Lending activities can be performed either directly or indirectly through capital markets. Due to their importance in the financial stability of a country, banks are highly regulated in most countries. Most nations have institutionalized a system known as fractional reserve banking under which banks hold liquid assets equal to only a portion of their current liabilities. In addition to other regulations intended to ensure liquidity, banks are generally subject to minimum capital requirements based on an international set of capital standards, known as the Basel Accords.
Banking in its modern sense evolved in the 14th century in the prosperous cities of Renaissance Italy but in many ways was a continuation of ideas and concepts of credit and lending that had their roots in the ancient world. In the history of banking, a number of banking dynasties – notably, the Medicis, the Fuggers, the Welsers, the Berenbergs, and the Rothschilds – have played a central role over many centuries. The oldest existing retail bank is Banca Monte dei Paschi di Siena, while the oldest existing merchant bank is Berenberg Bank.
The business of banking is not defined by statute but by common law.
The bank acts as a payment agent by conducting checking or current accounts for customers, paying checks drawn by customers in the bank, and collecting checks deposited to customers’ current accounts. Banks also enable customer payments via other payment methods such as Automated Clearing House (ACH), wire transfers and automated teller machines (ATMs).
Banks borrow money by accepting funds deposited on current accounts, by accepting term deposits, and by issuing debt securities such as banknotes and bonds. Banks lend money by making advances to customers on current accounts, by making installment loans, and by investing in marketable debt securities and other forms of money lending.
Banks provide different payment services, and a bank account is considered indispensable by most businesses and individuals. Non-banks that provide payment services such as remittance companies are normally not considered as an adequate substitute for a bank account.
Banks can create new money when they make a loan. New loans throughout the banking system generate new deposits elsewhere in the system. The money supply is usually increased by the act of lending, and reduced when loans are repaid faster than new ones are generated.
Range of Activities
Activities undertaken by banks include:
– personal banking
– corporate banking
– investment banking
– private banking
– transaction banking
– consumer finance
– foreign exchange trading
– commodity trading
– trading in equities
– futures and options trading, and
– money market trading.
A bank can generate revenue in a variety of different ways including interest, transaction fees and financial advice. Traditionally, the most significant method is via charging interest on the capital it lends out to customers. The bank profits from the difference between the level of interest it pays for deposits and other sources of funds, and the level of interest it charges in its lending activities.
This difference is referred to as the spread between the cost of funds and the loan interest rate. Historically, profitability from lending activities has been cyclical and dependent on the needs and strengths of loan customers and the stage of the economic cycle. Fees and financial advice constitute a more stable revenue stream and banks have therefore placed more emphasis on these revenue lines to smooth their financial performance.
Recently, American banks have taken many measures to ensure that they remain profitable while responding to increasingly changing market conditions.
– First, this includes the Gramm–Leach–Bliley Act, which allows banks again to merge with investment and insurance houses. Merging banking, investment, and insurance functions allows traditional banks to respond to increasing consumer demands for “one-stop shopping” by enabling cross-selling of products (which, the banks hope, will also increase profitability).
– Second, they have expanded the use of risk-based pricing from business lending to consumer lending, which means charging higher interest rates to those customers that are considered to be a higher credit risk and thus increased chance of default on loans. This helps to offset the losses from bad loans, lowers the price of loans to those who have better credit histories, and offers credit products to high risk customers who would otherwise be denied credit.
– Third, they have sought to increase the methods of payment processing available to the general public and business clients. These products include debit cards, prepaid cards, smart cards, and credit cards. They make it easier for consumers to conveniently make transactions and smooth their consumption over time (in some countries with underdeveloped financial systems, it is still common to deal strictly in cash, including carrying suitcases filled with cash to purchase a home).
However, with the convenience of easy credit, there is also increased risk that consumers will mismanage their financial resources and accumulate excessive debt. Banks make money from card products through interest charges and fees charged to cardholders, and transaction fees to retailers who accept the bank’s credit and/or debit cards for payments.
Capital and Risk
Banks face a number of risks in order to conduct their business, and how well these risks are managed and understood is a key driver behind profitability, and how much capital a bank is required to hold. Bank capital consists principally of equity, retained earnings and subordinated debt.
After the 2007-2009 financial crisis, regulators force banks to issue Contingent Convertible Bonds (CoCos).These are hybrid capital securities that absorb losses in accordance with their contractual terms when the capital of the issuing bank falls below a certain level. Then debt is reduced and bank capitalization gets a boost. Owing to their capacity to absorb losses, CoCos have the potential to satisfy regulatory capital requirement.
Some of the main risks faced by banks include:
– Credit risk: risk of loss arising from a borrower who does not make payments as promised
– Liquidity risk: risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit)
– Market risk: risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors
– Operational risk: risk arising from execution of a company’s business functions
– Reputational risk: a type of risk related to the trustworthiness of business
– Macroeconomic risk: risks related to the aggregate economy the bank is operating in
The capital requirement is a bank regulation, which sets a framework within which a bank or depository institution must manage its balance sheet. The categorization of assets and capital is highly standardized so that it can be risk weighted.
The economic functions of banks include:
– Issue of money, in the form of banknotes and current accounts subject to check or payment at the customer’s order. These claims on banks can act as money because they are negotiable or repayable on demand, and hence valued at par. They are effectively transferable by mere delivery, in the case of banknotes, or by drawing a check that the payee may bank or cash.
