What Do Banks Do and Why Do We Need Them - Essay Example

Essay “What do banks do and why do we need them” Banks are prevalent everywhere in many forms, while these were originated in the time the first currency note was issued, or probably they have been the part of human’s life before that time. During the ancient times, there were simple modes of payments used, but with the expansion of ancient empires, there emerged a need for better ways to pay for goods and services produced in other empires (R. Davies & G. Davies, 1996). Since then, the banking system has been the most important part of an economy, while in the twenty-first century the banks are globalised and are more connected through technological revolutions and developments in information technology (Berger, et al., 2000). It is seen in the contemporary financial environment, how the banks have been impacting the economy of a whole country or over the globe, as there is an example of financial crisis of 2008 (Baily, et al., 2008). Before the occurrence of global financial crisis, the developing economies have brought about a number of changes in the global economy and financial sector with the help of banks (Griffith-Jones, 2014). However, it is significant to know what exactly the banks do and how they have become such an important entity for the world’s economy, as they can be the major source of economic and financial wellbeing of any nation. The purpose of this essay is to investigate the roles played by the banks in an economy and to highlight their importance. Commencing from the preliminary idea of banks, it is unlike a normal business where products are manufactured and sold, rather it acts as an intermediary between the people who save money and the people who take money as a loan and use for some purpose. According to Jadhav, (2011), a bank is basically known as a financial institution, and it delivers lending and financial facilities to its customers. In general terms, it is an institution to take money as deposits and give loans for carrying out businesses or other purposes, though there are other institutions that are providing such facilities, but they do not fulfill the defining criteria of being a bank (Jadhav, 2011). Gobat (2012, p. 38) has explained the fundamental function of the banks as stated, “…Although banks do many things, their primary role is to take in funds—called deposits—from those with money, pool them, and lend them to those who need funds. Banks are intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money). The amount banks pay for deposits and the income they receive on their loans are both called interest…” (p. 38). So, the interest is the main revenue of the banks on the basis of which it earn and do business and compete with other banks. The major players of the banks are the depositors (loaning their money to banks) and borrowers (taking money from the bank as loan), and these can be anyone like individual customer or households, any corporate organization either financial or non-financial, or else it may include the local or national level government authorities (Gobat, 2012). The importance of banks can be understood with their primary role, as it highly depends on the banking function that how a bank gets the money from savers and channel it to the other developing or productive initiatives efficiently and effectively, which are quite significant for the growth and development of any country (Allen & Carletti, 2008). For this reason, the banks contribute a lot to any country’s economy, as they are responsible for the circulation of money in the whole country and making the funds to reach at right hands. Apart from this reason, the banking system has been developed due to insufficiencies seen in the earlier systems existed for performing the financial activities, where these activities were done by individuals themselves and money lenders. During those times, the interest rates set for loaning the money was too high, as individuals set the rates as per their willingness regardless of any standards. In addition, there was a lack of safety and security of the public savings made by savers, and no standardization for loans. For these issues to prevail over, the banks were made to develop a regulated and standardized banking sector that was maintained and controlled by the governmental agencies or authorities (Jadhav, 2011). So this necessitated the need of a bank and a regulated banking industry was established. The banks have a lot of functions to be performed and due to these functions and roles, the importance of the banks is an admitted fact. The core roles of the banks include its functioning in the financial system for giving loans and accepting the deposits in order to provide the financial facilities. Apart from it, there are some other important roles that are also provided by the banks. Banks are highly important for providing security to the customers’ deposits or saved money, and also it enables the circulation of the money in the country, where it regulates the money supply and credit supply (Heffernan, 2005). In addition, the significance of the banks can also be highlighted, as it circumvents the concentration of money in a few hands or investment of money in few institutions by its function of circulating the money (Allen & Carletti, 2008). The banks provide the common public with a confidence of securing the savings that enhance the people’s trust in the financial system of the country, which encourage people to save and deposit more efficiently and effectively. It also increases the security and trust of borrowers by providing them with a standardized system of loaning, where there are set regulations and conditions, interest rates, and tenure of lending for all customers regardless of any biasness (Jadhav, 2011). The literature also suggested some other roles, as (Heffernan, 2005) has argued that the banks also provide liquidity functions as the second basic role, where it is stated that “…Depositors, borrowers and lenders have different liquidity preferences. Customers expect to be able to withdraw deposits from current accounts at any time…” (p. 3). Though, customers can take their money any time, even if their money has been lent to any corporate client, this means the provision of liquidity, as “…Typically, firms in the business sector want to borrow funds and repay them in line with the expected returns of an investment project, which may not be realized for several years after the investment…” (Heffernan, 2005, p. 3). Thus it provides liquidity services to the customers. However, Boot