Banks and their role

in the economy

1.1. The functions of the bank

Every bank performs three banking functions:

• It accepts and safeguards deposits of money from customers’
• It permits money to be withdrawn or transferred from one account to
another
• It lends the surplus of deposited money to suitable customers who
wish to borrow. 30
While these are the most basic functions, modern banking in the early 1990s
offers a far wide range of services to the customers. In fact a large retail
bank often offers some 300 different services to its personal and business
customers.

These services can be grouped under the following headings:

-Deposits and savings;
-Advances;
-Money transmission;
-Financial and advisory services;
-Foreign services.
• Deposits are the funds that customers leave in their accounts,
whether these are current accounts, which are for “current” money
that is not intended to be saved, or deposit or savings accounts,
which are for money that will not be required immediately.
Customers with a current account are usually issued with a
checkbook, which enables them to draw or write out checks that
instruct the bank to pay cash from the account or to make payments
to other people. Deposit and savings account holders do not have the

30
David Cox, Success in elements of banking, 1990
 benefits of a checkbook; instead they are paid interest on money left
with the bank.
• Advances are money lent by a bank, generally in the form of an
overdraft on a current account, by which the customer draws out
more money than he has put into the account. They may also be
made by means of a loan or personal loan. Interest is charged on all
advances, the rate varying with the method of granting of granting
the advance, the creditworthiness of the customer and the length of
time for which the funds are borrowed. Advances represent that part
of customers’ deposits, which the bank considers may safely be lent,
while the remainder is retained in the form of cash and other assets.
• Money transmission enables customers to make payments without
having to carry around large sums of cash, because the check is a
convenient method of settling a debt. Equally a customer can pay in
money at any bank branch for the credit of an account at another
branch by completing a simple form known as bank giro credit. He
may also instruct his bank to debit or deduct amounts from his
account to make regular payments to meet recurring debts, such as
club subscription, life assurance premiums or mortgage repayments,
by means of the standing order or direct debit systems. Besides
enabling customers and, to some extent, non-customers to transfer
funds quickly and easily by means of a piece of paper or
electronically, the bank physically move many notes and coins from
branch to branch every day.
• Financial and advisory services cover a wide range of facilities that
can be tailored to suit the individual needs of the customer. One
example might be a business service such as factoring, in which the
bank administers a client’s sales ledger and enables a company to
obtain an advance against debts, which are due to it. The banks are
always willing to give advice, from suggesting suitable investments
to a customer with a few hundred dollars, to advising a private
limited company of the best time to go public, that is to have its
shares quoted on a stock exchange.
• Foreign services of the banks include traveler’s’ check and currency
services; they also made international payments. All large bank links
with overseas banking groups, so payments of this kind can easily be
made.

A sound banking system depends partly on the control exercised by the

central bank and, to a large extent, on trust: that is, the customer’s trust that
his deposits will be looked after in the best possible way and that when he
wishes to withdraw his money, the funds will be available. The banks have a
major responsibility to behave like good citizens in business: while
profitability remains a major consideration, this must sometimes be set aside
in favor of an informed and ethical judgement that takes account of the
interests of others. Whenever banks lend money, they must remember that
the source of their funds is customer’s deposits, and it is so important that
they should lend where there is a minimal risk of non-payment. They have
often been criticized for not lending money more freely, but a high risk of
loss will frequently deter them from granting an advance even if the highest
rates of interest could be charged.

The economic importance of banks

The banks are important economically because they act as financial
intermediaries between the large number of depositors and those who wish
to borrow: in this way the encourage savings by providing the means the
means of attracting and collecting funds through the various types of
accounts they offer and their extensive branch network, while at the same
time they put such funds to effective use. The provisions of finance to
businesses encourages enterprises and leads to the provision of extra jobs,
increased production and less reliance on the import of foreign goods.
Lending to personal customers, on the other hand, stimulates demand for
goods, which again helps to increase production. The banks are able to
“create money” by granting loan or overdraft facilities to a customer to buy
goods, since paying for these goods effectively produces new money as
soon as the borrower’s check is paid into the seller’s bank account. Thus, by
allowing in advance, a bank deposit has been created; this process is known
as the credit-creation multiplier. Whenever overdraft or loan facilities are
granted by a bank, the customer will have a reason for wishing to borrow-to
buy a new car, perhaps-and will draw a check on his or her account to pay
for it. The check will be paid into another bank account (that of the garage
selling the car) thus creating a new deposit and, when it has passed through
the clearing system, will take up the facilities granted by the bank. Therefore
by granting a loan or an overdraft, a new deposit has been created
somewhere in the banking system and the money stock increased.

