The Essence of Banking
In essence, banks are straightforward institutions: they accept deposits and lend out their depositors' funds. But the operation of a bank is rather complex, particularly in terms of the risks that bankers face by guaranteeing the return of deposits while having no guarantee of the timely payment of their loans.
The Financial System
A bank exists in the context of a financial system, which the author describes as consisting of the following components:
- Lenders - Those who provide money to the system. A bank may provide a loan, but it is lending out the funds of its depositors, who are ultimately the source of funds that others borrow.
- Borrowers - Those who borrow money to spend. Again, there are those who borrow funds to lend to others, but the ultimate borrowers have a need for the funds.
- Intermediaries - Middlemen to the lending process, who help connect those with money to lend with those with money to borrow, usually indirectly. Banks are financial intermediaries.
- Financial Instruments - Essentially, these are documents that represent money or debt.
- Money - This can be money itself, or it can be a financial instrument that can be used as a substitute for money in transactions (it serves as a means of payment)
- Financial Markets - A place, real or virtual, where financial instruments and money are traded
The rest of the chapter provides a bit more information about some of these components.
Very little lending takes place in which one party borrows and repays another directly. Aside of the difficulty of finding one another, there are differences in the amount of money they have to offer, the amount of risk they are willing to take, the rates and terms of the loan, etc. Banks provide a convenient location for both parties, standardizes transactions, and handles the various tasks necessary to establish and service the loan, as well as to obtain funds and sell loans outside the community when there is a n imbalance of capital and lending in the local market.
There's some consideration of the various kinds of financial instruments: notes, bonds, and other securities. They all function in basically the same way: they enable an investor to purchase the right to receive payments (and interest) on borrowed capital. Essentially, banks create these instruments in order to convert some of their existing debt into money (to lend) by selling off the loans to investors. In this sense, banks "make money" by securitizing debt, because the financial instruments can be used in transactions.
There is a mention of shares of ownership, which are financial instruments that entitle the bearer to ownership in a commercial endeavor, which may be a temporary undertaking but is most often an ongoing operation (company). Shares essentially entitle the owner to a share of the profit of the endeavor, but in the case of shares in a company the profits are often reinvested in operations, increasing the value of the shares without paying out dividends.
There's a list of the various organizations that typically offer securities, which includes commercial organization, national and local governments, and financial institutions such as the central bank and private sector banks. There is also the issuance of promissory notes and other forms of commercial paper, which are contracts promising future payment to the bearer.
Then, an elaboration upon financial markets, which are simply forums in which securities are bought and sold among their bearers. While these began informally, as gatherings of people who deal in the same kinds of investments, many have become organized and formalized around a specific type of security (hence there is a stock market, a bond market, a money market, foreign exchange market, etc.). There is also a distinction between the "primary market" where the issuer offers securities for sale and the "secondary market" where the present owner resells securities he holds (but did not issue).
Central banks are largely considered to be the creators of money: the dollars you hold are actually notes that are payable by the federal reserve (once redeemable for gold or silver, but that time has passed), however, any debt instrument may be offered in payment if the payee is willing to accept it.
Basic Principles of Banking
In the financial services industry, the bank is a nexus where ultimate lenders, ultimate borrowers, and all non-bank financial intermediaries interact. Some banking functions are largely unique, such that the failure of the banking system (or sometimes of a single large bank) can paralyze the nation's financial infrastructure. For this reason, they are also the most regulated and monitored intermediaries.
Most financial in large sums of money, whereas banks deal with individual depositors whose accounts can be quite small individually and this aggregation service is largely unique to banks. Also because they deal with many individuals with small sums of money, they process more daily transactions than other financial institutions and face the greatest risk, hence risk management is one of the most significant interests of banks. Also, the ability to create money in the form of transferrable loan contracts is largely unique to banks.
A few random bits are mentioned as well. The barriers to entry into the banking industry are relatively high; there is no such thing as a generic banking strategy; and the main threat to banks is presently the technology that enables customers to engage directly in securities markets without the bank's intervention.
There is some consideration of direct lending, but it remains small scale: people loan money to friends and family members, and there are some websites that facilitate person-to-person lending without absorbing the risk. There is also the ability of organizations to sell notes and bonds direct to the public, as the treasury does through its website. This activity is insignificant and all indications suggest it will remain so.
The main reasons that banks remain necessary includes the difficulty of borrowers and lenders finding one another, the disparity in the amounts and terms they wish to lend, and of course the risk inherent in lending. While the depositor makes little interest, working through a bank saves him a great deal of effort and inconvenience.
