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1.3 The role of banks

To understand fully the advantages of the intermediation process, it is necessary to analyse what banks do and how they do it. We have seen that the main function of banks is to collect funds (deposits) from units in surplus and lend funds (loans) to units in deficit. Deposits typically have the characteristics of being small-size, low-risk and high-liquidity. Loans are of larger-size, higher-risk and illiquid. Banks bridge the gap between the needs of lenders and borrowers by performing a transformation function:

a)size transformation;

b)maturity transformation;

c)risk transformation.

a) Size transformation

Generally, savers/depositors are willing to lend smaller amounts of money than the amounts required by borrowers. For example, think about the difference between your savings account and the money you would need to buy a house! Banks collect funds from savers in the form of small-size deposits and repackage them into larger size loans. Banks perform this size transformation function exploiting economies of scale associated with the lending/borrowing function, because they have access to a larger number of depositors than any individual borrower (see Section 1.4.2).

b) Maturity transformation

Banks transform funds lent for a short period of time into mediumand long-term loans. For example, they convert demand deposits (i.e. funds deposited that can be withdrawn on demand) into 25-year residential mortgages. Banks' liabilities (i.e., the funds collected from savers) are mainly repayable on demand or at relatively short notice. On the other hand, banks' assets (funds lent to borrowers) are normally repayable in the medium to long term. Banks are said to be 'borrowing short and lending long' and in this process they are said to 'mismatch' their assets and liabilities. This mismatch can create problems in terms of liquidity risk, which is the risk of not having enough liquid funds to meet one's liabilities.

c) Risk transformation

Individual borrowers carry a risk of default (known as credit risk) that is the risk

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that they might not be able to repay the amount of money they borrowed. Savers, on the other hand, wish to minimise risk and prefer their money to be safe. Banks are able to minimise the risk of individual loans by diversifying their investments, pooling risks, screening and monitoring borrowers and holding capital and reserves as a buffer for unexpected losses.

REVISION QUESTIONS

1.What is the role of financial intermediaries in an economy?

2.What is special about banks?

3.How do lenders’ and borrowers’ requirements differ? How can financial intermediaries bridge the gap between them/

4.Explain how banks can lower transaction costs.

5.How can bank minimize the problems connected with their lending function?

CHAPTER 2

Banking Services

GETTING STARTED

Working in groups, consider the issues below. After you have reached some conclusions, share your ideas with the whole class.

1.Make a list of services that are provided by the banks in your area. Say which banking services you and your family use.

2.Find out if there are credit card holders in your group and what for they use their cards.

3.What credit card systems do you know?

4.Is e-banking widely spread in your country?

5.Discuss recent changes and trends in the banking system of your country.

VOCABULARY STUDY

1).Study the words below and explain their meaning within the text 2). Suggest Russian equivalents of these words.

2.1. Introduction

This chapter offers some insights into the nature of the banking business; it reviews the main services offered by banks (loans and deposits, and payment services) as well as a wide range of additional services, such as insurance and investment services. In this context, special attention is given to the significant changes in payment systems with an extensive discussion on the major instruments and services that modern banks provide to their customers from plastic money to e- banking.

The second part of the chapter describes the main forces that generate change in the banking sector, such as the deregulation and re-regulation processes, competitive pressures, financial innovation and technology. Finally, the chapter highlights the main trends resulting from these forces of change, for example conglomeration and globalisation.

2.2 What do banks do?

We have seen in Chapter 1 that financial intermediaries channel funds from units in surplus to units in deficit. In order to better understand how banks work, we need to examine their assets and liabilities. Table 2.1 summarises a typical bank balance sheet

For banks, the main source of funding is customer deposits (reported on the liabilities side of the balance sheet); this funding is then invested in loans, other investments and fixed assets (such as buildings for the branch network), and it is reported on the assets side of the balance sheet. The difference between total assets and total liabilities is the bank capital (equity). Banks make profits by charging an interest rate on their loans that is higher than the one they pay to depositors.

As with other companies, banks can raise funds by issuing bonds and equity (shares), and saving from past profits (retained earnings). However, the bulk of their money comes from deposits (see Section 8.2); it is this ability to collect deposits from the public that distinguishes banks from other financial institutions, as explained in Section 2.3.

2.3 Banks and other financial institutions

Banks are deposit-taking institutions (DTIs) and are also known as monetary financial institutions (MFIs). Monetary financial institutions play a major role in a country's economy as their deposit liabilities form a major part of a country's money supply and are therefore very relevant to governments and Central Banks for the transmission of monetary policy. Banks' deposits function as money; as a consequence, an expansion of bank deposits results in an increase in the stock of money circulating in an economy. All other things being equal, the money supply, that is the total amount of money in the economy, will increase.

The monetary function of bank deposits is often seen as one of the main reasons why deposit-taking institutions (DTIs) are subjected to heavier regulation and supervision than their non-deposit-taking institution (NDTI) counterparts (such as insurance companies, pension funds, investment companies, finance houses and so on).