Investment and Commercial Banks: Their Differences, Essay Example

Abstract

This essay examines the major differences in business models and core principles between investment and commercial banks. The major difference is that commercial banks accept deposits from customers and gives loans to its customers, while investment banks provide risk management solutions to large corporations. The distinction line between these two institutions is blurring because banks that were traditionally commercial banks are now acting as holding companies, with subsidiaries that provide investment-banking activities.

Investment Banks and Commercial Banks: Their Differences

Investment banks refer to financial institutions involved in public and private market transactions for corporations, governments, and investors and provide strategic advisory services. Commercial banks, on the other hand, comprise of those institutions that accept customer deposits, give out loans to customers, small, medium-sized and large companies. In recent years, the distinction line between these two business models has been declining as banks that were traditionally commercial banks are now offering investment-banking services through their subsidiaries (Iannotta, 2010). This trend characterizes banking industries in most parts of the world including USA, Asia, and Europe. This essay will examine the differences in core principles and business models between these two kinds of financial institutions.

Discussion

One major difference between investment and commercial banks regards nature and scope of their business operations. According to Weert (2010), investment banks give large corporations access to capital market and advice on mergers and acquisitions. Investment banks also reduce risks associated with large corporations by engaging in transactions that reduce the exposure of the businesses to market instability. In contrast, core business of commercial banks is to manage customer deposits and to lend to small and medium-sized firms. The risk levels at a commercial bank are extremely low because they take deposits from one customer and lend the same to another customer.

Another difference concerns principle of financing business activities used by these banks. An investment bank does not view savings or deposits as a source of funding, but the principle of business is that financing would be sourced primarily in the institutional markets. In contrast, commercial banks focus on attracting customers by lowering their lending rates and increasing their interest rates on deposits because they mainly depend on the customer deposits. They also offer services such as mortgages to attract clients. Therefore, commercial banks normally make money from fees charged on customer deposits, advisory services, loans, and mortgages (Essvale Corporation Limited, 2006).

In recent years, the line between commercial and investment banks in the US has been declining as many commercial banks now offer investment-banking services. Initially, the “Glass Steagall Act” banned commercial banks from investing in investment banking businesses (Grosse, 2004, p.27). However, this started to change when the Gramm-Leach-Bliley Act lifted this ban to allow the banks carry out investment bank operations. For instance, banks such as Goldman Sachs are ‘pure’ investment banks while others like HSBC and Citigroup are holding companies with commercial and investment subsidiaries. Similarly, commercial banks in Europe and Asia have expanded from the realm of taking deposits from customers and lending to the realm of arranging, advising on, and underwriting securities. They engage in such services through their subsidiaries. This is an indication that such differences are now fading, not only in America, but also in Asia and Europe.

Conclusion

The major difference between investment and commercial banks regards nature and scope of their business operations. Investment banks provide large corporations with access to capital market while commercial banks manage customer deposits and provide loans to small and medium-sized firms. Another difference concerns principle of financing business activities used by these banks. However, such differences have been declining in most parts of the world including America, Asia, and Europe because most banks nowadays operate as holding companies, i.e. providing both investment- and commercial-banking services.

References

Essvale Corporation Limited. (2006). Business knowledge for IT in investment banking. London: Essvale Corporation Limited.

Grosse, R.E. (2004). The future of global financial services. Hoboken, NJ: Wiley-Blackwell.

Iannotta, G. (2010). Investment banking: A guide to underwriting and advisory services. Berlin: Springer.

Weert, F. (2010). Bank and insurance capital management. Hoboken, NJ: John Wiley and Sons.