Banks and Bank Risks – The Role of

Banks
Introduction
The business of banking has been around for a very long time, having first appeared in
ancient Mesopotamia around 2,000 BC. Back then, deposits were not in the form of
money but cattle or grain and, eventually, precious metals. But some of the basic
concepts underlying today’s banking system were present – deposits were taken, loans
were made and borrowers paid interest to lenders.

The people of ancient Mesopotamia would probably find it difficult to believe that today’s
banks trace their origins back to those early days. Nowadays, banks offer a wider range
of products and services than ever before, and deliver them faster and more efficiently.
But their central function remains the same – putting a community's surplus funds to
work by lending to people to buy homes and cars, to start and expand businesses and
for countless other purposes. Banks are vital to the health of economies around the
world.

In this suite of tutorials on banks and bank risks, we will look at the critical roles banks
play, the products and services they provide, and the nature of the risks arising from
their business.

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What Do Banks Do?
Most people think of a bank as somewhere safe to keep their money. While this is
certainly true (or at least it should be!), there is far more to banks than that. In fact,
banks play multiple roles in the economies of most countries. Key among them are the
following.

Financial Intermediation
The traditional – and perhaps most important – role of banks is that of a financial
intermediary. Most banks channel funds from individuals and businesses with surplus
funds to those that have a shortage of funds. In doing so, they facilitate maturity
transformation, typically by taking short-term deposits and lending this money on over
longer periods. And in the process of taking deposits and making loans, banks ‘create
money’, something we will explore in more detail later.

Payment and Settlement

Banks are key participants in the payment and settlement systems that are necessary
for individuals, businesses, other financial institutions and governments to settle day-to-
day transactions. These range from small-value retail transactions involving cash,
cheques, credit cards and various other forms of electronic money, to large-value – or
'wholesale' – transactions among businesses, financial institutions and governments.

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Risk Management, Investment and Advisory Services
Apart from their traditional role of taking deposits and making loans, banks today offer a
wide range of products and services designed to help their customers manage risk and
provide them with investment opportunities and various forms of advice.

In this tutorial, we will take a closer look at the role of banks, with a particular focus on
how banks create money and the range of products and services they offer.

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Banks Are Special
In principle, many of the roles banks perform can be provided directly through capital
markets. Banks and other financial institutions exist because they are an efficient
response to the fact that information is costly. Banks, in particular, specialise in
assessing the creditworthiness of borrowers and providing an ongoing monitoring
function to ensure borrowers meet their obligations. Their reward is the spread between
the rates they offer to depositors and those they charge to borrowers.

However, banks are special because of the critical functions they perform. In many
countries, their role is even more vital due to the share of financing they provide to the
real economy. Healthy banks are therefore essential to a well-functioning and growing
economy.

Do You Know? - Banks Versus Capital Markets

As a country becomes more developed, capital markets typically play a greater role in
supplying financial products and services relative to that supplied by the banks. For
example, in many advanced economies, the amount of debt raised by businesses
through the issuing of securities rivals or exceeds that provided by the banking system.

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Banking Is a Risky Business
Risk-taking is inherent in every role a bank fulfils. Excessive, poorly managed risk can
lead to large losses and, in the extreme, cause a bank to fail, endangering the safety of
its deposits and potentially subjecting the financial system to stress.

Banks are widely perceived to be more susceptible to failure than other firms due to the
nature of their balance sheets. For example:

• a high proportion of their funding is in the form of demand deposits

• their assets are typically of much longer duration than their liabilities
• the proportion of cash and other liquid assets to total assets is relatively small
• they are highly leveraged with little capital relative to assets

Consequently, given the crucial roles they play, banks must be licensed and subject to
supervision by the relevant authority – typically, the central bank or an independent
banking supervisory authority – in every country in which they operate.

Notwithstanding the prudential requirements established by the relevant authority, the

primary responsibility for the prudent management of a bank’s business lies with the
board and management of the bank. They are responsible for ensuring that a bank
operates in a safe and sound manner and holds sufficient capital and liquidity to protect
against the risks that arise in their business.

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Financial Intermediation and the Creation of Money
Deposits with banks are part of the money supply, by far the largest part in some
economies. By accepting deposits (classified as liabilities on the bank's balance sheet)
and making loans (classified as assets on the balance sheet), banks are in fact creating
money.

The idea that banks create money may appear strange if you think of money as currency
(paper money and coins). However, economists define money as anything that is
generally accepted as payment for goods or services or in the repayment of debts. In
that sense, most money has been in the form of bank debt for several centuries. A bank
account is simply money that the bank owes you, while paper money represents a debt
that your central bank owes you.

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How Do Banks Create Money?
Let’s walk through a simplified illustration of how banks create money.

