Investing 101: Commercial vs Investment Banking

When the word ‘bank’ is mentioned, for many of us, it is the functions of a retail bank that spring to mind; the act of depositing or withdrawing cash, mortgage loans, and, unfortunately, overdrafts. However, banks are commonly categorised by two factors - the services they provide and the customers they serve. As an example, investment banks and commercial banks are two separate financial entities with considerably different functions. Their clientele differs, they provide different services, and they earn money in different ways. In this article, we’re going to understand these differences.

Commercial banks serve millions of businesses globally, from small and medium enterprises (SMEs), to global corporations, by offering depository functions, merchant services and other corporate-oriented offerings. On the contrary, investment banks tend to act as an advisory service for large corporations and organisations.

Following the Wall Street Crash of 1929 and the global financial crisis in 2008, increasing regulatory efforts by governments (e.g. The Glass-Steagall Act and ring-fencing) have been imposed to separate commercial and investment banking operations. The purpose of these policies has been to prevent another financial crisis by minimising the amount of risk that commercial banks are exposed to through various operations. Although legally separated, the two divisions are often found alongside each other. Banks such as HSBC, Barclays and JPMorgan Chase are prime examples of banks that offers both services.

What is Commercial Banking?

Commercial banks, akin to retail banks, are, in their entirety, a depository institution.

Stripped down to their core, they provide two functions; a place to deposit and a place to borrow money. However, we should think of retail banks and commercial banks as two sides of the same coin. The services they provide are conceptually identical, but their clientele is slightly different. Retail banks offer their services to individuals like you and I, whereas commercial banks act as a wholesaler of these services, catering to businesses, organisations and sometimes even governments.

What Services do Commercial Banks Offer?

· Deposit Accounts: These include Current and Savings accounts which earn money through the rate of interest.

· Secured loans: A company may gain a loan of £5,000 from a bank to kickstart its business. But what happens if the company fails and can’t pay the loan back? Well, the borrowed money is secured and protected. This means that when the company applies for the loan, it does so using collateral assets. If the borrower can’t pay, it may have to forfeit these assets (e.g. a house/car/office etc).

· Unsecured loans: These are loans that are issued based on the borrower’s creditworthiness. The higher the credit score, the more likely they’ll be approved for the loan.

· Access to cash: Commercial banks give customers access to cash, either in physical terms (i.e. through ATMs), or without physically withdrawing the money (i.e. through bank transfers).

A commercial bank differentiates itself from a retail bank by meeting the needs of businesses and institutions. These services can present themselves in a range of products, as outlined below:

· Merchant services: Facilitating and accepting payments that are made to a company by a customer. For example, when you buy a t-shirt on ASOS, have you ever noticed your bank’s logo when it says that the payment is being processed?

· Specialised lending services: Tailored packages for lending to businesses.

· Benefits plans: Banks provide assistance by creating benefits plans such as insurance policies, pensions, and healthcare.

· Cash management: This is assistance offered by a bank to help businesses manage payments and collections, to facilitate exchanges of foreign currencies, and to secure large sources of capital.

Examples of commercial banks in the U.K. are HSBC, Lloyds, and Barclays.

What is Investment Banking?

Firstly, if you’ve not read our article on the functions and operations of an investment bank, you should read it here first! In simple terms, an investment bank acts as a financial intermediary, offering advice and support to clients, corporations, and governments, in financial transactions.

A couple of typical activities an investment bank would perform have been outlined below:

· Proprietary trading: Investment banks use their own funds, or their clients’, to invest in stocks and shares, currencies, commodities and bonds.

· M&A advisory: Investment banks act as the middleman in a Merger and Acquisition transaction. See our articles here and here about M&A’s for more information.

Investment banks offer a wider array of services and products, but these will be discussed in a future article.

Household names in the U.K.’s investment banking sector include the likes of J.P. Morgan, Goldman Sachs, Barclays and HSBC, to name a few. These aforementioned companies are referred to as bulge bracketinvestment banks, due to their large size. However, there are also much smaller boutique investment banks, which offer all, or some of the same services.

Key differences:

· Due to the clientele they serve, investment banking work is tailored to the requirements of the customer. On the other hand, commercial banks offer more general and routine services.

· Investment banks make money through charging fees for their services and advice, while commercial banks rely largely on the interest spread, though earn some money through other services mentioned.

What is an interest spread? Put simply, commercial banks will pay you (very low) interest in your savings account. However, they’ll charge a higher rate of interest to people and businesses that borrow money and take out loans. In this way, they are able to make profits based off the difference in interest rates that they charge different customers.

· Investment banks have more operational freedom than commercial banks.This gives investment banks a higher tolerance for and exposure to risk, albeit, at their client’s will. The greater the risk, the greater the potential to make a lot more money.

· The customer base of an investment bank is very concentrated compared to that of a commercial bank. For example, most investment banks will have a certain threshold to decide whether or not a firm is a suitable client, based on the size or market cap of the company.