Commercial banks and the central bank are both integral building blocks for the United States economy. While they influence the economy on different levels, the impact on both society and everyday life is monumental.
Commercial banks and the Federal Reserve influence how much money is circulating in the public, and they are able to increase or decrease it based on need and economic trends. Understanding how each type of bank operates and what they share in common can help businesses plan for economic trends and consumer needs.
What Is a Commercial Bank?
Commercial banks are what most people think of when they hear the word "bank." They lend money, accept deposits, offer checking and savings accounts and offer a variety of other financial products. Even though the word "commercial" makes it sound like they deal only with or primarily with businesses, this is not the case. Commercial banks provide banking services to both individuals and companies or enterprises.
How a Commercial Bank Makes Money
A commercial bank makes money through the interest rates it charges on loans, which it funds through the deposits made by individuals and businesses. The relationship central to its daily operations is its relationship with the public. Prior to the Great Recession, commercial banks were seen as separate from investment banks, but this line has since been blurred.
In order to make a profit, commercial banks must earn more money from loan interest than they pay out as interest on savings accounts, CDs and other interest-bearing accounts. While most banks set ethical loan interest rates and terms, others try to maximize their own profits through unfair terms and high interest rates.
What Is a Central Bank?
Central banks are in charge of producing and distributing money in a country or union. The United States has the Federal Reserve, which was established in 1913 as an institution that is independent from the government yet established by it. The aim of the Federal Reserve Act was to keep people from withdrawing money from commercial banks in bulk in ways that cause national economic instability.
While commercial banks can only issue liabilities, such as loans, a central bank is a legal monopoly that has the power to issue currency as well as set interest rates. In the U.S., the Federal Reserve has 12 locations throughout the nation that carry out these responsibilities as well as act as a bank to the federal government and an intermediary between member banks. The largest relationship central to its operation is the commercial banking industry that serves the public. The entire banking system is accountable to the federal government.
Three Functions of a Commercial Bank
The difference between reserve bank and commercial bank functions lies primarily in its audience. The central bank acts as a bank to member banks and the federal government, while commercial banks serve the general public. The following three functions characterize most of their responsibilities:
- Making money: Commercial banks aim to make a profit from the financial services they offer. If they only offered interest-bearing savings accounts without offering loans, they would not have the money to cover the interest. Thus, they also offer loans that charge an interest rate so they can cover the growth of the interest-bearing financial products while still making a profit for themselves. This profit is used for salaries, operations and growth.
- Creating money: Commercial banks aim to create money in the economy through the loans they issue. When consumers and businesses are approved for a loan, that money enters the economy in the same way that printed money from the Federal Reserve enters the economy. It goes toward job creation, goods and services, business growth and more.
- Providing services: When your business is in a financial pickle that you cannot get out of on your own, you rely on the financial services of a commercial bank to make ends meet. Likewise, when you are preparing for business growth or retirement, you rely on their services to help your money grow in a safe and stable way. These are things that we cannot do for ourselves, but commercial banks make it possible.
Three Functions of a Central Bank
Both commercial banks and central banks deal with money and impact the economy, but they are not one and the same. One way to tell the difference between reserve bank and commercial bank roles is to think about how a person cannot walk up to a Federal Reserve bank and open a checking account. Instead, member banks meet certain requirements and buy shares in order to be included in and served by the Federal Reserve.
In order to meet the needs of an economic system, our central bank performs the following three functions:
- Money supply: The Federal Reserve prints and issues bank notes to be circulated as currency through its member commercial banks that serve the public. They control how much currency is released, when and to whom, as well as interest rates. The hope is that this impacts and guides economic growth toward stability rather than chaos.
- Regulation: The Federal Reserve requires member commercial banks to keep a certain amount of reserve and capital that it cannot put up for loans. This ensures relative safety for banking customers and impacts the growth of the economy. When the Federal Reserve wants to inject our economy with money, it lowers the reserve requirements, and when it needs to slow down spending, it raises it.
- Lending: The Federal Reserve can choose to lend money to the government, commercial banks and other financial institutions facing hardship. This ensures stability to the population, who counts on the viability of their bank for their financial future. When the government is involved, it means that government loans do not always result in higher taxes for taxpayers.
