Commercial banks and investment banks – AQA Economics notes

This page contains notes for theme 4.2.4.2 Commercial banks and investment banks for AQA Economics A Level.

Contents

What is the difference between a commercial bank and an investment bank?

There are two types of banks:

Commercial banks are also known as high street banks. 

• These banks take in customer deposits. 
• While the bank may keep a fraction of the deposits in reserve, the commercial bank lends out most of the deposit funds. 
• This lending includes loans to businesses or consumers. 

Investment banks have several functions.

• Investment banks help firms to raise money through helping to issue stocks or to find investors.
• These banks also support firms with mergers (two companies becoming one) and acquisitions (one company buys another).
• Investment banks also manage investments for wealthy individuals and trade stocks and currencies.

You should also be aware that other institutions operate in financial markets. 

One example is a hedge fund. A hedge fund pools funds from different investors and actively manages the investment. They may aim to generate high returns but this may come at a high risk. 

Another example is a pension fund. Such a fund invests pension contributions from employers and employees to generate retirement income for employees.

Examples of commercial and investment banks Examples of commercial banks are Barclays, Natwest, Santander,  Starling and HSBC UK. Examples of investment banks include JP Morgan, Morgan Stanley and Goldman Sachs. Note that some banks have both investment and commercial arms, such as Barclays. This may increase the level of systemic risk. If the risky investment operations in the investment bank fail, the commercial arm may lose the funds needed to pay depositors. This could increase the risk of bank failure among commercial banks. So consumers may be more likely to lose confidence and withdraw funds from the bank, which could lead to a wider economic downturn. Therefore, for UK banks with more than £25bn in customer deposits, the investment and commercial banking arms of the company must be “ring-fenced” off in separate parts of the company. The goal of ringfencing is to reduce systemic risk, by reducing the extent to which a failure of an investment bank can spill over into the failure of the commercial banking arm.

What is the structure of a commercial bank’s balance sheet?

A balance sheet is a financial statement showing the company’s assets, liabilities and shareholders’ equity.

A balance sheet can be split into three categories:

• Assets (what the company owns).
• Liabilities (what the company owes to someone else).
• Shareholder equity.

What items would feature on a bank’s balance sheet?

The bank’s assets include:

• Cash.
• Balances at the Bank of England.
  • Many banks have an account with the Bank of England. 
  • Note that when the Bank of England changes its key interest rate, “Bank Rate”, this influences the rate of return for money held at the central bank by other banks. This is partly how changes in Bank Rate affect the whole economy, via the effect on these balances.
  • These are liquid. Balances at the central bank can be used to settle payments between different banks. When you make a payment to a friend at a different bank, the payment comes through instantly. 
  • But what’s going on in the background is the different banks are transferring money to each other’s accounts at the Bank of England. This can be done immediately.
• Investments.
  • This could include government and corporate bonds held by the bank.
  • These are not likely to be as liquid as the other assets mentioned so far. There isn’t always a buyer available, particularly for corporate bonds. 
• Loans advanced (also known as “advances”).
  • Loans to bank customers, such as mortgages.
  • Due to the long-term nature of loans such as mortgages, these are unlikely to be liquid. In other words, they will be difficult to convert into cash.
• Fixed assets.
  • This includes the bank’s premises.
  • Again these are not liquid. It may take time for the bank to sell its buildings if it wishes to do so.

The bank’s liabilities include:

• Long-term liabilities (also known as “long-term borrowing”).
  • For example, if the bank decides to issue its own bonds.

• Deposits.
  • Customer deposits are a bank liability. 
  • The deposits are money the bank holds but is ultimately owed to the person depositing the money.
  • Note that an investment bank would not have customer deposits on their balance sheet, as investment banks do not take customer deposits.
• Short-term borrowing from money markets.
  • This could include overnight lending in case the bank needs cash quickly.

Shareholder equity includes:

• Share capital is the money a company has raised by selling shares.
• Reserves (retained profit) is profit kept within the bank, instead of being paid out to shareholders as dividends.

• Together, share capital and reserves represent “shareholders’ funds”, “shareholder equity” or simply “equity”. The shareholders, being owners of the company, have a claim to these funds.
• You may also see share capital and reserves (retained profit) also listed on the right-hand side of the balance sheet, alongside liabilities, which is common practice. 

