Definition and Example of Commercial Banking
Commercial banks serve much larger customers than the standard retail bank, which is designed for individual account holders and some small businesses. These large banks are designed to handle the needs that businesses have for large loans, lines of credit, and deposit accounts. Often, retail banks are simply branches of these larger institutions.
Commercial banks can help small businesses through a corporate-banking arm as well as large enterprises through an investment-banking arm. They might also work with individual consumers, serving additionally as retail banks.
Since these banks are typically stock corporations, their aim is to make a profit for their shareholders. The way they typically do this is through what is known as "financial intermediation," whereby savers who are willing to hold their deposits with the bank are matched with borrowers who need loans.
To facilitate the movement of money between savers and borrowers, commercial banks receive customer deposits, place them in different types of accounts, extend loans with interest on those deposits to businesses and individuals, and pay interest to borrowers on the deposits.
Although the interest paid to borrowers represents a liability for commercial banks, these banks typically loan funds at higher interest rates than the rates they pay to borrowers, which allows them to turn a profit.
How Commercial Banking Works
Although commercial banks specialize in extending short-term credit to businesses, they provide a number of diverse offerings.
Businesses, like individuals, need checking and savings accounts. Checking accounts help firms make payments to suppliers and employees, while savings accounts can hold cash reserves and earn interest.
Businesses need money to operate and grow, but if they're just starting out, or their assets are tied up in inventory or expensive equipment, they may require additional funds for big purchases. Commercial banks fill this role, extending loans to help businesses purchase supplies, real estate, and vehicles that are necessary for operations.
Lines of Credit
A line of credit is similar to a small business credit card and provides short-term funding for various business expenses. A line of credit from a commercial bank can help provide an infusion of cash while waiting for receivables to come in—when a business needs to pay its employees but is still waiting for customer payments for recently shipped orders, for example.
Letters of Credit
This is a document that a business can secure from a bank to vouch for its ability to pay for goods or services. Trading with customers and suppliers overseas is complicated and can be risky. When businesses don’t know whom they’re dealing with, or the other person is in a different country with different laws, a letter of credit can increase the likelihood of a successful transaction.
If businesses need to efficiently handle payments in large volumes, lockboxes can help. Customers mail payments to a post office box set up by a bank at nearby locations, and the bank moves the funds into the business’s account. By accepting payments this way, firms can receive and deposit checks more quickly.
Payment and Transaction Processing
Just like individuals, businesses may need to accept payments from customers in a variety of ways. Customers like to pay with credit cards, electronic checks, and even paper checks. Banks help make this happen and can also help businesses manage their risks of fraudulent payments and chargebacks.
When businesses operate overseas by accepting money or spending it, they might need to handle local currencies. Commercial banks help them convert money and manage the risk of changing currency prices.
Many commercial banks have an investment banking arm that helps businesses carry out less frequent, major financial transactions. For example, if a business wants to “go public,” sell a large amount of debt, or use other methods to fund an expansion, this function of a commercial bank can help.
New business owners typically must personally guarantee, or agree to be responsible for, business loans unless the firm owns assets that it can pledge as collateral.
Benefits of a Commercial Bank Account
Even if you have a small, home-based business, opening a business account offers several advantages:
- It separates your business and personal finances. Having a different account for commercial banking can help with day-to-day bookkeeping, limit your personal liability in the event of a legal claim against your business, and prove useful when it's time to file your tax return. You'll know exactly which activities were personal and which were related to your business.
- It lends credibility to your company. Customers, for example, might be more comfortable making payments to a business than to you, personally, for a product or service.
- It helps your firm foot the bill for large expenses. A loan, line of credit, or credit card from a commercial bank can provide your business with capital that you may not be able to fund on your own.
- It can help build business credit. Opening a line of credit, for example, can help build your business's credit profile and secure better lending terms in the future.
- Business accounts are insured. Just as your personal bank accounts are FDIC-insured up to $250,000, your commercial accounts are protected, as well.
Business accounts might not have the same consumer protection as most personal accounts. If thieves drain your account, federal law might not require banks to reimburse you.
Commercial Banking vs. Investment Banking
|Commercial Banking||Investment Banking|
|Directly serves commercial banking customers||Serves as a go-between for investors and businesses|
|Facilitates banking services for commercial banking clients, such as deposit accounts, loans, and more.||Assists with raising capital, launching an initial public offering, conducting mergers and acquisitions, and more.|
Although commercial banks often have investment banking functions, it's important to note that these two types of banking serve different purposes. Investment banks serve as go-betweens for investors and businesses, helping with raising capital, launching an initial public offering, conducting mergers and acquisitions, and more. These are separate from the traditional banking functions offered by commercial banks.
- Commercial banking provides businesses with similar offerings that are available to consumers, plus additional services that uniquely cater to businesses.
- Opening a commercial banking account for your business can protect your personal accounts from any business liabilities or tax issues.
- Many businesses rely on commercial banking to provide cash in critical times of need and to keep their operations running.
If your retail bank also acts as a commercial bank, you can hold business deposits at the same bank for added convenience. But if you run a small business, even as a sole proprietor, it’s a good idea to open separate accounts for your business and personal needs.
State of Connecticut Department of Banking. "ABC's of Banking." Accessed Dec. 8, 2021.
Congressional Research Service. "Overview of Commercial (Depository) Banking and Industry Conditions," Page 1. Accessed Dec. 8, 2021.
U.S. Small Business Administration. "The Right Way to Think About Credit Lines for Business." Accessed Dec. 8, 2021.
International Trade Administration. "Letters of Credit." Accessed Dec. 8, 2021.
Northwestern Mutual. "Here's the Difference Between Banks, Credit Unions, and Brokerages." Accessed Dec. 8, 2021.
U.S. Small Business Administration. "Unsecured Business Funding for Small Business Owners Explained." Accessed Dec. 8, 2021.
U.S. Small Business Administration. "Open a Business Bank Account." Accessed Dec. 8, 2021.
FDIC. "Your Insured Deposits." Accessed Dec. 8, 2021.
Federal Reserve Bank of Cleveland. "Protecting Small-Business Borrowers." Accessed Dec. 8, 2021.