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Banks and Bank Risks The Role of Banks
Banks and Bank Risks The Role of Banks
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.
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.
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.
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.
Banks are widely perceived to be more susceptible to failure than other firms due to the
nature of their balance sheets. For example:
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.
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.
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.
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:
It is not hard to envisage how far more deposits and loans – and money – can be
created in a banking system containing many 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.
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.
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.
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:
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