Commercial Bank
How Commercial Banks Make Money
The commercial banking business model is built on a simple concept: borrow cheap, lend at a higher rate, and manage the risk in between. Here’s how the revenue breaks down:
| Revenue Source | Description | Typical Share of Revenue |
|---|---|---|
| Net interest income | Difference between interest earned on loans and interest paid on deposits | 60–80% for traditional banks |
| Fee income | Account fees, overdraft charges, wire transfers, wealth management fees | 15–25% |
| Mortgage banking | Origination fees and gains from selling mortgages | 5–15% (varies with rates) |
| Trading & investment income | Gains from the bank’s securities portfolio | Variable, typically small for pure commercial banks |
Key Metrics for Analyzing Commercial Banks
Bank financials look different from most companies. The standard ratios used for industrial firms don’t translate directly. Here are the metrics that matter:
| Metric | What It Measures | Healthy Range |
|---|---|---|
| Net Interest Margin (NIM) | Profitability of the bank’s core lending business | 2.5% – 4.0% |
| Loan-to-Deposit Ratio | How aggressively the bank is deploying deposits | 70% – 90% |
| Tier 1 Capital Ratio | The bank’s core capital buffer against losses | >10% (well-capitalized) |
| Return on Equity (ROE) | How efficiently the bank generates profits from equity | 10% – 15% |
| Return on Assets (ROA) | Profitability relative to total assets | 1.0% – 1.5% |
| Efficiency ratio | Non-interest expenses as a % of revenue (lower is better) | 50% – 60% |
| NPL ratio | Share of loans that are delinquent or in default | <2% |
Commercial Bank vs. Investment Bank
| Feature | Commercial Bank | Investment Bank |
|---|---|---|
| Core business | Taking deposits, making loans | M&A advisory, underwriting, trading |
| Primary revenue | Net interest income (spread) | Fees, commissions, trading gains |
| Clients | Individuals, small/medium businesses, corporates | Large corporations, governments, institutions |
| Deposit insurance | Yes — FDIC-insured up to $250K | No |
| Revenue stability | More stable, interest-rate driven | More volatile, deal-flow driven |
| Primary regulator | OCC, Federal Reserve, FDIC | SEC, FINRA |
The Balance Sheet of a Commercial Bank
A commercial bank’s balance sheet is fundamentally different from a non-financial company. The assets are primarily loans (money owed to the bank), while the liabilities are primarily deposits (money the bank owes to customers). This is the opposite of what you’d see at an industrial company.
Assets side: Loans make up the bulk — commercial loans, mortgages, consumer credit, and credit cards. The bank also holds investment securities (Treasuries, municipal bonds) for liquidity and income, plus cash reserves at the Federal Reserve.
Liabilities side: Customer deposits are the largest liability. The bank also relies on wholesale funding (borrowing from other banks), subordinated debt, and long-term bonds.
Equity: Shareholder equity is relatively thin compared to total assets — a typical bank has 8–12% equity-to-assets, versus 40–60% for non-financial companies. This inherent leverage is why bank regulation focuses so heavily on capital adequacy.
How Interest Rates Affect Commercial Banks
Interest rates are the single biggest driver of commercial bank profitability. When the Federal Reserve raises the federal funds rate, banks can charge more for loans. But deposit rates usually rise more slowly — widening the net interest margin and boosting profits, at least in the short term.
However, a prolonged high-rate environment creates problems: loan demand drops, borrowers struggle to repay, and non-performing loans rise. Banks must also mark down the value of their existing bond portfolios when rates rise, which can erode capital ratios.
Key Takeaways
- Commercial banks make money on the spread between deposit rates and loan rates — the net interest margin is the single most important metric.
- Bank balance sheets are inherently leveraged (8–12% equity), which is why regulatory capital requirements like Tier 1 and Basel III exist.
- Key health indicators: NIM trend, NPL ratio, loan loss provisions, and the efficiency ratio.
- Rising rates initially help banks (wider NIM) but eventually hurt through higher credit losses and weaker loan demand.
- Commercial banks differ from investment banks in revenue model, client base, and regulatory framework.
Frequently Asked Questions
What is a commercial bank?
A commercial bank is a financial institution that accepts deposits from the public and uses those funds to make loans to individuals and businesses. It earns money primarily on the interest rate spread between what it pays depositors and what it charges borrowers.
How do commercial banks differ from investment banks?
Commercial banks focus on deposits and lending, earning net interest income. Investment banks focus on capital markets activities like M&A advisory, securities underwriting, and trading. Many large financial institutions operate both under one holding company.
What are the most important metrics for analyzing a commercial bank?
The top metrics are net interest margin (profitability of lending), loan-to-deposit ratio (balance sheet efficiency), Tier 1 capital ratio (solvency buffer), ROE, and the NPL ratio (credit quality).
Are commercial bank deposits safe?
Deposits at commercial banks are insured by the FDIC up to $250,000 per depositor, per bank. This insurance covers checking accounts, savings accounts, CDs, and money market deposit accounts. Amounts above the limit are not insured.
How do interest rates affect commercial banks?
Rising rates generally boost net interest margins because loan rates increase faster than deposit rates. However, sustained high rates can reduce loan demand and increase non-performing loans as borrowers struggle with higher payments.