🏛 The government's bank
The government needs somewhere to keep its money. Tax payments go into its account at the central bank, and the government pays its bills from it. The central bank can also arrange loans for the government.
Money and Banking » Central Banks and Commercial Banks
What you'll learn this session
Study time: 30 minutes
Cambridge spec: 3.1.2
- What a central bank is and the six jobs it does
- What a commercial bank is and what it does for households and firms
- Why both kinds of bank matter to an economy
- How to tell the two apart in an exam answer
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Unlock This CourseTwo different kinds of bank
When you hear the word "bank", you probably think of the place where your family keeps its savings. That is only one kind. Every economy has two main types of bank, and they do very different jobs. One serves the public and firms. The other serves the government and the other banks.
Key terms:
- Central bank: the main bank of a country, which looks after the banking system and carries out the government's financial policy. It is usually owned or controlled by the government.
- Commercial bank: a private business that accepts deposits from the public and lends money, with the aim of making a profit.
- Deposit: money that a customer puts into a bank for safe keeping.
- Lender of last resort: the central bank's role of lending money to commercial banks that cannot borrow from anywhere else.
The central bank
A country normally has just one central bank. It does not offer accounts to ordinary families. Instead it has six important roles.
🏦 The bankers' bank
Commercial banks keep accounts at the central bank, just as you keep an account at a commercial bank. They use these accounts to settle payments with each other and to hold spare cash safely.
💵 Issuer of notes and coins
The central bank is usually the only body allowed to issue the country's banknotes and coins. This keeps the supply of cash under control and helps people trust it.
🆘 Lender of last resort
If a commercial bank runs short of cash and cannot borrow elsewhere, the central bank will lend to it. This stops one bank's trouble from spreading and keeps people's deposits safe.
📊 Managing monetary policy
The central bank helps the government control the amount of money in the economy and the cost of borrowing, to support its aims such as stable prices. How this works is covered in the lesson on Monetary Policy.
💱 Interest rates and the exchange rate
The central bank often sets the main interest rate, the basic price of borrowing that other banks follow. It may also buy or sell its own currency to influence the exchange rate.
Why the central bank is important
Think of the central bank as the referee of the banking system. Without it, banks would have no safe place to settle payments, no help in a crisis, and no single body in charge of the country's notes and coins. People would be less willing to trust the banking system, and trust is what makes banking work. If many customers rushed to take out their money at once, a bank could collapse. The lender of last resort role helps prevent that.
Commercial banks
Commercial banks are the ones you meet in everyday life. They are private firms, owned by shareholders, and they are in business to make a profit. Their main jobs are:
💰 Accepting deposits
They keep customers' money safe in current accounts and savings accounts. Savers may earn interest.
🤝 Lending
They lend to households and firms through loans, including loans to buy a home. Borrowers pay interest.
💳 Payment services
They provide cards, transfers and cheques so customers can pay and be paid without handling cash.
How commercial banks help households and firms
Banks sit between people who have spare money and people who need it. A household can save for a future goal in a safe place. A family that wants a home can borrow and pay it back over many years. A firm can borrow to buy machines or open a new shop, and it can keep its daily takings in a business account and pay its suppliers by transfer.
This is why commercial banks matter. They turn savings into loans, so money that would sit idle is put to use, and they make payments quick and safe.
The profit motive
A commercial bank earns its profit mainly because it charges borrowers a higher interest rate than it pays savers. Imagine a made-up bank, Sunvale Bank, that pays savers 2% a year and charges borrowers 6% a year. The 4% gap helps to pay its costs, such as staff and buildings, and what is left is profit for its owners. It also charges fees for some services.
The profit motive means a bank must be careful. If it lends to people who cannot repay, it loses money. Banks therefore check borrowers and keep some cash in reserve to meet customers' withdrawals.
Central bank or commercial bank?
| Feature | Central bank | Commercial bank |
|---|---|---|
| Main customers | Government and commercial banks | Households and firms |
| Main aim | A stable banking system and the government's policy | Profit |
| Issues notes and coins? | Yes | No |
| Takes deposits from the public? | No | Yes |
Common mistakes
Writing that the central bank gives loans and accounts to ordinary people. It does not. Another slip is saying commercial banks print the country's notes and coins. They do not. Finally, do not say a bank makes profit just by "keeping money". The profit comes mainly from the gap between the interest it charges and the interest it pays.
Exam-style question
Read this made-up context. In the country of Valmora, the central bank has announced it will lend to Orlen Bank, which has run short of cash after a rush of customers withdrew their money, and it cannot borrow from any other bank. Orlen Bank is a private firm owned by shareholders.
(a) Identify the role the central bank is performing when it lends to Orlen Bank. [1 mark]
(b) Explain two services a commercial bank provides for its customers. [4 marks]
(c) Explain why a central bank is important to an economy. [3 marks]
Model answer
(a) Lender of last resort. (1)
(b) It accepts deposits, so households and firms can keep their money safe and may earn interest. (1+1) It provides payment services such as cards and transfers, so customers can pay for goods without using cash. (1+1)
(c) It acts as the bank for the government and for commercial banks, so payments can be settled safely. (1) It lends to banks in trouble, which stops a bank failure spreading and protects people's deposits. (1) This builds trust in the banking system, so people and firms are willing to save and borrow. (1)
Exam tip
In (b), "Explain" means each service needs a reason or result after it, such as "so customers can pay without cash". A bare list only earns half the marks.