Commercial banking relates to deposit-taking and lending They provide services to corporate and individual customers Some commercial banks have investment banking arms e.g. Bank of America Merrill Lynch Commercial banks make their profits by taking small, short-term, relatively liquid deposits from retail savers and transforming these into larger, longer maturity loans e.g. in the form of business loans and mortgages An investment bank provides a wide range of specialized services for companies and large investors These include Underwriting and advising on securities issues and other forms of capital raising Advice on mergers and acquisitions and also corporate restructuring Trading on capital markets Research and private equity investments An investment bank trades and invests on its own account Investment banks deal mainly with corporate customers Goldman Sachs and Morgan Stanley are the last remaining major Wall Street investment banking businesses Commercial banks can provide investment banking services

1. Commercial Banks and Investment Banks
Financial Economics

2. Commercial Banks & Credit Creation
Financial Economics

3. Leading banks in the UK in 2014, by total assets
1,345,833
1,019,934
862,004
811,695
315,488
189,926
43,396
25,752
24,954
1,892
1,662
0 400000 800000 1200000 1600000
Barclays Bank Plc (headquarters: London)
The Royal Bank of Scotland (hq: Edinburgh)
Lloyds Bank Plc (hq: London)
HSBC Bank Plc (hq: London)
Santander UK Plc (hq: London)
Nationwide Building Society (hq: Swindon)
Co-operative bank (hq: Manchester)
Virgin Money (hq: Newcastle)
TSB Bank Plc (hq: Edinburgh)
Metro Bank Plc (hq: London)
Shawbrook Bank Ltd (hq: Brentwood)
Total assets in million GBP

4. Commercial banks and investment banks
• Commercial banking relates to deposit-taking and lending
• They provide services to corporate and individual
customers
• Some commercial banks have investment banking arms
e.g. Bank of America Merrill Lynch
• Commercial banks make their profits by taking small,
short-term, relatively liquid deposits from retail savers and
transforming these into larger, longer maturity loans e.g.
in the form of business loans and mortgages
• Other services of commercial banks include providing
debit and credit cards, private banking, money custody
and guarantees, cash management and settlement e.g.
through cheque accounts, as well as trade finance.

5. Main functions of a commercial bank
• Commercial banks provide retail banking services to
household and business customers
• They are licensed deposit-takers – providing a range of
savings accounts
• They are licensed to lend money (and thereby “create”
money e.g. in the form of bank loans, overdrafts and
mortgages
• Commercial banks are profit-seeking
• A commercial bank’s business model relies on receiving a
higher interest rate on the loans (or other assets) than the
rate it pays out on its deposits (or other liabilities)
• This “spread” on their assets and liabilities is used to pay
the operating expenses of a bank and also to make a profit

6. Objectives of a Commercial Bank
• Commercial banks are profit-seeking businesses
• Their main objective is to achieve a profit by earning more
from the interest charged on loans than the interest paid
to depositors
• Commercial banks can also make profits from providing
other services such as deposit security, currency trading,
business advice, cheque and credit-card processing
• Most commercial banks are privately owned but some in
the UK are part or majority-owned by the UK government
• The UK government owns 73% of Royal Bank of Scotland
• It also owns a 10% minority stake in Lloyds Banking Group

7. Market share of current accounts of UK banks (2014)
27%
18%
18%
12%
10%
6%
4.2%
2%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
Lloyds Bank Plc (hq: London)
Barclays Bank Plc (hq: London)
The Royal Bank of Scotland (hq: Edinburgh)
HSBC Bank Plc (hq: London)
Santander UK Plc (hq: London)
Nationwide Building Society (hq: Swindon)
TSB Bank Plc (hq: Edinburgh)
Co-operative bank (hq: Manchester)
Account market share
At the moment only 3% of personal and 4% of
UK business customers switch to a different
bank in any year (Source: CMA, August 2016)

8. Top global banks (April 2016) by market capitalisation
255.44
232.89
224.08
160.91
154.47
152.27
143.5
137.33
131.93
100.12
90.67
81.32
81.15
74.73
72.24
0 50 100 150 200 250 300
Wells Fargo (U.S.)
JP Morgan Chase (U.S.)
Industrial and Commercial Bank of China
China Construction Bank (China)
Bank of America (U.S.)
Agricultural Bank of China (China)
Bank of China (China)
Citigroup (U.S.)
HSBC Holdings (UK)
Commonwealth Bank of Australia
Royal Bank of Canada
Westpac (Australia)
Toronto-Dominion Bank (Canada)
U.S. Bancorp (U.S.)
Goldman Sachs (U.S.)
Market capitalization in billion U.S. dollars

