What is a Bank?
In our lessons so far, we have covered various classifications of banks and their functions. However, there are some similarities in the ways that they conduct business and the roles that they play in the economy. The fundamental service that they provide, whether it is an investment, commercial, or retail bank, is to connect those with capital to those who need capital. Next, we will examine exactly how banks do this.
When banks act to bring together those with capital and those who need capital, it is acting as a financial intermediary between the two parties. It can do this either as an active participant or as a passive facilitator.
Active (Taking on Balance Sheet)
When a bank accepts deposits and lends them out as loans, it is an active participant in the transferring of capital throughout the economy. It takes on risk because the deposits become liabilities (cash that the bank owes to its depositors) on its balance sheet and its loans become assets (investments that yields returns) on its balance sheet. To review accounting concepts, check out the lesson Company Financials under Investing. It generates revenue from lending at higher interest rates and paying its depositors at lower interest rates. This can be measure of profitability in banks called the net interest margin. In these situations when banks acts as an active intermediary, it assumes the risk of choosing the wrong investments - lending to risky borrowers without generating an appropriate return. Much of banking work is issuing loans at an attractive return and reasonable risk.
Passive (Connecting Borrowers and Lenders)
When a bank connects those that have capital with those that need capital without taking on any risk itself, it is a passive facilitator of a transfer of capital throughout the economy. For example, when a broker is simply connecting a buyer and seller as an agent, he (she) is called an agency trader instead of trading as principal (with his own money). Agency trading assumes no risk and collects a commission. Another fee-based business where the bank does not take principal risk is M&A advisory. Although there are passive businesses in a bank, much of it is active - there’s simply more money to make when you’re taking on more risk!
Specialization of Tasks
Instead of each individual deciding what/who to lend to, banks pool capital and use their intermediary position and information advantage to make smart loans (in theory). Each bank has access to hundreds of lenders and borrowers and has more information about these participants than these participants have about each other. Because the bank deals with everyone, it knows how risky and profitable each borrower may turn out to be compared to each other, and how risk-tolerant lenders are compared to each other. It can use this position to make the most suitable loans to each borrower.
This is in contrast to the borrowers and lenders themselves, who are less informed about each other, have difficulty gathering that information, or does not have the time to gather that information. Imagine borrowers 1, 2, 3 and lenders A, B, C. Borrower 1 would not know whether it should ask for low interest rate financing from A, B, or C. Lender A does not know whether it should seek to lend at higher interest rates to 1, 2, or 3. Instead of everyone going out to do this research, the bank does it for us, in exchange for fees and interest profits.
Let’s imagine a scenario with no bank and 3 companies seeking financing: a cancer research company in early drug development phase, an established cable tv company, and a consumer electronics company of moderate maturity. Assuming most depositors don’t have the time, willingness, or expertise to analyze the creditworthiness of a borrower, they would probably charge roughly the same interest rate to everyone. The cable tv company which generates revenues consistently year over year would be unhappy to pay too high of an interest rate. The cancer research company would be overjoyed to get such cheap financing despite not having proven itself yet, and this means the lender is probably taking too much risk. The consumer electronic company might be ok with the loan terms. If there was a bank, it would probably know to charge a higher interest rate to the cancer company with higher risk and a lower interest rate to the cable tv company with lower risk. This is also why banks charge such high interest rates for payday loans and to people with short credit history!
Consumers & Corporations
Liquidity and Payment - Aside from deposits and lending, banks offer other services. To the consumer, it offers storage and liquidity in the form of checking accounts - we can store and retrieve money easily. It also offers us payment services like credit cards - we can avoid paying in cash for everyday transactions and consolidate them to a monthly payment. It also offers corporations liquidity in when it provides accounts through which companies can carry out transactions.
Liquidity and Information - For the investor, banks offer liquidity in the form of reliable prices for investments. As a middleman, if banks facilitate more trades, markets should be more efficient and spreads should be narrower. Banks also offer information to the investor in the form of sellside research analysts. While every public recommendation needs to be taken with a grain of salt and compared to our own independent analyses, banks nevertheless have access to extensive resources. Research analysts have access to management of companies and go to events like healthcare and consumer electronic conferences.
However, with this wealth of information comes some risks. There are regulations in place that dictate barriers that information cannot and should not cross. These are in place to prevent transactions with conflicts of interest. Below is a diagram of important information barriers in banks.
Are Banks Necessary?
Given all the services and functions that we have covered so far, it might be easy to say, how can we live without banks? But to innovate and progress as a society, we can’t let the present define our future. Just because this is the way our economy has evolved doesn’t mean it is the only way forward. Other societies like China have proven that there are financial systems that work without banks at its heart. Payment and cash systems like Wechat have substantially replaced the function of bank accounts and credit cards in the daily lives of citizens in major cities. If you step foot in Beijing and Shanghai and go out to eat with people, many of them will not pull out a credit card to pay, but take out their phones. To embrace this kind of change is probably decades away in the US, but just something to keep in mind as we further explore the financial industry.
We have examined banks in the previous lesson from a perspective of its structure and organization. This lesson, we delved into a more theoretical approach to defining a bank and its role in the economy. We have now covered a central point in the financial industry, as visualized by our diagram in the lesson Structure. We will continue to examine the other participants - corporations, investors, and the public.