Key Activities of Banks

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Christine Copland

12166346

137.710 The Theory and Management of Banking Assignment 1

The first recorded history of banking type arrangements came from Mediterranean Europe approx 300 BC. Temples kept the valuables and gold (main medium of exchange) of people as temples were less likely to be invaded and plundered by thieves. This then evolved into lending this wealth out to people who were needed money for consumption of business purposes. This evolved in the 17/18 centuries to transaction type services to facilitate trade payments. Reserve or central banks emerged in the 20 th century to control the supply of money in a country and this enabled rapid expansion of trade due to expansion of the money supply. During the latter part of the 20th century, rapid improvements in technology and communication has dramatically changed banking operations and enabled them to cross borders, grow large in size and become even more crucial in an economy. Banking today is widespread and an important part of the exchange of good, services and wealth in most economies.

However the key activities of banks have changed very little during history. They act as financial intermediaries: “acting as a repository for the savings of those who have surplus funds and as a source of funds for those who want to borrow” (New Zealand Bankers' Association, 2006). This is a very simple explanation but does not adequately explain reasons why individuals would not just do this without the help of an intermediary, like a bank. I will be using Fama’s theory and his 1980 article ‘Banking in the Theory of Finance’ to expand on these reasons. Fama theorises that banks perform two main functions: a portfolio management and a transaction function.

Portfolio Function Brigham & Ehrhardt describes a portfolio as “a group of individual assets held in combination. An asset that would be relatively risky if held in isolation may have little, or even no, risk if held in a well-diversified portfolio (Brgham, 2008)”. Banks essentially gather a pool of cash from savers (depositors), which become liabilities to the bank, and lend out the cash to a diversified mix of borrowers, which become assets to the bank. 1

Christine Copland

12166346

If a saver was to lend money directly to the borrower, this creates significant undiversified risk to both parties as the saver is wholly reliant on the one borrower to return their funds, with interest, on time and the borrower is wholly reliant on the one saver to not demand their money back at an inconvenient time. This direct finance scenario also poses two further issues for the saver: their money is tied up and unable to be accessed at will (illiquid), and they generally do not have the skill and resources to assess if the borrower is creditworthy and then monitor this creditworthiness over the term of the loan. The direct finance scenario also poses two further issues for the borrower: the amounts of money will probably not big enough or for long enough for their project. The bank overcomes all these issues by acting as a financial intermediary between borrowers and savers by transforming the size and liquidity of money. Savers generally want their money liquid as they need the money to meet their living expenses in the short term and also always anticipate the rate of return on their deposited money (interest) will increase in the future so do not wish to be locked in to a lower rate of return. Borrowers, in contrast, usually need funding for illiquid purposes (business, property) and for larger amounts. They also fear that interest rates will increase and wish to lock in an interest rate to limit the effects of this. In summary: depositors generally have small amounts of liquid funds at variable interest rates; borrowers generally want large amounts of funds on fixed rate terms for illiquid assets. Banks transform a portfolio of small liabilities to large assets and assess and monitor the safety of the assets...
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