Banks as a Kind of Financial Intermediary - Assignment Example

Introduction Financial intermediation is one of the most critical elements of modern economics as it helps to cater for widespread needs of providinga channel between those who want to save and those who want to spend therefore the link between the two is filled up by various institutions which provide a sort of formal market place for both to transact with each other. It is argued that financial intermediation is the process which allows the process of investment and savings to take place. Financial intermediaries are firms who borrow from those who want to save and lend the same to those who want funding to finance themselves. (Winton, 2002). However, with the modern financial innovation, the role played by banks, in a financial system, has greatly increased their overall importance in modern economies. Banks are one of those institutions through which the process of financial intermediation takes place because banks offer a fundamental mechanism to channel the sources for external funding for those in needs of funds and those who wants to save. However, since banks are major source of external funding therefore banks not only play a greater part in financial intermediation but also indirectly monitor the firms therefore also attempt to monitor the process of corporate governance, especially when firms face financial distress.(Winton,2002). Thus “banks are one kind of financial intermediary” due to their perceived role within modern financial system. This paper will attempt to analyse and explain the above quoted statement and discuss what make banks so special and how they contribute towards the process of financial intermediation as a whole. What is Financial Intermediation? By definition, financial intermediary is “an entity that intermediate between providers and users of financial capital” (Greenbaum & Thankor, 2007). Though the definition may seem simple but it indicates a multifaceted nature of financial intermediation because the word financial intermediation itself encompasses a much larger significance and magnitude. As we will be discussing in following sections that the financial intermediaries especially banks perform different functions therefore the process of financial intermediation. As manufacturing firm holds inventories for resell purposes, similarly financial intermediaries hold contractual rights over the assets of their clients. For example, the liabilities of the financial intermediaries especially banks include deposits as well as equity and debt acquired by them. By far, for any bank’s balance sheet carries deposits as the largest single liability whereas the equity contributed by the shareholders as well as debt instruments issued by financial institutions are other major liabilities. On the asset side, most of the assets comprises of the lending made to the businesses, individuals, governments etc. besides holding other real assets. However, what is most important with financial intermediaries is the fact that they also hold contingent claims against the assets they financed i.e. by creating different types of legal rights such as mortgages, charges etc over those assets therefore technically, the assets of the financial intermediaries are backed up or securitized by the real assets. Since bank is a depository financial intermediary therefore by its nature, a bank is highly leveraged in nature therefore a very small return make greater impact as return on equity. What make banks special? The traditional view that is being held by many regarding what actually banks do is based on the assumption that banks provide a platform for those who wish to save and who wish to borrow. In this regard, the basic assumption therefore is the fact that the banks are intermediaries which provide a mechanism to facilitate the receipt and payment mechanism. According to James Tobin, the traditional or old view of the banks was that the banks tend to create multiple deposits and credits as loan granted by one bank ends up being the deposit of another bank therefore what banks traditional done was that they borrowed money, in the form of deposits, and lend the same usually to the business, individuals, governments, other financial institutions etc.(Tobin,1987). Thus the conventional functions of banks include lending and deposit taking however during this process of deposit taking and lending, they also perform different other functions. Such functions include offering checking account facilities to deposit holders besides offering other facilities. However, what is most important is the fact that banks contributed towards creation of money i.e. by offering the growth in deposits without actually printing new currency? (Kwast, 2007) Banks also serve as the commercial agents on behalf of their customer. This role is especially important when banks perform the role of financial intermediaries in an international setting between international buyers and sellers by providing a mechanism to ensure timely payments of trade obligations. Apart from performing the basic role of lending and borrowing, banks, as largest financial intermediaries also play following roles Mobilization of savings Banks play a critical role in mobilizing the savings within an economy. Since their basic role also includes taking deposits therefore banks by offering various deposits schemes tend to procure more deposits. By offering high interest rates, banks induce general public to increase their propensity to save. Since banks work, as one of their primary functions, seeks deposits and offer checking account services to its deposit holders therefore in order to attract more deposits, they offer more services such as high interest rates on time and demand deposits, offering ATM cards, online banking facilities, fund transfer etc. all these services are basically delivered in order to induce savers to increase their rate of savings. Mobilization of savings is also important because of the fact that the banks lend that savings to business, individuals etc at higher rates i.e. the rate greater than they offer to their deposit holders. The basic earnings of any bank come through this differential spread between the savings and the lending rates therefore mobilization of savings not provide them an opportunity to earn but also help them to pool essential excess resources within an economy to help them to channel towards their most efficient use. Maturity Intermediation Maturity intermediation is a process where a bank attempts to match the maturity preferences of different players. Maturity intermediation is basically a process where the short term and long term funding needs of borrowers are met through the short term and long term deposits. “The commercial bank by issuing its own financial claims in essence transforms a longer term asset into a short term one by giving the borrower a loan of the length of time sought and investor/deposits a financial asset for the desired investment horizon. This function of a financial intermediary is called maturity intermediation”(Fabozzi et.al, 2002). Banks therefore, through maturity intermediation offer more choices to both the borrowers as well as investors because by matching the time horizon needs of both the players banks basically reduce the searching as well as transaction costs. Capital Formation Commercial banks also perform the critical task of channelization of resources into different sectors of the economy. It also means that banks as a financial intermediary in between savers and investors. Such investments in different sectors of the economy like industry, business, transportation, communication and services etc will assist in the economic growth of the economy. Thus, the banks