and Thakor (1997) have also explained one of the important functions of the bank in the financial system, where the bank is delegated a monitoring function. As it monitors the actions of the borrowers and take care of the legality of all the activities performed by the borrowers, which cannot be monitored by the lenders who would not be able to bear the monitoring costs (Boot & Thakor, 1997). If the banks are not there to monitor the borrower’s activities, then there can be many frauds and borrower may give the blame to luck for his failures, even if he has not taken the right decisions regarding the project funded by lender’s money. In this way, the banks provide a monitoring facility as being an intermediary (Boot & Thakor, 1997). Additionally, (Allen & Gale, 2000a) argued that the significant role of the bank is to share the risk, where the banks provide risk sharing facility to the customers. In case of the failure of borrowers, the risk of losing money is shared by the bank and the depositor. The risk is always there until the household’s money is held by other borrowers, so the bank keeps reserves and provisions to hedge this risk (Allen & Gale, 2000a). The reserves are accumulated when the banks have high returns in any case, and these are used to pay to the lender in case of borrowers’ failure (Allen & Carletti, 2008). Banks are also considered to be the stimulator of the growth and efficiency in the markets, where banks provide financing to other industries of manufacturing and retailing for setting up businesses. Through this way, the bank based system is much better at stimulating the growth and development in the economy than the market based system, as according to the (Gerschenkron, 1962) and (Goldsmith, 1969), the banks are the major promoter of the growth and development efficiently, by fulfilling the financing requirements of the new businesses and growing businesses. Moreover, the banks are also involved in the resolutions of agency problems in the corporations, where the managers are working on behalf of the shareholders, or there is an agency issue between shareholders and bondholders (creditors of the firms). There are a number of scholars that are agreed to this function of the bank, as being a very important characteristic of the bank to provide a corporate governance role (Heffernan, 2005; Allen & Carletti, 2008; Aoki & Patrick, 1994). As (Allen & Carletti, 2008) have stated that “…this main bank relationship ensures the bank acts as delegated monitor and helps to overcome the agency problem between managers and the firm…” (p. 16). There is quite much evidence over the monitoring role of banks and providing a solution to the agency problems (Gorton & Winton, 2003). According to (Gobat, 2012, p.38), the banks are also involved in creating money for the country, as it states, “…Banks also create money. They do this because they must hold on reserve, and not lend out, some portion of their deposits—either in cash or in securities that can be quickly converted to cash…” (p. 38). And also banks act as the regulators or controllers of the money supply, as the banks are involved in delivering the monetary policy, which is most significant tool for the government, involved in assisting the country to attain the economic development and advancement without fostering the inflation problem (Gobat, 2012). It is the duty of the central bank to control the money supply, as these can draw back the money from the market, for example by offering bonds, or inject money into the market. These can be performed by increasing or decreasing the reserve requirements of the banks (Heffernan, 2005). Apart from all of these, in the current economic environment and global banking industry, the banks are also important in the global trading and business with the help of fulfilling the financing requirements and plummeting the dangers of exporting, as argued by (Niepmann & Schmidt-Eisenlohr, 2014). It can be concluded that the banks provide a number of facilities to the customers and also play significant roles in the development and growth of the overall economy and financial market. The banks are important for every entity, for households, for corporation, for industries, and for the whole nation. This essay provides a detail of banks and their importance by explaining the primary roles of the banks and their benefits for all the entities. The bank that providing the facilities efficiently, is a significant factor for the economic wellbeing of the country, in past and today, while it is also hopeful for the banks to enhance the financial wellbeing in the future as well. References Allen, F. & Carletti, E., 2008. The Roles of Banks in Financial Systems. In: A. Berger, P. Molyneux & J. Wilson, eds. Oxford Handbook of Banking. New York: John Wiley & Sons, pp. 20-22. Allen, F. & Gale, D., 2000a. Comparing Financial Systems. 1st ed. Cambridge: MIT Press. Aoki, M. & Patrick, H., 1994. The Japanese Main Bank System: Its Relevancy for Developing and Transforming Economies. 1st ed. New York: Oxford University Press. Baily, M. N., Litan, R. E. & Johnson, M. S., 2008. The Origins of Financial Crisis, Washington DC: The Initiative on Business and Public Policy at Brookings Institutions. Berger, A., DeYoung, R., Genay, H. & Udell, G. F., 2000. Globalization of Financial Institutions: Evidence from Cross-Border Banking Performance. Brookings-Wharton Papers on Financial Services, 3(1), pp. 23-158. Boot, A. & Thakor, A., 1997. Financial System Architecture. Review of Financial Studies, 10(1), pp. 693-733. Davies, R. & Davies, G., 1996. A History of Money from Ancient Times to the Present Day. 1st ed. Cardiff: University of Wales Press. Gerschenkron, A., 1962. Economic Backwardness in Historical Perspective. 1st ed. Cambridge: Harvard University Press. Gobat, J., 2012. What is a Bank?. Finance & Development, 1(1), pp. 38-39. Goldsmith, R., 1969. Financial Structure and Development. 1st ed. New Haven: Yale University Press. Gorton, G. & Winton, A., 2003. Financial Intermediation. In: G. Constantinides, M. Harris & R. Stulz, eds. Handbook of the Economics of Finance,. Amsterdam: North Holland, pp. 431-552. Griffith-Jones, S., 2014. A BRICS DEVELOPMENT BANK: A DREAM COMING TRUE?, New York: United Nations Conference on Trade and Development. Heffernan, S., 2005. Modern Banking. 1st ed. London: John Wiley & Sons Ltd. Jadhav, R. A., 2011. An Overview of Banking Sector, New Delhi: Indian Press. Niepmann, F. & Schmidt-Eisenlohr, T., 2014. International Trade, Risk, and the Role of Banks, New York: Federal Reserve Bank of New York. Read More