9. Investment banks
• An investment bank provides a wide range of specialized
services for companies and large investors
• These include
1. Underwriting and advising on securities issues and other
forms of capital raising
2. Advice on mergers and acquisitions and also corporate
restructuring
3. Trading on capital markets
4. Research and private equity investments
• An investment bank trades and invests on its own account
• Investment banks deal mainly with corporate customers
• Goldman Sachs and Morgan Stanley are the last remaining
major Wall Street investment banking businesses
• Commercial banks can provide investment banking services

10. Private Banks
• Private banks provide wealth management services to
high net worth individuals.
• Some of these banks are owned by larger banks, for
example Coutts (RBSG), and Cater Allen (Santander)
• Some are part of investments banks (e.g. BNP Paribas,
Credit Suisse and UBS Wealth Management)
• Some are self-standing private banks (e.g. Adam &
Company)

11. Building Societies
• Building societies are owned by their members (i.e.
customers) and not shareholders.
• Historically, they tended to focus on offering mortgages
and savings products
• Since 1986 many now offer a broad range of retail banking
products.
• There are over 40 building societies in the UK, many of
them with regional customer bases.
• The five largest building societies are
• Nationwide Building Society (Nationwide)
• Yorkshire Building Society
• Coventry Building Society
• Skipton Building Society
• Leeds Building Society.

12. Credit Unions
• Credit unions are small and local non-profit lending
institutions
• They are owned by their members and typically serving
those customers who are unable to access standard retail
bank products through the banks or building societies.
• Examples include:
• London Mutual
• Bristol Credit Union
• Glasgow Credit Union

13. Challenger Banks in the UK Financial System
A number of new banks are attempting to establish themselves in the UK financial
system and challenge the dominance of the leading UK commercial banks
TSB (Sabadell) Virgin Money Aldermore
Metro Bank Shawbrook Handelsbanken

14. How Challenger Banks are Competing
The dominance of leading high street commercial banks means there are
substantial barriers to entry in the market – new banks are competing by:
TSB (Sabadell) Virgin Money
Aldermore Metro Bank
Shawbrook Handelsbanken
• Keeping their operating costs low
• Offering attractive prices (higher
interest rates on savings, slightly
cheaper loans) … this lowers their
profitability
• Non-price competition including longer
opening hours, online banking apps
• Targeting specialist parts of the financial
market such as buy-to-let mortgages &
specialist corporate lending
• TSB was demerged from Lloyds Bank in
2013 TSB and then acquired last year by
Spanish bank Sabadell in a £1.7bn
takeover.

15. The Main Challenger Banks
• Aldermore
• Aldermore was established in 2009 and is a specialist lender and
savings bank. Aldermore specializes in secured lending to SMEs
• Handelsbanken
• It has 207 branches in the UK and provides private and
corporate customers with a range of services
• Post Office Money
• Provides credit cards, current accounts, insurance products,
mortgages and personal loans through the Post Office Money
brand which was launched in 2015. Santander and Bank of
Ireland providing payments / systems support

16. Barriers to Entry into Commercial Banking
• Commercial banking in the UK is an oligopoly
• In oligopolistic markets, barriers to entry make it harder for
new entrants to scale their business and make profits
• Entry barriers might include:
1. Cost of IT systems and the cost of establishing branches
2. Access to payment systems (e.g. cheque/card clearing)
3. Established banks have access to cheaper retail deposits
from their existing customers
4. Banks which are viewed by investors as ‘too big to fail’ are
seen as lower risk and therefore benefit from lower
wholesale funding costs
5. Customer resistance to changing accounts – including the
time and inconvenience – harder to build customer numbers
and achieve economies of scale

17. Mergers and Demergers in the UK Banking Industry
• 2004, Santander (Spain) bought Abbey National plc.
• 2007, Northern Rock was taken into state ownership in
February 2008, and split into two parts: assets (the so-
called ‘bad bank’) and banking (the so-called ‘good bank’),
in January 2010. Virgin Money acquired the ‘good bank’ in
January 2012 and the assets (the ‘bad bank’) in June 2012.
• 2008, Santander acquired Alliance & Leicester Building
Society and deposits and branches of Bradford & Bingley
Building Society
• 2009, Lloyds TSB acquired HBOS to create LBG
• 2014, Lloyds Banking Group demerged with TSB bank –
bought by Banco de Sabadell (Spain)

