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Commercial Banks and Investment Banks

What is the difference between a commercial bank and an investment bank?

If a company (or any other entity) wants to raise money, the company has two options: 1) borrow from a commercial bank or 2) issue stock or bonds in the capital markets. In order to take advantage of the capital markets, the company or other entity needs an investment banker. The investment banker buys the company's stocks or bonds and then tries to resell them to interested investors (like mutual funds, pension funds, or individual investors). The process is called underwriting securities. The investment bank gives the issuing company needed funds, and takes on the risk (sometimes substantial risk) of owning the securities. The process is risky because the bank may not be able to sell the securities later and thus would lose a lot of money. The bank also provides services such as setting up deals between merger and acquisition partners. The investment bank makes money on the later sale of these securities.

A commercial bank on the other hand is in business to do two main things: hold deposits and make loans. The commercial bank creates money by lending out deposits to individuals seeking a loan for some designated purpose (for example, a car loan or a loan to start a small business). The commercial bank also keeps deposits on hand for individuals wishing to use the money to make payments (like a checking account). The commercial bank makes profit by lending out to individuals and other entities and collecting payments from these borrowers for principal and interest.

Published on 10/03/08