Bank Services: Old and New

NEW OLD
Interest-bearing transactions accounts	Noninterest-bearing
Fixed rate certificates of deposit checking accounts
Floating rate certificates of deposit	Savings accounts
Floating rate commercial loans	Commercial and
Real estate and consumer loans	industrial loans
Credit cards
Debit cards
Cash management services
Mutual funds
Electronic funds transfer systems
Insurance
Underwriting of securities

What do banks do?

Because banks perform a large number of functions, we should discuss the general activities of banks rather than attempt to describe in minute detail the activities of banking organizations. Most of the functions performed by commercial banks may be subsumed under three broad areas:

1. Payments

2. Intermediation

3. Other financial services.

Payments

Banks are at the very core of the payments system. Most of the money supply of the United States is held in the form of bank money (i.e., transactions accounts at commercial banks). Because an efficient payments system is vital to a stable and growing economy, the role of banks in the payments system takes on an important social dimension. At one time,

commercial banks had a monopoly on transactions accounts. In recent years, however, savings and loans, savings banks, and credit unions (known collectively along with commercial banks as depository institutions) have obtained the authority to offer transactions accounts. Also, other types of financial service organizations, such as money market mutual funds (often referred to simply as "money funds"), have developed financial products against which checks may be written.

Commercial banks (along with the Federal Reserve System) are also at the heart of the electronic payment system, which is rapidly supplanting paper-based payment methods such as checks. For example, electronic payments between commercial banks are done through fad-wire (a wholesale wire transfer system operated by the Federal Reserve System), with more than 300,000 transfers per day amounting to about $ 1 trillion. In addition, CHIPS (The Clearing House Interbank Payments System) is a private electronic transfer system operated by large banks in New York that transfers another $1 trillion per day, principally involving international movements of funds. Further, SWIFT (the Society for Worldwide Interbank Financial Telecommunication) is operated by almost 2,000 banks throughout the world.

Intermediation

Commercial banks act as intermediaries between those who have money (i.e., savers or depositors) and those who need money (i.e., borrowers). The role of banks in the intermediation process is illustrated in Figure 1.1. Banks obtain deposits from savers by offering interest and other features that meet those customers' needs better than alternative uses of funds. Commercial banks are able to provide deposit instruments with low denomination, low risk, and high liquidity, characteristics that meet the needs of most savers better than stocks and bonds, which often have high denominations, high risk, and lesser liquidity. Commercial banks are able to package large amounts of small deposits and lend those funds to borrowers. Although at one time commercial bank loans were concentrated in short-term commercial lending (hence the term commercial bank), most banks now make any type of loan legally permissible that meets internal credit-quality standards. In the intermediation process of gathering funds (stage 1 of Figure 1.1) and using funds (stage 2) banks incur noninterest expenses such as employee salary expenses and premises and fixed asset expenses.

S ource; T. Siems, "Quantifying Managements Role in Bank Survival," Federal Reserve Bank of Dallas, Economic Review, First Quarter 1992, p. 31.

Some banks, however, do concentrate on drawing funds from and lending funds to businesses (those banks are known as wholesale banks], whereas other banks draw their funds from consumers and concentrate their lending to consumers (those banks are known as retail or consumer banks). In either case, however, the banks are performing an intermediation function.

Financial intermediation between savers and investors is crucial to the efficient operation of the economy. Economic growth fundamentally depends on a large volume of saving and the effective allocation of that saving to productive uses.

Efficient financial markets contribute to such an allocation. By offering depositors financial instruments that have desirable risk/return characteristics, commercial banks are able to encourage a greater volume of saving and, by effectively screening credit requests, they are able to channel funds into socially productive uses. Although the social role of commercial banks in financial intermediation is somewhat different than in the payments function, it is no less important.

Motivation for bank activities

Commercial banks are private, profit-seeking business enterprises. They provide payments services, financial intermediation, and other financial services in anticipation of earning profits from those activities. Along with other profit-seeking businesses, their principal goal is to maximize the market value of the equity of the common stockholders. Thus, decisions on lending, investing, borrowing, pricing, adding new services, dropping old services, and other such decisions ultimately depend on the impact on shareholder wealth. Because shareholder wealth is determined by three factors—(l)the amount of cash flows that accrue to bank shareholders, (2)the timing of the cash flows, and (3)the risk involved in those cash flows—management decisions involve evaluating the impact of various strategies on the return (the amount and timing of the cash flows) and the risk of those cash flows (Figure 1.2).