Roles and functions of commercial and investment banks

Commercial and investment banks play vital roles in the financial system by handling savings, lending, and facilitating transactions. They support economic activities such as trade and business expansion, though their operations can involve risks when combined.

Commercial banks

Commercial banks manage everyday financial needs for individuals and businesses, acting as intermediaries between savers and borrowers.

Main functions:

• Accepting savings - They receive deposits from customers, providing a safe place to store money.
• Financial intermediation - Banks channel funds from those with surplus money (lenders) to those needing funds (borrowers).
• Lending services - They provide loans to individuals and companies for purposes like purchasing homes or investing in operations.
• Payment facilitation - Banks enable transfers of money between people or firms, such as through cheques or electronic payments.
• Additional services - These include offering insurance products and providing financial guidance to customers.

Divisions within commercial banking:

• Retail banking - Focuses on individuals and small businesses, offering services like savings accounts, personal loans, and mortgages.
• Wholesale banking - Handles the needs of larger corporations, including complex financing and large-scale transactions.

Commercial banks contribute to business growth by supplying loans, offering expert advice on finances, and supporting international trade through currency exchanges and guarantees.

Investment banks

Investment banks focus on capital markets and corporate finance rather than everyday deposits, helping clients raise funds and manage investments.

Key activities:

• Arranging securities issues - They organise the issuance of shares and bonds to help companies raise capital.
• Advisory services - Provide guidance on obtaining finance, as well as on company mergers and acquisitions.
• Trading securities - Buy and sell assets like shares and bonds for clients to optimise their portfolios.
• Market making - Act as intermediaries in markets to ensure smooth trading of securities by providing liquidity.

Investment banks also pursue high-reward activities, such as proprietary trading, where they use their own funds to buy and sell shares, which carries significant risks but can yield substantial profits.

Risks when combining commercial and investment banking

Many large banks operate both commercial and investment functions, which can create broader economic vulnerabilities.

• Banks may use customer deposits from commercial operations to finance risky investment activities.
• Losses from poor investments could endanger depositors' funds, leading to systemic risks where an entire market or financial system might fail.

Other types of financial institutions

Beyond banks, various institutions manage funds, provide protection against risks, and invest in businesses. These entities support economic stability and growth but can introduce their own challenges.

Pension funds

Pension funds manage retirement savings by investing them to generate returns.

• They gather contributions from individuals and invest in assets like securities.
• Upon retirement, they distribute the accumulated savings plus investment gains.
• These funds offer substantial, long-term capital to companies, aiding their development.

Insurance firms

Insurance companies protect against uncertainties, which encourages economic activities like trade.

• They collect premiums from clients to cover risks, such as property damage or non-payment by customers.
• This protection allows businesses to operate more confidently, knowing potential losses are mitigated.

Hedge funds

Hedge funds aim for high returns by pooling investments from multiple sources.

• They diversify across various markets to maximise gains.
• Light regulation and a focus on rewards can lead to high risks for investors and potential instability in the wider economy.

Private equity firms

Private equity firms invest directly in companies to generate profits.

• They buy businesses and work to increase their value for resale at a gain.
• While they can foster success, they face criticism for practices like asset-stripping (selling off company assets) and reducing employment to cut costs.

The shadow banking system

The shadow banking system consists of unregulated financial activities that provide credit outside traditional banking channels. It has expanded rapidly, offering alternatives to conventional loans but increasing economic vulnerabilities.

• It includes unregulated intermediaries and activities by regulated institutions that fall outside oversight.
• Entities like hedge funds and private equity firms are often part of this system.
• The system supplies a growing volume of credit, but its lack of regulation means no emergency support is available, as it is for traditional banks.
• Its large, opaque size heightens the risk of triggering financial crises due to potential instability.

Concepts of money and liquidity

Money serves essential functions in the economy, but its forms vary in how easily they can be used for transactions. Understanding liquidity helps explain how assets function in financial systems.

Functions and liquidity of money

Money must be portable, widely accepted, hard to counterfeit, and durable to qualify as a medium of exchange, unit of account, store of value, and standard of deferred payment.

Liquidity measures how quickly an asset can be converted into spendable form. Notes and coins are highly liquid as they can be used immediately for purchases. Assets like shares or property are illiquid, requiring sale into cash before spending.

Narrow and broad definitions of money

Definitions of money range from the most liquid forms to broader categories including less accessible assets.

• Narrow money - Includes physical currency in circulation (notes and coins) plus central bank balances, representing the most liquid forms.
• Broad money - Encompasses narrow money plus less liquid assets, such as savings accounts or time deposits.

Balancing profitability, liquidity, and risk in banking

Banks must navigate the trade-offs between earning profits, maintaining enough liquid assets, and managing risks to ensure stability. This balance is crucial for their operations and the overall financial system.

How banks balance profitability and liquidity

Banks seek to maximise returns for shareholders while ensuring they can meet withdrawal demands.

• Profits are higher from illiquid assets, which offer better returns, so banks limit holdings of low-yield liquid assets.
• However, liquidity is essential because loans are long-term, while depositors may withdraw funds anytime.
• Banks maintain a reserve of liquid assets to handle withdrawals, relying on not all customers demanding money simultaneously.
• Excessive withdrawals can lead to a 'bank run' if liquidity is insufficient, eroding trust in the system.
• Central banks act as lenders of last resort to provide emergency funds and prevent collapses.

The relationship between risk and profitability

Risk influences returns in finance, requiring careful management, especially with others' money or systemically important institutions.

• Riskier investments typically yield higher profits to compensate for potential losses.
• Interest rates vary across markets based on risk levels, with safer options offering lower returns.
• Investors, including banks, weigh an investment's security against its potential profitability to avoid undue exposure.