Importance Of Banks In An Economy

Banking Topics

1. Importance of Banks in an Economy
By Rudo Chengeta

2. 2
Introduction
An overview of Banks
Key Function of Banks
Justification for Existence of Banks
Arguments against Financial Intermediaries
Conclusion

3. 3
Overview of Banks
Banks can be described as
–financial institutions whose current operations
consist of accepting deposits from the public and
issuing loans.
The receiving of deposits and provision of
loans distinguishes banks from other
financial institutions.
The term ‘banks’ includes commercial banks,
merchant banks, finance houses, building
societies, savings banks and credit unions.

4. 4
Key Function: Financial Intermediation…
Financial Intermediation
Banks act as intermediaries when they mobilize
savings from surplus units (savers) to shortage
units (borrowers) in order to finance productive
activities. Heffernan (1996)
Other financial institutions can also be
intermediaries e.g. between buyers and sellers of
shares
The taking of deposits and granting of loans
singles out banks.

5. 5
Why deal with Banks…
Banks achieve economies of scale, and/or economies of scope
which lie in transaction costs.
Small savers face costs of
–Searching;
–Contacting;
–Negotiating;
–trying to diversify;
–Monitoring;
–enforcement etc
Given the large number of savings and deposit by banks, related
transaction costs are either falling or constant.
Unlike individual lenders, banks enjoy information economies of
scope in lending decisions because of access to privileged
information on current and potential borrowers with accounts with
the bank.

6. 6
Banks reduce Transaction Costs…
Banks reduce costs through several other ways
including
–provision of convenient places of business
–standardized products and
–less costly expertise through the use of tested procedures and
routines.
The regulation and supervision of banks by regulatory
and supervisory bodies to ensure conformity with
acceptable codes of behavior frees customers from the
burden of collecting information and monitoring banks.

7. 7
Traditional Theory of the Role of
Banks
Eight significant elements by Llewellyn (1998)
information advantages,
imperfect information,
delegated monitoring,
control,
insurance role of banks,
commitment theories,
regulatory subsidies and the special role of banks in the payment
systems.
Banks solve problems associated with asymmetric information between
lenders: ex ante (adverse selection) and ex post (moral hazard)
behavior of borrowers.
With large investments in information technology and expertise, banks
are able to evaluate a borrower’s credit worthiness and verify the
borrower’s dealings at a lower cost than would individual savers.

8. 8
Asymmetry Information: Adverse Selection
and Moral Hazard
Borrowers do not always provide all the information required.
–Even if they do, not all information will be correct.
Asymmetric information:
–Banks face the problems of adverse selection and moral hazard.
To alleviate adverse incentives (high interest rates
encouraging borrowers to undertake riskier activities), banks
can reduce the size of loans and may refuse loans to some
borrowers.
Moral hazard arises as a result of changes in the two parties’
incentives after entering into a contract such that the riskiness
of the contract is altered. With bank close monitoring,
borrowers will not undertake to invest in more risky projects.
Information asymmetries generate market imperfections

9. 9
Delegated Monitoring
Contracts are necessarily incomplete
–borrowers need to be monitored to ensure maximum probability
that loaned funds will be repaid.
–Lending contracts are incomplete in that the value in large part is
determined by the behavior of the borrower after the issuance of
the loan.
Depositors delegate banks to monitor the behaviour of
borrowers.
Financial intermediaries act as delegated monitors of
depositors to overcome problems of asymmetric information
Diamond (1984)

10. 10
Banks provide Liquidity
Borrowers and lenders have different liquidity
preferences
–banks pool funds together
–banks rely on the law of averages to be able to
offer liquidity to their customers.
The existence of banks can be derived from
the bank’s balance sheet.
–liabilities side: banks accept deposits and in turn
provide transaction services,
–asset side: banks issue loans, thereby providing
liquidity.

11. 11
Small-Business Borrowers
Small-business borrowers find bank lending important
because due to small size and relative opacity, funding
through public markets is virtual impossible.
Banks build relationships with customers that give them
valuable information about their operations.
Enhanced bank-customer relationships help small
businesses access funding because the bank has got
special knowledge about the firm.
In difficult times, e.g. economic recession, firms with
strong relationships with a bank are better able to obtain
financing to endure the recession.

12. 12
Payment System and Monetary Policy…
‘Payment and settlement systems are to economic activity what
roads are to traffic, necessary but typically taken for granted
unless they cause an accident or bottlenecks develop’ Bank for
International Settlements (1994).
Banks administer payment systems which are core to an
economy.
Through payment system:
–banks execute customers’ payment instructions by transferring
funds between their accounts.
–customers receive payments and pay for the goods and services
by cheques, credit or debit cards or orders
–funds to flow between individuals, retail business and wholesale
markets quickly and safely.
Banks are the transmission belt for Monetary Policy Corrigan
(1982)

13. 13
Risk Pooling & Pricing…
Banks make riskier investments available through
risk-pooling mechanism.
–risk averse investors focus in low-risk financial instruments,
–risk loving investors specialize in risk bearing assets.
Riskier projects tend to yield higher returns than low-
risk projects;
–individuals might not want to take on much risk when their
available funds are too small to effectively insure
themselves.
–banks can offer this service at lower cost than savers can
manage individually.
–savers have access to economies of scale not otherwise
available to them.

14. 14
Risk Transformation…
With risk transformation borrowers’ promises are converted into
a single promise by the bank itself.
Depositors who hold the institutions’ liabilities must be able to
regard them as absolutely safe.
Banks’ loans inevitably bear some risk.
Banks’ ability to transform these risky assets into riskless
liabilities depends on several factors.
–they control risk by incorporating an allowance for probable losses
–they spread risk to guard against the probability that loans to some
customers or categories of customers will lead to unusually heavy
losses.
–they ensure that their own capital is adequate to absorb any losses
they may incur through a failure to control risk properly, adverse
economic conditions, or concentration of lending in their portfolios.

15. 15
Arguments against Financial Intermediaries…
In a world of perfect and complete markets,
financial intermediaries do not add value to the
economy. Fama, Modigliani & Miller, and Arrow
& Debreu
These institutions are irrelevant; households
can construct portfolios which offset financial
intermediaries’ actions. Miller-Modigliani
Theorem (1961)

16. 16
Justification for Bank’s Existence…
Banks are central to economic growth.
In capitalist economies, savings and
investments process is organized around
financial intermediation.
Banks influence the level of money stocks
through ability to create deposit liabilities.
Askari (1991), Yue (1992)
There are a number of reasons why savers and
borrowers choose to deal with banks –
transaction costs, payment system, risk
pooling, risk pricing, risk transformation etc.

17. 17
Conclusion
Banks play a central role in the economy
Opposing views are based on efficient
financial markets which are evidently at odds
with what is observed in practice.
Question: Are banks important to an
economy?
Answer: Yes

18. 18
END