Importance Of Banks In An Economy

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Importance Of Banks In An Economy

  1. 1. Importance of Banks in an Economy By Rudo Chengeta
  2. 2. Introduction <ul><li>An overview of Banks </li></ul><ul><li>Key Function of Banks </li></ul><ul><li>Justification for Existence of Banks </li></ul><ul><li>Arguments against Financial Intermediaries </li></ul><ul><li>Conclusion </li></ul>
  3. 3. Overview of Banks <ul><li>Banks can be described as </li></ul><ul><ul><li>financial institutions whose current operations consist of accepting deposits from the public and issuing loans. </li></ul></ul><ul><li>The receiving of deposits and provision of loans distinguishes banks from other financial institutions. </li></ul><ul><li>The term ‘banks’ includes commercial banks, merchant banks, finance houses, building societies, savings banks and credit unions. </li></ul>
  4. 4. Key Function: Financial Intermediation… <ul><li>Financial Intermediation </li></ul><ul><li>Banks act as intermediaries when they mobilize savings from surplus units (savers) to shortage units (borrowers) in order to finance productive activities . Heffernan (1996) </li></ul><ul><li>Other financial institutions can also be intermediaries e.g. between buyers and sellers of shares </li></ul><ul><li>The taking of deposits and granting of loans singles out banks. </li></ul>
  5. 5. Why deal with Banks… <ul><li>Banks achieve economies of scale, and/or economies of scope which lie in transaction costs. </li></ul><ul><li>Small savers face costs of </li></ul><ul><ul><li>Searching; </li></ul></ul><ul><ul><li>Contacting; </li></ul></ul><ul><ul><li>Negotiating; </li></ul></ul><ul><ul><li>trying to diversify; </li></ul></ul><ul><ul><li>Monitoring; </li></ul></ul><ul><ul><li>enforcement etc </li></ul></ul><ul><li>Given the large number of savings and deposit by banks, related transaction costs are either falling or constant. </li></ul><ul><li>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. </li></ul>
  6. 6. Banks reduce Transaction Costs… <ul><li>Banks reduce costs through several other ways including </li></ul><ul><ul><li>provision of convenient places of business </li></ul></ul><ul><ul><li>standardized products and </li></ul></ul><ul><ul><li>less costly expertise through the use of tested procedures and routines. </li></ul></ul><ul><li>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. </li></ul>
  7. 7. Traditional Theory of the Role of Banks <ul><li>Eight significant elements by Llewellyn (1998) </li></ul><ul><ul><li>information advantages, </li></ul></ul><ul><ul><li>imperfect information, </li></ul></ul><ul><ul><li>delegated monitoring, </li></ul></ul><ul><ul><li>control, </li></ul></ul><ul><ul><li>insurance role of banks, </li></ul></ul><ul><ul><li>commitment theories, </li></ul></ul><ul><ul><li>regulatory subsidies and the special role of banks in the payment systems . </li></ul></ul><ul><li>Banks solve problems associated with asymmetric information between lenders: ex ante (adverse selection) and ex post (moral hazard) behavior of borrowers. </li></ul><ul><li>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. </li></ul>
  8. 8. Asymmetry Information: Adverse Selection and Moral Hazard <ul><li>Borrowers do not always provide all the information required. </li></ul><ul><ul><li>Even if they do, not all information will be correct. </li></ul></ul><ul><li>Asymmetric information: </li></ul><ul><ul><li>Banks face the problems of adverse selection and moral hazard . </li></ul></ul><ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>Information asymmetries generate market imperfections </li></ul>
  9. 9. Delegated Monitoring <ul><li>Contracts are necessarily incomplete </li></ul><ul><ul><li>borrowers need to be monitored to ensure maximum probability that loaned funds will be repaid. </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><li>Depositors delegate banks to monitor the behaviour of borrowers. </li></ul><ul><li>Financial intermediaries act as delegated monitors of depositors to overcome problems of asymmetric information Diamond (1984) </li></ul>