The banks generally lend 65 per cent or more of their total deposits, the
remainder being held in the form of easily realizable assets so that the banks
will always have sufficient resources to enable them to repay their
depositors. Every loan creates a new deposit, and the proportion of every
new deposit may be re-lent to create still further deposits. The process can
continue until the total of the new deposits created is several times the
amount of the original advance.

An example will show just how this process works. Bank A grants its
customer, M, an overdraft of $500 to pay some new furniture. M writes out
a check an hands it to the seller of the furniture, N, who pays it into his
account with bank B. The banks keeps 35% of the deposit as reserves and
re-lends the other 65%, $325, to customer O to pay for its holiday. O gives
the check for this amount to the travel agent P, who pays it into his account
with bank C. This bank lends 65% of the deposit, $211, to customer Q, who
issues a check for this amount, which creates another deposit within the
banking system, and so the process goes on (as in the figure).

Original overdraft granted for…………………$500

Check drawn and deposit created……………...$500
Overdraft granted: 65% of $500……………….$325
Overdraft granted: 65% of $325……………….$211
Overdraft granted: 65% of $211……………….$137
Overdraft granted: 65% of $137………………...$89
Overdraft granted: 65% of $89……..…………...$58
Overdraft granted: 65% of $58……..…………...$38
Overdraft granted: 65% of $38……..…………...$25
Overdraft granted: 65% of $25…..……………...$16
Overdraft granted: 65% of $16…..……………...$10
Overdraft granted: 65% of $10..……………….....$7

Figure 1. The credit-creation process

The amount by which the banks create further bank deposits, and thus
increase the money stock, is measured by the credit-creation multiplier.
From figure 1, it can be calculated that original advance of $500 has created
deposits totaling $1 416. In this example is, therefore, a multiplier effect of:

Total amount of new deposits created/amount of original advance =$

1416/$500=2.8 times

The multiplier is easy to calculate if you know the percentage of deposits

retained as reserves and not re- lent. In the example, 35% was retained as
reserves. Divide the percentage (35 per cent) into 1(100 per cent) and the
answer, approximately 2.8 times, is the multiplier effect. If banks kept only
10 per cent of deposits as reserves, then the multiplier effect would be 10
times (100 divided by 10), so that our original deposit of $500 could create
up to $5000 of new deposits. If reserves were 50 per cent, than the
multiplier effect would be 2 times (100 divided by 50), so the original
deposit of $500 could create up to $1000 of new deposits. It is important to
appreciate that the banks’ ability to create money can be expanded or
restricted by altering the reserve percentages that that maintain.

As we have seen, one of the main limitations to credit creation is the amount
of reserves that banks maintain. A further limitation is that of “leakages” in
the flow of money out of the banking system. For example, the public may
wish to hold more cash, thus lowering the level of bank deposits; certain
transactions between the Government and the public have the effect of
transferring funds from bank accounts of members to the Government’s
bank account at the central bank.

Of course, a bank manager does not have to wait for deposits to be paid in
before loan or overdraft facilities can be granted; but the bank, as a whole
must consider its total deposits when formulating its lending policy.
However, the rate at which banks are able to create deposits depends, to
some extent, on the rate at which banks are able to increase their lending.
The volume of bank lending is determined by the banks themselves, by the
demand for advances in the economy and by the competition from other
lenders.

