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How Do Commercial Banks Work and Why Do They Matter?

    How Do Commercial Banks Work and Why Do They Matter

    What Is a Commercial Bank?

    A financial institution that accepts deposits, provides checking account services, makes different loans, and provides fundamental financial products like certificates of deposit (CDs) and savings accounts to individuals and small businesses is referred to as a “commercial bank.” Most people conduct their financial business at commercial banks.

    Commercial banks generate revenue through making loans, including mortgages, vehicle loans, business loans, and personal loans, and charging interest on those loans. The money needed to fund these loans is provided by customer deposits to banks.

    • Commercial banks provide basic banking services, such as deposit accounts and loans, to individuals and small to medium-sized businesses.
    • Commercial banks profit from a range of fees as well as from the interest they get on loans.
    • Commercial banks have historically had physical facilities, but an increasing number of them now run entirely online.
    • Because they generate capital, credit, and market liquidity, commercial banks are crucial to the economy.

    How Commercial Banks Work

    The general public, including both private citizens and small to medium-sized businesses, is served by commercial banks’ fundamental banking services and products. Checking and savings accounts, loans and mortgages, fundamental investment options like CDs, as well as other services like safe deposit boxes, are among the services offered.

    Fees and service charges are how banks are paid. These costs range from account fees (monthly maintenance fees, minimum balance fees, overdraft fees, non-sufficient funds (NSF) penalties), safe deposit box fees, and late fees, depending on the goods. In addition to interest fees, many loan packages also include other expenses.

    Banks also profit from interest earned on the loans they make to other customers. They use consumer deposits as collateral for loans. However, the bank pays less in interest on the money they borrow than they do on the money they lend. For instance, a bank might charge mortgage customers an annual interest rate of 4.75% while offering savings account customers an annual interest rate of 0.25%.

    Commercial banks have historically been situated in structures where clients come to conduct ordinary banking transactions using ATMs and teller window services. Most banks now allow their customers to do the majority of the same services—including transfers, deposits, and bill payments—online thanks to the development of internet technology.

    A growing number of commercial banks only conduct business online, necessitating electronic processing of all transactions. These banks can provide their customers with a greater choice of goods and services for a lower price—or none at all—because they don’t have any physical premises.

    Significance of Commercial Banks

    Commercial banks have a significant role in the economy. They not only offer consumers a crucial service, but they also support the influx of capital and increase market liquidity.

    By taking the money that their clients deposit in their accounts and lending it to other people, they maintain liquidity. Commercial banks contribute to the issuance of credit, which increases output, employment, and consumer spending while also stimulating the economy.

    As a result, the central bank of each nation or region has strict regulations in place for commercial banks. For example, commercial banks are subject to reserve requirements set by central banks. In order to protect themselves against a sudden surge in public withdrawals of money, banks are therefore compelled to keep a fixed portion of consumer deposits at the central bank.

    Special Considerations

    Savings accounts and certificate of deposit (CD) investments are popular with customers because they are easy to access and are covered by the Federal Deposit Insurance Corporation (FDIC). Customers can withdraw cash when they need it, and their holdings are fully protected up to $250,000 in total. Banks don’t have to pay much for this money, as a result.

    Many banks offer interest rates for savings accounts that are far lower than those for U.S. Treasury bonds (T-bonds), pay no interest at all on checking account balances, or at least pay very little interest.

    Residential mortgages account for the vast majority of consumer credit, which makes up the majority of bank lending in North America. Real estate is purchased through mortgages, and the homes themselves are frequently used as collateral for the loan. Mortgages are frequently written with 30-year payback terms and can have fixed, adjustable, or variable interest rates. Although many more risky mortgage options, such as pick-a-payment mortgages and negative amortization loans, were available during the U.S. housing bubble of the 2000s, they are now considerably less frequent.

    Another large area of secured lending for many banks is auto loans. Auto loans often have shorter durations and higher rates than home loans. Other financial organizations, such as captive car finance operations managed by automobile manufacturers and dealers, compete fiercely with banks in the auto lending market.

    Bank Credit Cards

    Another big form of funding is through credit cards. In essence, credit cards are readily accessible personal lines of credit. They are provided by private card issuers via corporate banks.

    The proprietary networks that allow money to be transferred between the banks of the merchant and the customer following a transaction are run by Visa and MasterCard. Since credit card default rates are typically substantially higher than those for mortgage default rates or other forms of secured lending, not all institutions provide money for credit cards.

    However, credit card lending generates lucrative fees for banks, including interchange fees paid to merchants for accepting the card and processing the transaction, late payment fees, exchange fees, over-the-limit fees, and other fees for cardholders, as well as higher interest rates on the balances that cardholders carry from month to month.

    Commercial Banks vs. Investment Banks

    Commercial and investment banks both offer significant services and have significant economic impact. Because of the Glass-Steagall Act of 1933, which was implemented during the Great Depression, these two sections of the banking industry were mostly kept apart in the United States for most of the 20th century. The Gramm-Leach-Bliley Act of 1999 essentially eliminated it and made it possible to establish financial holding companies that might have both commercial and investment bank subsidiaries.

    Investment banking offers banking services to big enterprises and institutional investors, whereas commercial banks have typically offered services to people and businesses. They serve as financial brokers, offering their clients underwriting services, merger and acquisition (M&A) plans, corporate restructuring services, and other kinds of brokerage services for institutions and high-net-worth people (HNWIs).

    Investment banking clients include governments, hedge funds, other financial institutions, pension funds, and large firms, whereas commercial banking clients include private individuals and small businesses.

    Examples of Commercial Banks

    Many of the major financial institutions in the world, including commercial banks and banks with commercial banking operations, are based in the United States. For instance, JPMorgan Chase’s commercial banking division is called Chase Bank. Chase Bank, with its headquarters in New York City, reported assets of over $3.2 trillion as of June 2021. With more than $2.35 trillion in assets and 66 million clients, including both individual consumers and small and mid-sized enterprises, Bank of America is the second-largest bank in the United States.

    Is My Bank a Commercial Bank?

    Possibly! The majority of people think of commercial banks when they hear the word “bank.” Commercial banks are for-profit organizations that interact with a wide range of clients, including the general public and businesses, and collect deposits, provide loans, protect assets, and collaborate with them. However, it would generally not be a commercial bank if your account is with a community bank or credit union.

    What Role Do Commercial Banks Play in the Economy?

    The fractional reserve banking system that is currently used in the majority of developed nations depends heavily on commercial banks. As a result, banks can issue new loans up to (usually) 90% of their available deposits, which should expand the economy by freeing up cash for lending.

    Is My Money Safe at a Commercial Bank?

    Generally speaking, yes. Commercial banks are closely regulated, and the FDIC insures most deposit accounts up to $250,000 for a maximum of $250,000. Additionally, it is against the law to combine funds from investment banking and commercial banking.

    Learn more: 4 Tips for Creators to Navigate Finances the Smart Way