  10. 10. Banks provide Liquidity <ul><li>Borrowers and lenders have different liquidity preferences </li></ul><ul><ul><li>banks pool funds together </li></ul></ul><ul><ul><li>banks rely on the law of averages to be able to offer liquidity to their customers. </li></ul></ul><ul><li>The existence of banks can be derived from the bank’s balance sheet. </li></ul><ul><ul><li>liabilities side: banks accept deposits and in turn provide transaction services, </li></ul></ul><ul><ul><li>asset side: banks issue loans, thereby providing liquidity. </li></ul></ul>
  11. 11. Small-Business Borrowers <ul><li>Small-business borrowers find bank lending important because due to small size and relative opacity, funding through public markets is virtual impossible. </li></ul><ul><li>Banks build relationships with customers that give them valuable information about their operations. </li></ul><ul><li>Enhanced bank-customer relationships help small businesses access funding because the bank has got special knowledge about the firm. </li></ul><ul><li>In difficult times, e.g. economic recession, firms with strong relationships with a bank are better able to obtain financing to endure the recession. </li></ul>
  12. 12. Payment System and Monetary Policy… <ul><li>‘ 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). </li></ul><ul><li>Banks administer payment systems which are core to an economy. </li></ul><ul><li>Through payment system: </li></ul><ul><ul><li>banks execute customers’ payment instructions by transferring funds between their accounts. </li></ul></ul><ul><ul><li>customers receive payments and pay for the goods and services by cheques, credit or debit cards or orders </li></ul></ul><ul><ul><li>funds to flow between individuals, retail business and wholesale markets quickly and safely. </li></ul></ul><ul><li>Banks are the transmission belt for Monetary Policy Corrigan (1982) </li></ul>
  13. 13. Risk Pooling & Pricing… <ul><li>Banks make riskier investments available through risk-pooling mechanism. </li></ul><ul><ul><li>risk averse investors focus in low-risk financial instruments, </li></ul></ul><ul><ul><li>risk loving investors specialize in risk bearing assets. </li></ul></ul><ul><li>Riskier projects tend to yield higher returns than low-risk projects; </li></ul><ul><ul><li>individuals might not want to take on much risk when their available funds are too small to effectively insure themselves. </li></ul></ul><ul><ul><li>banks can offer this service at lower cost than savers can manage individually. </li></ul></ul><ul><ul><li>savers have access to economies of scale not otherwise available to them. </li></ul></ul>
  14. 14. Risk Transformation… <ul><li>With risk transformation borrowers’ promises are converted into a single promise by the bank itself. </li></ul><ul><li>Depositors who hold the institutions’ liabilities must be able to regard them as absolutely safe. </li></ul><ul><li>Banks’ loans inevitably bear some risk. </li></ul><ul><li>Banks’ ability to transform these risky assets into riskless liabilities depends on several factors. </li></ul><ul><ul><li>they control risk by incorporating an allowance for probable losses </li></ul></ul><ul><ul><li>they spread risk to guard against the probability that loans to some customers or categories of customers will lead to unusually heavy losses. </li></ul></ul><ul><ul><li>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. </li></ul></ul>
  15. 15. Arguments against Financial Intermediaries… <ul><li>In a world of perfect and complete markets, financial intermediaries do not add value to the economy. Fama, Modigliani & Miller, and Arrow & Debreu </li></ul><ul><li>These institutions are irrelevant; households can construct portfolios which offset financial intermediaries’ actions. Miller-Modigliani Theorem (1961) </li></ul>
  16. 16. Justification for Bank’s Existence… <ul><li>Banks are central to economic growth. </li></ul><ul><li>In capitalist economies, savings and investments process is organized around financial intermediation. </li></ul><ul><li>Banks influence the level of money stocks through ability to create deposit liabilities. Askari (1991), Yue (1992) </li></ul><ul><li>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. </li></ul>
  17. 17. Conclusion <ul><li>Banks play a central role in the economy </li></ul><ul><li>Opposing views are based on efficient financial markets which are evidently at odds with what is observed in practice. </li></ul><ul><li>Question : Are banks important to an economy? </li></ul><ul><li>Answer : Yes </li></ul>
  18. 18. END

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