You may see the balance sheet presented as a table, showing the bank’s assets and liabilities:

Assets (something the bank owns)	Liabilities (something the bank owes) and equity
Cash	Customer deposits
Balances at the central bank	Short-term borrowing from money markets
Loans advanced	Long-term borrowing
Investments	Share capital
Fixed assets	Reserves (retained profit)

A commercial bank can fail in two main ways:

• Insolvency: The value of the bank’s assets are less than below the value of its liabilities. This may occur when asset values suddenly fall in value and the bank has become too reliant on risky or lower quality assets. 
• Liquidity issues: the bank runs out of liquid assets, such as cash, to pay its immediate bills, even if assets exceed liabilities. 

Example bank balance sheet and commentary As of March 31st 2025, Starling Bank had £15.7 billion of assets. The largest asset categories for the bank include: – Cash and balances at the central bank (£6.7 billion). – Loans and advances to customers (£4.7 billion). – Debt securities (£3.9 bn). This includes government and corporate bonds. At the same time, Starling had £14.7 billion of liabilities and £1.0 billion of equity. The largest liability categories for the bank include: – Customer deposits (£12.1 billion). – Deposits from other banks (£2.3 billion). (All figures are given to one decimal place) Source: Pillar 3 Report 2025 Starling Bank Limited, page 27

What are the objectives of a commercial bank? What are the conflicts between objectives?

There are three key objectives of a commercial bank:

• Profit maximisation.
  • One of a bank’s main costs is paying the customers interest on their savings.
    • This provides the means for the bank to effectively borrow money from customers in the short term.
  • The bank will then take most of these funds and lend them out.
    • Lending by the bank is often longer term.
    • For example a mortgage could last several years.
  • Typically the interest rate on savings (the bank “borrowing” from its customers) is lower than the rate of return from the bank lending longer term. 
  • The difference allows a bank to make profit.
  • In other words, banks aim to make profit by “borrowing short term and lending long term”.  
• Liquidity.
  • The bank may aim to have a proportion of their assets as liquid. This means the assets are easy to convert into cash.
  • The bank may want high levels of liquidity to ensure the bank can pay any unexpected bills. 
  • This also helps the bank to avoid the risk of a “bank run”.
  • A bank run is where many bank customers try to withdraw their money at once.
  • If banks may not have enough money or liquid assets (to convert into cash) to pay customers immediately, the bank could fail. 
• Security.
  • To avoid the risk of a bank run, the bank may hold more cash in reserve.
  • It may also choose to invest in lower risk assets with more certain returns. 

• Tradeoff between objectives: 
  • Profit maximisation versus liquidity.
    • For a bank to make higher average returns on its investments, it often needs to lend funds for a longer time period. This could include mortgages or longer-term business loans for example. 
    • Shorter-term loans are associated with lower average returns.
    • Such loans are less liquid. It is more difficult for the bank to convert the loan into cash quickly.
    • Hence, by pursuing profit maximisation, the bank may have to invest in less liquid assets.
  • Profit maximisation versus security
    • To achieve profits, some banks may decide to engage in risky investments to seek higher expected returns. 
    • However, such an investment strategy has a higher risk of failure. Specifically, if the assets suddenly fall in value or a risky borrower fails to repay, this could lead to a bank failing. 
    • There are examples of this in the 2008 financial crisis, where there were risky investments in mortgage-backed securities. 

How do banks create credit?

Central banks create money but high street banks also have a role to play.

Banks can create credit when they offer loans to businesses or individuals. The loan creates a new deposit in the borrower’s bank account, creating new money in the economy. As a result, high street banks can generate new money.

To explain, consider the numerical example below. 

Suppose a customer deposits £100 in bank A.

• Out of that £100, the bank may lend £90 out to someone else. For example to a customer who needs a loan.
• The bank may keep the remaining £10 as a liquid asset. This could be as cash in a vault or as a balance with the central bank.

The second customer then receives £90 from that loan directly. The £90 goes straight into their bank account at a different bank, bank B.

• There is now £90 more in the second customer’s bank account. So this bank has £90 more to keep or lend as they choose.
• The process could then repeat. The bank could keep £9 in cash and lend out £81 for instance. 
• This process continues.

At this point money supply has increased: customer 1 has £100 in their bank account, but also customer 2 has £90 in their bank account. This makes the total money supply £190.

Practice question on banks for financial markets

This is a practice question written in the style of AQA Economics A Level.

The Bank of England has informed UK banks to be more prepared for the risk of bank failure. It is particularly concerned that social media could lead to faster bank runs in the future. 

Explain how banks create money and how commercial banks may face a tradeoff between their objectives.  [15 marks]

Related AQA Economics A Level style resources

Macroeconomics resources:

For more A-Level Economics AQA style resources, click the blue button below: