Management of Financial Institutions
Lecture 9 ROLE OF COMMERCIAL BANKS A bank is a commercial or state institution that provides financial services, including issuing money in various forms, receiving deposits of money, lending money and processing transactions and the creating of credit.
A commercial bank accepts deposits from customers and in turn makes loans, even in excess of the deposits; a process known as fractional-reserve banking. Some banks (called Banks of issue) issue banknotes as legal tender. A commercial bank is usually defined as an institution that both accepts deposits and makes loans; there are also financial institutions that provide selected banking services without meeting the legal definition of a bank. Many banks offer ancillary financial services to make additional profit; for example, most banks also rent safe deposit boxes in their branches. Currently in most jurisdictions commercialbanks are regulated & require permission to operate. Operational authority is granted bybank regulatory authorities who provide rights to conduct the most fundamental banking services such as accepting deposits and making loans.
Purpose of a bank:
Banks have influenced economies & politics for centuries. Historically, the primarypurpose of a bank was to provide loans to trading companies. Banks provided funds toallow businesses to purchase inventory, and collected those funds back with interest when the goods were sold.
For centuries, the banking industry only dealt with businesses, not consumers. Commercial lending today is a very intense activity, with banks carefully analyzing the financial condition of their business clients to determine the level of risk in each loan transaction.
Banking services have expanded to include services directed at individuals, and risks inthese much smaller transactions are pooled.
A Bank’s Profit
A bank generates a profit from the differential between the level of interest it pays for deposits and other sources of funds, and the level of interest it charges in its lending activities. This difference is referred to as the spread between the cost of funds and the loan interest rate. Historically, profitability from lending activities has been cyclic and dependent on the needs and strengths of loan customers. In recent history, investors have demanded a more stable revenue stream and banks have therefore placed more emphasis on transaction fees, primarily loan fees but also including service charges on array of deposit activities and ancillary services (international banking, foreign exchange, insurance, investments, wire transfers, etc.). However, lending activities still provide the bulk of a commercial bank's income.
The name bank derives from the Italian word banco "desk/bench", used during the Renaissance by Florentines bankers, who used to make their transactions above a desk covered by a green tablecloth.
However, there are traces of banking activity even in the Babylonian times, and indeed a book about the history of banking is named: Banking, from Babylon to Wall Street.
Services Typically Offered by Banks
Although the basic type of services offered by a bank depends upon the type of bank and the country, services provided usually include:
Taking deposits from their customers and issuing current (Pak) or checking (US)accounts and savings accounts to individuals and businesses.
Extending loans to individuals and businesses.
Facilitating money transactions such as wire transfers and cashier's checks
Storing valuables, particularly in a safe deposit box
Consumer & commercial financial advisory services
Pension & retirement planning
Financial transactions can be performed through many different channels:
A branch, banking centre or financial centre is a retail location where a bank or financial institution offers a wide array of face to face service to its customers.
ATM is a computerized telecommunications device that provides a financial institution’s customers a method of financial transactions in a public space without the need for a human clerk or bank teller
Mail is part of the postal system which itself is a system wherein written documents typically enclosed in envelopes, and also small packages containing other matter, are delivered to destinations around the world
Telephone bankingis a service provided by a financial institution which allows its customers to perform transactions over the telephone.
Online banking is a term used for performing transactions, payments etc. over the Internet through a bank, credit union or building society's secure website
Types of banks
Banks' activities can be divided into retail banking, dealing directly with individuals and small businesses; business banking, providing services to mid-market business; corporate banking, directed at large business entities; and investment banking, relating to activities on the financial markets.
Most banks are profit-making, private enterprises. However, some are owned by government, or are non-profits
Central banks are non-commercial bodies or government agencies often charged with controlling interest rates and money supply across the whole economy. They generally provide liquidity to the banking system and act as Lender of last resort in event of a crisis.
• Commercial bank: the term used for a normal bank to distinguish it from an investment bank. After the Great Depression, the U.S. Congress required that banks only engage in banking activities, whereas investment banks were limited to capital market activities. Since the two no longer have to be under separate ownership, some use the term "commercial bank" to refer to a bank or a division of a bank that mostly deals with deposits and loans from corporations or large businesses.
• Community Banks: locally operated financial institutions that empower employees to make local decisions to serve their customers and the partners
• Community development banks: regulated banks that provide financial services and credit to underserved markets or populations.
• Postal savings banks: savings banks associated with national postal systems.
• Private Banks: manage the assets of high net worth individuals.
• Offshore Banks: banks located in jurisdictions with low taxation and regulation. Many offshore banks are essentially private banks.
• Savings bank: in Europe, savings banks take their roots in the 19th or sometimes even 18th century. Their original objective was to provide easily accessible savings products to all strata of the population. In some countries, savings banks were created on public initiative, while in others socially committed individuals created foundations to put in place the necessary infrastructure. Nowadays, European savings banks have kept their focus on retail banking: payments, savings products, credits and insurances for individuals or small and medium-sized enterprises.
