AQA A-level Economics: Banks, credit creation and financial regulation (7136)

This guide covers two sub-sections of the AQA A-level Economics (7136) specification, version 1.3: commercial banks and investment banks (4.2.4.2) and the regulation of the financial system (4.2.4.4). The specification PDF numbers the A-level content 4.2.4.2 and 4.2.4.4. The AQA website numbers it 3.2.4.2 and 3.2.4.4. Neighbouring sub-sections are taught on other pages. Every bank, country and figure below is invented for illustration, not real data.

Related pages: the AQA A-level Economics hub, the printable checklist, the revision notes, the practice set, the aggregate demand and supply guide and the free 10-minute diagnostics.

What the specification asks for

Content point	What you must be able to do
Commercial v investment bank	State the difference. No detailed knowledge of investment banking is required
Functions of a commercial bank	Explain the main functions
Balance sheet	Describe the structure: assets, liabilities, capital
Objectives	Explain liquidity, profitability and security, and conflicts between them
Credit creation	Explain how banks create credit. The credit multiplier is not calculated
Combined banks	Appreciate that doing both kinds of business may raise systemic risk
UK regulation	Appreciate the roles of the Bank of England, PRA, FPC and FCA
Bank failure	Explain why a bank might fail, including lending long and borrowing short
Ratios	Explain how liquidity and capital ratios affect stability. They are not calculated
Moral hazard, systemic risk	Explain both, and the effect of financial problems on the real economy

Commercial and investment banks

A commercial bank takes deposits from households and firms and lends to them. Its customers are mostly ordinary savers and borrowers, and it runs the payment system they use. An investment bank serves large firms, governments and financial institutions. It advises on mergers and takeovers, helps firms raise money by issuing shares or bonds, and trades financial assets. It earns fees and trading profits, not mainly interest from retail lending.

	Commercial bank	Investment bank
Main customers	Households and firms	Large firms, governments, institutions
Main income	Interest margin, charges	Fees, trading gains
Liabilities	Mostly deposits	Mostly market borrowing

Many banks do both. Other institutions also operate in financial markets, but you do not need to know their activities or functions.

Functions of a commercial bank

• Accepting deposits. A safe place to hold money, with easy access.
• Lending. Overdrafts, loans and mortgages to households and firms.
• Operating payments. Transfers, cards and cheques settle debts between customers.
• Creating credit. Lending creates new deposits, so it adds to the money available to spend.
• Maturity transformation. Short-term deposits fund longer-term loans. This is useful and also the main source of risk.

The balance sheet

A balance sheet lists what a bank owns (assets) and what it owes (liabilities), plus the owners’ stake (capital). It always balances: assets = liabilities + capital. Capital is the cushion that absorbs losses before depositors are hurt.

Worked example. Bank J is an invented commercial bank. Figures are in £m.

Assets	£m	Liabilities and capital	£m
Cash and central bank balances	25	Current accounts	210
Short-term loans to other banks	45	Savings accounts	170
Government bonds	70	Short-term wholesale borrowing	60
Mortgages	240	Bonds issued by Bank J	20
Loans to firms	110	Capital	40
Other assets	10
Total	500	Total	500

Liabilities are 210 + 170 + 60 + 20 = 460. With capital of 40, the total is 500, which equals total assets. A loan is an asset to the bank, because borrowers owe it money. A deposit is a liability, because the bank owes it to the depositor. Do not reverse them.

Objectives and conflicts

• Liquidity: being able to meet withdrawals as they fall due. Cash is the most liquid asset.
• Profitability: earning more on assets than the bank pays on liabilities.
• Security: keeping the risk of loss low, so loans are repaid and the bank survives.

The conflicts arise because liquid, safe assets earn little, and high-yielding assets are illiquid or risky.

Worked example. Bank J earns these illustrative annual rates: cash 0%, loans to other banks 1%, government bonds 2%, mortgages 4%, loans to firms 6%. Its interest income is 45 × 0.01 + 70 × 0.02 + 240 × 0.04 + 110 × 0.06 = 0.45 + 1.40 + 9.60 + 6.60 = £18.05m. It pays 0.5% on current accounts, 2.5% on savings, 3% on wholesale borrowing and 4% on its bonds: 1.05 + 4.25 + 1.80 + 0.80 = £7.90m. Net interest is £10.15m.

Now suppose a regulator wants more liquidity, and Bank J moves £40m from firm loans into government bonds. Income falls by 40 × (0.06 − 0.02) = £1.6m, so net interest is £8.55m. Liquidity and security improve while profitability falls. Another conflict: lending to a risky firm at a high rate raises expected profit but threatens security.

How banks create credit

Banks lend more than the cash they hold because depositors rarely all withdraw at once. When a bank makes a loan, it credits the borrower’s account, which creates a new deposit. The borrower spends it, the payee’s bank receives it as a new deposit, and that bank lends part of it. The chain continues.

Illustration. Suppose a bank wants to keep 25% of any deposit liquid and lends the rest. A new deposit of £600m arrives.

Round	New deposit	Kept liquid (25%)	Lent on (75%)
1	600.0	150.0	450.0
2	450.0	112.5	337.5
3	337.5	84.4	253.1
4	253.1	63.3	189.8

After four rounds total deposits are 600 + 450 + 337.5 + 253.1 = £1,640.6m, from an initial £600m. Each round is smaller, so the chain converges towards a limit (here 2,400). You are not asked to calculate the credit multiplier. You need to explain why the process happens and what limits it.

