What is Commercial Banking

What Is a Commercial Bank?

Commercial bank is a financial organization that provides a range of services to individuals and small businesses. These services include accepting deposits, offering checking account services, making various types of loans, and providing basic financial products like certificates of deposit (CDs) and savings accounts. It is the most commonly used type of bank for most people.

Commercial banks generate revenue by lending money and earning interest on loans such as mortgages, auto loans, business loans, and personal loans. These loans are made possible by the capital provided through customer deposits.

How Commercial Banks Work

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Commercial banks offer essential financial services and products to the general public, including individuals and small to midsize businesses. These services typically include checking and savings accounts, loans and mortgages, basic investment options such as CDs, and additional services like safe deposit boxes.

Banks generate revenue through various service charges and fees, which vary depending on the products offered. These fees may include monthly maintenance charges, minimum balance fees, overdraft fees, non-sufficient funds (NSF) charges, safe deposit box fees, and late fees. In addition to these charges, many loan products also include fees, in addition to interest charges.

Moreover, banks earn money by lending out funds to other clients, which is possible through customer deposits. However, the interest rate paid by banks for the money they borrow is typically lower than the rate they charge for the money they lend. For instance, a savings account customer may receive an annual interest rate of 0.25%, while a mortgage client may be charged an annual interest rate of 4.75%.

In the past, commercial banks were primarily situated in physical buildings where customers could access teller window services and automated teller machines (ATMs) for their banking needs. However, with the advancement of internet technology, most banks now provide online services that allow customers to perform many of the same transactions as they would in person, including transfers, deposits, and bill payments.

Moreover, an increasing number of commercial banks operate exclusively online, meaning that all transactions must be conducted electronically. These online banks do not have any physical branches, allowing them to offer a wider range of products and services at a lower cost or no cost at all to their customers.

Read More: What is Plaid Banking?

Significance of Commercial Banks

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The role of commercial banks in the economy is significant. They not only provide essential services to consumers but also help generate capital and liquidity in the market.

To ensure liquidity, commercial banks take the funds deposited by their customers and lend them out to others. This, in turn, contributes to the creation of credit, which leads to increased production, employment, and consumer spending, ultimately boosting the economy.

Due to their crucial role, commercial banks are subject to heavy regulation by their respective central banks. Central banks impose reserve requirements on commercial banks, which means that banks must hold a certain percentage of their customer deposits at the central bank as a safeguard in case there is a rush to withdraw funds by the general public.

Special Considerations

Customers are drawn to investment options such as savings accounts and CDs offered by commercial banks because of certain special considerations. These investments are insured by the Federal Deposit Insurance Corp. (FDIC), providing a sense of security to customers. Additionally, customers have the flexibility to withdraw their funds at any time, and the balances are fully insured up to $250,000.

Due to the FDIC insurance, banks do not have to pay much for the funds deposited by customers in these accounts.

Many banks offer little to no interest on checking account balances and low interest rates on savings accounts, which are considerably lower than the rates of U.S. Treasury bonds (T-bonds).

In North America, consumer lending comprises the majority of bank lending, with residential mortgages accounting for the largest share. These mortgages are used to purchase properties, and the homes themselves serve as collateral for the loan. Repayment periods for mortgages typically last 30 years, and interest rates can be fixed, adjustable, or variable. While a range of riskier mortgage products were available during the U.S. housing bubble of the 2000s, such as pick-a-payment mortgages and negative amortization loans, these products are now far less common.

Automobile lending is a notable type of secured lending for many banks. Auto loans typically have shorter terms and higher interest rates compared to mortgages. Banks face considerable competition in the auto lending market from other financial institutions, including captive auto financing operations operated by car manufacturers and dealers.

Bank Credit Cards

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Bank credit cards are a significant form of financing. Essentially, they are personal lines of credit that can be utilized at any time. Commercial banks offer them through private card issuers.

Visa and Mastercard are responsible for the proprietary networks that move money between a shopper's bank and a merchant's bank after a transaction is made. However, not all banks participate in credit card lending due to the high default rates associated with it, unlike mortgage lending or other types of secured lending.

Nevertheless, credit card lending is profitable for banks, as they earn interchange fees from merchants for accepting the card and processing transactions. They also charge late-payment fees, currency exchange fees, over-limit fees, and other fees to the card user. Furthermore, credit card users are charged elevated rates on balances they carry from one month to the next.

Read More: What is Investment Banking

Commercial Banks vs. Investment Banks

Commercial banks and investment banks are both essential in providing significant services and playing critical roles in the economy. In the United States, these two branches of the banking industry were typically kept separate during most of the 20th century. This was made possible by the Glass-Steagall Act of 1933, which was enacted during the Great Depression.

However, the Gramm-Leach-Bliley Act of 1999 largely repealed the Glass-Steagall Act, making it possible for financial holding companies to be created. These financial holding companies could have both commercial and investment bank subsidiaries.

The Gramm-Leach-Bliley Act removed the barrier between commercial and investment banking, but it also maintained some safeguards. It prohibits a bank and a nonbank subsidiary of the same holding company from promoting each other's products or services. This is to prevent banks from marketing securities underwritten by their subsidiaries to their customers. The Act also placed limitations on the size of subsidiaries.

While commercial banks typically provide services to individuals and businesses, investment banks cater to large corporations and institutional investors. They serve as financial intermediaries and offer underwriting services, merger and acquisition (M&A) strategies, corporate reorganization services, and other types of brokerage services for institutional and high-net-worth individuals (HNWIs).

Commercial banking clients consist of individual consumers and small businesses, whereas investment banking clients include hedge funds, governments, pension funds, other financial institutions, and large corporations.

Examples of Commercial Banks

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Some of the largest financial institutions in the world are commercial banks or have commercial banking operations, many of which are based in the United States. One example is Chase Bank, which is the commercial banking unit of JPMorgan Chase and headquartered in New York City. As of September 2022, Chase Bank reported over $3.3 trillion in assets.

Another example is Bank of America, the second-largest U.S. bank with more than $2.4 trillion in assets and 67 million customers. Bank of America serves both retail clients and small to midsize businesses.

Is my bank a commercial bank?

It's possible! When most people hear the term "bank," they are likely thinking of a commercial bank. Commercial banks are for-profit institutions that accept deposits, make loans, safeguard assets, and work with various types of clients, including the general public and businesses. However, if your account is with a community bank or credit union, it is unlikely to be a commercial bank.

What role do commercial banks play in the economy?

Commercial banks play a vital role in the fractional reserve banking system, which is present in most developed countries. This system enables banks to create new loans of up to 90% of the deposits they hold, thereby freeing up capital for lending and theoretically contributing to the growth of the economy.

Is my money safe at a commercial bank?

Generally speaking, yes, your money is safe at a commercial bank. Commercial banks are subject to strict regulation, and most deposit accounts are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC).

Furthermore, it is prohibited by law to commingle funds between commercial banking and investment banking.

In summary

Commercial banks are a crucial element of the US economy, offering essential capital to businesses and individuals in the form of loans and credit. They provide a secure environment for people to save money, earn interest, and make payments via checks, debit cards, and credit cards.

Commercial banks are typically located in brick-and-mortar establishments in cities and towns, with many having extensive branch networks. However, an increasing number of commercial banks have no physical location but can instead be accessed online or through mobile applications.

Read More: What Is a CD in Banking

Source: https://www.investopedia.com

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