5.2. Types of banks

The merchant banks

Merchant banks carry a great variety of businesses, and each tends to
specialize in certain activities or transactions with particular countries. Some
activities, however, are basic to all of them. These are acceptance of
deposits, underwriting, and management of clients’ funds. The tern
“merchant banking” comes from the early years when merchants in London
were willing to finance international trade by allowing overseas merchants
to draw bills of exchange on them.
Merchant banks in England prefer to be called “acceptance houses”; indeed,
this was made clear by Sir Edward Reid, a past chairman of the Accepting
Houses Committee.
An Acceptance House is a firm or company, an important part of whose
business is accepting Bills of Exchange to provide short-term finance for the
trade of others.
Girobank
In England, the giro banks were established because of the need to
modernize the remittance services of the post offices (postal and money
orders) and the substantial increase in recent years of the sort of transactions
for which a giro system is particularly appropriate: the payment of rates and
bills by installments, hire purchase, mail order remittance, and payments for
the renting of consumer durable. Personal customers are offered a wide
range of financial services including full current account checkbook banking
and particularly convenient money transfer service between girobank
accounts. The payer sends a completed transfer form, which has a message
space on the reverse, to the bank. On receipt the payer’s account is debited
and the transfer form is forwarded, with a credit slip, to the payee. Many
household bills-gas, electricity, telephone etc. incorporate a Girobank
transfer form as part of the bill, with relevant information such as customer
reference and amount pre-encoded. Girobank customers simply complete
the form and send it to Girobank. Non-account holders can pay these bills
over the counter at post office. Regular payments can be made by standing
order or direct debit either to another Girobank account or from Girobank to
an account with any other bank.
Retail banks
Retail banks have extensive branch networks and offer a wide range of
services to their many thousands of personal and business customers
through their large branch networks. By participating in the clearing system
they enable the payments mechanism to operate by exchanging cheques and
credits between other banks. It should be noted that other banks, particularly
some of the American banks, are rapidly developing a retail banking service
to rival that of the more “traditional” High Street banks.
Consortium banks
As the name suggests, a consortium bank is formed by a group of other
banks, usually from several different countries. The Bank of England
defines it as a bank which is owned by other banks but in which no one
bank has a direct shareholding of more than 50 percent and in which at least
one shareholder is an overseas bank. The first consortium bank to be formed
in England was Midland and International Banks in 1964. These banks are
formed in order to be able to put together large loan “packages” to meet the
financial requirements of large multinational companies for long periods of
time. They are also able to arrange syndicated loans: this means sharing out
large loans among syndicates of banks. The bank that is organizing the loan,
called the lead bank, contact up to fifty other banks inviting them to
participate.
The building societies
The building societies in England are the banks’ largest competitor in the
area of deposit taking. The main role of them is to take in funds from
customers, and to lend money to other customers for house purchase.
Building societies therefore act as financial intermediaries between savers
and borrowers. Over the time, the societies have expanded their activities,
providing a wide range of financial services and becoming more and more
like the banks. The building society basic service rage consists of: savings
facilities, borrowing for house purchase and other financial services.
Historically, the first two activities have played a major role in the
development of societies. Building societies are mutual institutions. They
operate to serve the mutual interests of their members, and any surpluses are
used for the members’ benefit. The society is owned by its members. These
members are the people who put their money in a share account. These
shareholders are then paid a dividend (interest) on their holding (savings).
Credit unions
Credit unions are more popular on the continent and America then in the
UK. The first credit unions grew up in Germany and Italy inththe 1850s and
1860s.America took up the idea in the first half of the 20 century. The
unions were set up as cooperative societies to offer loans to members out of
the pool of savings built up by the members. Members of a credit union
usually have a common interest or bond e.g. work, location, and church. In
the UK the first credit union was established in 1964 and 1979 the Credit
Union Act was passed to stimulate expansion in the number of societies by
providing them with own legal framework. The main aims of credit unions
are to encourage savings and provide members with a source of cheap credit
mainly for low- income groups and establish good budgeting and stimulate a
spirit of self- help and community involvement.
Study-case: Romanian Savings Bank
Romanian Savings Bank (Casa de Economii si Consemnatiuni) is the oldest bank established
in Romania. On November 24, 1864 Prince Alexandru Ioan Cuza approved the Law for the
establishment of the Deposits and Consignations Bank (Casa de Depunere si Consemnatiuni),
making thus the first successful attempt to create the Romanian Banking System. Until1880,
when the Central Bank was established, the Deposits and Consignations Bank also played the
role of issuing bank. In 1880, the Savings (Casa de Economii) was established as an appendix
to the Deposits and Consignations Bank. Since 1864, the bank performed a wide range of
transactions specific to an universal bank. In 1947, through the merger of this two banks’
patrimonies, Casa de Economii, Cecuri si Consemnatiuni was established, and in 1949,
following a new reorganization, the name of the institution became Romanian savings Bank
(Casa de Economii si Consemnatiuni) as it is today. The object of activity was restricted
though, mainly to attracting household savings and financing the state budget.
In 1996 Romanian Savings Bank was reorganized based on law no. 66, becoming a joint-
stock commercial bank with the state as unique shareholder, represented by the Ministry of
Finance. According to this law, Romanian Savings Bank offers a wide range of services and
products, such as: attracting, keeping and investing the individual and legal persons’
availabilities in ROL and performing collections, payments and settlement transactions in
customers’ account; providing loans to the population for houses’ purchases, building,
modernizing, receiving amounts for consignment; providing loans to small and medium
enterprises, to Public Administration Authorities, performing money market and T-Bills
operations, transactions on financial and banking market.
Summary