18. World’s best paid Bank bosses in 2015

19. Key Banking Terms / Concepts
Banking credit An arrangement with a bank for a loan, or bank lending in general
Bank A business that makes its profit by paying interest to people who keep
money there and charging a higher rate of interest to borrowers who
borrow money from the bank
Bank capital Bank capital is the value of the bank's assets minus its liabilities, or debts
Bank reserves Money and liquid assets (such as securities that can be sold quickly) held
by banks in order to meet withdrawals by customers
Banking system The way banks work together to make payments, make money available
Co-operative bank A bank that lends money, collected from its members, at low rates of
interest
Internet banking The services provided by banks that only exist on the Internet
Shadow banking Non-deposit taking financial intermediaries including investment banks,
hedge funds

20. Commercial Banks – Assets and Liabilities
Assets
Cash
Balances at Bank of England
Loans (Advances)
Securities (e.g. Bonds)
Fixed assets
Liabilities
Customer deposits
Money owed to bond holders
Money owed to other banks
The importance of capital reserves for a bank
The more capital there is on a bank’s balance sheet, this means the bank can absorb
more losses on its assets e.g. through bad debts before it becomes insolvent.

21. Structure of a commercial bank’s balance sheet
Assets Liabilities
Reserves Deposits
Deposits
This is a basic model of the balance sheet of a commercial bank
Assets are “owned” by the bank
Liabilities are “owed” by the bank e.g. customers can walk into a
bank or use an ATM machine to withdrawal some/all of their deposits

22. Structure of a commercial bank’s balance sheet
Reserves
Currency
Assets Liabilities
Deposits
Commercial banks before lending

23. Structure of a commercial bank’s balance sheet
Reserves
Currency
Assets Liabilities
Deposits
Commercial banks before lending
Key point: Bank deposits are simply a record of
how much the bank itself owes its customers.
So they are a liability of the bank, not an asset
that could be lent out.

24. Structure of a commercial bank’s balance sheet
Reserves
Currency
Assets Liabilities
Deposits
Commercial banks before lending
Key point: Bank deposits are simply a record of
how much the bank itself owes its customers.
So they are a liability of the bank, not an asset
that could be lent out.
Reserves can only be lent between
banks not lent to customers

25. Structure of a commercial bank’s balance sheet
Reserves
Currency
Assets Liabilities
Deposits
Commercial banks before lending
Commercial banks before lending
Reserves
Currency
Deposits
Assets Liabilities
New Loans
New
Deposits
Reserves can only be lent between
banks not lent to customers

26. The Old Textbook View of Banks and Credit Creation
Banks take deposits
of money from
savers and lend it
to borrowers
Banks then lend
money to businesses,
thus allocating funds
between alternative
investment projects

27. Alternative (Stylised) View of a Bank’s Balance Sheet
Other Assets
(Liquid Assets)
Loans to UK
Households and
Businesses
Assets
(Uses of funds)
Liabilities
(Sources of funds)
Capital (Equity)
Wholesale
Funding
Retail funding
(e.g.
households’
current
accounts)

28. Alternative (Stylised) View of a Bank’s Balance Sheet
Other Assets
(Liquid Assets)
Loans to UK
Households and
Businesses
Assets
(Uses of funds)
Liabilities
(Sources of funds)
Capital (Equity)
Wholesale
Funding
Retail funding
(e.g.
households’
current
accounts)
Retail funding remains
the main funding source
for UK retail commercial
banks
Banks will typically pay a
higher interest on retail
deposits that are saved
with a bank for a longer
period of time. This give
them a more secure
source of funds.
The saver gets higher
interest for sacrificing
some liquidity.

