THE ROLE OF BANKS IN THEORY

Banks are financial intermediaries, similar to credit unions, savings and loan associations, 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 task 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 carrying 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-known 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 in 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 a bank's 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.

1.What does the term ‘financial intermediary’ mean?

2.Explain the meaning of the following terms ‘deficit-spending individuals’ and ‘surplus-spending individuals’.

3.What task do banks perform?

4.Why do bank exist?

T E X T 3

Read the text. Divide it into logical parts. Defend your division. Give the title to the text.

Why are most banks so closely regulated? A number of reasons for this heavy burden of government supervision have been offered over the years, some of them centuries old. First, banks are among the leading repositories of the public's savings— especially the savings of individuals and families. Many savers lack the financial expertise and depth of information to correctly evaluate the riskiness of a bank. Therefore, regulatory agencies are charged with the responsibility of gathering all the information needed to assess the fi­nancial condition of banks in order to protect the public against loss. Cameras and guards patrol bank lobbies to reduce the risk of loss due to theft. Periodic bank examinations and audits are aimed at limiting losses from embezzlement, fraud, or mismanagement. Government agencies stand ready to loan funds to banks faced with unexpected short­falls of spendable reserves. While most of the public's savings are placed in relatively short-term highly liquid deposits with ready access, banks also hold large amounts of long-term savings for retirement in pension programs and Individual Retirement Accounts (IRAs). The loss of these funds due to bank failure or bank crime would be catastrophic in many cases. Regulation acts as a safeguard against such losses by providing deposit insurance and by periodically examining bank policies and practices in order to promote sound management of the public's funds, while minimizing the volume of claims made against the government's deposit insurance fund. On the other side of the coin, however, although safeguarding the public's savings may justify having a deposit insurance system (preferably, one in which banks creating greater risk for their depositors and for the deposit insurance fund pay higher insurance fees), it is not sufficient by itself to justify the entire basket of modern banking regulations. Banks are also closely watched because of their power to create moneyin the form of readily spendable deposits by making loans and invest­ments (extending credit). Moreover, changes in the volume of money creation appear to be closely correlated with economic conditions, es­pecially the creation of jobs and the presence or absence of inflation. However, merely because banks create money which impacts the vitality of the economy, this is not necessarily a valid excuse for regulating banks. As long as central banks can control money supply growth through their policies and operating procedures, the volume of money individual banks create should be of no great concern to the regulatory authorities or to the public. Banks are also regulated because they provide individuals and insti­tutions with loans which support consumption and investment spend­ing. Regulatory authorities argue that the public has a keen interest in an adequate supply of loans flowing from the banking system. Moreover, discrimination in the granting of credit would represent a significant obstacle to personal well-being and an improved standard of living. This is especially important if access to credit is denied because of age, sex, race, national origin, residential neighborhood, or similar factors. Per­haps, however, discrimination in providing services to the public could be significantly reduced or eliminated simply by promoting more com­petition among banks and other providers of financial services, such as by vigorous enforcement of the antitrust laws, rather than through reg­ulation.

1.Why are regulatory agencies charged with the responsibility of gathering the information needed to assess the financial condition of banks?

2.What are periodic bank examinations and audits aimed at?

3.What is regulation aimed at?

4.What are other reasons of bank regulation?

T E X T 4

WHAT IS A CENTRAL BANK?

Just as a prudent driver keeps an eye on the road and a hand on the wheel, every country's central bank watches economic data carefully and adjusts the money supply in an effort to keep the economy headed in the right direction.

Instead of taking deposits and making loans as normal banks do, a central bank controls the economy by increasing or decreasing the country's supply of money. Cranking up the printing presses is not the only way for a central bank to increase the economy's supply of money. In fact, in most modern economies printed notes and coins are only a small percentage—often less than 10 percent—of the money supply. Central banks usually print only enough currency to satisfy the everyday needs of businesses and consumers.

