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according to	согласно
on account of	по причине, из-за
by means of	посредством, при помощи
instead of	вместо
in spite of	несмотря на
because of	из-за
in case of	в случае, если
by virtue of	посредством
owning to	благодаря
thanks to	благодаря
due to	из-за, в силу
in addition to	кроме, в дополнение к
with respect to	по отношению к
in accordance with	в соответствии с
in order to	для того, чтобы

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either ...or	или ... или
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the ... the	чем ...тем

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Block 9.2 Supplementary reading

What is a bank?

The answer to the question "What is a bank?" might seem quite simple. In reality, however, the answer is rather complicated. A bank offers transaction accounts (such as demand deposits) to its customers. It also offers various types of savings accounts and certificates of deposits and makes a variety of loans. It might be argued then that a bank is an organization that offers these services.

Two problems immediately come to mind with such a definition. First, organizations other than commercial banks also provide these services. Savings and loan associations, savings banks, and credit unions provide deposit and loan services that are virtually identical to those of commercial banks, and money market funds and investment brokers such as Merrill Lynch also provide similar services. Second, banks do many things that are not included in the functions of offering deposit and loan services. They provide trust services, arrange mergers and acquisitions, and guarantee payment from one party to another through letters of credit and other devices.

Perhaps the best definition of a bank is the following: "A bank is an organization that has been given banking powers either by the state or the federal government." Although this definition might seem to be somewhat circular (a bank is as a bank does) and perhaps somewhat trivial, the definition provides useful insight into the nature of the institution by recognizing the dynamic and ever-changing nature of banking.

Imagine the entire range of financial services that exists in a modern economy. These services would certainly number in the hundreds, perhaps in the thousands. At a given time, government will allow banks to provide some of those services. At that time, commercial banks may be defined in terms of those services. As time passes, however, new financial services will be created and attitudes may change about the desirability of allowing banks to offer certain existing financial services. As a result, the range of financial services permissible for commercial banks may be altered—either expanded or reduced. In the last 20 years, the range of permissible services has been expanded considerably, both because of deregulation and the actions of bank managers who have created innovative financial services not expressly prohibited by legislation or regulation. Hence, a bank today is not like a bank 20 years ago (in terms of the services offered), which is again not the same as a bank 20 years earlier. Yet all are commercial banks. Table 1.1 provides some perspective on the types of services that banks now offer and compares them with the traditional range of services.

Definition of a commercial bank in terms of permissible activities also provides insight into the perpetual dispute over the limits of bank powers. Not surprisingly, managers of commercial banks attempt to have laws and regulations changed in order to obtain expanded powers to provide additional financial services. Managers of the firms that provide those financial services not now permitted to banks work just as hard to prevent bank competition in those areas. Much of the debate over bank regulation centers on the controversy between bankers and other financial service firms over the limits of bank powers.

Table 1.1. 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.

Banks in the intermediation process

Figure 1.1.

Source; 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).

Bank Goals and Constraints

Figure 1.2.

Risk management

As mentioned by Alan Greenspan in the quote at the beginning of this chapter, bank management is risk management. Banks accept risk in order to earn profits. They must balance the various alternative strategies in terms of their risk/return characteristics with the goal of maximizing shareholder wealth. In doing so, banks must recognize that there are different types of risk and that the impact of a particular investment strategy on shareholders depends on the impact on the total risk of the organization. That total risk is composed of six components:

1. Credit risk: The risk that the bank will not get its money back (or that payment will be delayed) from a loan or investment. This is what caused most bank failures in recent years.

2. Interest rate risk: The risk that the market value of a bank asset (i.e., loans and securities) will fall with increases in interest rates. For a commercial bank that promises to pay a fixed amount to depositors, any decline in the value of assets due to interest rate increases could have serious implications for the solvency of the organization.

3. Liquidity risk: The risk of being unable to meet the needs of depositors and borrowers by turning assets into cash (or being unable to borrow funds when needed) quickly with minimal loss. Given the large amount of bank deposits that must be paid on demand or within a very short period, liquidity risk is of crucial importance in banking.

4. Operational risk: The risk that operating expenses, especially noninterest expenses such as salaries and wages, might be higher than expected. Banks that lack the ability to control their expenses are more likely to have unpleasant earnings surprises. Over an extended time in a competitive market enviroment, banks with excessively high operating costs will have difficulty surviving.

5. Capital risk: The risk of having inadequate equity capital to continue to operate. This may be viewed either from an economic perspective so that inadequate equity capital occurs when customers refuse to leave their funds with the bank (causing a liquidity crisis) or from a regulatory perspective (where the bank regulatory authorities close the bank because of capital below regulatory minimums),

6. Fraud risk: The risk that officers, employees, or outsiders will steal from the bank by falsifying records, self-dealing, or other devices. Fraud risk is associated with unsound banking practices that could result in bank failure.

The principal risk that has caused problems for bank management is credit or default risk. Although banks fail for many reasons, the principal one is bad loans. Banks, of course, don't make "bad" loans. They make loans that go bad. At the time the loans were made the decisions seemed correct. However, changes in oil prices, real estate prices, crop prices, and other factors that were not foreseen resulted in credit problems. Recent problems with energy loans, agricultural loans, and loans to less-developed countries certainly illustrate this point. The crucial importance of credit risk in the loan portfolio has contributed to the extensive treatment of loans and the loan portfolio in this book.

Bank management must carefully balance risk and return in seeking to maximize shareholder wealth. However, such decisions are constrained by a number of factors. Of course, all businesses face constraints in their decision making, but the constraints under which banks operate are particularly important. These constraints may be classified into three separate though overlapping areas:

1. Market constraints: Banks face considerable market constraints as they attempt to manage risk in order to maximize shareholder values. These market constraints take the form of competition from other banks, from nonbank providers of financial services, and from the capital market. For example, if management believes that it must charge 8% on a loan in order to be fully compensated for credit risk, but if other lenders will provide credit to the borrower at 7%, this is a market constraint that has a potentially serious impact on the bank.

2. Social constraints: Social constraints stem from the historical position of the commercial bank at the core of the financial system. As such, banks often become the lender of next to last resort in times of financial crisis (the Federal Reserve is, of course, the lender of last resort) in providing credit to distressed institutions and in providing deposit and credit services to their customers. Because the financial performance of a bank is intimately linked with the economic health of the community it serves, banks often perform numerous social functions (and ar е expected to do so) despite, in many cases, being unable to determine the contributions of such activities to shareholder wealth.

3. Legal/regulatory constraints; Perhaps more significant is the enormous variety of legal and regulatory constraints on the portfolio management (i.e., its risk/return position) of a commercial bank.