What Is a Commercial Bank? How Commercial Banking Works

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A commercial bank is a for-profit financial institution that accepts deposits from individuals and businesses, keeps those funds safe, processes payments, and lends money out at interest. The spread between what it earns on loans and what it pays on deposits, plus the fees it charges for services, is how the commercial banking business model makes money. When most people say “my bank,” they mean a commercial bank.

What Is a Commercial Bank?

A commercial bank operates under a banking charter and serves the general public: households, small businesses and, at larger institutions, mid-size and large companies. In the United States, a bank can hold a national charter, granted and supervised by the Office of the Comptroller of the Currency (OCC), or a state charter, granted by a state banking regulator and supervised alongside the Federal Reserve or the FDIC.

Three activities define the institution:

1. Taking deposits. Checking accounts, savings accounts and certificates of deposit (CDs) give customers a safe place for money and give the bank its cheapest source of funding.
2. Lending. The bank turns those funds into mortgages, auto loans, credit card balances, business loans and lines of credit.
3. Payments. Debit cards, checks, transfers, bill pay and merchant services let money move between customers and between banks.

Commercial banks are owned by shareholders and run to earn a profit. That separates them from credit unions, which are nonprofit cooperatives owned by their members.

How Commercial Banking Works

On the balance sheet, when you deposit $1,000, the bank records that $1,000 as a liability, because it owes you the money on demand or at the end of a CD term. When the bank lends $1,000 to a borrower, it records the loan as an asset, because the borrower owes the bank principal and interest.

A bank does not keep every deposited dollar in its vault. It holds a portion as cash and reserves at the central bank to meet withdrawals, invests some in securities such as Treasury bonds, and lends the rest. This is the core of fractional reserve banking: deposits that customers can withdraw at any time fund loans that may run for years. Banks call this maturity transformation, and it is both the source of their profit and the source of their main risk.

Banks have traditionally served customers through branches with teller windows and ATMs, but most transactions, including transfers, mobile check deposits and bill payments, can now be done online. Some commercial banks have no branches at all and operate entirely through websites and apps, which cuts overhead and often lets them pay higher rates or charge fewer fees.

How Commercial Banks Make Money

Net interest income. A bank pays depositors less than it charges borrowers. Checking accounts often pay little or no interest, and savings rates at many banks sit well below Treasury yields, while loans carry higher rates to compensate for time and credit risk. The difference, multiplied across billions of dollars, is the largest revenue line for most commercial banks.

Fee income. Banks charge for services: monthly maintenance fees, minimum balance fees, overdraft and non-sufficient funds (NSF) charges, ATM fees, wire transfer fees, safe deposit box rent, loan origination fees and late fees. Card lending adds interchange fees, which merchants pay each time a customer uses a card.

Worked example: net interest margin

The standard measure of lending profitability is the net interest margin (NIM):

NIM = (Interest income − Interest expense) ÷ Average earning assets

Hypothetical bank, one year, simplified:

• Deposits: $100 million, paying an average of 1.0% → interest expense of $1.0 million
• Loans: $80 million at an average of 6.0% → $4.8 million
• Securities: $15 million at an average of 4.0% → $0.6 million
• Cash held as reserves: $5 million, assumed to earn nothing

Interest income is $5.4 million. Net interest income is $5.4 million minus $1.0 million, or $4.4 million. Earning assets are $95 million (loans plus securities), so NIM is about 4.6%.

That $4.4 million is not profit. The bank still has to pay staff, rent and technology costs, set aside money for loans that will default, and pay taxes. If depositors demand higher rates while loan rates stay fixed, interest expense rises and the margin shrinks.

Commercial Banks and Lending

Residential mortgages

Mortgages are usually a bank’s largest loan category. The home serves as collateral, which lowers the bank’s risk and the borrower’s rate. Terms are often 30 years, with fixed, adjustable or variable rates, and lenders size the loan against the property’s value using the loan-to-value ratio.

Auto loans

Auto loans are also secured, by the vehicle, but run for shorter terms and generally carry higher rates than mortgages. Banks compete here with credit unions and with captive finance companies owned by carmakers, which often offer promotional rates through dealers.

Credit cards

A credit card is a revolving personal line of credit the holder can draw on at any time. Visa and Mastercard operate the networks that route transactions between the cardholder’s bank and the merchant’s bank; the banks themselves issue the cards and carry the balances. Because card debt is unsecured, defaults run higher than on mortgages or auto loans, and some banks choose not to issue cards at all. Those that do earn interchange fees, late and over-limit fees, foreign transaction fees and interest on balances carried from month to month, usually quoted as an annual percentage rate (APR).

