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CH1: An Overview of Banks and the Financial Services Sector FIN 323
What is a bank?
Banks are involved in transferring funds from savers to borrowers (financial
intermediation) and in paying for goods and services. The commercial banks must offer
two essential services to qualify as banks: checkable (demand) deposits and commercial
loans.
Under U.S. law, commercial banks must offer two essential services to qualify as banks
for purposes of regulation and taxation, demand (checkable) deposits and commercial
loans. More recently, Congress defined a bank as any institution that could qualify for
deposit insurance administered by the FDIC.
How does a bank differ from most other financial-service providers?
A bank should be defined by what it does; in this case, banks are generally those financial
institutions offering the widest range of financial services. Other financial service
providers offer some of the financial services offered by a bank, but not all of them
within one institution.
Community banks and Money-Center banks
Money center banks are giant industry lenders, spanning whole regions, nations, and
continents, offering the widest possible services, gobbling up smaller businesses and
facing tough competition. Example HSBC. Community banks serving local
communities, towns, cities and offering small number of services.

Roles of the Financial System

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CH1: An Overview of Banks and the Financial Services Sector FIN 323
(Commercial banks and their closest competitors)
The primary purpose of the financial system is:
 to encourage individuals and institutions to save, and
 to transfer those savings to in new projects.
This process of encouraging transferring savings into investment spending causes the
economy to grow, new jobs to be created, and living standard to rise.
Besides transferring saving into investment spending, financial system provides a
variety of supporting services essential to modern life. These services or roles are
 Intermediation Role (credit services such as loans to customers, liquidity services
convert property into cash etc)
 Payment Role (or service such as checks, credit cards etc)
 Guarantor Role
 Risk Management Role (risk protection services such as insurance and
derivatives)
 Savings/Investment Advisor Role
 Safekeeping/Certification of Value Role
 Agency Role
 Policy Role

Examples

1. The Bank, N.A. accepts deposits from thousands of individuals and

lends that money to (among others) the Stillwater Body Shop to
expand their work bays. Which of the following roles is the bank
performing?
A) The intermediation role*
B) The payment role
C) The risk management role
D) The guarantor role
E) The policy role

2. Chris Jones gets a cashier’s check from Wachovia Bank to make his
down payment on a new home. Which of the following roles is the
bank performing?
A) The intermediation role
B) The payment role*
C) The risk management role
D) The guarantor role
E) The policy role

3. Alexander Phua goes to his local bank and gets an insurance policy
that protects him against loss in case he is in a car accident. Which of
the following roles is the bank performing?
A) The intermediation role
B) The payment role
C) The risk management role*
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CH1: An Overview of Banks and the Financial Services Sector FIN 323
D) The guarantor role
E) The policy role

4. The U.S. government wants to prevent money laundering by drug

cartels. To promote this goal, they have asked banks to report any
cash deposits greater than $10,000 to the government. Which of the
following roles is the bank performing?
A) The intermediation role
B) The payment role
C) The risk management role
D) The guarantor role
E) The policy role*

The Competing Challenge for Banks

 For many centuries banks were much in front of other financial service
institutions in supplying savings and investment services, payment and risk
protection services, liquidity and loan services.
 This is no longer true today. Banks’ market share generally has fallen as other
financial institutions are moved in.

Trends Affecting Banks and Other Financial Service Firms Today

 Service Proliferation
 Rising Competition
 Government Deregulation
 Increased Interest Rate Sensitivity
 Technological Change
 Consolidation and Geographic Expansion
 E-Banking and E-Commerce
 Convergence
 Globalization
 Increased Risk of Poor Performance and Failure

Traditional Services Offered By Banks

(Services banks have offered for centuries)
 Exchange of Currency
 Commercial Notes and Loans
 Offering Savings Deposits
 Safekeeping of Valuables
 Supporting Government Activities with Credit
 Checking Accounts
 Trust Services
Exchange of Currency
 Historically first services banks offered was foreign currency exchange. Banks
ready to exchange one form of currency (such as dinar) for another (such as dollar
or euro) in return for fees.
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CH1: An Overview of Banks and the Financial Services Sector FIN 323
 Nowadays primarily done by financial service firms due to risk involved and the
volume of transactions.

