1 cA r T E R AN OVERVIEW OF BANKS AND THEIR SERVICES Learning and Management Decision Objectives Introduction In this chapter you will learn about the many roles banks play in the economy today and see how recent trends in banking, including increased competition, technological change, consolidation into larger firms, and globalization, can affect a bank manager's decision making. The chapter explains why bank decision makers must take these trends into account if their banks are to survive and prosper. Banks are among the most important financial institutions in the economy. They are the, principal source of credit (loanable funds) for millions of individuals and families and for Tany units of government (school districts, cities, counties, etc.). Moreover, for small local businesses ranging from grocery stores to automobile dealers, banks are often the ‘major source of credit to stock the shelves with merchandise or to fill a dealer's showroom with new cars. When businesses and consumers must make. payments for purchases o' goods and services, more ofien than not they use bank-provided checks, credit or debit cards, or electronic accounts connected to a computer network. And when they need finan- “Gial information and financial plann is the banker to whom they turn most frequently for advice and counsel. Worldwide, banks grant more installment loans to consumers than any other finai:cial institution, In most years, they are among the leading buyers of bonds and notes issued by governments to finance public facilities, ranging from auditoriums and football stadiums to airports and highways. Banks are among the most important sources of short-term work- ing capital for businesses and have become increasingly active in recent years in making long-term business loans for new plant and equipment. The assets held by U.S. banks rep- resent about one-third of the total assets and a roughly equal proportion of the earnings of all U.S.-based financial institutions. In other countries, such as Japan, banks hold the 34 Part! Am Iniroduction ta the Business of Banking majority of assets possessed by all financial institutions, Moreover. bank reserves are the principal channel for government economic policy to stabilize the economy. For all these reasons and more, banks are one of the most important of society's institutions for us to study and understand. What Is a Bank? ‘As important as banks are to the economy as a whole and to local communities, there is Bank much confusion about exactly what a bank is. Certainly banks can be identified by the A financial {functions (services or roles) they perform in the economy. The problem is that not only are intermediary accepting he functions of banks changing, but the functions of their principal competitors are chang- sand grant ing as well. Indeed, many financial institutions—including leading security dealers, bro- eine oT kerage firms, mutual funds, and insurance companies—are trying to be as similar as pos- Services of any ible to banks in the services they offer. financial institution, Bankers’ Insights and Issues A Brief History of Banking When did the first banks appear? Linguistics (the science of language) and etymology (the. study of the origin of words) suggest an interesting story about banking’s origins. Both the Old French word bangue and the Italian word banca were used centuries ago to mean a “bench” or “money changer’s table.” This describes ata well what historians have observed 6 ‘concerning the first bankers, who lived more than ago. They were money chang: /. 9/7 ad _£ts, situated usually at a table or in a small ee jal district, aiding travelers ) { “ ¥ ‘who came to town by exchanging foreign coins for local money or disc ‘or discounting commercial ' Eirigs ere mie tees i ates aie ‘The first bankers probably used their own capital to fund their activities, but it wasn’t long before the idea of attracting deposits and securing temporary loans from wealthy customers became an important source of bank funding. Loans were then made to merchants, shippers, and landowners at rates of interest as low as 6 percent per annum to as high as 48 percent a ‘month for the riskiest ventures! Most of the early banks of any size were Greek in origin ‘The banking industry gradually spread outward from the classical civilizations of Greece: * and Rome into northern and western Europe. Banking encountered religious opposition dur- ing the Middle Ages, primarily because loans made to the poor often carried high interest rates. However, as the Middle Ages drew to a close and the Renaissance began in Europe, the bulk of bank Joans and deposits involved relatively wealthy customers, which helped to reduce religious opposition to banking practices. ‘The development of new overland trade routes and improvements in navigation in the 15th, 16th, and 17th centuries gradually shifted the. center of world commerce from the Mediterranean region toward Europe and the British Isles, where banking became a leading industry. During this period were planted the seeds of the Industrial Revolution, which demanded a well-developed financial system. In particular, the adoption of mass productiontubank banks tpository institutions ering checking fsounts or jmmercial loans but prboth. Chapter 1 An Overviews uf Banks und Their Services Bankers, in turn, are challenging their nonbank competitors by demanding—and today often receiving—expanded authority to cffer security trading and insurance ser- vices, real estate development, sales of mutual funds. and many other newer. more risky. but also more revenue-driven services, ‘A good example of the strenuous efforts on the part of many institutions to become banklike occurred in the 1980s when several large insurance and security firms. including Merrill Lynch, Dreyfus Corporation. and Prudential, moved aggressively to enter the banking business by establishing what they called nonbank banks. They