This guide explains what commercial banking is and explains commercial banking products and services. We will look at the different focuses that commercial banks have, services offered, and the challenges that they help businesses solve. Here are some key takeaways about commercial banking:
Commercial banks provide businesses with financing, operating, and loan products so that they can run daily operations, accept payments from customers, send payments to suppliers, facilitate payroll, and finance growth. We will discuss the products and services that commercial banks offer in the next sections.
Before we discuss the particular services commercial banks offer, we need to understand the role of commercial banking and its impact on everyday business.
First, businesses need commercial banking services to facilitate daily operations. Businesses need bank accounts to accept payments from customers, to pay suppliers, facilitate payroll, and to put aside money for future capital expenditures.
Second, businesses need help with working capital management. There are often gaps between when a business has to outlay initial costs up front and when its able to receive cash flows later on. An example of this would be if they needed to pay for inventory in May but weren’t able to collect final payment from their end customers until July.
Third, commercial banks help businesses raise capital through debt. When businesses need money for growth, but don’t have the ability to finance that growth out of cash flow from operations, they will look to borrow outside capital. Commercial banks have advisory and lending services that can help businesses borrow money to finance that growth.
Now that we understand what commercial banks do, we’ll look at how they typically focus their products and services to serve different size businesses.
Commercial banks essentially come in three sizes: business banks, commercial banks, and corporate banks.
Business banks focus on small businesses, commercial banks focus on mid-size companies, and corporate banks focus on large companies. The services that these banks offer is designed to match the level of complexity in the needs of businesses of those respective sizes. As an example, business banks, which cater to small businesses, offer more basic products and services because the banking needs of small businesses are much simpler than those of large corporations.
Although these three focuses are used to distinguish commercial banks from one another based on their market focus, the term commercial banking is often used to refer to all three sizes, more generally.
This guide will look at the banking products and services that commercial banks offer to businesses of various sizes.
Small businesses have the simplest banking needs and as a result the banking products and services offered are more familiar to most people because they are similar to many of the services that retail banks offer to consumers.
First, commercial banks (business banks) offer operational accounts, savings accounts, and merchant services to businesses. These services are designed to help businesses with operations.
Business checking accounts work like personal checking accounts do for consumers (they are sometimes called operational accounts). Here, businesses can accept payments from their customers, make payments to their suppliers, and run payroll. Business savings accounts give businesses the ability to separate and put money aside for future capital expenditures. Additionally, merchant services give businesses the ability to process payments and accept credit cards both online and at point-of-sale.
In addition to services designed to help businesses with operations, commercial banks help small businesses with financing. Sometimes, businesses need extra cash to support day-to-day operations. The two main areas that small businesses need help with from a financing perspective are working capital and financing for growth (CapEx).
Working capital helps businesses manage the time period between when upfront cash is needed and when cash flows come in. The time period between when cash is outlaid initially to when they receive final payment from customers is called a working capital funding gap. The three areas that create working capital funding gaps for most small businesses are inventory (or raw materials), financing customers (accounts receivable), and hiring staff.
The first and most basic commercial banking service that helps businesses with working capital management is electronic funds transfers. Today, the ability to transfer funds electronically is taken for granted. In the past it has taken days to send and receive payments. EFT’s help with working capital because they allow businesses to pay suppliers faster and receive money from customers faster (shortening accounts receivable). Today there are multiple types of EFT’s available. Some take days to process, and others are in effect almost instant.
Another commercial banking service offered to help with working capital is the overdraft on checking accounts, which allows bank accounts to go into a small negative cash balance for shorter periods of time.
So far, the services offered have been extremely simple. Now, we’ll look at some traditional debt products that help businesses with working capital management. Next, we’ll look at revolving lines of credit and business credit cards. Both credit cards and revolving lines of credit are forms of revolver debt.
Revolving lines of credit are a form of short-term financing where the authorized amount of the credit line will stay at that amount. The business owner can draw from and repay the borrowed amount and they only owe interest on the amount they’ve borrowed. The business can use the line of credit to cover expenses without reapplying to the bank each time. Once cash from sales comes in, the business owner can pay off the outstanding balance.
Revolving lines of credit are excellent for working capital when there is an upfront need for cash and the payment needs to be made via electronic fund transfer. The line of credit that a commercial bank will extend to a small business will be contingent upon factors like the length of time in business, and the quality of the business’ inventory and accounts receivable.
Revolving lines of credit are more cost effective than going into overdraft multiple times a month. Commercial banks charge application fees, annual maintenance fees (both about $150) as well as interest on the balance outstanding (if any). The rates charged on outstanding balances are normally between 2 and 5 percent (but can go as high as 20 percent).
In addition to revolving lines of credit, business credit cards (another form of revolver debt) are very useful for working capital management. Credit cards work similar to the way that revolving lines of credit work. Additionally, credit cards often come with points, cash back, and perks that provide additional benefits to using them. Business credit cards tend to come with lower limits than revolving lines of credit do. Business credit cards are a great option when the upfront payments don’t need to be paid for in cash, or via an electronic funds transfer.
