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Home Learn To Trade

What Is a Commercial Bank?

fxvnpro by fxvnpro
June 23, 2022
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The term commercial bank refers to a 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.

Commercial banks make money by providing and earning interest from loans such as mortgages, auto loans, business loans, and personal loans. Customer deposits provide banks with the capital to make these loans.

How Commercial Banks Work?

Commercial banks provide basic banking services and products to the general public, both individual consumers and small to mid-sized businesses. These services include checking and savings accounts, loans and mortgages, basic investment services such as CDs, as well as other services such as safe deposit boxes.

Banks make money from service charges and fees. These fees vary based on the products, ranging from account fees (monthly maintenance charges, minimum balance fees, overdraft fees, non-sufficient funds (NSF) charges), safe deposit box fees, and late fees. Many loan products also contain fees in addition to interest charges.

Banks also earn money from interest they earn by lending out money to other clients. The funds they lend comes from customer deposits. However, the interest rate paid by the bank on the money they borrow is less than the rate charged on the money they lend. For instance, a bank may offer savings account customers an annual interest rate of 0.25%, while charging mortgage clients 4.75% in interest annually.

Commercial banks have traditionally been located in buildings where customers come to use teller window services and automated teller machines (ATMs) to do their routine banking. With the rise in internet technology, most banks now allow their customers to do most of the same services online that they could do in person including transfers, deposits, and bill payments.

Significance of Commercial Banks

Commercial banks are an important part of the economy. Not only do they provide consumers with an essential service, but they also help create capital and liquidity in the market.

They ensure liquidity by taking the funds that their customers deposit in their accounts and lending them out to others. Commercial banks play a role in the creation of credit, which leads to an increase in production, employment, and consumer spending, thereby boosting the economy.

As such, commercial banks are heavily regulated by a central bank in their country or region. For instance, central banks impose reserve requirements on commercial banks. This means banks are required to hold a certain percentage of their consumer deposits at the central bank as a cushion if there’s a rush to withdraw funds by the general public.

Special Considerations

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. 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.1

Many banks pay no interest at all on checking account balances (or at least pay very little) and offer interest rates for savings accounts that are well below U.S. Treasury bond (T-bond) rates.

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 properties 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.

Bank Credit Cards

Credit cards are another significant type of financing. Credit cards are, in essence, personal lines of credit that can be drawn down at any time. Private card issuers offer them through commercial banks.

Visa and MasterCard run the proprietary networks through which money is moved around between the shopper’s bank and the merchant’s bank after a transaction. Not all banks engage in credit card lending, as 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.

Commercial Banks vs. Investment Banks

Both commercial and investment banks provide important services and play key roles in the economy. For much of the 20th century, these two branches of the banking industry were generally kept separate from one another in the U.S., thanks to the Glass-Steagall Act of 1933, which was passed during the Great Depression.2 It was largely repealed by the Gramm-Leach-Bliley Act of 1999, allowing for the creation of financial holding companies that could have both commercial and investment bank subsidiaries.

Examples of Commercial Banks

Some of the world’s largest financial institutions are commercial banks or having commercial banking operations—many of which can be found in the United States. For instance, Chase Bank is the commercial banking unit of JPMorgan Chase. Headquartered in New York City, Chase Bank reported about $3.2 trillion in assets as of June 2021.

Bank of America is the second-largest bank in the United States, with more than $2.35 trillion in assets and 66 million customers including both retail clients and small and mid-sized businesses.

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