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Commercial Banks

commercial banks

Financial institutions that accumulate deposits from savers and provide credit to firms, individuals, and government agencies.

Commercial banks accumulate deposits from savers and use the proceeds to provide credit to firms, individuals, and government agencies. Thus they serve investors who wish to "invest" funds in the form of deposits. Commercial banks use the deposited funds to provide commercial loans to firms and personal loans to individuals and to purchase debt securities issued by firms or government agencies. They serve as a key source of credit to support expansion by firms. Historically, commercial banks were the dominant direct lender to firms. In recent years, however, other types of financial institutions have begun to provide more loans to firms.

Table 1

Major Financial Institutions

Institutions

Description

Commercial Bank

Accepts both demand (checking) and time (savings) deposits. Offers interest-earning savings accounts (NOW accounts) against which checks can be written. Offers money market deposit accounts, which pay interest at rates competitive with other short-term investment vehicles. Makes loans directly to borrowers or through the financial markets.

Mutual Fund

Pools funds of savers and makes them available to business and government demanders. Obtains funds through sales of shares and uses proceeds to acquire bonds and stocks. Creates a diversified and professionally managed portfolio of securities to achieve a specified investment objective. Thousands of funds, with a variety of investment objectives, exist. Money market mutual funds provide competitive returns with very high liquidity.

Securities Firm

Provides investment banking services by helping firms to obtain funds. Provides brokerage services to facilitate the sales of existing securities.

Insurance Company

The largest type of financial intermediary handling individual savings. Receives premium payments and places these funds in loans or investments to cover future benefit payments. Lends funds to individuals, businesses, and governments or channels them through the financial markets.

Pension Fund

Accumulates payments (contributions) from employees of firms or government units, and often from employers, in order to provide retirement income. Money is sometimes transferred directly to borrowers, but the majority is lent or invested via the financial markets.

Savings Institution

Similar to a commercial bank except that it may not hold demand (checking) deposits. Obtains funds from savings, NOW, and money market deposits. Also raises capital through the sale of securities in the financial markets. Lends funds primarily to individuals and businesses or real estate mortgage loans. Channels some funds into investments in the financial markets.

Savings Bank

Similar to a savings institution in that it holds savings, NOW, and money market deposit accounts. Makes residential real estate loans to individuals.

Finance Company

Obtains funds by issuing securities and lends funds to individuals and small businesses.

Credit Union

Deals primarily in transfer of funds between consumers. Membership is generally based on some common bond, such as working for a given employer. Accepts members' savings deposits, NOW account deposits, and money market accounts.

Like most other types of firms, commercial banks are created to generate earnings for their owners. In general, commercial banks generate earnings by receiving a higher return on their use of funds than the cost they incur from obtaining deposited funds. For example, a bank may pay an average annual interest rate of 4 percent on the deposits it obtains and may earn a return of 9 percent on the funds that it uses as loans or as investments in securities. Such banks can charge a higher interest rate on riskier loans, but they are then more exposed to the possibility that these loans will default.

Although the traditional function of accepting deposits and using funds for loans or to purchase debt securities is still important, banks now perform many other functions as well. In particular, banks generate fees by providing services such as travelers checks, foreign exchange, personal financial advising, insurance, and brokerage services. Thus commercial banks are able to offer customers "one-stop shopping."

 
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