Money and Banking – Objectives of Commercial Banks (Cambridge IGCSE/A‑Level Economics 9708)
Learning outcomes (what you need to know)
- Define the four functions of money and explain how commercial banks help create the money supply.
- Describe the three core objectives of commercial banks – liquidity, security (safety & soundness) and profitability – and link each to the wider banking system.
- Calculate and interpret the key ratios used by banks (Liquidity Ratio, Reserve‑Requirement Ratio, Capital‑Adequacy Ratio, Liquidity Coverage Ratio, Net‑Interest Margin, Return on Equity, Cost‑to‑Income Ratio) and the money‑multiplier.
- Analyse the trade‑offs between the three objectives and evaluate the impact of regulatory changes (e.g. Basel III, reserve‑requirement adjustments) on bank behaviour.
- Apply the concepts to a recent real‑world example and use appropriate diagrams to illustrate your answer.
1. Functions of Money and the Money Supply
Functions of money (Cambridge syllabus requirement)
- Medium of exchange – used to buy goods and services.
- Store of value – retains purchasing power over time.
- Unit of account – provides a common measure for pricing and accounting.
- Standard of deferred payment (often combined with the above in the syllabus).
Money supply aggregates
| Aggregate | Includes |
|---|
| M0 | Physical currency (notes & coins) held by the public. |
| M1 | M0 + demand deposits (current accounts) + other liquid deposits. |
| M2 | M1 + savings deposits, time deposits, and other near‑money assets. |
Commercial banks expand M1 and M2 by accepting deposits and creating loans – the core of the money‑creation process.
2. The Role of Commercial Banks in the Economy
- Mobilise savings and channel them into productive investment (credit creation).
- Provide a safe place for the public to hold money, supporting the functions of money.
- Facilitate payments and settlement between households, firms and the government.
- Assist the central bank in transmitting monetary‑policy decisions (interest‑rate channel, reserve‑requirement channel, open‑market operations).
3. Money Creation and the Money‑Multiplier
When a bank receives a deposit, it must keep only a fraction as reserves (set by the reserve‑requirement ratio) and can lend out the remainder. The loan becomes a deposit in the same or another bank, and the process repeats.
Money‑multiplier formula (syllabus AO2)
\[
\text{Money Multiplier (}m\text{)} = \frac{1}{\text{Reserve‑Requirement Ratio (}r\text{)}}
\]
Example
- Reserve‑requirement ratio = 5 % (0.05)
- \(m = 1 / 0.05 = 20\)
- £1 bn of new high‑powered money can theoretically generate up to £20 bn of broad money (M1).
In practice the multiplier is lower because banks hold excess reserves, cash, and high‑quality liquid assets for liquidity and security reasons.
4. Core Objectives of Commercial Banks
In a competitive market banks must constantly balance three inter‑related objectives.
4.1 Liquidity
Definition (AO1): The ability of a bank to meet its short‑term obligations (withdrawals, inter‑bank payments, loan disbursements) as they fall due.
- Why it matters: A loss of liquidity can trigger a bank run, damage confidence and force forced liquidation.
- Key sources of liquid funding
- Cash and balances with the central bank.
- High‑quality liquid securities (Treasury bills, sovereign bonds).
- Discount‑window borrowing and repurchase (repo) agreements.
- Short‑term wholesale funding (commercial paper, certificates of deposit).
- Liquidity Ratio (AO2):
\[
\text{Liquidity Ratio} = \frac{\text{Liquid Assets}}{\text{Total Deposits}}
\]
Example: Liquid assets = £12 bn, Total deposits = £100 bn → Liquidity ratio = 12 %.
- Reserve‑Requirement Ratio (central‑bank tool):
\[
\text{Reserve Ratio} = \frac{\text{Reserves}}{\text{Deposits}}
\]
UK: statutory reserve ratio = 0 % for most deposits, but banks voluntarily hold a 2–3 % buffer.
4.2 Security (Safety & Soundness)
Definition (AO1): Protecting depositor funds, the bank’s own capital and maintaining confidence in the banking system.