Since most "money" is actually nothing more than a savings or checking account at a local bank, the most effective way for a central bank to control the economy is to increase or decrease bank lending and bank deposits. When banks have money to lend to their custom­ers, the economy grows. When the banks are forced to cut back lending, the economy slows.

Once a customer deposits money in a local bank, it becomes available for further lending. A hundred dollars deposited at a bank in London, for example, doesn't lie idle for long. After setting aside a small amount of each deposit as a "reserve," the bank can lend out the remainder, further increasing the money supply—without any new currency being printed. When these loans are redeposited in banks, more money becomes available for new loans, increasing the money supply even more. A bank's supply of money for lending is limited only by its deposits and its reserve requirements, which are determined by the central bank.

Central banks often use these reserve requirements to control the money supply. When a bank is required to keep a certain amount of its funds on reserve with the central bank—10 percent of deposits for example—it is unable to lend these funds back to customers. When a central bank decides to increase the money supply, it can reduce this reserve requirement, allowing banks to use more of their funds to lend to businesses and consumers. This increases the money supply quickly because of a multiplier effect: as the new loans enter the economy, deposits increase—and banks have even more money to lend, which generates further deposits providing more money for further loans.

Another way of controlling the money supply is to raise or lower interest rates. When a central bank decides that the economy is grow­ing too slowly—or not growing at all—it can reduce the interest rate it charges on the loans to the country's banks. When banks are allowed to get cheaper money at the central bank, they can make cheaper loans to businesses and consumers, providing an important stimulus to eco­nomic growth. Alternatively, if the economy shows signs of growing too quickly, a central bank can increase the interest rate on its loans to banks, putting the brakes on economic growth.

Perhaps the most dramatic way of increasing or decreasing the money supply is through open market operations, where a central bank buys or sells large amounts of securities, such as government treasury bonds, in the open market. By buying a large block of bonds, from a bank or a securities house for example, the central bank pumps money into the economy because it uses funds that previously were not part of the money supply. The money used to buy the bonds then becomes available for banks to lend out to consumers and businesses.

A central bank, unlike other players in the economy, does not have to secure funding from any other source. It can simply print more money or use its virtually unlimited credit with banks in the system. Once a central bank's payment enters the economy, it becomes part of the money supply, providing fuel for businesses and consumers to increase their economic activities. Likewise, when a central bank sells bonds in the open market, the payments from banks and securities houses disappear into the black hole of the central bank's vault, com­pletely removed from the economy at large.

An error in judgment at the central bank has grave consequences for everyone in the economy. If a central bank allows the economy to expand too rapidly by keeping too much money in circulation, it may cause inflation. If it slows down the economy by removing too much money from circulation, an economic recession could result, bringing unemployment and reduced production. A central serves as a watchdog to supervise the banking system, in most cases acting independently of its government to provide a stabilizing influence on the country's economy.

The activities and responsibilities of central banks vary widely from country to country. For example, Britain's Bank of England is responsible for printing the money as well as supervising the banking system and coordinating monetary policy. In the United States, the duties of a central bank are divided among different agencies: the U.S. Treasury borrows the government's money through Treasury bond and note issues, while the Federal Reserve Board is put in charge of mone­tary policy and oversees the printing of money at the Bureau of Print­ing and Engraving.

The French central bank, the Banque de France, prints and issues the money, but the French treasury makes the decisions regarding monetary policy and bank supervision. In Germany, the central bank, called the Bundesbank, is noted for its active policy of strict monetary control, limiting money supply growth in order to control inflation at all costs.

The Bank of Japan, like many of the world's central banks, acts as banker to the government. This activity is a major source of revenue for the bank since fees are charged for issuing the government's checks

1. What are the main functions of a central bank?

2. In what way can a central bank control the economy?

3. How can central banks control the money supply?

4. Do the activities and responsibilities of central banks vary from country to country?

Give your examples.

5. What is the BIS?

6. What does the BIS provide?

T E X T 5