Best Bank has just opened as the first and only bank in a small town. On the first day,
the bank receives a deposit of AUD 10,000 from a customer. In theory, this entire
amount could be loaned out to other customers in need of bank financing. But Scott
Richardson, the manager of Best Bank, knows that the depositor is entitled to withdraw
some or all of their deposit on short notice, which means the bank should keep some
portion of it ‘in reserve’, whether in cash or invested in other liquid assets, so that the
bank will be in a position to honour such withdrawal requests as and when they occur.

Some time after the initial deposit, Scott notices that the customer has only drawn down
a small amount, while other customers have also started to make deposits.

After observing this behaviour for a while, it becomes obvious to Scott that people in this
town tend to only withdraw on average 20% of their deposits over a one-month period.

He therefore decides that he can lend the remaining 80% of their deposits to other
customers requiring loans, which means the bank is operating with a 20% ‘reserve ratio’.
These customers take out loans to purchase goods and services from other individuals
and businesses, who in turn place the proceeds on deposit with Best Bank.

The table below shows how Best Bank makes use of the initial customer deposit to
create new deposits – or create money, as bank deposits are a form of money –
assuming a 20% withdrawal rate.

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This process continues until the full amount of ‘excess’ deposits (effectively, 80% of
each deposit made) is loaned out. As shown in the table above, the end result is the
creation of new deposits (that is, money) of AUD 40,000 from the initial deposit of AUD
10,000. Total deposits of AUD 50,000 are accompanied by new loans of AUD 40,000.

The reserve ratio (in this case, 20%) can be used to determine the total amount of
deposits and loans expected from a given increase in deposits as follows:

Total deposits = initial deposit x (1/reserve ratio)

AUD 50,000 = AUD 10,000 x (1/0.2)

New loans = initial loans x (1/reserve ratio)

AUD 40,000 = AUD 8,000 x (1/0.2)

It is not hard to envisage how far more deposits and loans – and money – can be
created in a banking system containing many banks.

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Bank Products and Services
Banks come in many forms and offer a wide array of products and services. While their
offerings continue to expand and the distinctions between different types of bank have
become increasingly blurred over time, banks can still be broadly categorised as
commercial, investment or universal banks.

Commercial Banks

Historically the largest and most important financial institutions in most jurisdictions,
commercial banks generally focus on providing traditional banking services to
households (retail and private banking), businesses of all sizes and governments
(corporate banking). The services they offer include deposit-taking, lending, selling and
managing basic investment products (such as mutual funds), as well as selling credit,
travel and other types of insurance.

Investment Banks

Investment banks primarily cater to businesses and governments. They offer such
services as securities underwriting, merger and acquisition advice and financing,
leveraged buyouts, export and commodities financing and trading in equities, fixed
income and foreign exchange, both for their own account and on behalf of their clients.

Universal Banks

Many institutions offer the entire spectrum of commercial and investment banking
services under one roof. These institutions are generally referred to as universal banks.

Do You Know? - Securities Underwriting

Securities underwriting is the process by which an investment bank, referred to as the
underwriter, agrees to purchase equity or debt securities from businesses and
governments that wish to raise capital and then sell these securities to the public. The
underwriter, in consultation with the issuer, then decides on the basic terms and
structure of the offering, for example, the:

• amount of capital to be raised

• cost to the issuer
• issue price

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Financial Services in the 21st Century

More than 20 years after Bill Gates’s famous quote, banks are still around. But will they
still be here tomorrow? At first this may seem like a radical question – but maybe it isn’t.
After all, it hasn’t been that long since Amazon proved that a company doesn’t need a
chain of physical stores to be successful at selling books.

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Financial Services and Technology
The financial services landscape is constantly changing, perhaps more profoundly and
at a faster pace today than ever before. Technology’s role in this transformation has
spawned a new term, FinTech, which can be defined as technologically enabled
financial innovation that could result in new business models, applications, processes or
products with an associated material effect on financial markets and institutions and the
provision of financial services.

Since the turn of the century, FinTech innovations have emerged in many areas that
were traditionally the domain of banks, including retail and wholesale payments, credit
provision, investment management and equity capital raising. Non-banks now offer
many of these services directly to banks’ traditional customer base.

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Review Question
Complete the following statement:

Assuming a reserve ratio of 10%, an initial deposit of ZAR 25,000 ultimately leads to the
creation of ZAR (225,000/250,000) in new deposits and ZAR (225,000/250,000)
in new loans.

Assuming a reserve ratio of 10%, the initial deposit of ZAR 25,000 ultimately leads to the
creation of ZAR 225,000 in new deposits and, with total deposits reaching ZAR 250,000,
new loans of ZAR 225,000, calculated as follows:

Total deposits = initial deposit x (1/reserve ratio)

Total deposits = ZAR 25,000 x (1/0.1) = ZAR 250,000
New deposits = ZAR 250,000 – ZAR 25,000 = ZAR 225,000

New loans = initial loans x (1/reserve ratio) = (25,000 x (1 – reserve ratio)) x (1/reserve
ratio)
New loans = ZAR 22,500 x (1/0.1) = ZAR 225,000

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