Finance - III
Banks and Other Financial Institutions
3 Jan 2025
Financial intermediation
While individuals can invest directly in the securities of business firms and government units, most individuals invest indirectly through financial institutions that do the lending and investing for them. Financial intermediation is the process by which individual savings are accumulated in depository institutions, and, in turn, lent or invested.
Financial intermediaries may be classified into four major categories:
The banking system
We can distinguish between commercial banks, which accept deposits, make loans, and issue check-writing accounts, and investment banks, which help businesses raise capital by issuing securities in the primary market. This distinction was introduced in the US by the Glass-Steagall Act of 1933, but was later repealed by the Gramm-Leach-Bliley Act of 1999. Today, universal banks exist that combine both commercial and investment banking functions.
The six key functions of banks are:
Banks provide a safe place for individuals and businesses to deposit their money. Savers, who want to earn a return on their savings, can deposit their money in a bank and earn interest on it. Banks, in turn, lend this money to borrowers who need funds to finance their projects or businesses. Whenever the saver wants to withdraw the money, they usually write a check or use an ATM card to access their account. When this happens, the bank must ensure that the funds are available and that the check is valid. Thus, banks play a crucial role in the economy by facilitating the flow of funds from savers to borrowers, and also by providing a safe and efficient means of transferring money between individuals and businesses.
Historical development of the US banking system
We can look at the historical development of the US banking system to understand how and why it has evolved over time. Here is a quick overview:
Regulation of the banking system
A number of laws have been passed in the US to regulate the banking system.
Bank charters
Before a bank can open its doors for business, it must obtain a charter from some state authority. The US uses a dual banking system, where banks can be chartered by either the federal government or by state governments. Federally chartered banks must be members of both the Federal Reserve System and the Federal Deposit Insurance Corporation (FDIC), though most state banks are also members of the FDIC. Both state and federally chartered banks are subject to various regulations and oversight by state and federal agencies. For instance, reserve requirements must be met by both.
Branched banking
Banks are subject to different branching laws depending on how much they branch. Unit banks are banks that operate from a single location. Limited branch banks are allowed to open a limited number of branches within a specific geographic area. Statewide branching allows banks to open branches anywhere within the state. Branched banks are less likely to fail than unit banks, as they can diversify their risks across different locations. Consumers also benefit from branched banks, as they can access banking services more easily.
Bank holding companies
Banks may be owned by investors, or they may be part of a holding company. A holding company owns and controls a group of companies, which may include banks, insurance companies, and other financial institutions. Holding companies do not necessarily engage in banking activities themselves, but they are subject to regulation. In the US, for instance, the Bank Holding Company Act of 1956 requires that any company that controls a bank must register as a bank holding company with the Federal Reserve Board.
Bank balance sheets
A bank's balance sheet is a snapshot of its financial position at a given point in time. It shows the bank's assets, liabilities, and equity.
The principal assets of a bank are: cash, securities, loans, and other fixed assets (such as buildings and equipment).
Banks hold vault cash to meet the cash demands of their customers. Although the amount of cash deposited roughly equals the amount of cash withdrawn, banks must hold some cash in reserve to meet unexpected withdrawals. For instance, a large account holder may withdraw all their funds at once, or a series of withdrawals may occur simultaneously due to a bank run. Some banks keep their deposits with other correspondent banks, to speed up the clearing process. Banks are also required to hold a certain amount of cash at the Federal Reserve Bank, to meet reserve requirements.
Banks also hold securities issued by other entities. They include debt securities issued by some government entities, or investments in mutual funds or other financial institutions.
The most important asset on a bank's balance sheet is its loans. For example, mortgages are secured loans that are backed by real estate. Banks also offer commercial loans to businesses. The prime rate is the interest rate charged by banks for short-term unsecured loans to their most creditworthy customers. Less qualified borrowers are usually charged a higher rate. For short-term loans, the interest is often paid along with the principal when the loan matures. With a discount loan, the interest is deducted from the principal when the loan is made (the borrower receives less than the face value of the loan). Discount loans are slightly more expensive because the borrower receives less money upfront.
