How Do Commercial Banks Work, and Why Do They Matter? (2024)

What Is a Commercial Bank?

The term commercial bank refers to a financial institution that accepts deposits and offers different banking and financial products. Commercial banks provide these services to people and businesses. 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.

Key Takeaways

  • Commercial banks offer basic banking services, including deposit accounts and loans, to consumers and businesses.
  • These financial institutions make money from a variety of fees and by earning interest income from loans.
  • Commercial banks have traditionally been located in physical locations, but a growing number now operate exclusively online.
  • Commercial banks are important to the economy because they create capital, credit, and liquidity in the market.

How Do Commercial Banks Work, and Why Do They Matter? (1)

How Commercial Banks Work

Commercial banks provide basic banking services and products to the general public, both individual consumers and businesses. The following table highlights some of the key services commercial banks provide to their retail customers:

Banking ServicesLending ServicesInvestment Services
Checking and savings accountsLoans and mortgagesCertificates of deposit (CDs)
Debit card transactionsLines of creditRetirement account services
Safe deposit boxesLetters of CreditInvestment portfolio services

Business banking services also include bank accounts, investments, and lending products. Commercial banks also provide their business clients with merchant services, which allows companies to accept payments electronically from their customers.

These financial institutions 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.

The money that customers deposit at commercial banks is insured by the Federal Deposit Insurance Corporation (FDIC), including cash in savings accounts and CDs. 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.

A growing number of commercial banks operate exclusively online, where all transactions with the commercial bank must be made electronically. Because these banks don’t have any brick-and-mortar locations, they can offer a wider range of products and services at a lower cost—or none at all—to their customers.

How Commercial Banks Make Money

Banks make money by imposing service charges on their customers. These fees vary based on the products, ranging from account fees (monthly maintenance charges, minimum balance fees, overdraft fees, and 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 make money from the interest they earn when they lend money to their clients. The funds they lend come from customer deposits. However, the interest rate paid by banks on the money they borrow is less than the rate charged on the money they lend. For example, a bank may offer savings account customers an annual interest rate of 0.25%, while charging mortgage clients 4.75% in interest annually.

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

Commercial Banks and Lending

Consumer lending makes up the bulk of North American bank lending. Some of the most significant categories include residential mortgages, automobile lending, and credit cards.

Residential Mortgages

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.

Auto Loans

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.

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 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.

Credit card lending delivers lucrative fees for banks. For example, interchange fees are charged to merchants for accepting the card and entering into the transaction. Banks also charge customers late-payment fees, currency exchange, over-limit, and other fees, as well as elevated rates on the balances that credit card users carry from one month to the next.

4,867

The total number of commercial banks in the United States in 2023.

Importance of Commercial Banks

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

Commercial banks 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, these 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 that banks are required to hold a certain percentage of their consumer deposits at the central bank as a cushion if the public rushes to withdraw funds.

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 United States, thanks to the Glass-Steagall Act of 1933, which was passed during the Great Depression. 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.

While commercial banks traditionally provide services to individuals and businesses, investment banks focus on offering banking services to large companies and institutional investors. They act as financial intermediaries, providing their clients with underwriting services, strategies, corporate reorganization services, and other types of brokerage services for institutional and high-net-worth individuals (HNWIs).

While commercial banking clients include individual consumers and small businesses, investment banking clients include governments, hedge funds, other financial institutions, pension funds, and large companies.

The Gramm-Leach-Bliley Act tore down the wall between commercial and investment banks but maintained some safeguards. For instance, it forbids a bank and a nonbank subsidiary of the same holding company from marketing the products or services of the other entity—to prevent banks from promoting securities underwritten by other subsidiaries to their customers—and placed size limitations on subsidiaries.

Examples of Commercial Banks

Some of the world’s largest financial institutions are commercial banks or have commercial banking operations—many of which can be found in the U.S. For instance:

  • Chase Bank is the commercial banking unit of JPMorgan Chase (JPM). Headquartered in New York City, Chase Bank reported more than $3.39 trillion in assets as of December 2023.
  • Bank of America (BAC) is the second-largest U.S. bank, with more than $2.54 trillion in assets and 6 million customers, including both retail clients and small and midsize businesses.

As noted above, banking has had to change with the rise of financial technology (fintech). Some of the major commercial banks have an increased online presence. Some banks operate exclusively online. For example, Ally Bank (ALLY) is one of the major online commercial banks in the United States. The bank is headquartered in Detroit and has $196 billion in assets as of December 2023.

Is My Bank a Commercial Bank?

Possibly! Commercial banks are what most people think of when they hear the term “bank.” Commercial banks are for-profit institutions that accept deposits, make loans, safeguard assets, and work with many different types of clients, including the general public and businesses. However, if your account is with a community bank or credit union, it probably would not be a commercial bank.

What Role Do Commercial Banks Play in the Economy?

Commercial banks are crucial to the fractional reserve banking system, currently found in most developed countries. This allows banks to extend new loans of up to (typically) 90% of the deposits they have on hand, theoretically growing the economy by freeing capital for lending.

Is My Money Safe at a Commercial Bank?

For the most part, yes. Commercial banks are heavily regulated, and most deposit accounts are covered up to $250,000 by the Federal Deposit Insurance Corporation. Moreover, commercial and investment banking funds cannot be co-mingled by law.

The Bottom Line

Commercial banks are a critical component of the U.S. economy by providing vital capital to businesses and individuals in the form of credit and loans. They provide a secure place where people save money, earn interest, and make payments through checks, debit cards, and credit cards.

