Understanding the Four Types of Banks: Roles and Functions
- Felipe Malfitani
- Nov 12, 2024
- 6 min read
Updated: Jan 14
Introduction
A bank is a broad term that encompasses any financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Because of this broad definition, many different banking types have emerged over the last few centuries.
There are many types of banks and banking systems, with many of them overlapping and sharing common elements. This can make it especially confusing when dealing with specific types, each dealing with different elements, especially when we don’t have a clear idea of which each of these banks refers to and is responsible for.
This article will go into the four most common banking types: central banks, commercial banks, retail banks, and investment banks.
Central Banks
Also called a national or a reserve bank, a central bank manages the currency and monetary policy of a country. The central bank of the United States is the U.S. Federal Reserve (commonly referred to as the “Fed”). The Fed is responsible for setting interest rates, managing the circulating money supply, and regulating financial markets. In some occasions, the Fed also lends large amounts of money to commercial and retail banks in times of economic crisis. The Fed consists of twelve public-private regional banks. The New York Fed, one of these regional banks, runs the Fed’s trading desks, helps regulate Wall Street, and oversees the largest pool of assets.
One especially important aspect of the Fed is “setting rates.” This common Wall Street lingo refers to the federal funds rate, which is the interest rate at which banks lend to each other overnight. Changes to this rate affect borrowing costs across the economy, impacting everything from mortgage rates to business loans. Lowering rates generally stimulates economic growth by encouraging borrowing and spending, while raising rates can help control inflation by reducing spending. If the Fed sets new rates which surprises the general expectations and operations of the economy, the stock market may fluctuate violently.
The Fed controls many other aspects of the U.S. economy and is the driving factor for things like inflation (generally aiming for an inflation rate of 2%), unemployment levels (promoting maximum employment), and general financial market stability. It influences the interest rates for loans, averaging a federal funds target range of 4.75% - 5%, though this changes over time. Their current goal is set at 4.5% - 4.75%, which can be found on their website.
Commercial Banks
A commercial bank is a financial institution that accepts deposits from the public and provides loans for consumption and investment purposes, aiming to make a profit. These banks offer a range of services, including checking and savings accounts, loans, and other financial products for individuals and businesses.
Commercial banks provide many financial services, accepting deposits through various accounts like savings, current, and fixed deposits, offering secure places for individuals and businesses to store funds. They also lend funds, typically through loans, advances, cash credit, overdrafts, and bill discounting. By lending more than their deposits, commercial banks effectively create new money in the economy, which can stimulate economic growth. Additionally, they facilitate payment transfers, act on behalf of customers for collecting cheques, paying bills, and offer safe deposit lockers and foreign exchange services.
American Express (AmEx) essentially functions as a commercial bank by offering a range of financial services, such as accepting deposits and opening personal savings accounts, like High Yield Savings Accounts (HYSA) and Certificates of Deposit (CDs). AmEx can also provide loans to eligible customers, facilitate financial payments, and offer services such as foreign exchange (e.g., trading US dollars for British Pounds).
Retail Banks
A retail bank is very similar to a commercial bank, and often, a financial institution can be classified as both due to the similarity in services, as is the case with JPMorgan Chase. Both accept deposits, provide credit, facilitate payment services, and offer financial advisory services. However, key differences help distinguish these two types of financial institutions.
Retail banks primarily serve individual consumers and small businesses, offering personal banking products like checking and savings accounts, personal loans, mortgages, credit cards, and financial advisory services. They handle a high volume of low-value transactions, focusing on personal financial management. In contrast, commercial banks cater to businesses, from small enterprises to large corporations and government entities, offering business-oriented products like business loans, lines of credit, treasury and cash management services, merchant services, and trade financing. They handle fewer, high-value transactions, emphasizing corporate financial operations.
JPMorgan Chase & Co. can be considered both a retail and commercial bank, providing personal banking services under the Chase brand and commercial banking solutions to businesses of various sizes.
Investment Banks
Investment banks are the most complex of the four types of banks, involving a lot of technical terminology. When a company wants to raise capital, it has many options, with issuing stocks and bonds as primary methods. However, specific tasks, like pricing financial instruments to maximize revenue and ensuring legality, require expertise. Investment banks provide this expertise. Their primary roles include advising businesses and governments on financial challenges and helping procure financing through stock offerings, bond issues, or derivative products.
Investment banks handle underwriting and issuing new securities, evaluating these securities, determining pricing, and managing sales. They also provide advice on mergers and acquisitions (M&A), assess potential deals, advice for or against them, negotiate terms, and offer counter-proposals. Additionally, investment banks may buy and sell securities on behalf of clients. They also have a research sector to conduct in-depth analysis of markets, industries, and companies.
To prevent conflicts of interest, the “Chinese wall” or “ethical wall” serves as an information barrier within an organization to prevent the exchange of information that could lead to conflicts. In investment banks, this wall typically separates the research department from trading and sales, as those with non-public information are restricted from public stock trading. Finally, many investment banks offer asset management services, managing investment portfolios for individuals, corporations, and institutions to meet specific financial goals.
Summary
The banking industry is home to several different systems, structures, and domains, with a wide range of institutions, each with a unique purpose and role within the economy. Central banks shape monetary policy and economic stability, commercial and retail banks provide essential financial services to the public and businesses, and investment banks drive capital markets and corporate financial growth. Understanding the functions of each bank type provides insight into how they collectively support economic health and financial infrastructure.
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