Commercial Notes and Loans
 Early in history, banks began discounting commercial notes – making loans to
local merchants who sold the debts (account receivable) they held against their
customers to a bank to raise cash quickly.
 It was an indirect step. Now banks and other financial competitors make direct
loans.
Offering Savings Deposits
 Banks offered savings deposits – interest bearing funds left with depository
institutions for a period of time.
 In ancient Greece paid as much as 16% in annual interest to attract savings.

Safekeeping of Valuables
 During middle ages, banks and other merchants (goldsmiths) used to receive gold
and valuables from their customers for safekeeping (in vaults).

Supporting Government Activities with Credit
 During middle ages, banks would buy government bonds (to fund specially wars,
American revolution, civil wars) with a portion of the deposits they received.

Checking Account
 The industrial revolution ushered the new financial service – demand or checking
deposits – a checking account that permitted the depositor to write drafts in
payments for goods and services that banks had to honor immediately.
 Significantly improved efficiency by making transactions easier, faster and safer.
 Now offered by credit unions, saving associations, security brokers and by other
financial service providers.

Trust Services
 The property management function is known as trust service
 For many years banks have managed the financial affairs and property of
individuals and businesses firms with trust in return for fees.

Services Banks and Many of Their Financial-Service Competitors Began Offering in

the Past Century
 Granting Consumer Loans
 Financial Advising
 Managing Cash
 Offering Equipment Leasing
 Making Venture Capital Loans
 Selling Insurance Policies
 Selling and Managing Retirement Plans

Granting Consumer Loans

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CH1: An Overview of Banks and the Financial Services Sector FIN 323
 Historically banks did not pursue consumer loans to individuals and families
considered a high default rate making such lending unprofitable.
 By 1920s and 1930s and specially after WWII consumers loans were among the
fastest growing forms of bank credit.
 Growth rate of banks’ consumer loans has slowed down recently because of
competition from credit unions, savings and loans associations and finance
companies.
Financial Advising
 Customers ask banks and financial institutions for their advice how they can earn
best returns for their saving or investing of funds.
 Banks offer financial plans for individuals and business customers at home and
abroad.
Managing Cash
 Under a most prominent cash management services, banks (or other financial
intermediary) agree to handle cash collections and disbursements for business
firm and invest any temporary cash surpluses in interest bearing assets until cash
is needed to pay bills.

Offering Equipment Leasing

 Banks (and other financial institutions) offer their business customers the option
to purchase equipments through a lease agreement in which banks buy the
equipments and rents it to the customer.
 Banks (lessor) get additional tax benefits for depreciation of the equipments.

Making Venture Capital Loans

 Increasingly, banks and other financial conglomerates have become active in
financing the start-up costs of new equipments. Though such loans are generally
done through a separate venture capital firm because of the added risk involve in
it.
Selling Insurance Policies
 For many years bankers have sold credit life insurance to their customers
receiving loans, guaranteeing repayment if borrowers die or has become disabled.
 Beginning from the Great Depression of the 1930s, banks are not allowed
automobiles, homeowners’ coverage or general life insurance.
 However, beginning of this century the banking companies in the US are allowed
to acquire insurance companies and conversely, permitting insurers to acquire
banks.

Selling and Managing Retirement Plans

 Banks, trust departments, mutual funds, and insurance companies are active in
managing the retirements plans that most businesses make available to their
employees, investing incoming funds and dispensing payments to qualified
recipients.

Dealing in Securities: Offering Security Brokerage and Investment Banking

Services
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CH1: An Overview of Banks and the Financial Services Sector FIN 323
Investment banks (also known as securities firms) help corporations to issue securities.
First it advises the corporation on which type of securities (stocks or bonds) to issue; then
it helps sell (underwrite) the securities by purchasing them from the corporation at a
predetermined price and reselling them in the market. Also act as deal makers (mergers
and acquisitions) and makes a lot of profit from it.
 The Gramm-Leach-Bliley Act of 1999 now allows banks to affiliate with
investment banks and securities firms can acquire banks.
 For example, the Bank of America (the largest bank in the US) acquired Merrill
Lynch (investment bank). In 2008 Goldman Sachs and Morgan Stanley became
commercial banking companies instead of just investment banks.