- Risk‑management framework
- Credit risk – borrower repayment ability.
- Market risk – interest‑rate, exchange‑rate and price movements.
- Operational risk – fraud, system failures, cyber‑security.
- Capital‑Adequacy Ratio (CAR) – Basel III (AO2):
\[
\text{CAR} = \frac{\text{Tier 1 + Tier 2 Capital}}{\text{Risk‑Weighted Assets}}
\]
Minimum regulatory requirement = 8 % (plus buffers such as the Capital Conservation Buffer).
- Regulatory capital buffers (syllabus wording)
- CET1 (Common Equity Tier 1) – core equity, must be ≥ 4.5 % of RWA.
- Tier 1 – CET1 + additional Tier 1, minimum 6 % of RWA.
- Tier 2 – supplementary capital, brings the total to the 8 % minimum.
- Liquidity Coverage Ratio (LCR) (AO2):
\[
\text{LCR} = \frac{\text{High‑Quality Liquid Assets}}{\text{Total Net Cash Outflows (30 days)}} \ge 100\%
\]
Ensures the bank can survive a 30‑day stressed cash‑outflow scenario.
- Internal controls & cyber‑security – segregation of duties, regular audits, encryption, multi‑factor authentication.
4.3 Profitability
Definition (AO1): Generating a satisfactory return for shareholders after covering all costs.
Basic profit equation
\[
\text{Profit}= \text{Total Revenue} - \text{Total Cost}
\]
| Revenue sources | Cost components |
|---|
| Interest margin (interest earned on loans – interest paid on deposits) |
Interest expense on deposits & wholesale funding |
| Fee income (account fees, transaction charges, advisory & underwriting fees) |
Operating expenses (staff, premises, IT, compliance) |
| Trading & investment income (securities, FX, derivatives) |
Provision for loan losses & tax |
- Net Interest Margin (NIM) (AO2):
\[
\text{NIM}= \frac{\text{Interest Income} - \text{Interest Expense}}{\text{Average Earning Assets}}
\]
Example: Interest income £5 bn, interest expense £2 bn, earning assets £80 bn → NIM = 3.75 %.
- Return on Equity (ROE) (AO2):
\[
\text{ROE}= \frac{\text{Net Profit}}{\text{Average Shareholders’ Equity}}
\]
- Cost‑to‑Income Ratio (AO2):
\[
\text{Cost‑to‑Income}= \frac{\text{Operating Costs}}{\text{Operating Income}}
\]
5. Inter‑relationship and Trade‑offs (AO3)
The three objectives are inter‑dependent; improving one often affects the others.
- Liquidity vs. Profitability – Holding large buffers of cash or high‑quality liquid assets improves liquidity but reduces the amount of higher‑yielding loans, lowering profit.
- Security vs. Profitability – Higher capital buffers (CAR) and stricter risk limits enhance safety but increase the cost of capital and can restrict credit growth.
- Liquidity vs. Security – Reliance on short‑term wholesale funding can boost liquidity in the short run but raises vulnerability to market stress, undermining security.
Sample AO3 essay outline
- Introduce the three objectives and why they matter.
- Explain the inherent trade‑off between liquidity and profitability using the NIM example.
- Discuss how Basel III’s higher CET1 requirement strengthens security but may compress ROE.
- Evaluate the impact of a policy change (e.g., an increase in the reserve‑requirement ratio) on each objective, citing the money‑multiplier mechanism.
- Conclude with a balanced judgement – e.g., “In the current low‑rate environment, banks are likely to prioritise liquidity and security, accepting lower profitability, but will seek efficiency gains to protect shareholder returns.”