Business lending

Commercial banks also lend to companies through term loans, lines of credit, equipment financing, commercial real estate loans and letters of credit, which guarantee payment to a supplier in trade transactions.

The Role of Commercial Banks in the Economy

They create credit and money. When a bank approves a loan, it typically credits the borrower’s account with a new deposit. That deposit is spendable money that did not exist before. So commercial banks do create money, within limits set by loan demand, their capital and regulation. Repaying a loan reverses the process. This credit supports home buying, business investment, hiring and consumer spending.

They provide liquidity. Savers want access to their money; borrowers want long-term funds. Banks sit between the two, pooling many small deposits so that a household can withdraw cash tomorrow while a business keeps a five-year loan.

They run the payment system. Paychecks, card purchases, rent payments and wire transfers all pass through bank accounts. Even apps such as a digital wallet ultimately settle through accounts at banks.

Because a bank failure can spread to depositors, borrowers and other banks, commercial banks are heavily regulated. Central banks have historically imposed reserve requirements, a share of deposits that must be held as cash or at the central bank. In the U.S., the Federal Reserve cut that requirement to zero in March 2020, so regulators now rely more on capital and liquidity rules. Banks must hold minimum capital relative to their risk-weighted assets, measured by the capital adequacy ratio, and large banks face international standards under Basel III.

Is Your Money Safe at a Commercial Bank?

At an FDIC-insured commercial bank, deposits are covered up to $250,000 per depositor, per insured bank, per ownership category. Checking, savings, money market deposit accounts and CDs all qualify. Ownership categories (for example single accounts, joint accounts and certain retirement accounts) are insured separately, so a household can hold more than $250,000 at one bank with full coverage if the money is spread across categories.

FDIC insurance does not cover stocks, bonds, mutual funds, annuities or crypto, even when you buy them through your bank’s branch or app. Those products carry market risk, and any protection against a brokerage firm’s failure comes from separate arrangements, not deposit insurance.

Commercial Banks vs. Investment Banks

The two are often confused because many large financial groups own both.

• Commercial banks serve individuals and businesses with deposits, loans and payments.
• Investment banks serve corporations, governments, pension funds, hedge funds and other institutions. They underwrite stock and bond issues, advise on mergers and acquisitions (M&A), handle corporate restructurings and provide trading and brokerage services to institutions and high-net-worth clients. They do not take retail deposits in the same way.

For much of the 20th century, U.S. law kept the two apart. The Banking Act of 1933, known as Glass-Steagall and passed during the Great Depression, barred commercial banks from most securities underwriting. The Gramm-Leach-Bliley Act of 1999 largely repealed those barriers and allowed financial holding companies to own commercial banks, investment banks and insurers under one roof.

Commercial Banks vs. Other Banking Institutions

“Retail bank” describes the consumer-facing side of a commercial bank. Industry usage also applies “commercial banking” narrowly to a bank’s division serving mid-size and large companies, separate from its retail and investment banking divisions.

Examples of Commercial Banks

Most of the largest banks in the U.S. have commercial banking operations:

• Chase, the commercial and consumer banking arm of JPMorgan Chase.
• Bank of America, which serves retail customers and small and mid-size businesses.
• Wells Fargo, Citibank and U.S. Bank, each with national branch networks.
• Ally Bank, which operates online without branches.

Limitations of Commercial Banks

• Low deposit yields. Savings rates at many branch-based banks lag Treasury yields and online banks.
• Fees. Maintenance, overdraft and NSF fees can cost more than the interest a small balance earns.
• Run risk. Because deposits fund long-term loans, a sudden wave of withdrawals can force a bank to sell assets at a loss. Insurance protects covered depositors, not the bank’s shareholders or uninsured balances above the limit.
• Credit cycles. Banks tighten lending when the economy weakens, which can make loans hardest to get when borrowers need them most.
• Interest rate risk. When rates rise, long-term fixed-rate loans and bonds lose value while deposit costs climb.

FAQs

The Bottom Line

Anyone who keeps a checking or savings account or borrows for a home, car or business relies on a commercial bank. Keeping deposits within FDIC limits by depositor, bank and ownership category protects your cash. Comparing deposit rates and fees, including at online banks, helps you avoid charges that can outweigh the interest a small balance earns.