can promote capital formation in the country, by being a financial intermediary, through offering channelization of scarce resources to their most efficient use. (Claus, 2007). Capital formation is important in the sense that when banks lend to the businesses, entrepreneurs, governments etc, the funds are utilized for acquiring assets which are productive in nature i.e. those assets from whom other assets can be created too. In this way, the process of capital formation helps to reduce unemployment level within the economy. The reduction in unemployment therefore not only creates further jobs but also increase the production capacity of the firms. Helpful in foreign trade Apart from playing their part in capital formation, banks also facilitate international trade by providing an independent payment mechanism to international buyers and sellers. Since international trade is risk because buyers and sellers hardly know each other and there is always a chance of default, therefore banks, action as financial intermediaries, play the role of middle men by not only facilitating the movement of trade documents but also facilitate trade by offering different financing facilities such as letter of credits and guarantees to effectively mitigate and diversify the risk involved in international trade. There are different aspects involved when a buyer and seller interact with each other in an international market to make a transaction. These include the shipment of goods, payments etc. Banks, acting as financial intermediaries, deal with the different documents involved in international trade. These include, letter of credits, shipping documents, bills of exchange etc. In a typical transaction of import and export there is always a risk involved of non-payment of dues therefore in order to reduce that risk, banks promise to act third party guarantors where, in the event of default on payment, banks promise to pay those dues to the beneficiary if everything is concluded as per agreed terms and conditions. Credit Creation James Tobin’s theory of optimal portfolio is considered as an extension of the liquidity preference theory of Keynes. According to this theory, a wealth holder will attempt to strike a balance in his wealth in such a way which minimizes costs and maximize return therefore an investor or a wealth holder will prefer to keep either bonds or cash or both in such a way that it makes a risk return trade off. (doc. Ing. Vladimír Gonda,2003) Building on same principle, Tobin is of the view that the financial intermediary role of banks is to “satisfy simultaneously the portfolio preferences of two types of individuals or firms” (Tobin, 1987). Within the perspective of this new view on role of banks as financial intermediary, banks tend to fulfill the requirements of those firms or borrowers who wish to increase their portfolio of wealth by purchasing more inventories, real estate plant and machinery etc beyond their actual net worth by borrowing from the banks whereas on the other side, lenders i.e., deposit holders who wish to hold part or whole of their wealth in the form of stable money in order to reduce the risk i.e. risk aversion. (Tobin, 1987). Thus based on the above categorization, banks while functioning as financial intermediaries also create money because lending of one deposit to a borrower always ends up being the deposit of another bank therefore through credit creation or extension banks create money or wealth in financial system. It is also important to understand that the banks are the only financial intermediaries that are creating money. Other financial intermediaries, though despite having the legal mandate to take deposits however does not have the capability to create money. This fact is critical in the sense that banks offer checking account facilities which other financial intermediaries do not. Current Scenario The current economic situation suggests that the banks have probably failed as institutions offer financial intermediary services. The large scale failure of some of the biggest banks like Lehman Brothers suggest that the banks, as financial intermediaries have probably failed to offer what is discussed above as the maturity intermediation. The current subprime crises suggest that the banks lent to such individuals who were not eligible for getting funding from the banking channels due to their bad credit history. It is also important to understand the large scale banking failures during recent times also suggest that the banks, due to their highly leveraged nature, failed to give proper head to the regulatory environment. Since banks are one of the highly regulated institutions due to the fact they can experience a run therefore banks, as financial intermediaries, are supposed to act prudently because they also act as the custodian of their deposit holders money. The large scale mushrooming of banks and their subsequent failures lead to the consolidation of banking companies. (Mester, 2007). This consolidation of banks however prompted the need for De-regulating the industry however, as we now witness the collapse of modern financial system in the world, the future of banks as financial intermediaries will greatly rest into the fact that how well they are at managing the element of risk in the whole process of financial intermediation. The shifting patterns of globalization as well as increasing regulations such as BASEL II and other initiatives may greatly constrain the role of banks as financial intermediaries as their overall impact on the economy may not remain same as it was in the past. Imprudent lending coupled with innovations in financial industry led to a great melt down where most of the biggest banks in the world are collapsing. The so called agency role of banks as commercial agents and custodians of their deposit holders’ money may very well become the history because future of banks as financial intermediaries has been bleak due to current economic meltdown caused by banks. Conclusion Banks are one of the most critical institutions in modern economy because by providing the financial intermediation, they actually help financial system to not only create money in the form of new deposits but also help to accomplish different complex transactions. Banks, as financial intermediaries, not only serve as a link between buyers and sellers but also create assets not only in the form of money but also by facilitating businesses to undertake capital expenditure to upgrade and enhance their production capacity. By providing payment mechanism in both domestic as well as international trade setting, banks are one kind of financial intermediary. References 1) Winton, Andrew . (2002). Financial Intermediation. Available: http://www.nber.org/papers/w8928. Last accessed 15 November 2008. 2) Claus, Iris. (2007). The Effects of Bank Lending in an Open Economy. Journal of Money, Credit and Banking. 39 (5), pp. 1213-1243. 3) Tobin, James. (1987). Commercial Banks as creator of Money. In: Tobin, James Essays in Economics. New York: MIT Press. 287. 4) doc. Ing. Vladimír Gonda.. (2003). JAMES TOBIN.. Available: .. Last accessed 15 November 2008. 5) Mester, Loretta J. (2007). Some Thoughts on the Evolution of the Banking System and the Process of Financial Intermediation.. Economic Review. 92 (1/2), p67-75, 9p. 6) Kwast, Myron L. (2007). How Have the Banking System and the Process of Financial Intermediation Changed?. Economic Review. 92 (1/2), p76-82. 7) Stuart I. Greenbaum, Anjan V. Thakor (2007). Contemporary Financial Intermediation. New York: Academic Press. 643 8) Fabozzi, Frank J, Modigliani, Franco, Jones, Frank J, Ferri, Michael G (2002). Foundations of Financial Makrets and Institutions. 2nd ed. New York: Pearson Education Inc. 16-18. Read More