Commercial banks are typically in brick-and-mortar locations in cities and towns, many with extensive branch networks. A growing number have no physical location, however—instead, they are accessible online and through mobile applications.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in oureditorial policy.

  1. Federal Deposit Insurance Corp. “Understanding Deposit Insurance.”

  2. IBIS World. "Commercial Banking in the US - Number of Businesses."

  3. Federal Reserve History. “Banking Act of 1933 (Glass-Steagall).”

  4. GovInfo. “Public Law 106-102: Gramm-Leach-Bliley Act,” 113 Stat. 1349 (Page 13 of PDF).

  5. Federal Reserve System. “Statistical Release: Large Commercial Banks.”

  6. Bank of America, Newsroom. “Company Overview.”

  7. Ally. "Who We Are."

  8. GovInfo. “Public Law 106-102: Gramm-Leach-Bliley Act,” 113 Stat. 1399 (Page 62 of PDF).

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How Do Commercial Banks Work, and Why Do They Matter? (2024)

FAQs

How Do Commercial Banks Work, and Why Do They Matter? ›

Commercial banks are an important part of the economy. They not only provide consumers with an essential service but also help create capital and liquidity in the market. Commercial banks ensure liquidity by taking the funds that their customers deposit in their accounts and lending them out to others.

How do commercial banks work and why do they matter? ›

Commercial banks may offer other services such as brokering insurance contracts, giving investment advice, and so on. They also provide a wide variety of loans and offer other credit vehicles like cards and overdrafts.

What is commercial bank answers? ›

A commercial bank is a financial institution that provides services like loans, certificates of deposits, savings bank accounts bank overdrafts, etc. to its customers. These institutions make money by lending loans to individuals and earning interest on loans.

How do banks work? ›

Although banks do many things, their primary role is to take in funds—called deposits—from those with money, pool them, and lend them to those who need funds. Banks are intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money).

What is the role of a commercial bank? ›

Role. The general role of commercial banks is to provide financial services to the general public and business, ensuring economic and social stability and sustainable growth of the economy. In this respect, credit creation is the most significant function of commercial banks.

What are 5 functions of a commercial bank? ›

Commercial banks perform various functions that are as follows:
  • Accepting deposits. The basic function of commercial banks is to accept deposits of the customers. ...
  • Granting loans and advances. ...
  • Agency functions. ...
  • Discounting bills of exchange. ...
  • Credit creation. ...
  • Other functions.

How do commercial banks benefit? ›

They make money mainly by loaning money to businesses and earning back interest and fees from these loans. Commercial banks loan money to businesses to cover supplies, real estate, hiring, or any other cost the business might incur.

What is the goal of the commercial bank ___________? ›

Answer and Explanation: The correct option is (a) maximize the wealth of its shareholders. A commercial bank is a profit-seeker. Its main goal is to earn profits so that its shareholders see an appreciation in the amount that they have invested.

Why are banks important? ›

Although banks do many things, their primary role is to take in funds—called deposits—from those with money, pool them, and lend them to those who need funds. Banks are intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money).

What is a commercial bank for dummies? ›

The commercial bank definition describes a financial institution tasked with accepting customer deposits for safekeeping purposes, granting loans to individuals and businesses at an interest rate, and providing basic financial products and services like certificates of deposits and savings accounts.

How do banks work and make money? ›

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.

What are the 5 most important banking services? ›

The 5 most important banking services are checking and savings accounts, loan and mortgage services, wealth management, providing Credit and Debit Cards, Overdraft services. You can read about the Types of Banks in India – Category and Functions of Banks in India in the given link.

How do commercial banks create credit? ›

All commercial banks create credit by advancing loans and purchasing securities. They lend money to the individuals as well as to the businesses out of deposits accepted from the public. Commercial banks are not allowed to use the entire amount of public deposits for lending purposes.

What are the 4 functions of banks? ›

Primary Functions of Banks
  • Accepting Deposits. The banks accept deposits from their customers, who can withdraw their funds at will. ...
  • Lending Loans & Advances. A bank lends funds to needy people at a certain rate of interest. ...
  • Issue of Notes/ Drafts. ...
  • Credit Deposits.
Oct 12, 2023

What is the role of a commercial bank quizlet? ›

is to provide financial services to the general public, businesses, and companies. Banks also ensure economic stability and sustainable growth of a country's economy.

What is the major role of a commercial bank quizlet? ›

One of the primary functions of a commercial bank is accepting deposits, allowing customers to deposit and save money. One of the primary functions of a commercial bank is making advances, which allows customers to borrow money (loans, overdrafts, mortgages, credit cards).

How do commercial banks contribute to the economy? ›

Economic impact analysis (or economic contribution analysis) is based on the idea that a dollar spent in a region stimulates additional economic activity, or multiplies as it circulates through the economy. (

What is the role of commercial banks in everyday life? ›

Commercial banks play a crucial role in the economy since they generate money and market liquidity in addition to offering their clients critical services. By giving out loans from the savings of their customers, banks ensure market liquidity.

What are the pros and cons of commercial banks? ›

Commercial banking allows customers to get loans at low-interest rates. Commercial bank accounts are often more expensive than traditional bank accounts. Banks may charge fees for night deposits, for processing a certain number of cheques and for payroll services.

What are the main services of a commercial bank? ›

Primary services: A commercial bank's primary services include lines of credit, credit cards, small to medium-size business loans, mortgage loans, vehicle loans, personal checking and savings, and ATM services. Investment banks provide larger funding amounts for corporate financing and investing.

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