Commercial banks are among the most important financial institutions in the economy because they provide savers with a secure place to invest funds and they offer both individuals and companies loans to finance investments, such as the purchase of a new home or the expansion of a business.
Investment banks are institutions that (1) assist companies in raising capital, (2) advise firms on major transactions such as mergers or financial restructurings, and (3) engage in trading and market making activities.
The traditional business model of a commercial bank—taking in and paying interest on deposits and investing or lending those funds back out at higher interest rates—works to the extent that depositors believe that their investments are secure.
Since the 1930s, the U.S. government has given some assurance to depositors that their money is safe by providing deposit insurance (currently up to $250,000 per depositor). Deposit insurance was put in place in response to the banking runs or panics that were part of the Great Depression.
The same act of Congress that introduced deposit insurance, the Glass-Steagall Act, also created a separation between commercial banks and investment banks, meaning that an institution engaged in taking in deposits could not also engage in the somewhat riskier activities of securities underwriting and trading.
Commercial and investment banks remained essentially separate for more than 50 years, but in the late 1990s Glass-Steagall was repealed. Companies that had formerly engaged only in the traditional activities of a commercial bank began competing with investment banks for underwriting and other services.
In addition, the 1990s witnessed tremendous growth in what has come to be known as the shadow banking system. The shadow banking system describes a group of institutions that engage in lending activities, much like traditional banks, but these institutions do not accept deposits and are therefore not subject to the same regulations as traditional banks.
For example, an institution such as a pension fund might have excess cash to invest, and a large corporation might need short-term financing to cover seasonal cash flow needs. A business like Lehman Brothers acted as an intermediary between these two parties, helping to facilitate a loan, and thereby became part of the shadow banking system.
In March 2010, Treasury Secretary Timothy Geithner noted that at its peak the shadow banking system financed roughly $8 trillion in assets and was roughly as large as the traditional banking system.
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