There's a bit more on the "information costs" of banking, which include search cost (to find a borrower or lender), verification costs (to assess their ability to repay), monitoring costs (to track and process payments), and enforcement costs (to collect from debtors who are reluctant to repay).
Then, a bit more on preferences for liquidity, as a borrower and lender must haggle over the terms of the loan and, once a contract is struck, the capital of the lender is tied up in the loan. Banks set standard trades (take or leave) to eliminate direct haggling and can use aggregated capital to provide depositors access to their funds at their own convenience.
The author provides a list of the "broad" functions of banks:
- Facilitate the flow of funds - The most basic function of a bank is to enable funds to flow from those who have "surplus" money to those who need it, and does so in a more efficient manner than would be possible without an intermediary.
- Assist in price discovery - Banks also help to normalize the rate at which money is loaned. Though lender and borrower ultimately decide what rate they will accept, banks do much to normalize the negotiation of rates.
- Create money - Banks originally created money by honoring notes of withdrawal against funds held in their vaults, but in present day create money by securitizing loans and enabling people to trade in instruments backed by future payments rather than present capital.
- Enhance liquidity - Banks pool the money of their depositors for lending purposes, ensuring that any depositor can gain access to his funds without having to wait for payment or selling loans.
- Decrease risk to lenders - Banks guarantee the availability of deposits regardless of the repayment of loans, taking upon themselves the risk of non-repayment.
- Improve diversification - Because funds are aggregated, the depositors benefit from the return of a diversified portfolio of loans to different borrowers, for different rates, and over different terms. In general, diversification increases returns while decreasing risks for investors.
- Create economies of scale - Another benefit of aggregation is the lower costs of lending large amounts to fewer borrowers, which decreases various transaction costs that would be incurred if the same sum were divided into a multitude of smaller loans.
- Provide a payment system - Banks facilitate payments among their depositors by journaling money from one account to another rather than requiring it to be withdrawn and re-deposited, and can participate in exchanges with other banks to provide similar functions in making/receiving payments to depositors in other banks. The convenience of debit cards and the security of checks (as opposed to cash) is also mentioned as benefits of this payment system.
- Support monetary policy - Banks support the national monetary policy by lending to and borrowing from the central bank. Without their support, the central bank would have no means to regulate the money sypply of the nation.
The Balance Sheet of a Bank
In a basic sense, the balance sheet of a bank reflects the amounts that they pay to others (liabilities) and the amounts they are entitled to collect from others (assets).
The third component, their equity, indicates the degree to which assets exceed liabilities - which is generally the result of collecting more interest on lending than it pays out to depositors for use of their funds. Equity is significant for banks, as regulators require banks to maintain a certain level of equity (around 8-10% of total capital) as a means to protect the bank's stability.
Deposits provide the bank with an asset (cash) coupled with a liability (accounts payable) that increases with interest due. The greatest risk for the bank is that deposits can be withdrawn at any time. The creation of certificates of deposit that charge penalties for early withdrawal is an attempt to ensure the availability of funds (and control fluctuations in interest), but this merely discourages (rather than prevent) depositors from withdrawing at will.
Banks may borrow in order to mitigate the fluctuations in their supply of cash: they may take loans from other banks or the central bank for various terms and at various rates of interest.
The author mentions repurchase agreements, called "repo"s, in which the bank temporarily sells a parcel of securities (usually loans), assigning to others the right to collect the payments on those securities during the period of the agreement. Banks may also use repos when they expect interest rates to rise, selling temporary ownership of low-interest securities and purchasing higher-interest ones with the cash generated from the sale. Unlike the permanent sale of a security, a repo security remains on the bank's balance sheet as an asset, maintain its creditworthiness.
The assets of a bank include its cash holdings as well as notes payable. Its cash may be notes and coins in its own vault or sums on deposit with the central bank. The notes payable includes loans it has made to individual borrowers as well as loans to other banks (including the central bank).
There is much banking activity around the management of the bank's portfolio of loans (those which it keeps to collect the interest over time, and those which it sells to others to generate cash to repay depositors or write other loans at higher rates). In essence, a bank is constantly looking for ways to earn more on the money it lends and pay less for the money it borrows. When there is great volatility in interest rates, this activity can be quite substantial and frantic - and when there is stability of interest rates, banks can seem quite stodgy and lethargic.
There's a brief mention of "off-balance-sheet" activities, which are often maligned by the media as being subversive and questionable, but in reality are entirely mundane. Refinancing a loan to a more favorable rate is an OBS activity (the exact same amount of asset/liability exists on the books, so there is no alteration to the balance sheet).