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What is a 'Commercial Bank'

A commercial bank is a type of financial institution that accepts deposits, offers checking account services, makes business, personal and mortgage loans, and offers basic financial products like certificates of deposit (CDs) and savings accounts to individuals and small businesses. A commercial bank is where most people do their banking, as opposed to an investment bank

BREAKING DOWN 'Commercial Bank'

Commercial banks make money by providing loans and earning interest income from those loans. The types of loans a commercial bank can issue vary and may include mortgages, auto loans, business loans and personal loans. A commercial bank may specialize in just one or a few types of loans. 

Customer deposits, such as checking accounts, savings accounts, money market accounts and CDs, provide banks with the capital to make loans. Customers who deposit money into these accounts effectively lend money to the bank and are paid interest. However, the interest rate paid by the bank on money they borrow is less than the rate charged on money they lend. 

How a Commercial Bank Makes Money

The amount of money earned by a commercial bank is determined by the spread between the interest it pays on deposits and the interest it earns on loans, which is known as net interest income

Customers find commercial bank investments, such as savings accounts and CDs, attractive because they are insured by the Federal Deposit Insurance Corporation (FDIC) and money can be easily withdrawn. However, these investments traditionally pay very low interest rates compared to mutual funds and other investment products. In some cases, commercial bank deposits pay no interest, such as checking account deposits.

When a commercial bank lends money to a customer, it charges a rate of interest that is higher than what the bank pays its depositors. For example, suppose a customer purchases a five-year CD for $10,000 from a commercial bank at an annual interest rate of 2%. On the same day, another customer receives a five-year auto loan for $10,000 from the same bank at an annual interest rate of 5%. Assuming simple interest, the bank pays the CD customer $1,000 over five years, while it collects $2,500 from the auto loan customer. The $1,500 difference is an example of spread — or net interest income — and it represents revenue for the bank.

In addition to the interest it earns on its loan book, a commercial bank can generate revenue by charging its customers fees for mortgages and other banking services. For instance, some banks elect to charge fees for checking accounts and other banking products. Also, many loan products contain fees in addition to interest charges. 

An example is the origination fee on a mortgage loan, which is generally between 0.5% and 1% of the loan amount. If a customer receives a $200,000 mortgage loan, the bank has an opportunity to make $2,000 with a 1% origination fee on top of the interest it earns over the life of the loan.

How a Commercial Bank Creates Money

In a fractional reserve banking system, commercial banks are permitted to create money by allowing multiple claims to assets on deposit. Banks create credit that did not previously exist when they make loans. This is sometimes called the money multiplier effect.

There is a limit to the amount of credit lending institutions can create this way. Banks are legally required to keep a certain minimum percentage of all deposit claims as liquid cash. This is called the reserve ratio.

The reserve ratio in the United States is 10%. This means for every $100 the bank receives in deposits, $10 must be retained by the bank and not loaned out, while the other $90 can be loaned or invested.

At any given point in time, fractional reserve commercial banks have more cash liabilities than cash in their vaults. When too many depositors demand redemption of their cash titles, a bank run occurs. This is precisely what happened during the bank panic of 1907 and in the 1930s.

There is no difference between the type of money creation that results from the commercial money multiplier or a central bank, such as the Federal Reserve. A dollar created from loose monetary policy is interchangeable with a dollar created from a new commercial loan.

Most newly created central bank money enters the economy through banks or the government. The Federal Reserve can create new assets to be carried on bank balance sheets, and then banks issue new commercial loans from those new assets. Most central bank money creation becomes, and is exponentially increased by, commercial bank money creation.

Evolution of the Commercial Bank

Traditionally, commercial banks are physically located in buildings where customers come to use teller window services, ATMs and safe deposit boxes. But a growing number of commercial banks operate exclusively online, where all transactions with the commercial bank must be made electronically. These “virtual” commercial banks often pay a higher interest rate to their depositors. This is because they usually have lower service and account fees, as they do not have to maintain physical branches and all the ancillary charges that come along with them, such as rent, property taxes and utilities.

For many years, commercial banks were kept separate from another type of financial institution called an investment bank. Investment banks provide underwriting services, M&A and corporate reorganization services, and other types of brokerage services for institutional and high net-worth clients.

This separation was part of the Glass-Steagall Act of 1932, which was passed during the Great Depression. It was thought that financial markets would be more stable if commercial banking and investment banking were kept separate. The Glass-Steagall Act was repealed by the Gramm-Leach-Bliley Act of 1999.

Now, some commercial banks, such as Citibank and JPMorgan Chase, also have investment banking divisions, while others, such as Ally, operate strictly on the commercial side of the business.

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