The major liabilities of a bank are deposits and borrowed funds. When a customer deposits money in a bank, the bank issues a certificate of deposit, which indicates an obligation to pay the customer the amount deposited (plus interest, depending on the type of account). CDs can be traded in the secondary market. Banks also borrow funds from other banks, usually short-term, either to meet their reserve requirements or to lend to other customers. Other liabilities include the bank's own debt, as well as taxes, interest, and any wages owed to employees.
The difference between a bank's assets and liabilities is its equity. Equity is the bank's net worth, or the amount of money that would be left if all the bank's assets were sold and all its liabilities were paid off. Equity is also known as the bank's capital, and it serves as a cushion against losses. If a bank's assets fall in value, its equity will also decrease. If the bank's equity falls below a certain level, the bank may be required to raise more capital or sell off assets to meet its obligations.
Bank management
Banks are managed to make a profit for their owners. However, there is a trade-off between risk and return. Generally speaking, profitability can be increased by taking on more risk, but at the expense of safety. Bank depositors, although they are protected by the FDIC, may be concerned about the safety of their deposits when a bank takes on too much risk.
Banks fail in two ways: they can become insolvent, or they can become illiquid. A bank becomes insolvent when its liabilities exceed its assets. On paper, an insolvent bank has failed, but it may continue to operate as long as it can (somehow) meet its obligations to depositors. A bank that is unable to meet depositor withdrawals and other obligations is said to be illiquid.
Liquidity management
Liquidity risk is the likelihood that the bank will not have enough to meet depositor withdrawal demands and/or other obligations. Lower liquidity risk is associated with higher bank safety, and (generally) lower profitability. Thus, the primary role of the bank manager is to balance the bank's liquidity needs with its profitability goals. Banks hold cash assets to stay liquid, but these assets do not earn interest, and so they are not profitable. Instead, they earn interest on loans and securities, but these assets are not as liquid as cash. There is a conversion cost that has to be paid in order turn them into cash.
A bank's primary reserve includes its own cash, and its deposits held at other banks. Some deposits are also held at the Federal Reserve Bank. Cash items that are in the process of collection are also considered to be part of the bank's primary reserve. Secondary reserves include short-term securities that can be sold quickly. One example is Treasury bills. These securities are not as liquid as cash, but they earn interest.
Bank loans earn more interest than securities, but they are less liquid, and also riskier (a borrower may default on a loan). Banks combat credit risks by charging higher interest rates to riskier borrowers, and by requiring collateral. Banks also invest in other longer-term securities, which are riskier (though not as risky as loans), but provides more return. We can summarize the trade-off between liquidity and profitability of various bank assets as follows, in order of increasing profitability:
Bank managers can also stay liquid by managing its liabilities. Certain liabilities are very sensitive to interest rate changes. A bank manager can exploit this by borrowing short-term funds when interest rates are low, or issuing commercial papers (unsecured promissory notes) to businesses when interest rates are high. Banks may also borrow federal funds from other banks, if the prevailing interest rates are favorable. Other financial instruments such as time and savings deposits do not receive as much focus as they are less sensitive to interest rate changes (i.e. there is no space for arbitrage).
Capital management
Banks also need to remain solvent (have more assets than liabilities) by maintaining adequate capital. One way banks become insolvent is through excessive credit risk. When borrowers default on their loans, the bank's assets decline by the amount of that loan. Another reason banks become insolvent is through interest rate risk, i.e. risks associated with changing market interest rates. For example, when a bank purchases long-term bonds at some fixed interest rate, and market interest rates rise later, the value of their already-purchased bonds will decline, because similar bonds are now available at a higher interest rate, i.e. that generate more return.
Since bank capital represents a cushion against losses from credit risk and interest rate risk, bank regulators require banks to maintain a certain level of capital to remain solvent. One example is capital ratio requirements, where the ratio of a bank's capital to its assets must be above a certain threshold. Banks that do not meet these requirements may be required to submit a plan indicating how they intend to raise more capital, or they may be required to restructure their balance sheets, replace their managers and directors, or even be shut down.
During the financial crisis of 2007-2008, underperforming mortgages and mortgage-backed securities were categorized as troubled or toxic assets, and banks that held these assets were instructed to write down their value, resulting in capital ratios falling below the required levels. Basel III was introduced in 2010 requiring international banks to maintain a higher capital ratio to protect against future losses.