What Is a Commercial Bank?
A commercial bank is a type of financial institution that accepts deposits, offers checking account services, makes various 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.
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.
- 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.
- Commercial banks make money by providing loans and earning interest income from those loans.
- A growing number of commercial banks operate exclusively online, where all transactions with the commercial bank must be made electronically.
How a Commercial Bank Works
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 it issues, 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 Corp. (FDIC), and money can be easily withdrawn. However, these investments traditionally pay very low interest rates compared with mutual funds and other investment products. In some cases, commercial bank deposits pay no interest, such as checking account deposits.
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.
The largest source by far of funds for banks is deposits; money that account holders entrust to the bank for safekeeping and use in future transactions, as well as modest amounts of interest. Generally referred to as "core deposits," these are typically the checking and savings accounts that so many people currently have.
In most cases, these deposits have very short terms. While people will typically maintain accounts for years at a time with a particular bank, the customer reserves the right to withdraw the full amount at any time. Customers have the option to withdraw money upon demand and the balances are fully insured, up to $250,000, therefore, banks do not have to pay much for this money. Many banks pay no interest at all on checking account balances, or at least pay very little, and pay interest rates for savings accounts that are well below U.S. Treasury bond rates. (For more, check out Are Your Bank Deposits Insured?)
If a bank cannot attract a sufficient level of core deposits, that bank can turn to wholesale sources of funds. In many respects these wholesale funds are much like interbank CDs. There is nothing necessarily wrong with wholesale funds, but investors should consider what it says about a bank when it relies on this funding source. While some banks de-emphasize the branch-based deposit-gathering model, in favor of wholesale funding, heavy reliance on this source of capital can be a warning that a bank is not as competitive as its peers.
Investors should also note that the higher cost of wholesale funding means that a bank either has to settle for a narrower interest spread, and lower profits, or pursue higher yields from its lending and investing, which usually means taking on greater risk.
For most banks, loans are the primary use of their funds and the principal way in which they earn income. Loans are typically made for fixed terms, at fixed rates and are typically secured with real property; often the property that the loan is going to be used to purchase. While banks will make loans with variable or adjustable interest rates and borrowers can often repay loans early, with little or no penalty, banks generally shy away from these kinds of loans, as it can be difficult to match them with appropriate funding sources.
Part and parcel of a bank's lending practices is its evaluation of the credit worthiness of a potential borrower and the ability to charge different rates of interest, based upon that evaluation. When considering a loan, banks will often evaluate the income, assets and debt of the prospective borrower, as well as the credit history of the borrower. The purpose of the loan is also a factor in the loan underwriting decision; loans taken out to purchase real property, such as homes, cars, inventory, etc., are generally considered less risky, as there is an underlying asset of some value that the bank can reclaim in the event of nonpayment.
As such, banks play an under-appreciated role in the economy. To some extent, bank loan officers decide which projects, and/or businesses, are worth pursuing and are deserving of capital.
Consumer lending makes up the bulk of North American bank lending, and of this, residential mortgages make up by far the largest share. Mortgages are used to buy residences and the homes themselves are often the security that collateralizes the loan. Mortgages are typically written for 30 year repayment periods and interest rates may be fixed, adjustable, or variable. Although a variety of more exotic mortgage products were offered during the U.S. housing bubble of the 2000s, many of the riskier products, including "pick-a-payment" mortgages and negative amortization loans, are much less common now.
Automobile lending is another significant category of secured lending for many banks. Compared to mortgage lending, auto loans are typically for shorter terms and higher rates. Banks face extensive competition in auto lending from other financial institutions, like captive auto financing operations run by automobile manufacturers and dealers.
Prior to the collapse of the housing bubble, home equity lending was a fast-growing segment of consumer lending for many banks. Home equity lending basically involves lending money to consumers, for whatever purposes they wish, with the equity in their home, that is, the difference between the appraised value of the home and any outstanding mortgage, as the collateral. As the cost of post-secondary education continues to rise, more and more students find that they have to take out loans to pay for their education. Accordingly, student lending has been a growth market for many banks. Student lending is typically unsecured and there are three primary types of student loans in the United States: federally sponsored subsidized loans, where the federal government pays the interest while the student is in school, federally sponsored unsubsidized loans and private loans.
Credit cards are another significant lending type and an interesting case. Credit cards are, in essence, personal lines of credit that can be drawn down at any time. While Visa and MasterCard are well-known names in credit cards, they do not actually underwrite any of the lending. Visa and MasterCard simply run the proprietary networks through which money (debits and credits) is moved around between the shopper's bank and the merchant's bank, after a transaction.
Not all banks engage in credit card lending and the rates of default are traditionally much higher than in mortgage lending or other types of secured lending. That said, credit card lending delivers lucrative fees for banks: Interchange fees charged to merchants for accepting the card and entering into the transaction, late-payment fees, currency exchange, over-the-limit and other fees for the card user, as well as elevated rates on the balances that credit card users carry, from one month to the next. (To learn how to avoid getting nickeled and dimed by your bank, check out Cut Your Bank Fees.)
Example of a Commercial Bank
Traditionally, commercial banks are physically located in buildings where customers come to use teller window services, ATMs and safe deposit boxes.
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.
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.
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 1933, which was passed during the Great Depression, and repealed by the Gramm-Leach-Bliley Act of 1999.
Example of How a Commercial Bank Earns Money
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.
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.