were aware that under law in the United States any institution offering deposits subject to withdrawal on demand (such as by writing a check or by making an electronic withdrawal) and making Joans of a commercial or business nature is a bank. Merrill Lynch, Prudential Insurance, JC Pennéy and other nonbank firms decided they could skirt these laws. avoid regulation. and still sell banklike services to the public simply by stripping the banks they controlled of either their business loans or their checking accounts. In 1987, Congress put a halt to ‘methods required a corresponding expansion in global trade to absorb industrial output, requiring new methods for making payments and credit available, Banks that could deliver on these needs grew rapidly, led by such institutions as the Medici Bank in Italy and the Hochstetter Bank in Germany. ‘The early banks in Europe were places for safekeeping of valuable items (such as gold and silver bullion) as people came to fear loss of their assets due to war, theft, or expropriation by government. Merchants shipping goods across the sea found it safer to place the gold and sil- _ ver they were paid at the nearest bank rather than risking its loss to pirates orto storms at sea. In England during the reigns of King Henry VIII and Charles 1, government efforts to seize private holdings of gold and silyer resulted in people depositing their valuables in goldsmiths’ - shops, who, in tum, would issue tokens or certificates, indicating that the customer had made ‘a deposit at these businesses. Soon, goldsmith tokens or certificates began to circulate as money because they were more convenient and less tisky to carry around than gold or other valuables. The goldsmiths also offered certification of value services—what we today might call property appraisals. Customers would bring in gol, silver, jewels, or other valuables to have an expert certify that these items were, indeed, real and not fakes—a service many banks still provide their customers, ‘When colonies were established in North and South America, Old World banking prac~ tices were transferred to the New World. At first the colonists dealt primarily with established ‘banks in the countries from which they had come. As the 19th century began, however, state ‘governments in the United States began chartering banking companies. Many of these were simply extensions of other commercial enterprises in which banking services were largely secondary to merchants’ sales—for example, the farm equipment business. The development of large, professionally mangged banking firms was centered ina few leading commercial centers, especially New York \The federal government became a major force in U.S. banking during the Civil War. The Office ofthe Comptroller of the Currency (OCC) was established in 1864, created by Congress to charter national banks. This divided bank regulatory system, With both the federal government and the states playing Key roles in the control and supervi- sion of banking activity, has persisted in the United States to the present day.12 Part! An Introduction 10 the Business of Banking Bankers’ Insights and Issues ‘The Role of Banks in Theory Above all else, banks are financial intermediaries. similar to credit unions, insurance compa- nies, and other institutions selling financial services. The term financial intermediary simply means a business that interacts with two types of individuals and institutions in the economy: (1) deficit-spending individuals and institutions. whose current expenditures for consumption and investment exceed their current receipts of income and who, therefore, need to raise funds externally through borrowing; and (2) surplus-spending individuals and 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 individ uals and institutions in order to attract funds and then loaning those funds to deficit-spending individuals and institutions. Banks’ intermediation activities will take place (a) if there is a positive spread between the expected yields on the loans banks make to deficit-spending individuals and institutions and the ‘expected interest rate (cast) on the funds banks borrow from surplus-spending individuals and institutions, and (b) if there is @ positive correlation between the yields on bank loans and the interest rate banks pay for deposits and other funds provided by surplus-spending units, If a bank's loan rates and its borrowing costs are positively correlated, this will reduce uncertainty about its expected profits, encouraging it to continue borrowing from and lending funds to its customers. There is an ongoing debate in the theory of finance and economics about w/ty banks exist. ‘What essential services do banks provide that other businesses and individuals cannot provide for themselves? This question has proven to be extremely di jcult to answer. Research evidence has accu- mulated over many years showing that our financial system and financial markets are extremely eff 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. com-_ petitive and financial system, in which all participants have open and equal access to the financial markets and can borrow and lend at the same interest rate, in which no one Partic- pant can exercise control over interest rates or prices, in which all peninent information affect ing the value of loans, securities, and other assets is readily available to all market participants at negligible cost, in which transactions costs are not significant impediments to trading assets, and all loans and securities are available in denominations anyone can afford, why would banks be needed at all? Most current theories explain the existence of banks by pointing 1 imperfections in our financial system. For example. all loans and securities are ot perfectly divisible into small denominations that everyone can afford. To take one. well-known example, U.S. Treasury bonds—one of the most popular marketable