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1.4. Principles of banking

1.4.1. Introduction

The previous section presented the banking sector in the context of the financial system. This section goes a little further and covers:

• Fundamental issues in banking.

• Basic raison d'être for banks: information costs and liquidity.

• Broad functions of banks.

1.4.2. Fundamental issues in banking

Banks are unique financial intermediaries.4 They are the only intermediaries that intermediate between all ultimate lenders and borrowers and all other non-bank financial intermediaries. In this way they perform crucial functions, including providing the means of payments. In fact, they are such significant intermediaries that their very survival (particularly the large banks) is in the interests of the country; there exist social costs to their failure.

For this reason, banks are the most regulated intermediaries. In most countries the central bank regulates and supervises the banks, and they are obliged to have large departments and skilled persons to carry out this function. The banks are innovative and create new products continually, because of the competitive nature of banking, making the task of the supervisor challenging.

The hardware and software systems requirements of banks are sophisticated, not only because of the complex deals they undertake, but to cater for the strict and diverse reporting requirements of banks. This and the high capital resource requirements create substantial barriers to entry.

Banks exist because of the information costs they carry and because of the demand for liquidity by deposit clients. Banks earn their keep by the management of financial risks, and this is what differentiates them from other companies. Essentially, they are risk managers. According to Heffernan5, the "organisation of risk management within a bank is as important as the development of risk management techniques and instruments to facilitate risk management.... There is no such thing as a generic banking strategy. But banks need to be planning how, in the future, existing competitive advantage is going to be sustained and extended. The outlook for banks is optimistic, provided they can create, maintain, and sustain a competitive advantage in the products and services (old and new) they offer."

The main threat to banking is the securities markets. Many large, highly rated companies do not require the intermediation of banks to satisfy their borrowing requirements. Cognizant of this threat, many banks have are involved in the creation of marketable debt instruments, and hold many of these in portfolio.

The most unique function of banks is their money creating ability, under the guidance of the central bank, and the central bank uses the profit-maximising behaviour of banks to execute monetary policy. This is where interest rates have their genesis.

In summary:

• Banks are the only intermediaries that intermediate between all ultimate lenders and borrowers and all other financial intermediaries.

• They perform vital functions, including providing the means of payments.

• They are such significant intermediaries that their very survival (particularly the large banks) is in the interests of the country; there exist social costs to their failure.

• Banks are the most regulated and supervised financial intermediaries.

• The banks are innovative and create new products continually, because of the competitive nature of banking, making the task of the regulator / supervisor challenging.

• There exist substantial barriers to entry into banking - systems and capital.

• Banks earn their keep by offering liabilities which suit clients' financial requirements, and holding assets which represent the satisfied financial requirements of ultimate borrowers.

• Because the requirements of lenders / depositors and borrowers are so diverse, banks are exposed to diverse financial and other risks. The management of risk is at the core of banking, and this is what differentiates them from other companies.

• There is no such thing as a generic banking strategy.

• The main threat to banking is the securities markets.

• The most unique function of banks is their money creating ability; by extending new loans they create new deposits (= money). The central bank plays the role of referee in this respect.

• Interest rates have their genesis in the relationship between the private sector banks and the central bank.

 
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