Hi everyone, my name is Kenji and in this video I want to explain the key difference between commercial banks and investment banks.
So just taking a step back and looking at banking on the whole, basically banking would be an intermediary between those who have money and those who need it. Linking them up, and that’s basically what banking is.
Now within that, it’s divided into two main categories. The commercial banks and the investment banks, so let’s get into the main differences between the two.
The first main difference is the customers they serve.
Between commercial banks, and investment banks, there's a clear split.
So let´s start with the one you're probably more familiar with, commercial banks. They deal like I mentioned earlier with people like you and I, and small and medium sized companies like your local coffee shop for example. They may also deal with some larger companies, but that's not really their biggest focus. Some examples of these banks are Capital One in the US, and NatWest in the UK.
On the other hand, we have investment banks. These typically don't work with normal people like you and I. Instead, they only work for large players like big companies, institutional investors (which are investors like pension funds and mutual funds), governments and high net worth individuals. By high net worth I mean like really rich, as in well above the millionaire mark.
Some examples of investment banks might include Evercore and Morgan Stanley and they tend to have offices all across the main financial cities like London, New York, or Hong Kong.
Now let’s look at some of the differences in the services they offer.
On the one hand, for commercial banks one of the main services is accepting deposits, so if I make some money I might leave it there. And secondly taking out loans. So it could be a loan for a mortgage, a car or whatever.
They also provide some more secondary services such as credit cards and exchanging foreign currencies.
So it’s really quite simple on the whole.
On the other hand, the services of investment banks are far more complex and are a lot more personalized.
Generally, they offer two main services: advising and financing.
Advising consists of things like whether they should your business merge or acquire another company (called M&A), should you restructure your business because it’s not doing very well, and other things along those lines.
Financing mainly consists of raising money through the financial markets for clients. Examples include an IPO (initial public offerings, which is the first time a company sells its shares to the public markets) as well as bond offerings.
Some other services include trading income, which they generate by either trading with other people's money (basically their clients), or their own money (known as proprietary trading), as well as doing economic research.
Those are the main services that they offer.
Now looking into how they actually make money.
Commercial banks make money by lending to borrowers with an interest rates above what they pay to depositors.
Lets look at an example. Suppose this depositor has been paid $1000 dollars this month. She's putting the money in the bank. In turn, the bank pays her 2% for trusting them with the money. So what does the bank do with that $1000? They decide to lend it out to somebody that needs it! In this case, this person wants to borrow $1000 dollars. Maybe it's to pay for education, a car or whatever really. In turn, he has to pay the bank a 5% interest rate.
So the difference between what the banks pays in interest and what it gets in interest (i.e. the interest income vs. The interest expense is what gives them the 3% spread, and that's how they make their money! This concept also applies to businesses.
As I mentioned earlier, they also have other services like exchanging currencies and credit cards, where they also take fees.
On the other hand we have investment banks.
Investment banks mainly earn money by charging fees and commissions. For example, suppose company A wants to sell its shares to the public market because its short in cash. Let's say that's 10M shares. The investment bank will underwrite all the shares. That means that they pledge to buy all the unsold shares. So they take on the risk for those 10M shares. So the bank takes these shares and asks for a price to all the investors in the market. After that, they agree to a $25 price per share.
So for company A, that's 250M dollars. As for the investment bank, let's say they charge a 3% fee, so they've made 7.5million dollars through this transaction. And that's one of the main ways they make money.
They may also get fees for selling bonds, derivatives and other financial instruments. And as I mentioned earlier they might have advisory fees, so they might take a fee for giving out that advice, that one thing. For trading they either take a fee for managing that money or they might take a percentage of the profits as well. And then lastly for economic research, they’re basically going to sell those research papers say.
So as you can imagine, commercial banks have way more customers than investment banks do, because they deal with everyday regular people. But while commercial banks generally collect small amounts from customers, investment banks have huge fees from a limited number of customers. So it’s a bit of a difference in business models here.
The last key difference that I wanna touch on has to do with Risk and Regulation
As you can probably tell by now, Commercial banks and investment banks have very different models, so they don’t have the same regulation.
In the US, commercial banks are regulated by the by a bunch of different regulators including the Federal Reserve & the Federal Deposit Insurance Corporation (FIDC).
And so these essentially ensure that the bank doesn’t go bust and people’s money stays safe. Also, the account balance of a customers is fully insured by the government for up to 250,000. And so it’s very well regulated because they government doesn’t want to be paying out that money right.
On the other hand, Investment banks don't have the same degree of regulation. That's because, number one, they don't deal with regular people, and two, their services are much more personalized so they can't be effectively regulated in the same way. In the U.S., the main regulator for investment banks is the Securities and Exchange Commission (SEC).
In terms of risk, a commercial bank has much lower risk exposure. Basically, the government regulations that the commercial banks must adhere to make them less prone to risk. Additionally, when you deposit your money in a savings account, not expecting to get rich with it, but rather that it's secure there. Also, when you as a client go to deposit your money, you’re not hoping to get rich just by depositing in the bank. Instead, you’re hoping that it’s going to be secure. As such, the bank doesn’t take too much risk.
On the other hand, investment banks are paid to create value for their customers by taking high risks. Customers come to them to find investors and capital, so the nature of the business, and the looser regulations makes them riskier.
Now we've looked at both commercial banks and investment banks. But sometimes, this split isn't so clear. That's because of universal banks. These are the biggest banks in the world, and they actually offer both services commercial and investment banking services
These are the household names you probably see in movies like JPMorgan Chase, which is a merger of JPMORGAN, which used to be just an investment bank, and Chase, which used to be just a commercial bank. Other examples include deutsche bank and HSBC.
So why would commercial banks and investment banks want to merge? Basically, it's because they can become a one stop shop for customer, where they can help with absolutely anything related to a company's finances. In short, it's just another way to sell more products to clients.
Now this hasn't been without controversy. Traditionally, commercial banks and investment banks had to be separate in an act called the Glass-Steagall Act. In came around the 1930s, just after the great depression, and it was around until 1999 that the Glass Steagall act was repealed, and hence why we have universal banks today.
Back in 2008, this came into controversy during the financial crisis, and some of the blame was put on this act. But to be honest, this is not something for this video, and maybe I’ll cover it in a different one
Well there you have it. Hope you found the video helpful, thank you for watching and I'll see you in the next one