securities in the world—usually have minimum t f aChapter 1 An Overview of Banks and Their Services 13 denominations of $1,000, which is beyond the reach of many 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 borrow- ers, while issuing low-risk securities to their depositors. In effect, banks engage in risky arbi- trage across the financial markets. Banks also satisfy the strong need of many customers for lianiity. Financial instruments are liquid if they can be sold quickly in a ready market with litle risk of lass to the seller. | ‘Many households and businesses, for example, demand large precautionary balances of liq- uid funds to cover expected future cash needs and to meet emergencies, Banks satisfy this need by offering high liquidity in the deposits they sell and in the loans they provide, giving borrowers access to liquid funds to spend precisely when those funds are needed. Suill another reason banks have prospered is their superior ability to evaluate information. Pertinent data on financial investments is both limited and costly. lenders know more than others, and some individuals and institutions nforma-_ “Tion that allows them to choose excey ly profitable investments while avoiding the poor- “Gs ones. This uneven distribution of information and the talent to analyze information is known as informational asymmetry. Informational asymmetries reduce the efficiency of mar- kets, but provide a profitable role for banks that have the expertise and experience to evalu- ate financial instruments and to 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. Bank depositors ofien have neither the time nor the skill to evaluate the credentials of a borrower and to choose good loans over bad loans. They tum the monitoring process over to a bank that has invested ‘human and reputational capital in this process. Thus, a bank serves as an agent on behalf of its depositors, monitoring the financial condition of those customers who do receive loans to ensure that the depositors will recover their funds. In return for monitoring services, deposi- tors pay a fee to the bank that is probably less than the cost they would incur if they moni- (ored borrowers themselves. By making a large volume of loans, banks as delegated monitors can diversify and reduce, their risk exposure, resulting in increased safety for their depositors. Moreover, whet rowing customer has received the bank's stamp of approval, it is easier and less costly for that ‘customer to raise funds elsewhere. This signals the financial marketplace that the borrower is trustworthy and likely to repay his or her loans. This signaling effect of bank lending seems to be strongest, not when a bank makes the first loan to a new borrower, but when it grants renewal of a maturing loan,16 Part! An Introduction 10 the Business of Banking Bankers’ Insights and Issues How and Why Banks Create Money and Credit When They Make Loans All moder banks create money (instant spending power), and they create credit (the obliga- tion to pay money in the future) as well. Exactly how does this occur? First, remember that money is simply a medium of exchange, an object or data item that is readily accepted by sellers in payment for the goods and services they offer. In most indus- trialized economies, checks are still the principal means of paying for goods and services, though electronic media are capturing a growing share of all payments. 4n the United States, for example, checks account for about four-fifths of the dollar value &f all payments made annually. When and how do banks create money? It happens in two ways. First, when a customer is, granted a loan (cred), he or she will sign a promissory note and receive, in turn, a bank's deposit (transaction account), The customer's promissory note is not money; it cannot be used: ‘o buy goods and services. Buta bank's transaction deposit is money and can readily be spent almost anywhere, Thus, in granting loans (creating credit), banks create money as well by set- ting up a spendable deposit in the name of the borrower. Second, the entire system of banks also creates money as the deposits generated by lending flow from bank to bank. By law, each bank must set aside only a fractional reserve bbehind each deposit it receives and the remaining excess reserves cani be loaned out. As customers spend the proceeds of their loans, these funds flow out to other banks, giving them deposits from which to create loans (credit) as well. While no single bank can lend ‘out more than its excess reserves, the entire banking system can create a multiple volume ‘of deposits (money creation) through bank lending (credit creation). If there were no leak- ages from the banking system (such as customers withdrawing cash from their transaction Offering Mutual Funds and Annuities. Concerned that many banks have offered too- low interest rates on traditional deposit accounts, many customers have come to demand so-called investment products from their banker, especially mutual fund accounts and annuities that offer the prospect of higher yields than are currently available on conven- tional bank deposits. These products also carry more risk, Annuities consist of long-term savings plans that promise the payment of a stream of income to the annuity holder begin- ning on a designated future date (such as at retirement). In contrast, mutual funds are pro- fessionally managed investment programs that acquire stocks, bonds, and other securities that appear to “fit” the funds’ afinounced goals (such as to maximize income or to achieve Jong-term capital appreciation). Some banking firms have organized special subsidiary organizations to market these services (e.g., Citicorp’s Investment Services) or entered into joint ventures with security brokers and dealers. Recently bank mutual fund sales have slowed due to lack of strong profitability, strict regulations, and changing public attitudes, .