If you're diving into Theme 4.2.4: Financial Markets & Monetary Policy for your AQA A-Level, you've probably noticed that banks are at the absolute heart of the macroeconomic machine. But what do they actually do behind those grand facades and sleek banking apps? Today, we break down the economics of commercial banks, from how they create credit to why they sometimes spectacularly fail. Grab a coffee, and let's get into it!

Commercial vs. Investment Banks: What’s the Difference?

First things first, don't mix up your high street bank with the wolves of Wall Street.

• Commercial Banks: Think of these as your everyday financial hubs. They take deposits from the public, provide savings accounts, and lend that money out for mortgages, personal loans, and business investments. They make their money primarily through the interest they charge on loans and various service fees.
• Investment Banks: These are the heavy hitters serving governments, institutional investors, and huge corporations. They don't take your public deposits. Instead, they help entities raise capital by issuing stocks and bonds, and they facilitate massive Mergers & Acquisitions (M&A). They earn their keep through advisory fees, underwriting, and trading.

⚙️ The Engine Room: Functions of a Commercial Bank

Commercial banks are the ultimate financial multitaskers. While their main gig is accepting deposits and providing loans, they also:

• Create Credit (more on this superpower below!)
• Handle payments and settlements (moving your money around safely)
• Safeguard money and valuables
• Provide foreign exchange services for international trade and travel
• Offer financial advisory services for things like pensions.

⚖️ Balancing the Books: Assets and Liabilities

To score those top analysis marks, you need to understand a bank's balance sheet. It all boils down to two categories:

1. Liabilities (Sources of Funds): This is money the bank owes. The biggest liability? Your deposits. Retail funding (everyday savings and current accounts) is the main source of cash for UK banks. They pay you a higher interest rate on long-term savings because it gives them a secure pool of money to lend out.
2. Assets (Uses of Funds): This is what the bank owns. It includes cash reserves kept at the central bank, liquid assets, and crucially, loans to households and businesses. When a bank gives out a mortgage, that loan is an asset to the bank because it will generate income over time.

✨ The Magic Trick: How Banks Create Credit

This is a classic exam topic. Banks don't just lend out the exact money you deposit; they actually create new deposits through lending. Here is the cycle:

1. Accepting Deposits: You deposit £100 into your account.
2. Maintaining Reserves: The central bank requires the commercial bank to keep a small fraction (e.g., 2%) safe as reserves.
3. Lending Money: The bank is free to lend out the remaining 98% (£98) to a borrower.
4. Creating New Deposits: That £98 gets spent and eventually deposited into another bank account. That second bank then keeps 2% of the £98 and lends out the rest. The cycle repeats, multiplying the amount of credit in the economy!

🛑 Pumping the Brakes: Limits to Credit Creation

So, why can't banks just create infinite money? Regulators and reality stand in the way. Credit creation is limited by:

• Reserve Requirements: The central bank mandates how much cash must be kept in reserve.
• Capital Adequacy Ratios: Banks must hold enough equity capital relative to their risky assets to absorb potential losses.
• Availability of Creditworthy Borrowers: Banks can only lend if there are reliable people to lend to (they check income and credit history).
• Liquidity Constraints: They must have enough cash on hand to meet daily customer withdrawals.
• Demand for Loans: In a recession, consumers and businesses are too nervous to take on new debt, slowing the whole process down.

💷 Show Me the Money: How Banks Profit

The main profit engine for a commercial bank is Net Interest Income. Simply put, they charge a higher interest rate to borrowers than they pay out to savers, and they pocket the difference. They also rake in cash from account fees, trading profits, and commissions.

💥 When It All Goes Wrong: How Banks Fail

For your evaluation marks, you need real-world application. Banks fail when they take on too much risk or face massive economic shocks.

• Lehman Brothers (2008): The classic example. They were heavily invested in high-risk subprime mortgage-backed securities. When the housing market crashed, these assets became worthless, leading to the largest bankruptcy in US history and triggering the Great Recession.
• Silicon Valley Bank (2023): A modern case study of concentrated exposure. SVB heavily relied on the tech industry and invested deeply in long-term Treasury bonds. When interest rates spiked and tech struggled, SVB faced massive losses, triggering a fatal bank run.