The Functioning of Commercial Banks

Commercial banking is a field in which services are provided based on an individual or businesses financial capacity and ability. In other words when lending money banks look for several things to ensure their money is returned with interest. These factors include credit risk, assets, liabilities, payment history, credit rating, number of credit inquiries etc. In the case of a business loan a business plan is submitted to a loan officer and reviewed for potential profitability. If the business plan is sound and acceptable to the loan officer a loan contract is offered.

The business of commercial banking is competitive as many banks exist. This creates what economists call ‘monopolistic competition’ at the retail level and this is where pricing power is largely determined by market forces such as prime rate, competing loan rates, federal funds overnight rate and competitor rates. Sometimes commercial banks borrow money with rates in the 100’s or the third decimal point in after the singles digit. For example, a bank may borrow money from another bank at a rate of 1.234% interest.


After the Great Depression of the 1930’s the Banks became heavily regulated to prevent another Depression from occurring. After time improvements in economic management allowed for deregulation of Banking which began around 1980. Since then new Banking legislation has given commercial banking more scope and ability to pursue expanded Banking functions. This enables banks to compete across banking services and improves banking functions as whole. Some of this recent legislation includes the Financial Services Modernization Act of 1999, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, Omnibus Budget Reconciliation Act of 1993 and the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) (Fraser, Gum and Kolari p.44)


To compete commercial banks use a strategy combining advertising, interest rate adjustment, fees, market positioning, product positioning and a host of other factors relating to daily operational activities. With an increase in competition from Banking deregulation these services have become more refined and efficient. Bank performance can be measured using metrics such as ration analysis. Some of the more widely used ratios are Profit Rations such as Return on Equity (ROE), Return on Assets (ROA),; Risk Ratios such as ‘Provision for Loss Ration, Liquidity and Operating Efficiency. (Ibid p.74-77). These ratios help clients, managers and investors determine the safety, security, profitability, efficiency and competitiveness of a bank.

Since banks have so much assets and liabilities how they manage these finances is crucial to their success. Combining fees, interest rates, and financial leveraging in profitable ways allows a bank to continue operating. If a bank has too much debt and not enough assets and that debt becomes faulty or delinquent in can damage a banks reputation leading to an undesirable bank performance rating. These ratings are measured and monitored by the Federal Deposit and Insurance Corporation (FDIC). They maintain statistics and analytics pertaining to commercial banks. The link at the bottom of this page is a gateway to a wealth of banking information.

Thus we have a brief overview of the Commercial Banking environment and how they function. Banks are highly specialized institutions whose main product is money. Money is a banks business and the business of their clients whether they be individuals, companies or countries. There are many laws and nuances to banking that create a nexus of commercial ingenuity and financial management that is highly evolved.



Donald R. Fraser, Benton E. Gup and James W. Kolari. ‘Commercial Banking: The Management of Risk’. Cincinnati, Ohio. South-Wester College Publishing, 2001.