The Meaning of Banking - Modern 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 below, a simple model of the deposit and credit markets. On the vertical axis is the rate of interest (i);

The Banking Firm–Intermediary.

The Banking Firm–Intermediary.

iL− iD: bank interest differential between the loan rate (iL) and the depositrate (iD) which covers the cost of the bank's intermediation
SL: supply of loans curve
DL: 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 above, DL is the demand for loans, which falls as interest rates increase. In Figure above, 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 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 are supplied. The interest margin is equal to iLiD and covers the institution’s intermediation costs, the cost of capital, the risk premium charged on loans, tax payments and the institution’s profits. Market structure is also important: the greater the competition for loans and deposits, the more narrow the interest margin.

Intermediation costs will also include the cost of administration and other transactions costs related to the savings and loans products offered by the bank. Unlike individual agents, where the cost of finding a potential lender or borrower is very high, a bank may be able to achieve scale economies in these transactions costs; that is, given the large number of savings and deposit products offered, the related transactions costs are either constant or falling.

Unlike the individual lender, the bank enjoys information economies of scope in lending decisions because of access to privileged information on current and potential borrowers with accounts at the bank. It is normally not possible to bundle up and sell this information, so banks use it internally to increase the size of their loan portfolio. Thus, compared to depositors trying to lend funds directly, banks can pool a portfolio of assets with less risk of default, for a given expected return.

Provided a bank can act as intermediary at the lowest possible cost, there will be a demand for its services. For example, some banks have lost out on lending to highly rated corporations because these firms find they can raise funds more cheaply by issuing bonds.

Nonetheless, even the most highly rated corporations use bank loans as part of their external financing, because a loan agreement acts as a signal to financial markets and suppliers that the borrower is creditworthy (Stiglitz and Weiss, 1988).

The second core activity of banks is to offer liquidity to their customers. Depositors, borrowers and lenders have different liquidity preferences. Customers expect to be able to withdraw deposits from current accounts at any time. Typically, firms in the business sector want to borrow funds and repay them in line with the expected returns of an investment project, which may not be realised for several years after the investment. By lending funds, savers are actually agreeing to forgo present consumption in favour of consumption at some date in the future.

Perhaps more important, the liquidity preferences may change over time because of unexpected events. If customers make term deposits with a fixed term of maturity (e.g., 3 or 6 months), they expect to be able to withdraw them on demand, in exchange for paying an interest penalty. Likewise, borrowers anticipate being allowed to repay a loan early, or subject to a satisfactory credit screen, rolling over a loan. If banks are able to pool a large number of borrowers and savers, the liquidity demands of both parties will be met. Liquidity is therefore an important service that a bank offers its customers. Again, it differentiates banks from other financial firms offering near-bank and non-bank financial products, such as unit trusts, insurance and real estate services. It also explains why banks are singled out for prudential regulation; the claims on a bank function as money, hence there is a ‘‘public good’’ element to the services banks offer.

By pooling assets and liabilities, banks are said to be engaging in asset transformation, i.e., transforming the value of the assets and liabilities. This activity is not unique to banks.

Insurance firms also pool assets. Likewise, mutual funds or unit trusts pool together a large number of assets, allowing investors to benefit from the effects of diversification they could not enjoy if they undertook to invest in the same portfolio of assets. There is, however, one aspect of asset transformation that is unique to banks. They offer savings products with a short maturity (even instant notice), and enter into a loan agreement with borrowers, to be repaid at some future date. Loans are a type of finance not available on organised markets.

Many banking services have non-price features associated with them. A current account may pay some interest on the deposit, and offer the client a direct debit card and cheque book. The bank could charge for each of these services, but many recoup the cost of these ‘‘non-price’’ features by reducing the deposit rate paid. On the other hand, in exchange for a customer taking out a term deposit (leaving the deposit in the bank for an agreed period of time, such as 60 days or one year), the customer is paid a higher deposit rate. If the customer withdraws the money before then, an interest penalty is imposed. Likewise, if customers repay their mortgages early, they may be charged for the early redemption.

Figure above does not allow for the other activities most modern banks undertake, such as off-balance sheet and fee for service business. However, the same principle applies. Figure below shows the demand and supply curve for a fee-based product, which can be anything from

The Banking Firm – Fee Based Financial Products.

The Banking Firm – Fee Based Financial Products.

P: price for fee based services
Q: quantity demanded and supplied in equilibrium

deposit box facilities to arranging a syndicated loan. The demand and supply curves are like any other product, and the market clearing price, P, is determined by the intersection of the demand and supply curves. Again, market structure will determine how competitive the price is. Banks will operate in other ‘‘non-banking’’ financial markets provided they can create and sustain a competitive advantage in each of them.

Banks do not necessarily charge a direct price for their services, as suggested by figure above. Many modern banks offer stock broking services to their customers, and ‘‘make markets’’ in certain equities. In this case, some or all of the ‘‘fee’’ may be reflected in the difference between the bid and offer price, that is, the price the bank pays to purchase a given stock and the price the customer pays. The difference between the two is the spread, which is normally positive, since the bid price will always be lower than the offer price, so the bank, acting as a market maker, can recoup related administrative costs and make a profit. Again, the amount of competition and volume of business in the market will determine how big the spread is. When the bank acts as a stockbroker, it will charge commission for the service. Suppose a bank sells unit trusts or mutual funds.4 Then the price of the fund often consists of an initial charge, an annual fee, and money earned through the difference between the bid and offer price of the unit trust or mutual fund.

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