Text 5. The role of banks in theory

Banks are financial intermediaries, similar to credit unions, savings and loan associations, and other institutions selling financial services. The term financial intermediary simply means a busi­ness that interacts with two types of individuals or institutions in the economy: (1) deficit-spending individuals or institutions whose cur­rent expenditures for consumption and investment exceed their cur­rent receipts of income and who, therefore, need to raise funds exter­nally by negotiating loans with and issuing securities to other units; and (2) surplus-spending individuals or institutions, whose current receipts of income exceed their current expenditures on goods and services so they have surplus funds to save and invest. Banks per­form the indispensable task of intermediating between these two groups, offering convenient financial services to surplus-spending individuals and institutions in order to raise funds and then loaning those funds to deficit-spending individuals and institutions.

There is an ongoing debate in the theory of finance and econom­ics about why banks exist. What essential services do banks provide that other businesses and individuals couldn't provide for themselves?

This may at first appear to be an easy question, but it has proven to be extremely difficult to answer. Why? Because research evidence has accumulated over many years showing that our financial system and financial markets are extremely efficient. Funds and information flow readily to both lenders and borrowers, and the prices of loans and securities seem to be determined in highly competitive markets. In a perfectly effi­cient financial system, in which pertinent information is readily available to all at negligible cost, in which the cost of carrying out financial trans­actions is negligible, and all loans and securities are available in denom­inations anyone can afford, why are banks needed at all?

Most current theories explain the existence of banks by pointing to imperfections in our financial system. For example, all loans and securities are not perfectly divisible into small denominations that everyone can afford. To take one well-known example, U.S. Treasury bills — probably the most popular short-term marketable security in the world — have a minimum denomination of $10,000, which is clearly beyond the reach of most small savers. Banks provide a valuable serv­ice in dividing up such instruments into smaller securities, in the form of deposits, that are readily affordable for millions of people. In this instance a less-than-perfect financial system creates a role for banks in serving small savers and depositors.

Another contribution banks make is their willingness to accept risky loans from borrowers, while issuing low-risk securities to their depositors. In effect, banks engage in risky borrowing and lending activity across the financial markets by taking on risky financial claims from borrowers, while simultaneously issuing almost riskless claims to depositors.

Banks also satisfy the strong need of many customers for liquidi­ty. Financial instruments are liquid if they can be sold quickly in a ready market with little risk of loss to the seller. Many households and businesses, for example, demand large precautionary balances of liq­uid funds to cover expected future cash needs and to meet emergen­cies. Banks satisfy this need by offering high liquidity in the deposits they sell.

Still another reason banks have grown and prospered is their supe­rior ability to evaluate information. Pertinent data on financial invest­ments is both limited and costly. Some borrowers and lenders know more than others, and some individuals and institutions possess inside infor­mation that allows them to choose exceptionally profitable invest­ments while avoiding the poorest ones. Banks have the expertise and experience to evaluate financial instruments and choose those with the most desirable risk-return features.

Moreover, the ability of banks to gather and analyze financial infor­mation has given rise to another view of why banks exist in modern soci­ety—the delegated monitoring theory. Most borrowers and depositors prefer to keep their financial records confidential, shielded especially from competitors and neighbors. Banks are able to attract borrowing custom­ers, this theory suggests, because they pledge confidentiality. Even a bank's own depositors are not privileged to review the financial re­ports of its borrowing customers. Instead, the depositors hire a bank as delegated monitor to analyze the financial condition of prospective borrowers and to monitor those customers who do receive loans in order to ensure that the depositors will recover their funds. In return for bank monitoring services, depositors pay a fee that is probably less than the cost they would have incurred if they monitored the borrowers themselves.

By making a large volume of loans, banks as delegated monitors can diversify and reduce their risk exposure, resulting in increased deposit safety. Moreover, when a borrowing customer has received the bank's stamp of approval, it is easier and less costly for that customer to raise funds elsewhere. In addition, when a bank uses some of its owners' mon­ey as well as deposits to fund a loan, this signals the financial market­place that the borrower is trustworthy and has a reasonable chance to be successful and repay its loans.

EXERCISES

Exercise 1. In each paragraph, find the sentences supporting the main idea of the text. What paragraph contains the most important information?

Exercise 2. Answer the questions.

l. What does the term 'financial intermediary' mean?

2. Explain the meaning of the following terms 'deficit-spending individuals' and 'surplus-spending individuals'.

3. What task do banks perform?

4. Why does bank exist?

Exercise 3. Complete the sentences. Provide, banks, explain, popular, evaluate, debate, risk, market, afford, data, confidential, system, need.

1. There is an ongoing … in the theory of finance and econom­ics about why banks exist.

2. What essential services do banks … ?

3. Our financial ... and financial markets are extremely efficient.

4. Most current theories … the existence of banks by pointing to imperfections in our financial system.

5. Loans and securities are not divisible into small denominations that everyone can ….

6. U.S. Treasury bills are the most … short-term marketable security in the world.

7. Pertinent … on financial invest­ments is limited and costly.

8. Banks satisfy the strong … of many customers for liquidi­ty.

9. Financial instruments are liquid if they can be sold quickly in a ready … with little risk of loss to the seller.

10. Banks have the expertise and experience to … financial instruments and choose those with the most desirable risk-return features.

11. … can gather and analyze financial infor­mation.

12. People prefer to keep their financial records ….

13. Banks can diversify and reduce their … exposure by making a large volume of loans.

Exercise 4. Write down the Russian equivalents.

Financial intermediary, savings, loan, to interact, deficit-spending individuals, surplus-spending individuals, current receipts of income, current expenditures, an ongoing debate, to provide, evidence, lenders and borrowers, a highly competitive markets, to afford, a less-than-perfect financial system, financial instruments, financial invest­ments, profitable invest­ments, trustworthy.

Exercise 5. Match the nouns and the verbs as they are used in the text.

1. to per­form A. the financial condition

2. to offer B. emergen­cies

3. to provide C. borrowing custom­ers

4. to take D. a fee

5. to engage E. information

6. to satisfy F. services

7. to cover G. in risky borrowing

8. to meet H. expected cash needs

9. to evaluate I. financial infor­mation

10. to gather J. the indispensable task

11. to keep K. financial services

12. to attract L. an example

13. to analyze M. the strong need

14. to pay N. a loan

15. to make O. a large volume of loans

16. to fund P. financial records сonfidential