market makers - They facilitate easier trading of securities by providing a platform where buyers and sellers can trade without relying on a formal stock exchange.

Investment banks also participate in high-reward but high-risk activities, such as proprietary trading, where they use their own funds to buy and sell shares for profit.

Overlap between commercial and investment banking

Many major banks, like Barclays or HSBC, function in both commercial and investment capacities.

This dual operation can introduce systemic risk, where issues in one area affect the entire financial system. For instance, banks might use customer deposits from commercial activities to finance risky investment ventures. If those investments fail, it could endanger depositors' funds and potentially lead to broader market instability or collapse.

Other types of financial institutions and the shadow banking system

Beyond banks, various financial institutions operate in global markets, each contributing to economic functions like investment, risk management, and credit provision. Some of these form part of the unregulated shadow banking system, which poses unique challenges.

Examples of non-bank financial institutions

• Pension funds - These gather contributions from individuals' retirement savings and invest them in assets like securities. Upon retirement, they distribute the original savings plus any investment gains. They also channel large, long-term funds into businesses.
• Insurance firms - They collect premiums from customers to cover risks, such as property damage or non-payment by clients. This supports economic activity by encouraging trade, as businesses can protect against uncertainties.
• Hedge funds - These pool money from multiple investors to seek high returns across various markets. While diversification is common, their light regulation and pursuit of aggressive profits can create risks for investors and the economy.
• Private equity firms - They acquire stakes in companies, aiming to maximise returns, often by improving operations for resale at a profit. However, they face criticism for practices like asset-stripping, where a company's valuable assets are sold off, or for reducing staff numbers to cut costs.

The shadow banking system

The shadow banking system consists of unregulated financial intermediaries and the unregulated operations of otherwise regulated entities. It has expanded significantly, though its exact size is unclear due to limited oversight.

Features of the shadow banking system:

• Components - Includes entities like hedge funds and private equity firms.
• Role in credit supply - It provides a growing share of loans and financing outside traditional banking.
• Associated risks - Without regulation, it lacks emergency support available to standard banks. Its large but opaque scale increases the potential for triggering financial crises, as problems can spread quickly without safeguards.

Different levels of liquidity in money

Money serves key functions in the economy, but its forms vary in how easily they can be used for transactions. Liquidity measures this ease of conversion into spendable forms.

Money and liquidity

Any asset that fulfils money's core roles—such as acting as a medium of exchange, store of value, unit of account, and standard of deferred payment—while being portable, widely accepted, hard to counterfeit, and long-lasting, counts towards the money supply.

Liquidity describes how readily an asset can be spent. For example, notes and coins are highly liquid, as they can be used immediately. Assets like shares or property are illiquid, requiring sale into cash before use.

Narrow and broad definitions of money

Economists classify money based on liquidity levels, which also apply to the overall money supply:

• Narrow money - Includes only highly liquid items, such as physical currency in circulation and reserves held at a central bank.
• Broad money - Encompasses narrow money plus less liquid assets, like certain bank deposits or short-term securities.

How banks balance profitability, liquidity, and risk

Banks must manage competing priorities to remain viable, weighing the need for profits against the demands of liquidity and the dangers of risk.

Balancing profitability and liquidity

• As profit-driven entities, banks aim to maximise returns for shareholders.
• However, they must maintain sufficient liquid assets to meet customer demands.
• Preference for illiquid assets - These, like corporate bonds, often yield higher returns than liquid ones, such as central bank deposits. Banks avoid holding excessive liquidity to protect profitability.
• Need for liquid reserves - Banks lend over long periods but allow instant withdrawals by depositors. They calculate reserves carefully to cover typical demands without overcommitting to low-yield assets.
• Risk of bank runs - Banks assume not all depositors will withdraw simultaneously. However, if trust erodes and many demand funds quickly (a 'bank run'), liquidity shortages can occur, distinct from insolvency.
• Importance of trust and support - Public confidence in banks is vital to prevent runs. Central banks act as lenders of last resort in emergencies to provide liquidity.

Managing risk in investments

• Risk is central to finance, with higher risks typically offering greater rewards.
• Risk-return relationship - Riskier investments, like volatile stocks, generally provide higher profits than safer ones, reflected in varying interest rates across markets.
• Balancing security and profitability - Investors, including banks, must weigh potential gains against losses, especially when handling others' money or when their stability affects the financial system.