Commercial banks: the business model · RiskAtoms Academy

By the end you will be able to

1Explain maturity transformation and how a commercial bank earns net interest income.
2Read a simple bank balance sheet and say which items earn interest and which cost it.
3Calculate net interest income and the net interest margin.
4Name the main risks the business model creates, and why banks are closely regulated.

Why it matters

You can take your savings out of the bank tomorrow. The bank has lent much of that money as a 25-year mortgage. Both promises hold at once, most of the time. When they stop holding, you get a bank run.

Core explanation

Borrow short, lend long, keep the difference

A commercial bank is the bank on the high street or in your phone. It takes deposits from households and firms, and it lends to them: mortgages, car loans, credit cards and business loans. Its core business is the gap between the interest it earns on loans and the interest it pays on deposits.

Think of a market trader who buys apples at 30 cents and sells them at 40. A bank “buys” money from savers at, say, 2% a year and “sells” it to borrowers at 5%. The difference, added up across every loan and deposit, is the bank's net interest income (NII). For most commercial banks it is the largest source of revenue.

Three transformations. A bank does more than pass money along. It changes the shape of the money as it goes:

Maturity: deposits can be withdrawn any day, while a mortgage runs for decades. Funding long-term loans with short-term money is maturity transformation.
Liquidity: savers hold something they can spend at once, while the bank holds loans that are hard to sell quickly.
Credit: a saver lends to the bank, which is safer than lending to one stranger. The bank spreads the risk across thousands of borrowers and checks each one.

This works because depositors rarely all want their money on the same day. The bank keeps a slice of its assets as cash and reserves at the central bank, and lends the rest. If too many depositors ask at once, the bank cannot sell its loans fast enough. That is a bank run.

ExploreFollow the money through a bank

Click a box to see what happens there.

Depositors

Savers and firms place money with the bank. For the bank this is a liability: it owes the money back. Most deposits can be withdrawn on demand. Banks also borrow from other banks and investors (wholesale funding), which usually costs more.

The balance sheet. Everything a bank owns is an asset: loans, bonds, reserves. Everything it owes is a liability: deposits, wholesale borrowing, bonds it has issued. Assets minus liabilities is equity. Your current account is an asset to you but a liability to the bank, which often surprises people.

Sort itAsset or liability, from the bank's point of view?

Your current account balance
A 25-year mortgage the bank has made
Reserves held at the central bank
Bonds the bank has issued to investors
Government bonds the bank has bought
An overnight loan from another bank

Rates and the margin. When the central bank raises its policy rate, some bank rates follow at once (floating-rate loans, reserves, wholesale funding), while others are fixed for years (many mortgages, bonds the bank holds). Deposit rates usually rise only partly. The share passed on is the pass-through. Whether a bank gains or loses from a rate rise depends on this mix, which you can test in the Try it below.

Where the risks sit. The business model creates three big risks. Credit risk: borrowers may not repay. Liquidity risk: depositors may withdraw faster than assets can be sold. Interest rate risk: if the bank holds fixed-rate assets and rates rise, their value falls and its funding gets dearer. Because equity is thin, small losses on assets can wipe out a large share of it. This leverage is why banks are among the most tightly regulated firms in the economy.

The formal version

The idea fits in one line. Let $A_i$ be the size of each asset and $r_i$ the rate it earns; let $L_j$ be each liability and $c_j$ the rate it costs. All rates are annual.

The two formulas, for reference

\text{NII} = \sum_i r_i A_i - \sum_j c_j L_j \qquad \text{NIM} = \frac{\text{NII}}{\text{interest-earning assets}}

Banks report NIM over a year, using average balances. Typical margins run from about 1% to 4%, depending on the country, the mix of loans and the level of rates.

Try it

Here is a toy bank with €1,000m of assets. Mortgages carry rates fixed when they were written. Business loans pay the policy rate plus 2.5 points, reserves earn the policy rate, wholesale funding costs the policy rate plus 0.5 points, and deposits pay a share of the policy rate. At the starting settings NII is €28.55m and NIM is 2.86%.

Push the policy rate up and down. Then lower the deposit pass-through below 24%: the line turns upwards, and higher rates now help the bank.

Try itRun a toy bank

Central bank policy rate3.00%

Share of the policy rate paid to depositors30%

Rate fixed on existing mortgages4.00%

Interest earned€41.25m

Interest paid−€12.70m

Net interest income€28.55m

Net interest margin2.86%

A 1-point rise in the policy rate changes NII by −€0.45m.

Assets (earn)	€m	Rate	Interest
Mortgagesfixed	500	4.00%	20.00
Business loansmoves	250	5.50%	13.75
Government bondsfixed	150	3.00%	4.50
Reserves at the central bankmoves	100	3.00%	3.00
Liabilities (cost)
Customer depositsmoves	750	0.90%	6.75
Wholesale fundingmoves	170	3.50%	5.95
Equity (no interest)	80

NII at every policy rateOther settings held. The dot is today's rate. A rising line means higher rates help this bank.

