The first recorded history of banking type arrangements came from Mediterranean Europe approx 300 BC. Temples kept the valuables and gold (main medium of exchange) of people as temples were less likely to be invaded and plundered by thieves. This then evolved into lending this wealth out to people who were needed money for consumption of business purposes. This evolved in the 17/18 centuries to transaction type services to facilitate trade payments. Reserve or central banks emerged in the 20 th century to control the supply of money in a country and this enabled rapid expansion of trade due to expansion of the money supply.
During the latter part of the 20th century, rapid improvements in technology and communication has dramatically changed banking operations and enabled them to cross borders, grow large in size and become even more crucial in an economy. Banking today is widespread and an important part of the exchange of good, services and wealth in most economies. However the key activities of banks have changed very little during history. They act as financial intermediaries: “acting as a repository for the savings of those who have surplus funds and as a source of funds for those who want to borrow” (New Zealand Bankers’ Association, 2006).
This is a very simple explanation but does not adequately explain reasons why individuals would not just do this without the help of an intermediary, like a bank. I will be using Fama’s theory and his 1980 article ‘Banking in the Theory of Finance’ to expand on these reasons. Fama theorises that banks perform two main functions: a portfolio management and a transaction function. Portfolio Function Brigham & Ehrhardt describes a portfolio as “a group of individual assets held in combination. An asset that would be relatively risky if held in isolation may have little, or even no, risk if held in a well-diversified portfolio (Brgham, 2008)”.
Banks essentially gather a pool of cash from savers (depositors), which become liabilities to the bank, and lend out the cash to a diversified mix of borrowers, which become assets to the bank. 1 Christine Copland 12166346 If a saver was to lend money directly to the borrower, this creates significant undiversified risk to both parties as the saver is wholly reliant on the one borrower to return their funds, with interest, on time and the borrower is wholly reliant on the one saver to not demand their money back at an inconvenient time.
This direct finance scenario also poses two further issues for the saver: their money is tied up and unable to be accessed at will (illiquid), and they generally do not have the skill and resources to assess if the borrower is creditworthy and then monitor this creditworthiness over the term of the loan. The direct finance scenario also poses two further issues for the borrower: the amounts of money will probably not big enough or for long enough for their project. The bank overcomes all these issues by acting as a financial intermediary between borrowers and savers by transforming the size and liquidity of money.
Savers generally want their money liquid as they need the money to meet their living expenses in the short term and also always anticipate the rate of return on their deposited money (interest) will increase in the future so do not wish to be locked in to a lower rate of return. Borrowers, in contrast, usually need funding for illiquid purposes (business, property) and for larger amounts. They also fear that interest rates will increase and wish to lock in an interest rate to limit the effects of this.
In summary: depositors generally have small amounts of liquid funds at variable interest rates; borrowers generally want large amounts of funds on fixed rate terms for illiquid assets. Banks transform a portfolio of small liabilities to large assets and assess and monitor the safety of the assets on behalf of the depositors (delegated monitoring). This transformation enables parties in an economy to smooth out their consumptions patterns – borrowing when they are short of funds, saving when they have excess funds.
Consumption smoothing also works over very long periods as generally individuals and businesses have a cash deficit early in their life and a cash surplus later in their life. This smoothing enables an economy to function efficiently and, according to R Levine (1997) “a growing body of empirical analyses” “demonstrate a strong positive link between the functioning of the financial system and long-run economic growth”. Part of this portfolio function is monitoring asset quality (ongoing ability of borrowers to repay debt) to ensure that both depositors can be repaid and that losses do not eliminate profits of the bank.
In practice this is done in varying ways depending on the size of the 2 Christine Copland 12166346 debt, Basel III framework and agreements with the Reserve Bank. Large borrowers are assessed and monitored on an individual basis quite intently, quarterly or at least annually if no distress warning signs are shown, using a combination of the financial statements of the business (key performance ratios) and the behaviour of their account conduct (adherence to approved limits, etc). Their risk to their bank, and therefore their overall riskiness of the bank’s loan portfolio, is individually rated and capital allocated accordingly.