What limits credit creation:

• Demand for loans: borrowers must want and qualify for credit.
• Liquidity: banks keep assets that can meet withdrawals.
• Capital: each extra loan is an asset that must be backed by capital if it goes wrong.
• Leakage: money held as cash leaves the chain.
• Regulation and monetary policy: both affect the cost and amount of credit.

Combined banks and systemic risk

Systemic risk is the risk that the failure of one institution, or a shock to the system, spreads and threatens the whole financial system. A bank that combines retail and investment banking has a larger and more complex balance sheet. Trading losses can threaten the deposits of ordinary savers. Governments may then feel obliged to rescue it, which links to moral hazard below. Against this, combined banks are more diversified.

UK regulation

You need to appreciate the role of each body, not know their detail.

Body	Role in financial stability
Bank of England	Responsible for financial stability in the UK. It houses the PRA and the FPC
Prudential Regulation Authority (PRA)	Supervises individual firms such as banks, building societies and insurers, setting standards on capital and liquidity
Financial Policy Committee (FPC)	Monitors the system as a whole and acts to reduce systemic risks
Financial Conduct Authority (FCA)	Regulates how financial firms treat customers and behave in markets

The PRA looks at whether each firm is safe. The FPC looks at the whole system. The FCA looks at conduct.

Why banks fail

A bank can fail in two ways. It may be illiquid: unable to meet payments as they fall due even though its assets are worth enough in the long run. Or it may be insolvent: its assets are worth less than its liabilities, so its capital is wiped out.

Borrowing short and lending long. Deposits can be withdrawn at short notice, but mortgages and business loans are repaid over years and cannot be sold quickly without a loss. If depositors lose confidence, they withdraw together. This is a bank run, and it can feed itself: fear of failure causes the failure.

Worked example (a run on Bank J). Bank J’s liquid assets are 25 + 45 + 70 = £140m. Depositors withdraw 25% of current and savings accounts: 0.25 × 380 = £95m. Wholesale lenders also refuse to renew £60m. Demands are 95 + 60 = £155m, so the shortfall is £15m. Bank J must sell mortgages. In a hurry it sells £40m of them for 85% of their value, receiving £34m and losing £6m.

Insolvency. Suppose a recession causes 10% of loans to firms (£11m) and 2% of mortgages (£4.8m) to default: total £15.8m. Capital of 40 absorbs this and leaves £24.2m. A similar bank with capital of only 10 would end at −£5.8m. It is insolvent.

Liquidity and capital ratios

A liquidity ratio compares liquid assets with liabilities that may be demanded soon. A higher ratio means the bank can survive withdrawals without selling assets at a loss. A capital ratio compares capital with assets, often adjusted for risk. A higher ratio means more cushion against losses. You will not calculate either ratio. You need to explain how they affect stability.

Higher required ratios make failure less likely, but they cost the bank profit and restrict lending: this is the security versus profitability conflict again.

Moral hazard

Moral hazard exists when a party is protected from the full cost of its own risks, so it gambles more freely. In banking, deposit protection, limited liability or an expectation of a government rescue can encourage risky lending, because gains go to the bank and losses partly go elsewhere.

Worked example. A bank can invest £100m safely for a 3% return (£3m). Or it can take a risky investment: a 60% chance of a 12% gain and a 40% chance of a 15% loss.

• Expected return on the risky option, with no rescue: 0.6 × 12 + 0.4 × (−15) = 7.2 − 6.0 = £1.2m. The safe option is better, so a bank bearing its own risk avoids it.
• If a rescue means the bank never loses, its expected return is 0.6 × 12 + 0.4 × 0 = £7.2m. The risky option now wins.
• The taxpayer’s expected cost is 0.4 × 15 = £6m.

The bank’s private incentive is to gamble, though society’s expected return is still low. Regulators respond with capital requirements, supervision and rules that let failing banks go under without ruining the system.

Systemic risk and the real economy

Banks are linked by lending to each other. If Bank K fails and repays only 40p in the pound on a £30m loan from Bank J, Bank J loses 30 × 0.6 = £18m. Added to the £15.8m loan losses above, losses reach £33.8m, leaving capital of £6.2m. One failure has nearly destroyed another bank.

The real economy suffers through these links:

1. Banks lose capital and confidence, so they cut lending (a credit crunch).
2. Firms cannot finance investment or working capital, so investment falls.
3. Households cut spending on credit-dependent goods.
4. Aggregate demand falls, output falls and unemployment rises.
5. Lower incomes cause more loan defaults, which weakens banks further.

Illustration. In Country A, bank lending to firms falls £8bn. Investment falls £8bn. With a multiplier of 1.5, aggregate demand falls 8 × 1.5 = £12bn, which is 12 ÷ 400 = 3.0% of a £400bn economy. This is an invented example.

Evaluation. The effect depends on how well capitalised banks are, how fast regulators respond, whether firms can borrow elsewhere, and whether confidence returns.

Common errors

• Putting deposits on the asset side of a bank balance sheet.
• Treating illiquid and insolvent as the same.
• Describing moral hazard as “risky behaviour” without saying who bears the cost.
• Saying the FPC supervises individual banks. That is the PRA.

Next, test yourself with the practice set.

Official syllabus

AQA, AS and A-level Economics specification (7135 and 7136), version 1.3, 29 June 2022, sections 4.2.4.2 and 4.2.4.4.