Bank

What Exactly Is a Bank?

Banks are the unsung heroes of our financial world, acting as the bridge between those who have surplus funds and those in need. They mobilize deposits from savers to fund borrowers, creating a dynamic ecosystem that keeps economies ticking. But what exactly do they do? How did banking evolve into its current form?

The Evolution of Banking

Banking has roots stretching back to ancient times, with concepts of credit and lending forming the backbone of early financial systems. The oldest existing retail bank, Banca Monte dei Paschi di Siena, was founded in 1472, while Berenberg Bank, the oldest merchant bank, dates back to 1590. These institutions laid the groundwork for what we know today as modern banking.

Fractional Reserve Banking

One of the key concepts in banking is fractional reserve banking, where banks hold only a fraction of their deposits in liquid assets. This system allows them to lend out more money than they have on hand, effectively creating new money through loans. The emergence of this practice in the 17th and 18th centuries marked a significant shift in how financial transactions were conducted.

Key Players in Banking History

The Medici family, for instance, established one of the most famous Italian banks in 1397. The Rothschild family later pioneered international finance on a large scale, financing major projects like the Suez canal purchase for the British government in 1875. These families and institutions played pivotal roles in shaping global financial landscapes.

What Do Banks Actually Do?

Banks are more than just places to keep money; they act as payment agents, conduct checking accounts, pay and collect cheques, and enable customer payments through various methods. They borrow by accepting deposits, term deposits, and issuing debt securities, and lend by making advances to customers, installment loans, and investing in marketable debt securities.

Diverse Services Offered

Banks provide a wide range of services including personal banking, corporate banking, investment banking, private banking, transaction banking, insurance, consumer finance, trade finance, and more. They offer various channels to access these services such as branch banking, automated teller machine (ATM) banking, online banking, mobile banking, telephone banking, video banking, relationship managers, and direct selling agents.

Revenue Streams

Banks generate revenue through interest, transaction fees, and financial advice. Traditionally, they profit from lending activities by charging interest on capital lent to customers, but this method has been cyclical and dependent on market conditions. In recent years, banks have implemented various strategies to ensure profitability, including mergers with investment and insurance houses under the Gramm-Leach-Bliley Act, expanding risk-based pricing in consumer lending, and increasing payment processing options for consumers and businesses.

Risks and Challenges

Banks face numerous risks that can trigger crises. Credit risk involves loss of payments from borrowers, while liquidity risk pertains to the inability to trade securities quickly enough. Market risk refers to a decrease in portfolio value due to market changes, operational risk encompasses errors or failures in business operations, and reputational risk concerns damage to trustworthiness.

Regulation and Capital Requirements

To manage these risks, banks must meet capital requirements set by regulators. The financial crisis of 2007-2008 led to the introduction of Contingent Convertible bonds (CoCos) as a type of hybrid capital security. These have the potential to satisfy regulatory capital requirements due to their capacity to absorb losses.

Economic Functions

The economic functions of banks include issuing money, netting and settlement of payments, credit quality improvement, asset liability mismatch/maturity transformation, and money creation/destruction. These activities are crucial for the smooth functioning of financial systems.

Banking Industry Statistics

The size of global banking industry assets grew by 6.8% in the 2008-2009 financial year to a record US$96.4 trillion, while profits declined by 85% to US$115 billion. EU banks held 56% of total shares in 2008-2009, down from 61% the previous year. Asian banks’ share increased from 12% to 14%, while US banks rose from 11% to 13%. Global investment revenue grew to $66.3 billion in 2009, up 12% on the previous year.

Bank Mergers and Acquisitions

Between 1985 and 2018, there were around 28,798 bank mergers or acquisitions, worth $5,169 billion. There have been two major waves of deals in history, with a steep decline from 2007 to 2018.

Regulation and Licensing

Banks are regulated by government entities requiring a special license to operate. Regulators participate in the market and typically issue banknotes; some countries allow private sector participation. Banking law is based on contractual analysis between banks and customers, outlining rights and obligations.

Different Types of Banks

Banks can be categorized into different types including retail banking, business banking, corporate banking, private banking, investment banking, commercial banks, community banks, credit unions or co-operative banks, postal savings banks, private banks, offshore banks, and savings banks. Commercial banks engage in banking activities, while investment banks focus on capital market activities.

Specialized Banks

Other types of banks include commercial banks, community development banks, land development banks, credit unions or co-operative banks, postal savings banks, private banks, offshore banks, and savings banks. Nowadays, European savings banks focus on retail banking and are decentralized, socially responsible. Ethical banks prioritize transparency and social responsibility investments. Direct or internet-only banks operate without physical branches using ATMs and electronic transfers.

Investment Banks

Investment banks underwrite stock and bond issues, provide investment management, and advise corporations. Merchant banks provide capital to firms in the form of shares. Universal banks engage in multiple services including distribution of insurance.

Central Banks and Their Role

Central banks are government-owned and regulate commercial banks, controlling interest rates and providing liquidity. Islamic banks follow Islamic law and avoid interest, earning profit on financing facilities instead. The US banking industry is heavily regulated with specialized regulators like the FDIC, Federal Reserve, and Office of the Comptroller of the Currency.

Challenges in Banking

The changing economic environment affects banks’ ability to manage interest rate spreads, set growth strategies, and maintain asset quality. Lax attitudes among some banks and reduced regulatory oversight contribute to this issue. Additionally, ageing ownership groups, shareholder pressure, and competitive pressures from other financial services providers pose significant challenges.

Asset Management

Banks also face difficulties in managing their assets, including loans, which are a primary asset category. Declining loan quality has become a major problem for financial institutions. To compete for deposits, banks must adapt to changes in the market such as disintermediation and the growth of money market funds.

Bank Statements and Deposit Accounts

Banks offer various types of deposit accounts including passbook accounts, NOW accounts, Super NOW accounts, and more. Bank statements are accounting records produced by banks following GAAP standards. Debit and credit accounts have different balances and credits/debits applied to them. Brokered deposits provide funds to banks from deposit brokers often through trust corporations.

Custodial Accounts

Custodial accounts hold assets for third parties such as businesses managing client funds. Globalization in the banking industry has reduced global competition barriers, and increased telecommunications and financial technologies enable banks to extend their reach worldwide. The growth in cross-border activities has increased demand for banks that can provide services across borders.

Conclusion

Banks are the backbone of our economic systems, playing a crucial role in mobilizing funds and facilitating transactions. From ancient times to today’s complex financial landscape, they have evolved significantly but remain essential for the smooth functioning of economies worldwide. As we move forward, understanding their roles and challenges will be key to navigating the ever-changing world of finance.