Modern Banking

Topics: Bank, Central bank, Banking Pages: 64 (19147 words) Published: February 3, 2011


1.1. Introduction1
The term ‘‘banking’’ can be applied to a large range of financial institutions, from savings and loans organisations to the large money-centre commercial banks in the USA, or from the smallest mutually owned building society to the ‘‘big four’’ shareholder owned banks in the UK. Many European countries have large regional/cooperative banks in addition to three to five universal banks. In Japan, the bank with the largest retail network is Sumitomo Mitsui Banking Corporation,2 but its main rival for savings deposits is the Post Office. The objective of this chapter is to provide an overview of banking and the role played by banks in an increasingly complex financial world. It begins with a review of the meaning of banking, identifying the features of banks that distinguish them from other financial institutions. The most common forms of organisational structure for banks in the developed world are reviewed in section 1.3. Section 1.4 considers the relationship between the central banks and commercial banks, including key debates on the functions and independence of a central bank. The chapter ends with a brief summary of the major theoretical contributions to the banking literature, followed by conclusions.

1.2. The Meaning of Banking
The provision of deposit and loan products normally distinguishes banks from other types of financial firms. Deposit products pay out money on demand or after some notice. Deposits are liabilities for banks, which must be managed if the bank is to maximise profit. Likewise, they manage the assets created by lending. Thus, the core activity is to act as intermediaries between depositors and borrowers. Other financial institutions, such as stockbrokers, are also intermediaries between buyers and sellers of shares, but it is the taking of deposits and the granting of loans that singles out a bank, though many offer other financial services. To illustrate the traditional intermediary function of a bank, consider Figure 1.1, a simple model of the deposit and credit markets. On the vertical axis is the rate of interest (i); 1 2

 No part of this chapter is to be copied or quoted without the author’s permission. This banking giant is the result of a merger between Sakura and Sumitomo Mitsui Banks in April 2001.




Figure 1.1 The Banking Firm–Intermediary.

iL i∗





Volume of loans/deposits

i L − i D: bank interest differential between the loan rate (i L) and the deposit rate (i D) which covers the cost of the bank's intermediation S D: supply of deposits curve S L: supply of loans curve D L: demand for loans curve 0T: volume of loans supplied by customers

i ∗: market interest rate in the absence of intermediation costs

the volume of deposits/loans appears on the horizontal axis. Assume the interest rate is exogenously given. In this case, the bank faces an upward-sloping supply of deposits curve (SD ). There is also the bank’s supply of loans curve (SL ), showing that the bank will offer more loans as interest rates rise. In Figure 1.1, DL is the demand for loans, which falls as interest rates increase. In Figure 1.1, i∗ is the market clearing interest rate, that is, the interest rate that would prevail in a perfectly competitive market with no intermediation costs associated with bringing borrower and lender together. The volume of business is shown as 0B. However, there are intermediation costs, including search, verification, monitoring and enforcement costs, incurred by banks looking to establish the creditworthiness of potential borrowers. The lender has to estimate the riskiness of the borrower and charge a premium plus the cost of






W H A T D O T H E Y D O?

the risk assessment. Thus, in equilibrium, the bank pays a deposit rate of iD and charges a loan rate of iL . The volume of deposits is 0T and 0T loans...
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