Worked example

Harbour Bank's year

Harbour Bank is a made-up US lender. Amounts are in US$ millions, rates are simple annual rates on average balances for the year, and the tax rate is 21%. Try each step before revealing it.

Balance sheet	US$m	Rate
Asset: Loans	8,000	5.5%
Asset: Securities	2,500	3.2%
Asset: Reserves	1,000	4.4%
Liability: Deposits	9,000	2.0%
Liability: Wholesale borrowing	1,400	4.8%
Equity	1,100

From balance sheet to profit

Step 1 of 6

1
Interest earned
8,000 × 5.5% + 2,500 × 3.2% + 1,000 × 4.4% = 564.0

Regulatory lens

Because a bank's failure hurts depositors and the wider economy, governments protect deposits and regulate banks closely. Most rules trace back to standards from the Basel Committee on Banking Supervision (BCBS), which you meet in L1.2.09.

Deposit insurance. If a bank fails, a public scheme repays insured deposits up to a limit: US$250,000 per depositor per bank for each ownership category in the US (FDIC), and €100,000 per depositor per bank across the EU. The UK, Japan, Hong Kong, Australia and many others run similar schemes. Insurance makes runs less likely, because small savers have less reason to rush.
Capital. Basel III requires banks to hold common equity of at least 4.5% of their risk-weighted assets, plus a 2.5% conservation buffer, and a leverage ratio (equity against all assets) of at least 3%.
Liquidity. The Liquidity Coverage Ratio (LCR) makes banks hold enough easy-to-sell assets to survive 30 days of stressed outflows. The Net Stable Funding Ratio (NSFR) limits how much long-term lending can rest on short-term funding: a direct cap on maturity transformation.
Interest rate risk. Supervisors ask banks to measure how rate moves affect both NII and the value of their assets and liabilities (interest rate risk in the banking book).

Bank balance sheets and income statements are read in detail in L1.8.02 and L1.8.03, and capital and leverage in L1.8.06. The Basel rules themselves return in later levels.

Sparks

SparkLoans create deposits

When a bank makes a loan, it does not hand over someone else's savings. It credits the borrower's account with a new deposit. In this sense banks create most of the money people use. The Bank of England explained this in a 2014 Quarterly Bulletin article, “Money creation in the modern economy”. What limits lending is demand from borrowers, the bank's profit motive, and the capital and liquidity rules.

SparkA run in a day

On 9 March 2023, depositors tried to pull about US$42 billion out of Silicon Valley Bank, much of it through phone apps. The bank was closed by its regulators the next morning. Runs once took days of queues outside branches; now they can happen in hours.

Key takeaways

A commercial bank takes deposits and makes loans, and earns the gap: net interest income.
It transforms maturity (short deposits into long loans), liquidity and credit risk.
NII = interest earned minus interest paid. NIM = NII ÷ interest-earning assets.
Whether higher rates help a bank depends on which rates are fixed and how much it passes on to depositors.
Thin equity makes banks leveraged and fragile, so they face deposit insurance, capital and liquidity rules.

Reaction

Check what stuck

Glossary

Deposit: Money a customer has placed with a bank. For the bank it is a debt: it must pay it back on demand or at a set date.
Maturity transformation: Funding long-term loans with short-term borrowing, such as deposits that can be withdrawn at any time.
Net interest income (NII): Interest a bank earns on its loans and securities, minus the interest it pays on deposits and other borrowing.
Net interest margin (NIM): Net interest income divided by the assets that earn interest. It lets you compare banks of different sizes.
Central bank reserves: Money a bank holds in its own account at the central bank. It is the bank's most liquid asset.
Wholesale funding: Borrowing from other banks, funds and investors rather than from ordinary savers.
Pass-through: The share of a change in the central bank's rate that a bank passes on to its depositors. Also called the deposit beta.
Loan loss provision: Money set aside from profit to cover loans the bank expects will not be fully repaid.
Equity: The owners' stake: assets minus liabilities. It is the first thing to absorb losses.
Bank run: A rush of depositors withdrawing at once, out of fear the bank cannot pay them all.

Deep Dives & Origins

Deep Dives

Mishkin, The Economics of Money, Banking and Financial Markets (Pearson), the chapters on banking and the management of financial institutions. Beginner.
McLeay, Radia and Thomas, “Money creation in the modern economy”, Bank of England Quarterly Bulletin, 2014 Q1. Beginner.
Saunders and Cornett, Financial Institutions Management: A Risk Management Approach (McGraw-Hill), the chapters on interest rate and liquidity risk. Intermediate.

Origins

Diamond and Dybvig, “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy 91(3), 1983.
Board of Governors of the Federal Reserve System, Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank, April 2023.
Basel Committee on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems, BIS, 2010 (revised 2011).
FDIC, “Deposit Insurance FAQs”; EU Deposit Guarantee Schemes Directive 2014/49/EU.

Watch this lesson

Video version

Prefer to watch? The same lesson as a 12-minute video will sit here, made from this page's script.