The role of banks in an economy

Topics: Bank, Debt, Fractional-reserve banking Pages: 6 (1761 words) Published: September 23, 2013

The role of banks in an economy
One think one knows what a bank is and what it does. And not without reason: most people have had experience of at least one bank, even if it is only through having a salary account or withdrawing cash from an ATM. A bank's activities in all its divisions can basically be simplified as follows: it transfers money and information, and in doing so transforms money, maturities and risks. Some of the example of four lines of a bank's business to examine how it does this, the value added it creates, the risks it encounters and the restrictions to which it is subject: (1) Lending and deposit business,

(2) Securities issuing,
(3) Asset management
(4) Foreign exchange trading.

Lending and deposit business
A bank's role as an "intermediary" is clearest in the credit and deposit business. Clients "bring" to the bank their savings, i.e. the money they have chosen not to spend. The bank transfers this money to its credit clients in the form of loans. What is on the face of it extremely simple is nevertheless fraught with a great many risks. A bank's loans lack liquidity, either partially or totally. This means that the bank cannot sell them in return for demand deposits or central bank funds whenever it likes. On top of this, a borrower's credit rating may change during the life of a loan, thereby changing the value of the loan at that point in time, which reflects the interest and amortisation payments expected in the future. A bank guarantees its creditors the nominal value of their deposits plus interest due, irrespective of the profit or otherwise made in lending transactions. Furthermore, the amounts a bank owes are generally more liquid than the amounts it is owed; in other words, creditors can call in the amounts the bank owes them more quickly than the bank can call in what is due to it from its borrowers. One of the banks' fundamental roles in the economy is to "transform" maturities in this way at its own risk. This is part of the service it offers as intermediary and a form of risk management. Another function which the banks perform within an economy is rating and selecting the loans they finance. The supply of client deposits is limited; the demand for credit generally less so. This being the case, credits has to be subject to a selection process. The reason why this selection process cannot be performed solely via the price (or rate of interest) is that lending transactions are not the same as cash transactions, where payment is provided immediately upon a product or service being rendered. Instead, the borrower undertakes to make future payments of interest and principal. As a consequence, the bank cannot base itself solely on the ability to pay as presented at that particular point in time; it also has to attempt to make some sort of assessment with regard to the borrower's ability to pay in the future. As financial intermediaries, banks have a responsibility towards both their borrowers and creditors. Their prime responsibility is that towards their creditors together with protecting the function and reputation of the banks, the main aim of the law on banks and savings banks is to protect creditors.

Securities issuing
Loans account for only part of the long-term financing provided by the banks. While bank loans are often the only source of outside financing for many small and medium-sized enterprises, a substantial proportion of the capital raised by larger companies comes from the issuing of securities. In a securities issue, a bank or group of banks generally agrees to underwrite the entire amount of the issue. The securities acquired in this way are then offered for public subscription for the account and at the risk of the bank or banks involved. The risk that not all the securities will be placed with clients is carried by the bank. The issuer, for its part, has immediately available to it the entire proceeds from the transaction, regardless of how successful...
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