The model used to assess this will fit within the Basel III framework and approved by the Reserve Bank. A perceived increase in riskiness will mean the bank will move to either counsel the customer to change whatever is causing the increased risk or exit the customer. Retail and small business customers are monitored and assessed on a portfolio basis as a group using largely behavioural indicators. Again, the models and indicators used are within the Basel III framework and approved by the Reserve Bank.
Customers that have large deposits and stay within their approved limits or cash held will score low risk. Conversely, customers that continually exceed approved limits or deposit little cash will score high risk. Holding too many high risk clients will negatively affect a bank’s capital holding requirements (more capital required to be held than other banks) and their cost of funds will be higher (they will need to pay higher interest to attract deposit or bond funding). Also their administrative costs in monitoring individual customers to limit losses will be higher.
To maintain liquidity, as loan assets are by nature very illiquid as noted previously, banks also hold assets in the form of highly liquid cash and securities able to be sold or pledged to central/reserve banks very quickly or same day. On the deposit side, banks also need to hold a diverse portfolio of liabilities. If, for example, they only held deposits from very small depositors, a bank would need to hold a lot of this as liquid cash as this money would be moved in and out of the bank frequently as those depositors consumed their cash for daily living expenses.
On the flip side, holding deposits from only a few large depositors would also pose a serious liquidity risk if the funds were withdrawn all at once, it would be hard to find replacement funds. So banks obtain their deposit liabilities from a mix of investor types and location, thereby they can diversify their mix of amounts, terms, rates and currency, thereby reducing the risk. ANZ Bank notes in their 2012 Annual Report that they hold “a diversified portfolio of cash and high credit quality securities that may be sold or pledged to provide same-day liquidity.
This portfolio 3 Christine Copland 12166346 helps protect the Group’s liquidity position by providing cash in a severely stressed environment”. Banks’ function as a portfolio holder of diversified assets and liabilities is reflected in their financial statements. The funding composition of ANZ Banking Group is broken down in their 2012 Annual Report “Funding Composition”. This clearly shows the bank holds funds from wholesale and retail investors, bond holders, both in New Zealand and overseas, loans to ANZ, commercial paper and from other financial institutions.
On the financial asset side (loans) minimal information is provided, except on a product basis (overdraft, housing loan, non-housing loan, etc). This will be commercially sensitive and control over diversification will be managed internally by a bank’s business writing strategy to ensure there is not ‘too much’ exposure to one type of customer (geographic, socio-economic, industry, collateral, etc). Transaction Function According to Fama, the other main function of a bank is the transaction function, “banks provide an accounting system of exchange in which transfers of wealth are carried out with bookkeeping entries” (Sinkey, 1992).
Banks used to issue their own currency notes, as a claim against cash held by the bank on a depositor’s behalf. This is now solely the domain of a country’s reserve bank but banks act as the distribution system for printed notes and coins. They also control and operate the clearing and settlement functions for electronic transactions and inter-bank transfers. They also turn a deposit into a much larger amount of deposits and loans through fractional banking. They do this by providing the means for people to exchange or transfer currency between themselves, without the need for the physical exchange of cash.
Each dollar deposited can be reprocessed by lending out, spending, receiving and redepositing many times in a day. All exchanges are accounting debit or credit entries however all currency transactions now occur via a bank. “Generally, the banking system is the major source of liquidity which enables buyers and sellers of goods and services to settle payments in a smooth and continuous manner. Without this financial infrastructure, the scope for an economy to progress beyond a subsistence level is limited” (NZBA 2006).
Furthermore, banks have continually improved the potential speed of exchanges of money, through technology and collaboration, so money (movement of 4 Christine Copland 12166346 capital), and therefore wealth, is spread around all parties in the economy (e. g. pretty much everyone) faster, making everyone wealthier in the process. With any form of payment however, there needs to be trust between the parties that fair value is being exchanged. In the case of cash, the buyer and seller both accept that physical cash holds a certain value and can be exchanged for goods or deposited to a bank.
This is despite the physical cash having no intrinsic value, being just paper. In the same way, electronic transactions need the general trust and acceptance of being as good as cash. A shop owner needs to trust that an EFTPOS or credit card transaction will process money into their account, so they can immediately hand over the good. Receivers of cheques also need to trust that the cheque will be paid by the bank it is drawn on, although this trust has eroded in recent times due to fraudulent use of cheques. Bank issued cheques are now considered as good as cash for one off large payments.