29. How Commercial Banks Create Credit
• Banks create credit by extending
loans to businesses and
households – pure and simple!
• They do not need to attract
deposits from savers to do this
• When a bank makes a loan, for
example to someone taking out
a mortgage to buy a house, or a
business taking out a loan to
finance their expansion it credits
their bank account with a bank
deposit of the size of the
loan/mortgage.
• At that moment, new money is
created.
“Banks making loans and consumers
repaying them are the most significant
ways in which bank deposits are created
and destroyed in the modern economy.”
(Source: Bank of England)

30. The benefit of a bank attracting fresh deposits
• Traditional economics teaching emphasised that banks could only
lend out if they attracted new deposits from savers – UNTRUE!
• By attracting new deposits, the bank can increase its lending without
running down its reserves.
• There is intense competition between banks and building societies for
the retail deposits of individuals and businesses
• But in recent years, the average interest rate on savings deposits has
been historically low and usually less than the rate of consumer price
inflation (i.e. real interest rates on savings have been negative)
• Commercial banks prefer to attract stable deposits, i.e. deposits that
cannot be withdrawn immediately as this helps them to control their
“liquidity risk”.
• Longer-term savings deposits therefore typically offer a higher rate of
interest for savers, a reward for the inconvenience of sacrificing some
of their liquidity

31. Limits to Money Creation by Commercial Banks
In a modern economy, there are a number of constraints that restrict
the amount of money that banks can create.
Market forces – the scale of profitable lending opportunities
Regulatory policies e.g. capital reserve requirements
Behaviour of consumers and businesses e.g. decisions about
how much debt to repay
Monetary policy - level of policy interest rates influences the
aggregate demand for loans

32. Interest Rates on Consumer Loans in the UK
0
5
10
15
20
25
1-Jan-95
1-Oct-95
1-Jul-96
1-Apr-97
1-Jan-98
1-Oct-98
1-Jul-99
1-Apr-00
1-Jan-01
1-Oct-01
1-Jul-02
1-Apr-03
1-Jan-04
1-Oct-04
1-Jul-05
1-Apr-06
1-Jan-07
1-Oct-07
1-Jul-08
1-Apr-09
1-Jan-10
1-Oct-10
1-Jul-11
1-Apr-12
1-Jan-13
1-Oct-13
1-Jul-14
1-Apr-15
1-Jan-16
Selection of interest rates on different household loans, per cent, source: Bank of England
£5,000 Personal Loan Credit Card £10,000 Personal Loan Overdraft

33. Difference between liquidity risk and credit risk
• Liquidity risk:
• Banks tend to attract short term deposits
• They often lend for longer periods of time
• As a result, a commercial bank may not be able to repay all of
those deposits if savers decide to withdraw their funds
• To reduce liquidity risk banks will try to attract longer term
deposits and also hold some liquid assets as capital reserves
• Credit risk
• This is the risk to the commercial bank of lending to borrowers
who turn out to be unable to repay their loans
• Credit risk can be controlled by proper safeguards / research into
the credit-worthiness of borrowers
• Credit risk also controlled through prudential regulation i.e. the
size of reserves banks must hold back in case of bad debts

34. UK Household Debt to Income Ratio
0
20
40
60
80
100
120
140
160
1-Mar-80
1-Aug-81
1-Jan-83
1-Jun-84
1-Nov-85
1-Apr-87
1-Sep-88
1-Feb-90
1-Jul-91
1-Dec-92
1-May-94
1-Oct-95
1-Mar-97
1-Aug-98
1-Jan-00
1-Jun-01
1-Nov-02
1-Apr-04
1-Sep-05
1-Feb-07
1-Jul-08
1-Dec-09
1-May-11
1-Oct-12
1-Mar-14
1-Aug-15
Household debt to income, measured as a % of GDP
Risks of high household debt
1. Sudden fall in incomes e.g. due to an economic downturn
2. Unexpected rise in interest rates on existing debts
especially mortgage borrowing
Both 1 and 2 could cause a significant squeeze on consumers’
ability to service their debts

35. Annual growth of lending to UK individuals
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
1-Mar-08
1-Jul-08
1-Nov-08
1-Mar-09
1-Jul-09
1-Nov-09
1-Mar-10
1-Jul-10
1-Nov-10
1-Mar-11
1-Jul-11
1-Nov-11
1-Mar-12
1-Jul-12
1-Nov-12
1-Mar-13
1-Jul-13
1-Nov-13
1-Mar-14
1-Jul-14
1-Nov-14
1-Mar-15
1-Jul-15
1-Nov-15
1-Mar-16
Total lending to UK individuals since 2008, annual growth, per cent

36. Commercial Banks & Credit Creation
Financial Economics