6. Key Formulas to Master (AO2)
| Concept | Formula |
|---|
| Liquidity Ratio | \(\displaystyle \frac{\text{Liquid Assets}}{\text{Total Deposits}}\) |
| Reserve‑Requirement Ratio | \(\displaystyle \frac{\text{Reserves}}{\text{Deposits}}\) |
| Money Multiplier | \(\displaystyle m = \frac{1}{\text{Reserve Ratio}}\) |
| Capital‑Adequacy Ratio (CAR) | \(\displaystyle \frac{\text{Tier 1 + Tier 2 Capital}}{\text{Risk‑Weighted Assets}}\) |
| Liquidity Coverage Ratio (LCR) | \(\displaystyle \frac{\text{High‑Quality Liquid Assets}}{\text{Net Cash Outflows (30 days)}}\ge 100\%\) |
| Net Interest Margin (NIM) | \(\displaystyle \frac{\text{Interest Income} - \text{Interest Expense}}{\text{Average Earning Assets}}\) |
| Return on Equity (ROE) | \(\displaystyle \frac{\text{Net Profit}}{\text{Average Shareholders’ Equity}}\) |
| Cost‑to‑Income Ratio | \(\displaystyle \frac{\text{Operating Costs}}{\text{Operating Income}}\) |
7. Real‑World Illustration (2023 data – Barclays PLC)
- Total deposits: £1,200 bn
- Liquid assets (cash + Treasury bills): £150 bn → Liquidity Ratio = 12.5 % (above the UK industry average of ≈9 %).
- Risk‑Weighted Assets: £1,800 bn; Tier 1 capital: £120 bn → CAR = 6.7 % (below the Basel III minimum of 8 %; the bank announced a £5 bn capital raise).
- Net Interest Margin: 3.1 % (down 0.2 % from 2022 after the Bank of England’s 0.5 % policy‑rate increase).
- Profit before tax: £5.4 bn; ROE: 9.3 %.
Discussion points
- How could Barclays improve its CAR without severely cutting NIM? (e.g., retain earnings, issue Tier 1 capital, optimise risk‑weighted asset mix).
- What effect does the recent policy‑rate rise have on the bank’s liquidity position and interest‑margin strategy?
- Evaluate the trade‑off if Barclays decides to increase its holdings of high‑quality liquid assets to meet the LCR of 100 %.
8. Suggested Diagrams (what examiners expect)
- Triangular model of objectives – draw an equilateral triangle labelled “Liquidity”, “Security (Safety & Soundness)”, “Profitability”. Use double‑headed arrows to show inter‑dependence.
- Balance‑sheet flowchart – left side: assets (Cash, HQLA, Loans, Securities). Right side: liabilities (Deposits, Wholesale funding, Equity). Highlight reserves (against deposits) and capital (against risk‑weighted assets).
- Money‑creation diagram – start with an initial deposit, show reserve requirement, illustrate successive rounds of lending and redeposit, and annotate the multiplier effect.
When drawing, label each component clearly and keep the sketch simple – examiners award marks for correct labeling and logical flow.
9. Quick‑Reference: AO Weightings for this Sub‑topic (Paper 4)
| Assessment Objective | Typical weighting |
|---|
| AO1 – Knowledge & Understanding | ≈ 20 % |
| AO2 – Application & Calculation | ≈ 40 % |
| AO3 – Analysis & Evaluation | ≈ 40 % |
10. Checklist for Exam Preparation
- Define the four functions of money and the three money‑supply aggregates (M0, M1, M2).
- Explain how commercial banks create money and state the money‑multiplier formula.
- State the purpose of the Liquidity Ratio, Reserve‑Requirement Ratio, CAR, LCR and give the relevant formulae.
- Calculate a money‑multiplier, liquidity ratio and CAR from supplied data.
- Interpret NIM, ROE and Cost‑to‑Income Ratio for a given bank’s annual‑report figures.
- Analyse how a change in central‑bank policy (e.g., interest‑rate rise or reserve‑requirement increase) influences each of the three objectives.
- Evaluate the impact of tighter Basel III standards on profitability and credit‑creation capacity.
- Draw and label one of the suggested diagrams to illustrate the trade‑off between liquidity and profitability.
- Practice a short AO3 answer using the sample essay outline – focus on balanced judgement and use of real‑world data.