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1. Essence of banking

1.1. Learning outcomes

After studying this text the learner should / should be able to:

1. Describe the context of banking: the financial system.

2. Explain the principles of banking.

3. Elucidate the broad functions of banks.

4. Analyse and explain the basic raison d'etre for banks.

5. Describe the components of the balance sheets of banks.

6. Elucidate the liability and asset portfolio management "problem" of banks.

1.2. Introduction

Private sector banks play a significant role in the financial system and the real economy. They intermediate between all sectors of the economy and other financial intermediaries and institutions, and some of them provide the payments system, which most of us use every day.

Banks are unique in that their liabilities, bank notes and coins (N&C - central bank) and deposits (BD -private sector banks) are regarded as the means of payments / medium of exchange, which is the definition of money. So, put simply M31 = N&C + BD (held by the domestic non-bank private sector (NBPS). Because of this, banks are able to create additional money when required by individuals, businesses and government (with the assistance of the central bank). This unique feature, plus their balance sheet structure, places banks in a unique position in another way: they are inherently unstable, and therefore require robust regulation and supervision.

Banks are innovative, largely a function of intense competition, and they are therefore at the forefront of new developments, not only in banking but also in the wider financial markets. This makes regulation and supervision complex.

In essence, banks are straightforward institutions: they take existing deposits (and loans to a small degree) and loan these funds, and, at the same time, make new loans and create new deposits (new money). However, while their basic function may be simple, the risks they assume are not, and this makes them complex. This text aims to cover banking in a comprehensible manner, and the following are the sections:

• Essence of banking.

• Money creation.

• Risks in banking.

• Bank models & prudential requirements.

This section serves as introduction to banking and offers the following sections:

• The financial system.

• Principles of banking.

• The balance sheet of a bank.

1.3. The financial system

1.3.1. Introduction

simplified financial system

Figure 1: simplified financial system

It may be useful to introduce the subject of private sector banking by briefly describing the financial system, thus contextualizing banking. The financial system may be depicted simply as in Figure 1. It is essentially concerned with borrowing and lending and has six parts or elements (not all of which are visible in Figure 1):

• First: lenders (surplus economic units) and borrowers (deficit economic units), i.e. the non-financial-intermediary economic units that undertake lending and borrowing. They may also be called the ultimate lenders and borrowers (to differentiate them from the financial intermediaries who do both). Lenders try and earn the maximum on their surplus money and borrowers try and pay the minimum for money borrowed.

• Second: financial intermediaries, which intermediate the lending and borrowing process; they interpose themselves between the ultimate lenders and borrowers and endeavour to maximise profits from the differential between what they pay for liabilities (borrowings) and earn on assets (overwhelmingly loans). In the case of the banks this is called the bank margin. Obviously, they endeavour to pay the least on deposits and earn the most on loans. (This is why you must be on your guard when they make you an offer for your money or when they want to lend to you.)

• Third: financial instruments, which are created to satisfy the financial requirements of the various participants. These instruments may be marketable (e.g. treasury bills) or non-marketable (e.g. a utilised bank overdraft facility).

• Fourth: the creation of money when demanded. As you know banks (collectively) have the unique ability to create their own deposits (= money) because we the public generally accept their deposits as a means of payment.

• Fifth: financial markets, i.e. the institutional arrangements and conventions that exist for the issue and trading (dealing) of the financial instruments.

• Sixth: price discovery, i.e. the price of shares and the price of debt (the rate of interest) are "discovered", i.e. made and determined, in the financial markets. Prices have an allocation of funds function.

We need to present you with a little more information on these six elements.

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