LESSON 4: INTRODUCTION TO BANKING

A bank is a financial intermediary that offers loans and deposits, and payment services. Nowadays banks also
offer a wide range of additional services, but it is these functions that constitute banks’ distinguishing features.
Because banks play such an important role in channelings funds from savers to borrowers, in this chapter we
use the concepts of ‘bank’ and ‘financial intermediary’ almost as synonyms as we review the role of banks and
their main functions: size transformation; maturity transformation and risk transformation.

1. The Nature of financial intermediation

 A bank is a financial intermediary whose core activity is to provide loans to borrowers and to
collect deposits from savers. In other words, they act as intermediaries between borrowers and
savers.
 By carrying out the intermediation function banks collect surplus funds from savers and allocate
them to those (both people and companies) with a deficit of funds (borrowers). In doing so, they
channel funds from savers to borrowers thereby increasing economic efficiency by promoting a
better allocation of resources.
 Arguably, savers and borrowers do not need banks to intermediate their funds: in direct finance,
borrowers obtain funds directly from lenders in financial markets.
 A financial claim is a claim to the payment of a future sum of money and/or a periodic payment
of money. More generally, a financial claim carries an obligation on the issuer to pay interest
periodically and to redeem the claim at a stated value in one of three ways:
A. On demand;
B. After giving a stated period of notice;
C. On a definite date or within a range of dates

Financial claims are generated whenever an act of borrowing takes place. Borrowing occurs whenever
an economic unit’s (individuals, households, companies, government bodies, etc.) total expenditure exceeds its
total receipts. Therefore borrowers are generally referred to as deficit units and lenders are known as surplus
units. Financial claims can take the form of any financial asset, such as money, bank deposit accounts, bonds,
shares, loans, life insurance policies, etc. The lender of funds holds the borrower’s financial claim and is said to
hold a financial asset. The issuer of the claim (borrower) is said to have a financial liability

Lender’s requirements:

1. The minimum risk- this includes minimization of the risk of default and the risk of the assets
dropping in value.
2. The minimization of cos- lenders aim to minimize their costs.
3. Liquidity- lenders value the ease of converting a financial claim into cash without loss of
capital value; therefore they prefer holding assets that are more easily converted into cash,
one reason for this is the lack of knowledge of future events, which results in lenders
preferring short-term lending to long-term.
Borrower’s requirements:

1. Funds at a particular specified date.

2. Funds for a specific period of time; preferably long-term.
3. Funds at the lowest possible cost.

Transactions costs relate to the costs of searching for a counterparty to a financial transaction;1 the costs
of obtaining information about them; the costs of negotiating the contract; the costs of monitoring the
borrowers; and the eventual enforcements costs should the borrower not fulfil its commitments. In addition to
transaction costs, lenders are also faced with the problems caused by asymmetric information. These problems
arise because one party has better information than the counterparty. In this context, the borrower has better
information about the investment (in terms of risk and returns of the project) than the lender. Information
asymmetries create problems in all stages of the lending process.

Transaction costs and information asymmetries are examples of market failures; that is, they act as
obstacles to the efficient functioning of financial markets. One solution is the creation of organized financial
markets. However, transaction costs and information asymmetries, though reduced, still remain. Another
solution is the emergence of financial intermediaries. Organized financial markets and financial intermediaries
co-exist in most economies; the flow of funds from units in surplus to unit in deficit in the context of direct and
indirect finance.

2. The Role of Banks

To understand fully the advantages of the intermediation process, it is necessary to analyse what banks
do and how they do it. We have seen that the main function of banks is to collect funds (deposits) from
units in surplus and lend funds (loans) to units in deficit. Deposits typically have the characteristics of
being small-size, low-risk and high-liquidity. Loans are of larger-size, higher-risk and illiquid. Banks’s
bridge the gap between the needs of lenders and borrowers by performing a transformation function:

A. Size transformation
Generally, savers/depositors are willing to lend smaller amounts of money than the amounts required
by borrowers. For example, think about the difference between your savings account and the money
you would need to buy a house! Banks collect funds from savers in the form of small-size deposits
and repackage them into larger size loans. Banks perform this size transformation function
exploiting economies of scale associated with the lending/borrowing function, because they have
access to a larger number of depositors than any individual borrower
B. Maturity Transformation
Banks transform funds lent for a short period of time into medium- and long-term loans. For
example, they convert demand deposits (i.e. funds deposited that can be withdrawn on demand) into
25-year residential mortgages. Banks’ liabilities (i.e., the funds collected from savers) are mainly
repayable on demand or at relatively short notice. On the other hand, banks’ assets (funds lent to
borrowers) are normally repayable in the medium to long term. Banks are said to be ‘borrowing
short and lending long’ and in this process they are said to ‘mismatch’ their assets and liabilities.
 This mismatch can create problems in terms of liquidity risk, which is the risk of not having enough
liquid funds to meet one’s liabilities.
C. Risk Transformation
Individual borrowers carry a risk of default (known as credit risk) that is the risk that they might not
be able to repay the amount of money they borrowed. Savers, on the other hand, wish to minimise
risk and prefer their money to be safe. Banks are able to minimise the risk of individual loans by
diversifying their investments, pooling risks, screening and monitoring borrowers and holding
capital and reserves as a buffer for unexpected losses.

