The Role of Banks in Theory

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Banks are among the most important financial institutions in the economy and are essential businesses in thousands of local towns and cities. They are the principal source of credit (loanable funds) for households (individuals and families) and for most local units of government (school districts, cities, etc.). Nationwide and worldwide, banks grant more installment loans to consumers than any other financial institution and, in most years, they are among the leading buyers of bonds and notes issued by states and local governments to finance public facilities. The deposits held by banks are the principal money medium for global transactions and the principal channel for government economic policy to stabilize the economy.

Banks are financial intermediaries, similar to credit unions, savings and loan association, and other institutions selling financial services. The term ‘financial intermediary’ simply means a business that interacts with two types of individuals or institutions in the economy: (1) deficit-spending individuals or institutions whose current expenditures for consumption and investment exceed their current receipts of income and who, therefore, need to raise funds externally by negotiating loans with and issuing securities to other units; and (2) surplus-spending individuals or institutions, whose current receipts of income exceed their current expenditures on goods and services so they have surplus funds to save and invest. Banks perform the indispensable tasks of intermediating between these two groups, offering convenient financial services to surplus-spending individuals and institutions in order to raise funds and then loaning those funds to deficit-spending individuals and institutions.

There is an ongoing debate in the theory of finance and economics about why banks exist. What essential services do banks provide that other businesses and individuals couldn’t provide for themselves?

This may at first appear to be an easy question, but it has proven to be extremely difficult to answer. Why? Because research evidence has accumulated over many years showing that our financial system and financial markets are extremely efficient. Funds and information flow readily to both lenders and borrowers, and the prices of loans and securities seem to be determined in highly competitive markets. In a perfectly efficient financial system, in which pertinent information is readily available to all at negligible cost, in which the cost of carving out financial transactions is negligible, and all loans and securities are available in denominations anyone can afford, why are banks needed at all?

Most current theories explain the existence of banks by pointing to imperfections in our financial system. For example, all loans and securities are not perfectly divisible into small denominations that everyone can afford. To take one well-know example, U.S. Treasury bills – probably the most popular short-term marketable security in the world – have a minimum denomination of $10,000 which is clearly beyond the reach of most small savers. Banks provide a valuable service in dividing up such instruments into smaller securities, in the form of deposits, that are readily affordable for millions of people. In this instance a less-than-perfect financial system creates a role for banks in serving small savers and depositors.

Another contribution banks make is their willingness to accept risky loans from borrowers, while issuing low-risk securities to their depositors. In effect, banks engage in risky borrowing and lending activity across the financial markets by taking on risky financial claims from borrowers, while simultaneously issuing almost riskless claims to depositors.

Banks also satisfy the strong need of many customers for liquidity. Financial instruments are liquid if they can be sold quickly in a ready market with little risk of loss to the seller. Many households and businesses, for example, demand large precautionary balances of liquid funds to cover expected future cash needs and to meet emergencies. Banks satisfy this need by offering high liquidity of the deposits they sell.

Still another reason banks have grown and prospered is their superior ability to evaluate information. Pertinent data on financial investments is both limited and costly. Some borrowers and lenders know more than others, and some individuals and institutions possess inside information that allows them to choose exceptionally profitable investments while avoiding the poorest ones. Banks have the expertise and experience to evaluate financial instruments and choose those with the most desirable risk-return features.

Moreover, the ability of banks to gather and analyze financial information has given rise to another view of why banks exist in modern society – the delegated monitoring theory. Most borrowers and depositors prefer to keep their financial records confidential, shielded especially from competitors and neighbors. Banks are able to attract borrowing customers, this theory suggests, because they pledge confidentiality. Even banks’ own depositors are not privileged to review the financial reports of its borrowing customers. Instead, the depositors hire a bank as delegated monitor to analyze the financial condition of prospective borrowers and to monitor those customers who do receive loans in order to ensure that the depositors will recover their funds. In return for bank monitoring services, depositors pay a fee that is probably less than the cost they would have incurred if they monitored the borrowers themselves.

By making a large volume of loans, banks as delegated monitors can diversify and reduce their risk exposure, resulting in increased deposit safety. Moreover, when a borrowing customer has received the bank’s stamp of approval, it is easier and less costly for that customer to raise funds elsewhere. In addition, when a bank uses some of its owners’ money as well as deposits to fund a loan, this signals the financial marketplace that the borrower is trustworthy and has a reasonable chance to be successful and repay its loans.