Independence From Government
The Federal Reserve is an independent central bank, which means that its decisions do not need to be approved by anyone in the federal government. In addition, our federal government does not fund the Federal Reserve. Instead, it gains its income for operations primarily through the government securities it issues.
So, while the Federal Reserve is independent from the government, it also serves it and is accountable to it. The choices of the Federal Reserve, the policies of the Federal Reserve and the loan amounts the Federal Reserve issues directly impact the government, its policies and even taxation of the public.
Commonalities of a Central Bank and a Commercial Bank
The Federal Reserve and commercial banks have very different roles within the economy, but one needs the other to exist well and to serve the public well. Even with all of the differences between reserve bank and commercial bank responsibilities, they still share several things in common:
- Loans: Both commercial banks and central banks issue loans. While the Federal Reserve issues loans to its member banks or to the federal government, commercial banks issue loans to individuals and businesses. Loans work in the same way. They utilize interest rates in order to generate income streams that sustain growth.
- Money: Both commercial banks and central banks create money. While the Federal Reserve issues legal tender and injects it into the economy, commercial banks create money by offering loans to the public. While the commercial bank is likely to have more liabilities than assets, the reserve requirements set by the Federal Reserve ensure they keep it in check and prevent bank runs.
- Economy: Both commercial banks and the Federal Reserve have a powerful influence on the economy. Both can create money or slow down economic growth with their lending patterns. The Federal Reserve influences how commercial banks do this, and commercial banks must answer to the regulations of the Federal Reserve.
Commercial and Central Bank Differences
The Federal Reserve would not function properly without its member banks, the commercial banks. Because they work as a team or in tandem in our economy, they do not perform the same tasks in the same way. That would make as much sense as giving your top manager the same responsibilities as your brand new sales associate who just started last week.
Here are some major differences in how commercial banks and the Federal Reserve function. You will notice that even in their differences, they are still very intertwined:
- Audience: The Federal Reserve tailors its services to the federal government as well as commercial banks so they can be strong in serving the public. Commercial banks tailor their services to businesses and individuals who need financial products so they can strongly engage with the marketplace.
- Money: The Federal Reserve controls the release of legal tender, lending between banks and federal government loans. This frees up money so banks can loan money to the public. While the Federal Reserve creates money, commercial banks lend it. Even though commercial bank loans do create money in the economy, they do not create newly printed legal tender.
- Regulation: The Federal Reserve regulates the banking system in the U.S. through establishing the reserve rate and interest rates between banks and in its own loans. Commercial banks do not establish regulations, but they must follow them in order to maintain their shares in the Federal Reserve. Their loan rates to consumers are greatly influenced by the Federal Reserve's interest rates to banks.
- Customer service: While the Federal Reserve provides customer service in the sense that it maintains employees who are responsible for interacting with the government and commercial banks, it does not need to provide the same kind of customer service as commercial banks. Commercial banks provide customer service to individual customers as well as invest in advertisements and consumer education about their products.
Banks and the Economy
Commercial banks do not always make the best decisions about how to lend, when to lend and under what terms to lend money to consumers and businesses. In the Great Recession of 2008, this was evidenced in how the housing bubble burst, banks went belly up, retirement savings crashed and many people lost their jobs. The Federal Reserve's response to this crisis was intended to help the economy recover from it as quickly as possible, so even though they do not serve businesses and individuals directly, their actions impact everyday life.
In a perfect world, the central bank would set interest rates and reserve requirements in ways that increase stability in the economy instead of decrease it. Unfortunately, both commercial banks and the Federal Reserve sometimes make wrong choices that do not have a positive impact on the overall economy or the global economy.
Some economists respond to this challenge by suggesting that commercial banks need greater regulation on one hand or less regulation on the other. Others argue that the Federal Reserve should no longer be independent on one hand or that it should be more independent (or nonexistent) on the other. While everyone is looking to increase economic stability, there is great disagreement about the best way to achieve it.
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- Bloomberg: Central Bank Independence
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- Center on Budget and Policy Priorities: The Critical Importance of an Independent Central Bank
- Online Accounting Degree Programs: How Does the Federal Reserve Affect the Economy?
- Investopedia: The Role of Commercial Banks in the Economy
- European Central Bank: Commercial Bank Failures During the Great Recession: The Real (Estate) Story