Banks and Other Financial Institutions
Chapter 3, Melicher & Norton, Introduction to Finance, 17th Edition
1 June 2024
Banks and Other Financial Institutions
Banks and other financial institutions play a key role in the financial system by accumulating savings and lending or investing these savings. They provide means for individuals to put their savings to work through various financial instruments. There are four broad categories of financial
Depository institutions accept deposits from individuals and then lend these deposits to other individuals or businesses. Commercial banks are the most common type of depository institutions. Other noncommercial bank depository institutions include savings banks, savings and loan associations, and credit unions.
Contractual savings institutions obtain funds from individuals and invest them in various securities. Insurance companies and pension funds are examples of contractual savings institutions. Insurance companies collect premiums from policyholders, and then provide benefits to policyholders when they file claims. Pension funds collect contributions from employees and employers, and then provide benefits to employees when they retire.
Securities firms perform several financial functions. Some are active in the savings-investment process, while others focus on the marketing and trading of securities. Investment companies issue shares in their firms and use the pooled proceeds to invest in various corporate and government securities. Other securities firms, on the other hand, are less involved in the gathering of savings. Investment banking firms and brokerage firms are examples of securities firms that market and sell securities directly to individuals, rather than pooling the proceeds and investing them in securities.
Finance firms focus on providing loans to individuals and businesses. Finance companies provide loans directly to individuals to aid in the purchase of durable goods such as cars and furniture. Mortgage companies help individuals finance the purchase of homes by offering mortgage loans.
A bank falls under the category of depository institutions. Banks can appear in the form of commercial banks, investment banks, and universal banks. Commercial banks are the most common type of bank, and they offer a wide range of services, such as checking and savings accounts, and loans. An investment bank, on the other hand, focuses on helping corporations raise capital by issuing and selling securities. Universal banks offer both commercial and investment banking services.
Banks and the banking system in general perform five key functions:
Banks provide a safe place for individuals to deposit their money, and then put these deposits to work by lending them to other individuals or businesses. Banks also play a key role in the payment process by issuing deposit money, which can be transferred to other individuals or businesses through checks or electronic transfers.
Before a bank is allowed to operate, it has to obtain a charter from the government. Most banks operate branches in different locations, which makes it easier for customers to access their services. Branch banking also allows banks to be more resilient to economic downturns: one branch failing does not cause the entire banking chain to fail. Some banks are owned by a holding company, which is a corporation that owns a a number of subsidiary companies.
The bank balance sheet is a financial statement that shows the assets, liabilities, and equity of a bank at a specific point in time.
The major assets of a bank are cash, securities, and loans. Banks need to hold some cash to meet any unexpected surge in withdrawals by depositors. Banks also hold various securities issued by the government or corporations. The most important asset of a bank is loans, which generate interest income for the bank. The prime rate is the interest rate that banks charge their most creditworthy customers.
The major liabilities of a bank are deposits, which are the funds that depositors have entrusted to the bank. The major source of equity for a bank is the capital contributed by the owners of the bank. The capital of a bank is used to absorb any losses that the bank may incur, and to accomodate expansion of the bank's operations.
Banks are managed to ensure that they are profitable. Profitability objectives, however, must be balanced with the need to maintain liquidity and solvency. Liquidity is the ability of a bank to meet depositor withdrawals and to pay off its liabilities when they come due. Solvency is the ability of a bank to keep the value of its assets greater than the value of its liabilities. A bank fails when it is unable to meet withdrawal and payment demands.
Banks hold cash to meet unexpected withdrawals by depositors. However, holding too much cash can reduce the profitability of the bank, since cash does not earn any interest. A bank's primary reserves are the cash that it holds in its vaults and which are immediately available to meet withdrawal demands. Banks also hold secondary reserves, which are short-term, low-risk securities that can be easily converted to cash if needed.
Recall that the most important asset of a bank is loans, which generate interest income for the bank. However, these loans are less liquid and have a higher risk, since the borrower may default on the loan. Credit (default) risk is the risk that the borrower will not repay the loan. Banks can charge higher interest rates to borrowers with higher credit risk, who are more likely to default on the loan. Banks also face interest rate risk, which is the risk that the value of the bank's assets will fall if interest rates rise. For example, if a bank has purchased a bond with a fixed interest rate, and interest rates rise, the demand for the existing bond will fall, since investors can now purchase new bonds with higher interest rates. Banks protect themselves from credit and interest rate risk by holding an adequate amount of capital.