This trust and acceptance of electronic and paper transactions enables commerce to operate the same as using cash. This transaction function is now a key part of any banks day-to-day operations and fees from it an important and growing income stream. Banks generally now have more staff devoted to promoting, receiving, processing and monitoring domestic and international transactions than they do lending staff. This is reflected in non-interest income (or other operating income) increasing steadily over the past two decades in New Zealand (Reserve Bank of New Zealand 2013).
It is also reflected in the trading derivative instruments section of a bank’s financial statements, in particular foreign exchange contracts and commodity contracts, which are instruments held to facilitate trade for customers. Banks also facilitate international trade by having agreements or arrangements with overseas banks (correspondent banks) to exchange foreign money and other trade guarantees such as letters of credit, which are designed to reduce risk to both parties by transferring it to the bank.
Again the role of trust in the transaction is important as customers must trust their bank and the banks must trust each other. “Without commercial banks, the international finance and import-export industry would not exist. Banks make possible the reliable transfer of funds and translation of business practices between different countries and different customs all over the world. Banking also serves as a worldwide barometer of economic health and business trends. ” (Chron 2013). 5 Christine Copland 12166346.
Conclusions: Banks operate as a portfolio manager, enabling depositors to diversify their risk and earn interest on their deposits, while delegating the monitoring of the underlying asset their funds are used for; while borrowers are able to access funds at the size and term they need but without the higher costs of direct finance. This reduces the risk to depositors, borrowers and the bank itself by diversifying both assets and liabilities across their books to maintain liquidity and maximise profits.
Banks also play an important role in economies by clearing and processing the transactions of its customers, allowing goods and services to be exchanged rapidly and efficiently and be at the forefront of innovation of wealth exchange methods. 6 Christine Copland 12166346 References New Zealand Bankers’ Association. (2006). Banking in New Zealand. Wellington: New Zealand Bankers’ Association. Fama, E. F. (1980). Banking in the Theory of Finance. North-Holland Publishing Company. Retrieved from http://www. bu. edu/econ/files/2012/01/Fama1-Banking-in-the-theory-of-finance1.
pdf Australia and New Zealand Banking Group Limited. (2012). Annual Report. Retrieved from http://media. corporate-ir. net/media_files/IROL/96/96910/2012AnnualReport. pdf Bhattacharya, S. (1993). Contemporary Banking Theory. Journal of Financial Intermediation 3, 2-50. Retrieved from http://apps. olin. wustl. edu/workingpapers/pdf/2006-06-005. pdf Brgham, E. F. (2008). Financial Management: Theory and Practice 12. Manson, OH: South-West Cengage Learning. Fama, E. F. (1980). Banking in the Theory of Finance. North-Holland Publishing Company.
Retrieved from http://www. bu. edu/econ/files/2012/01/Fama1-Banking-in-the-theory-of-finance1. pdf Hoggson, N. F. (1926). Banking Through the Ages. New York: Dodd, Mead & Company. Retrieved from http://ia700603. us. archive. org/9/items/bankingthroughag00hogg/bankingthroughag00hogg . pdf Houston Chronicle. (2013, April 14). Chron. Retrieved from http://smallbusiness. chron. com/rolecommercial-banks-international-business-733. html Levine, R. (June 1997). Financial Development and Economic Growth: Views and Agenda. Journal of Economic Literature, 720.
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In J. F. Sinkey, Commercial bank finance management (4th edition) (p. 92). Hoggson, N. F. (1926). Banking Through the Ages. New York: Dodd, Mead & Company. Retrieved from http://ia700603. us. archive. org/9/items/bankingthroughag00hogg/bankingthroughag00hogg . pdf 7 Christine Copland 12166346 Bhattacharya, S. (1993). Contemporary Banking Theory. Journal of Financial Intermediation 3, 2-50. Retrieved from http://apps. olin. wustl. edu/workingpapers/pdf/2006-06-005. pdf Payments NZ. (2013, April 13). Retrieved from http://www. paymentsnz. co. nz/home.