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

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.

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:

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.

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.

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, merger and acquisition (M&A) 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.

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.

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.