Offering Mutual Funds, Annuities, and Other Investment Products

 Banks offer mutual funds and annuities. Mutual funds investment (in stocks and
bonds) is expected to give higher yield than bank deposits but also carry more
risks.
 Annuities consist of long-term savings plan that promise the payment of stream of
income in future date (e.g. at retirement).
Offering Merchant Banking Services
 Merchant banking services consist of the temporary purchase of corporate stock
(with a risk) to aid the launching of a new business venture or to support the
expansion of an existing company. Thus, a merchant banker becomes a temporary
stockholder and bears the risk that the stock purchased may decline in value.
Offering Risk Management and Hedging Services
 Larger banks (such as J.P. Morgan Chase) are now moving away from
traditionally heavy emphasis on deposit-taking and loan-making towards risk
intermediation – providing their customers with financial tools (such as swaps,
options, and future contracts) to combat risk exposure in return for substantial
fees.
Key Trends Affecting All Financial-Service Firms
All financial services firms including banks have become a more volatile industry due, in
part, to deregulation, intensified competition among the financial service providers.
Foreign banks entered and attract away profitable domestic business and households
accounts. Key trends are as follows:
 Service Proliferation
 Rising Competition
 Government Deregulation
 An Increasingly Interest-Sensitive Mix of Funds
 Technological Change and Automation
 Consolidation and Geographic Expansion
 Convergence
 Globalization

Q. What is a financial department store? A universal bank? Why do you think these
institutions have become so important in the modern financial system?
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CH1: An Overview of Banks and the Financial Services Sector FIN 323
Financial department store and universal bank refer to the same concept. A financial
department store is an institution where banking, fiduciary, insurance, and security
brokerage services are unified under one roof. A bank that offers all these services is
normally referred to as a universal bank. These have become important because of
convergence and changes in regulations that have allowed financial service providers to
offer all services under one roof.

Q. Why do banks and other financial intermediaries exist in modern society, according
to the theory of finance?

There are multiple approaches to answering this question. The traditional view of banks
as financial intermediaries sees them as simultaneously fulfilling the financial-service
needs of savers (surplus-spending units) and borrowers (deficit-spending units),
providing both a supply of credit and a supply of liquid assets. A newer view sees banks
as delegated monitors who assess and evaluate borrowers on behalf of their depositors
and earn fees for supplying monitoring services. Banks also have been viewed in recent
theory as suppliers of liquidity and transactions services that reduce costs for their
customers and, through diversification, reduce risk. Banks are also critical in the
payment system for goods and services and have played an increasingly important role as
a guarantor and a risk management role for customers.

Q. How have banking and the financial services market changed in recent years? What
powerful forces are shaping financial markets and institutions today? Which of these
forces do you think will continue into the future?

Banking is becoming a more volatile industry due, in part, to deregulation which has
opened up individual banks to the full force of the financial marketplace. At the same
time the number and variety of banking services has increased greatly due to the pressure
of intensifying competition from nonbank financial-service providers and changing
public demand for more conveniently and reliably provided services. Adding to the
intensity of competition, foreign banks have enjoyed success in their efforts to enter
countries overseas and attract away profitable domestic business and household accounts.

# A bank which manages the investment portfolio and pays the bills of an elderly customer who
is unable to do it for him or herself is carrying out the __________ of banks.
A) The intermediation role
B) The payment role
C) The guarantor role
D) The agency role*
E) The policy role

# The phenomenon of convergence refers to:

A) Financial service firms expanding into other product lines *
B) Firms reducing their product lines
C) Bank merger activity
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CH1: An Overview of Banks and the Financial Services Sector FIN 323
D) Globalization in banking
E) Technological innovation in banking

# The principal functions and services offered by many financial-service firms

today include:
A) Lending and investing money
B) Making payments of behalf of customers to facilitate their
purchases of goods and services
C) Managing and protecting customers’ cash and other property
D) Assisting customers in raising and investing funds profitably
E) All of the above*