• Apart from this retail focus, they also differ from commercial banks by their broadly decentralized distribution network, providing local and regional outreach and by their socially responsible approach to business and society.
• Building societies and Lands-banks: conduct retail banking.
• Ethical banks: banks that prioritize the transparency of all operations and make only what they consider to be socially-responsible investments.
Investment banks "underwrite" (guarantee the sale of) stock and bond issues, trade for their own accounts, make markets, and advise corporations on capital markets activities such as mergers and acquisitions.
Merchant banks were traditionally banks which engaged in trade financing. The modern definition, however, refers to banks which provide capital to firms in the form of shares rather than loans. Unlike Venture capital firms, they tend not to invest in new companies
Banks in the Economy
Role in the money supply
A bank raises funds by attracting deposits, borrowing money in the inter-bank market, or issuing financial instruments in the money market or a capital market. The bank then lends out most of these funds to borrowers.
However, it would not be prudent for a bank to lend out all of its balance sheet. It must keep a certain proportion of its funds in reserve so that it can repay depositors who withdraw their deposits.
Bank reserves are typically kept in the form of a deposit with a central bank. This is called fractional-reserve banking and it is a central issue of monetary policy.
Note that under Basel I (and the new round of Basel II), banks no longer keep deposits with central banks, but must maintain defined capital ratios
Size of Global Banking Industry
Worldwide assets of the largest 1,000 banks grew 15.5% in 2005 to reach a record $60.5 trillion. This follows a 19.3% increase in the previous year. EU banks held the largest share, 50% at the end of 2005, up from 38% a decade earlier.
The growth in Europe’s share was mostly at the expense of Japanese banks whose share more than halved during this period from 33% to 13%. The share of US banks also rose, from 10% to 14%. Most of the remainder was from other Asian and European countries.
The US had by far the most banks (7,540 at end-2005) and branches (75,000) in the world. The large number of banks in the US is an indicator of its geography and regulatory structure, resulting in a large number of small to medium sized institutions in its banking system.
Japan had 129 banks and 12,000 branches. In 2004, Germany, France, and Italy had more than 30,000 branches each—more than double the 15,000 branches in the UK.
Banks are susceptible to many forms of risk which have triggered occasional systemic crises. Risks include liquidity risk (the risk that many depositors will request withdrawals beyond available funds), credit risk (the risk that those who owe money to the bank will not repay), Interest rate risk (the risk that the bank will become unprofitable if rising interest rates force it to pay relatively more on its deposits than it receives on its loans), among others. Banking crises have developed many times throughout history when one or more risks materialize for a banking sector as a whole. Prominent examples include the U.S. Savings and Loan crisis in 1980s and early 1990s, the Japanese banking crisis during the 1990s, the bank run that occurred during the Great Depression, and the recent liquidation by the central Bank of Nigeria, where about 25 banks were liquidated.
Challenges within the Banking Industry
Economic Environment The changing economic environment has a significant impact on banks and thrifts as they struggle to effectively manage their interest rate spread in the face of low rates on loans, rate competition for deposits and the general market changes, industry trends and economic fluctuations.
Growth Strategies It has been a challenge for banks to effectively set their growth strategies with the recent economic market. A rising interest rate environment may seem to help financial institutions, but the effect of the changes on consumers and businesses is not predictable and the challenge remains for banks to grow and effectively manage the spread to generate a return to their shareholders.
The Management of the Banks The management of the banks’ asset portfolios also remains a challenge in today’s economic environment. Loans are a bank’s primary asset category and when loan quality becomes suspect, the foundation of a bank is shaken to the core. While always an issue for banks, declining asset quality has become a big problem for financial institutions. There are several reasons for this, one of which is the lax attitude some banks have adopted because of the years of “good times.” The potential for this is exacerbated by the reduction in the regulatory oversight of banks and in some cases depth of management. Problems are more likely to go undetected, resulting in a significant impact on the bank when they are recognized. In addition, banks, like any business, struggle to cut costs and have consequently eliminated certain expenses, such as adequate employee training programs. Banks also face a host of other challenges such as aging ownership groups. Across the country, many banks’ management teams and board of directors are aging. Banks also face ongoing pressure by shareholders, both public and private, to achieve earnings and growth projections. Regulators place added pressure on banks to manage the various categories of risk. Banking is also an extremely competitive industry.
Competing in the financial services industry has become tougher with the entrance of such players as insurance agencies, credit unions, check cashing services, credit card companies, etc. Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions, and guidelines, aiming to uphold the soundness and integrity of the financial system. The combination of the instability of banks as well as their important facilitating role in the economy led to banking being thoroughly regulated.
The amount of capital a bank is required to hold is a function of the amount and quality of its assets. Major Banks are subject to the Basel Capital Accord promulgated by the Bank for International Settlements.
In addition, banks are usually required to purchase deposit insurance to make sure smaller investors are not wiped out in the event of a bank failure. Another reason banks are thoroughly regulated is that ultimately, no government can allow the banking system to fail.