§ Definition of the bank:

1. Financial intermediary
2. Risk administrator:
- interest rate risk
- exchange risk
- maturity risk/ delivery risk/ credit risk
- liquidity risk
- country risk (political, economical)
- transfer risk/ payment risk
3. Institution of public interest

§ The basic functions of any bank

- Accepts and safeguards deposits of money from customers
- Allows money to be withdrawn or transferred from one account to
another
- Lends the surplus of deposited money to suitable customers who wish
borrow

§ Banking services
I Retail banking activities:
1. Financing: mortgage loans; loans for consumer goods; short,
medium and long terms.
2. Payments: check, card and giro account.
3. Advisory services
4. Other services: safeguard and deposits.
II. Corporate banking activities
1. Financing: advances and overdraft, long and medium loans, leasing,
forfeiting, factoring, banking guarantees, export financing.
2. Payments: check, draft, B/E, card, giro account.
3. International transaction: services for exporter, payment method,
documents in international trade, services for importer.
4. Investment services
 5. Advisory services.
6. Other services: safeguard and deposit cash management.

§ International transactions
1. Services for exporter: - trade inquiries
- credit information
- economical and political reports
- trade regulations
- exchange control regulation
- forward foreign exchange
2. Payments methods: - advance payment (AP)
- letter of credit (L/C)
- documentary collections
- open account (OA)
3. Documents in international trade: - invoice
- transport documents
- insurance documents
- certificates
4. Services for importers

§ Types of banks
I. a) The so-called commercial banks:
- Retail banks
- Wholesale/corporate banks
b) Savings banks
c) Mortgage banks
d) Consumer-credit banks

II. A) Universal Banks

B) Specialized banks

Check out questions

1. What are the basic functions of any bank?

2. Write three banking instruments or facilities used by the exporters.

3. Write three types of instruments or banking facilities offered to the legal

persons and not to the natural persons.
4. Explain briefly how the banks act as a risk administrator.

5. How does a sound banking system contribute to the prosperity of a

country?

6. What is meant by “deposit banking” and in what ways does it

contribute to the expansion of trade and industry?

7. What are the main services provided by the banks?

8. Give two reasons why is preferable to borrow from a financial

intermediary rather than from an acquaintance.
9. Summarize the main services provided by the retail banks.
Choose the correct answer(s)
10. In a particular economy banks are required to keep 20 per cent of all
deposits in the form of reserves; this gives a credit-creation
multiplier of:
a. five
b. one-sixth
c. six
d. one- fifth.
11. The banks provide a range of services grouped under the following
headings:
a. deposits and savings, advances, money transmission,
advisory services and international ones.
b. only deposits
c. deposits, credits and payments
d. advisory services in some cases.
12. The basic function of a bank is to
a. issue cheque books
b. accept deposits
c. respond to status enquiry.
13. A consortium is:
a. a decision on monetary policy
b. a group of financial institutions
c. a savings scheme for small savers.
References

1. F.E.Perry, The elements of banking, sixth edition, Routledge & The

Chartered Institute of Bankers London, 1989.

2. Don Wright & Wally Valentine, Business of banking and financial

services, third edition, Northcote House, 1992.

3. Graham Bannock, R.E. Baxter and Evan Davis, Dictionary of

Economics, fifth edition, Penguin books, 1992.

4. Piata Financiara magazine collection, 2000-2002

5. Romanian Financial Directory, Finmedia Directories Series, 2000-

2002