3. Theories of Financial Intermediation

1. Delegated monitoring
One of the main theories put forward as an explanation for the existence of banking relates to the
role of banks as ‘monitors’ of borrowers. Since monitoring credit risk (likelihood that borrowers
default) is costly, it is efficient for surplus units (depositors) to delegate the task of monitoring to
specialised agents such as banks. Banks have expertise and economies of scale in processing
information on the risks of borrowers and, as depositors would find it costly to undertake this
activity, they delegate responsibility to the banks. One of the most relevant studies explaining why
banks exist on the basis of contract theory is by Diamond (1984), according to whom delegated
monitoring on behalf of small lenders
2. Information Production
If information about possible investment opportunities is not free, then economic agents may find it
worthwhile to produce such information. For instance, surplus units could incur substantial search
costs if they were to seek out borrowers directly. If there were no banks, then there would be
duplication of information. An intermediary (such as a bank) is delegated the task of costly
monitoring of loan contracts written with firms who borrow from it. It has a gross cost advantage in
collecting this information because the alternative is either duplication of effort if each lender
monitors directly or a free-rider problem in which case no lender monitors. An alternative is to have
a smaller number of specialist agents (banks) that choose to produce the same information. Banks
have economies of scale and other expertise in processing information relating to deficit units – this
information may be obtained upon first contact with borrowers but in reality is more likely to be
learned over time through repeated dealings with the borrower. As banks build up this information
(e.g., the knowledge of credit risk associated with different types of borrowers – ‘customer
relationships’) they become experts in processing this information. As such they have an information
advantage and depositors are willing to place funds with a bank knowing that these will be directed
to the appropriate borrowers without the former having to incur information costs.
3. Liquidity Transformation
Banks provide financial or secondary claims to surplus units (depositors) that often have superior
liquidity features compared to direct claims (like equity or bonds). Banks’ deposits can be viewed as
contracts that offer high liquidity and low risk that are held on the liabilities side of a bank’s balance
sheets. These are financed by relatively illiquid and higher risk assets (e.g., loans) on the assets side
of the bank’s balance sheet. It should be clear that banks can hold liabilities and assets of different
liquidity features on both sides of their balance sheet through diversification of their portfolios. In
contrast, surplus units (depositors) hold relatively undiversified portfolios (e.g., deposits typically
have the same liquidity and risk features). The better banks are at diversifying their balance sheets,
the less likely it is that they will default on meeting deposit obligations.
4. Consumption Smoothing

The three aforementioned theories are usually cited as the main reasons why financial intermediaries
(typically banks) exist. However, recent studies have suggested that banks perform a major function
as consumption smoothers. Namely, banks are institutions that enable economic agents to smooth
consumption by offering insurance against shocks to a consumer’s consumption path. The argument
goes that economic agents have uncertain preferences about their expenditure and this creates a
 demand for liquid assets. Financial intermediaries in general, and banks in particular, provide these
assets via lending and this helps smooth consumption patterns for individuals
5. Commitment Mechanism
Another theory that has recently developed aims to provide a reason as to why illiquid bank assets
(loans) are financed by demand deposits that allow consumers to arrive and demand liquidation of
those illiquid assets. It is argued that bank deposits (demand deposits) have evolved as a necessary
device to discipline bankers. To control the risk-taking propensity of banks, demand deposits have
evolved because changes in the supply and demand of these instruments will be reflected in
financing costs and this disciplines or commits banks to behave prudently (ensuring banks hold
sufficient liquidity and capital resources).

4. Benefits of Financial Intermediation

A. The Benefits to Ultimate Lenders
 Greater liquidity is generally achieved by lending to a financial intermediary rather than
directly to an ultimate borrower.
 Less risk is involved, due to the pooling of risk inherent with financial intermediation, the
improved risk assessment that intermediaries are able to undertake and the portfolio
diversification that can frequently be achieved. This reduction in risk may be reflected in
guaranteed interest rates on deposits with a financial intermediary.
 Marketable securities may be issued as the counterpart to deposits with a financial
intermediary. For example, a certificate of deposit (CD) is a type of time deposit where the bank
issues a certificate that a deposit has been made (this is particularly common in the US). The
certificate of deposit can then be sold in the market whenever an individual/firm needs cash.
Hence depositors, instead of waiting until maturity of the securities, may sell them in the market
to regain the cash. This clearly enhances the liquidity of the depositors’ funds (in the broadest
sense).
 Transaction costs associated with the lending process are likely to be reduced significantly,
especially where straightforward deposit facilities are utilised.
 The lending decision is simplified, since there are fewer lending opportunities to financial
intermediaries than there are ultimate borrowers. In addition, the assessment of the opportunities
for lending to intermediaries is generally a simpler procedure than the assessment of the
opportunities for lending to ultimate borrowers
B. The Benefits to Ultimate Borrowers
 Loans will generally be available for a longer time period from financial intermediaries than
from the ultimate lenders.
 Financial intermediaries will generally be prepared to grant loans of larger amounts than will
ultimate lenders.
 Using financial intermediaries will generally involve lower transaction costs than would be
incurred if borrowers had to approach ultimate lenders directly.
 The interest rate will generally be lower when borrowing from financial intermediaries,
compared with borrowing directly from ultimate lenders. As we have seen, financial
intermediaries, through the minimisation of information costs and the diversification of risk,
can actually reduce the cost of intermediation.
 When borrowing from financial intermediaries, there is a greater likelihood that loans will be
available when required.
C. The Benefits to Society as a Whole

 Cause a more efficient utilisation of funds within an economy, since the evaluation of
lending opportunities will be improved.
 Cause a higher level of borrowing and lending to be undertaken, due to the lower risks and
costs associated with lending to financial intermediaries.
 Cause an improvement in the availability of funds to higher-risk ventures, due to the
capability of financial intermediaries to absorb such risk. High-risk ventures are widely
considered to be important for creating the basis of future prosperity for an economy.