Commercial and Investment Banks

1. What Are Commercial Banks?

Commercial banks are the most recognized institutions. They are "everyday banks," with which we open a savings account or deposit our paycheck, for instance. Being "the Bank" almost seems to be a part of the American experience. The primary purpose of a commercial bank is to serve individuals, small businesses, and corporations, providing them with basic financial products.

Some of the primary services provided by commercial banks include:

• Deposits and withdrawals:  Safeguarding the funds deposited by customers.

• Loans: Personal loans, business loans, and mortgages

• Payment services: Debit cards, credit cards, and money transfers

• Financial advice: help customers learn how to manage their accounts and save wisely.

Commercial and consumer banks have a reasonably straightforward profit model; they lend money and charge interest on those loans, while also charging fees on other services and assets. For example, if I take out a $10,000 car loan, I will have to repay the loan plus interest, which becomes the bank's income.

2. What Are Investment Banks?

Investment banks exist in a different space. Rather than facilitating and managing your banking needs, investment banks work with corporations, governments, and institutional investors on large financial activities.

Some of the primary functions of investment banks include:

• Raising Capital: Helping businesses issue stocks or bonds.

• Mergers and Acquisitions (M&A): Advising and managing the buyout and merger of companies

• Trading and Market Making: Buying and selling securities on behalf of someone else, or for their accounts.

• Advisory Services: Providing advisory services to help businesses and organizations make a better financial strategy, restructuring, and/or manage risk.

You can think of an investment bank as the architect of large financial deals. When a tech giant goes public or two multinational firms decide to merge, someone is orchestrating that process, likely an investment bank.

3. Key Differences between Commercial Banks and Investment Banks

While both commercial and investment banks are part of the banking universe, their goals, client bases, and operations are entirely different.

4. Their Roles in The Economy

Both banks are necessary for economic growth, but they perform distinctively different roles in the economy.

- Commercial banks increase both spending and investment through the provision of credit to individuals and small businesses. When you get a loan from your commercial bank to purchase your first-home, vehicle, or expand your neighbourhood small shop, you are adding to the economy.

- Investment banks increase corporate growth by raising funds and developing businesses internationally. The international development of a company permits it to expand, hire more employees, innovate new products, and increase market competition.

Without commercial banks, basic operations using money would slow down to nearly stop in the economy. Without investment banks, innovation and the ability to scale internationally become almost impossible tasks.

5. The Glass-Steagall Separation of Commercial vs. Investment Banking

Over the years, many countries have had considerable disagreement over commercial and investment banks. In the U.S., this disagreement was hotly contested and became law based on the separation between the two types of banks. The Glass-Steagall Act (1933) restricted commercial banks from engaging in investment banking activities. The purpose was to protect deposits from the risky nature of investment banks.

In 1999, Congress passed a law eliminating restrictions on actions based on Glass-Steagall, allowing any institution to have and operate as both a commercial bank and an investment bank. This resulted in the birth of universal banks, which provide commercial and investment services as a single institution. Some advocates support the efficiency universal banks provide; critics say they pose added and systemic risk to the economy by confusing the two. Famous Examples

Commercial Banks:

•  JPMorgan Chase (retail division)

•  Wells Fargo

•  HSBC (retail banking)

Investment Banks:

•  Goldman Sachs

•  Morgan Stanley

•  Lazard

Both JPMorgan Chase and Citigroup, among others, do this…and serve retail clients with checking accounts while they are also engaged in billion-dollar corporate capital raising transactions for the investment bank.

6. How They Make Money

Commercial banks primarily earn revenues from:

•  Net interest margin (difference between interest paid on deposits and interest earned from loans)

•  Service charges (e.g., ATM charges, overdrafts, account maintenance).

Investment banks earn revenues from:

•  Underwriting fees for helping “companies” raise capital,

•  Advisory fees for helping “companies” raise capital through mergers and acquisitions,

•  Trading profits when they are buying and selling securities.

7. Risks They Face

•  Commercial banks face loan default risk or the borrower's inability to repay the debt.

•  Investment banks face market risks, deal failures, and reputational failure if the deals go bad.

Both types face liquidity risk—ensuring they have cash on hand to fulfill payment obligations.

8. Why You Need to Know the Difference

For the average consumer, the difference could seem theoretical. But understanding what each can do for you is beneficial in that it is going to:

•  Help you determine if one type of bank is more appropriate for you.

•  Help you understand where your money is going after your deposit.

•  Help you understand economic news at a deeper level.

•  Help you make better decisions regarding investment or borrowing.

If you are looking to buy a house, a commercial bank is a good option. If you are a start-up who plans to go public at some point, you are going to want to have an investment bank on your side.

9. The Future of Commercial Banks and Investment Banks

Technology, regulation, and global implications are changing either of these industries.

•  Digital banking and investing made commercial banking services even more accessible through iPhone applications

•  Fintech is a competition to banks, forcing the banks to adopt innovations or lose market share

•  Globalization is forcing investment banks to seek new emerging markets

•  Sustainability finance is becoming a growing focus with both commercial and investment banks seeking to fund climate change projects, environmentally friendly projects, and socially responsible investments.

Conclusion

Commercial and investment banks may represent different worlds, but together, they form the basis of the world financial system. One ensures that individuals and small businesses can save, borrow, and spend, while the other actively connects the pieces between capital and opportunity at a larger level.

By seeking to understand their basis for how they perform their jobs—and by defining the differences between the two—you are now seeing some of the forces that are not only shaping Wall Street, but also Main Street. You can now read about the next company going public, or spot the next bank branch opening in your neighborhood, and you will observe exactly which part of the banking world you are reading/seeing—and why it is essential.