– Netting and settlement of payments – banks act as both collection and paying agents for customers, participating in interbank clearing and settlement systems to collect, present, be presented with, and pay payment instruments. This enables banks to economize on reserves held for settlement of payments, since inward and outward payments offset each other. It also enables the offsetting of payment flows between geographical areas, reducing the cost of settlement between them.
– Credit intermediation – banks borrow and lend back-to-back on their own account as middle men.
– Credit quality improvement – banks lend money to ordinary commercial and personal borrowers (ordinary credit quality), but are high quality borrowers. The improvement comes from diversification of the bank’s assets and capital which provides a buffer to absorb losses without defaulting on its obligations. However, banknotes and deposits are generally unsecured; if the bank gets into difficulty and pledges assets as security, to raise the funding it needs to continue to operate, this puts the note holders and depositors in an economically subordinated position.
– Asset liability mismatch / maturity transformation – banks borrow more on demand debt and short term debt, but provide more long term loans. In other words, they borrow short and lend long. With a stronger credit quality than most other borrowers, banks can do this by aggregating issues (e.g. accepting deposits and issuing banknotes) and redemptions (e.g. withdrawals and redemption of banknotes), maintaining reserves of cash, investing in marketable securities that can be readily converted to cash if needed, and raising replacement funding as needed from various sources (e.g. wholesale cash markets and securities markets).
– Money creation / destruction – whenever a bank gives out a loan in a fractional-reserve banking system, a new sum of money is created and conversely, whenever the principal on that loan is repaid money is destroyed.
Types of Banks
– Commercial banks: the term used for a normal bank to distinguish it from an investment bank.
– Community banks: locally operated financial institutions that empower employees to make local decisions to serve their customers and the partners.
– Community development banks: regulated banks that provide financial services and credit to under-served markets or populations.
– Land development banks: The special banks providing long-term loans are called land development banks (LDB).
– Credit unions or co-operative banks: not-for-profit cooperatives owned by the depositors and often offering rates more favorable than for-profit banks. Typically, membership is restricted to employees of a particular company, residents of a defined area, members of a certain union or religious organizations, and their immediate families.
– Postal savings banks: savings banks associated with national postal systems.
– Private banks: banks that manage the assets of high-net-worth individuals.
– Offshore banks: banks located in jurisdictions with low taxation and regulation. Many offshore banks are essentially private banks.
Savings bank: they differ from commercial banks by their broadly decentralized distribution network, providing local and regional outreach, and by their socially responsible approach to business and society.
– Building societies: institutions that conduct retail banking.
– Ethical banks: banks that prioritize the transparency of all operations and make only what they consider to be socially responsible investments.
– Investment banks underwrite (guarantee the sale of) stock and bond issues, trade for their own accounts, make markets, provide investment management, and advise corporations on capital market activities such as mergers and acquisitions.
– Merchant banks were traditionally banks which engaged in trade finance. The modern definition, however, refers to banks which provide capital to firms in the form of shares rather than loans. Unlike venture caps, they tend not to invest in new companies.
Other Types of Banks
– Central banks are normally government-owned and charged with quasi-regulatory responsibilities, such as supervising commercial banks, or controlling the cash interest rate. They generally provide liquidity to the banking system and act as the lender of last resort in event of a crisis.
– Islamic banks adhere to the concepts of Islamic law. This form of banking revolves around several well-established principles based on Islamic canons. All banking activities must avoid interest, a concept that is forbidden in Islam. Instead, the bank earns profit (markup) and fees on the financing facilities that it extends to customers.
There has been huge reductions to the barriers of global competition in the banking industry. Increases in telecommunications and other financial technologies, such as Bloomberg, have allowed banks to extend their reach all over the world, since they no longer have to be near customers to manage both their finances and their risk. The growth in cross-border activities has also increased the demand for banks that can provide various services across borders to different nationalities. However, despite these reductions in barriers and growth in cross-border activities, the banking industry is nowhere near as globalized as some other industries. In the US, for instance, very few banks even worry about the Riegle–Neal Act, which promotes more efficient interstate banking. In the vast majority of nations around the globe the market share for foreign owned banks is currently less than a tenth of all market shares for banks in a particular nation. One reason the banking industry has not been fully globalized is that it is more convenient to have local banks provide loans to small business and individuals. On the other hand, for large corporations, it is not as important in what nation the bank is in, since the corporation’s financial information is available around the globe.
The changing economic environment has a significant impact on banks and thrifts as they struggle to effectively manage their interest rate spread in the face of low rates on loans, rate competition for deposits and the general market changes, industry trends and economic fluctuations. It has been a challenge for banks to effectively set their growth strategies with the recent economic market. A rising interest rate environment may seem to help financial institutions, but the effect of the changes on consumers and businesses is not predictable and the challenge remains for banks to grow and effectively manage the spread to generate a return to their shareholders.
Banks also face a host of other challenges such as aging ownership groups. Many banks’ management teams and board of directors are aging. Banks also face ongoing pressure by shareholders, both public and private, to achieve earnings and growth projections. Regulators place added pressure on banks to manage the various categories of risk. Banking is also an extremely competitive industry. Competing in the financial services industry has become tougher with the entrance of such players as insurance agencies, credit unions, check cashing services, credit card companies, etc.
As a reaction, banks have developed their activities in financial instruments, through financial market operations such as brokerage and have become big players in such activities.
Another major challenge is the aging infrastructure, also called legacy IT. Backend systems were built decades ago and are incompatible to new applications. Fixing bugs and creating interfaces costs huge sums, as knowledgeable programmers become scarce.
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