Small businesses can often pay for inventory (and many other expenses) with credit card and they can use these credit cards to manage working capital funding gaps. As an example, say a business needs to buy inventory and the terms of repayment are 30 days. The small business may be able to pay with a credit card. If they are at the beginning of their billing cycle, it may mean they get an additional 28 days before any cash outflow. So, in this example, instead of having a cash outflow in 30 days, that company won’t have a cash outflow for 58 days (30+28). If that business paid off the credit card balance in full when due, this business would not even owe any financing costs.
The downside to credit cards in this instance would be if the small business were unable to pay. It would then be subject to fees, and interest rates that can be as high as 24 percent.
In addition to these banking products and services, commercial banks also offer businesses with traditional term loans and commercial mortgages, however, traditional term loans are not normally available to small businesses (unless they have been around for a long time). Because of this, we’ll look at them in the next section.
Now that we’ve seen the commercial banking products and services typically offered to small businesses, we’ll look at what commercial banks offer to mid-size businesses. These businesses will also benefit from many of the same products and services as small businesses, but will have more complicated banking needs. This is often due to increased complexity with inventory management and supply chains.
First, we’ll talk about term loans. Term loans are different than revolver debt in that they are for a fixed amount, for a fixed term, and they are associated with a specific expenditure. With revolving lines of credit, the business gets constant access to the loan amount. If they have a $100,000 line of credit, borrow $5,000 and pay it back two weeks later, then they still have access to the $100,000. With term loans, once the loan has been repaid, the business would need to reapply for a new loan to get more money.
Revolver debt is intended to help businesses with working capital management. Term loans are intended to help businesses with capital expenditures.
Businesses use term loans to finance growth when they don’t have the ability to pay for what they need out of cash flow from operations. Term loans are typically used to purchase things like equipment, vehicles, and machinery.
There are three components to a term loan: the term length of the loan, the amortization structure and period, and the interest rate charged.
Typically, the length of the term loan will depend on the creditworthiness of the business. If they are perceived to be a higher risk the loan may be for one or two years. If the business is perceived to be a lower risk, then the lender may offer a term length of three to five years.
The interest rates charged on term loans are dependent on market interest rates as well as the creditworthiness of the borrower.
Term loans can be fully-amortized, partially-amortized or non-amortized loans. To learn more about term loans, we’d recommend our guides: Term loans (Part 1): How They Work and Term Loans (Part 2): Structure & Amortization.
In addition to term loans, commercial banks also provide businesses with commercial mortgages. Commercial mortgages work very similarly to term loans, but are specifically for the purchase of real estate.
For mid-size businesses, commercial banks often offer increased revolving lines of credit. It’s not uncommon for commercial banks to extend lines of credit to mid-size businesses for several million dollars.
In addition, commercial banks offer mid-size businesses assistance with cash and treasury management services. These can help businesses manage supplier payments, receipts from receivables, and direct cash flow.
Commercial banks also help mid-size businesses with trade finance and foreign exchange. Banks help mid-size businesses by helping to finance importing, buying, exporting, and selling activities that help companies trade across global boarders. These banks also help businesses with foreign exchange services. Foreign exchange services involve the exchanging of domestic currency with the currency of another country.
Now that we’ve seen some of the commercial banking products and services extended to small and mid-size businesses, we’ll look at what banks offer to larger corporations. Often commercial banks that cater to large corporations call themselves corporate banks.
To understand how the banking needs of businesses change as they grow, we’ll briefly look at banking from the perspective of a larger business.
Businesses grow organically in four ways:
These are forms of organic growth. When businesses grow to a certain point, their growth rate declines. Part of this has to do with the fact that they reach the limits of their total addressable market. At this point, it becomes faster to grow through merger and acquisition deals than it is to grow core operations further. To learn more about these concepts, we recommend our guides: Organic vs Inorganic Growth and Types of Mergers & Acquisitions.
So, businesses that corporate banks cater to are often looking to grow through mergers and acquisitions and some are even looking to become publicly traded. Because of this shift, corporate banks offer banking products and services that help larger businesses with these more complex needs.
Corporate banks offer advisory services geared towards larger businesses that are intended to help them prepare for going public through an initial public offering. They also offer acquisition finance to businesses that are looking to grow through M&A deals. These acquisition financing services involve both the advisory services on the best financing options that would fit with the business’ current capital structure, as well as providing the financing directly to the corporations. To learn more about this, we recommend our guides: Capital Stack Quick Guide and What Is Financial Leverage? In these guides, we explain how the use of financial leverage is important in making acquisitions and we look at how a business is financed and can raise capital through various types of debt and equity.
In addition to large businesses, corporate banks also service governments and financial institutions.