The role of banks
1. What do banks do?
Banks play an important role as an intermediary, or go-between, in the financial system. They have three main functions:
- Banks are where people can safely deposit their savings, which banks then pay interest on. If there were no banks, people would have to store and protect their savings themselves, which would involve major risks.
- Banks are largely responsible for the payments system. Electronic payments are becoming more important as people use less cash. This means that banks are processing more card payments, transfers, direct debits, etc. every day.
- Banks issue loans to both people and companies. Without banks, it would be very hard for people to buy a home or start a business, or for companies to make investments, for example.
Banks do a variety of other things, such as helping corporations with their, often more complex, financial needs. This can range from the various ways to gain access to capital for growth and investments, to assisting in mergers and acquisitions, to converting currencies.
2. Why is this important?
Our economy couldn’t function without banks. By attracting savings and granting credit, banks are the oil for the wheels that keep the economy turning.
Without banks we’d have to pay for everything with cash, which we’d have to save somewhere. That’s obviously very risky.
Without banks as a go-between, savers and borrowers would have to find each other personally, and a single transaction between a saver and a borrower would be very costly: just think of the fees you’d have to pay a solicitor to draw up a contract.
Plus, the saver would be assuming a big risk—if the borrower can’t repay, the saver would lose all their savings. A bank lends money to a lot of people and companies. If some are unable to repay their loans, the bank can absorb these losses and savers won’t be affected.
Banks also help solve the issue that customers generally want ready access to the money they deposit, while many loans require long-term commitments, such as a 30-year mortgage for financing a house.
So banks borrow (i.e. hold customers’ deposits) short-term but lend long-term. By doing this they transform debts with short maturities (deposits) into credits with very long maturities, managing the risks associated and collecting the difference in the interest rate as profit. This is known as “term transformation” and is a vital part of banking.
3. Why and how does using a bank minimize risk for customers?
Managing and monitoring risks are at the heart of banking, and most banks have strict policies in place at various levels to handle both financial and non-financial risk, including social and environmental risk.
But more generally speaking, banks make transactions possible that otherwise wouldn’t have been possible, or that only would’ve been possible with huge risks. One reason why banks can handle such transactions, and private individuals and companies can’t, is scale.
Even though savers can generally withdraw their savings at any time, the total amount of money held by a bank doesn’t fluctuate much because they have many customers. This scale helps banks cover risks, such as those related to term transformation mentioned above.
Other risks, such as a borrower not being able to repay, are reduced through diversification, meaning that banks can spread risks over various countries and industries.
This doesn’t mean that risks are non-existent, but they’re spread over the bank's portfolio and initially absorbed by the bank’s margins, with “equity capital” there to cushion unexpectedly high losses.
Above all, banks specialize in estimating possible risks. However, it’s important to realise that risks can never be eliminated completely. In fact, that wouldn’t be a good thing either. A certain level of risk is necessary to keep the economy going.
Economic growth is driven by entrepreneurs who start up new enterprises, i.e. take risks. Sometimes they fail, but if no one would take such risk, there would be no economic growth.
4. How does a bank make money?
A bank can make money in a variety of ways. Most of a bank's revenue comes from the interest they receive on the money they lend. Interest is, however, also a major cost for a bank, as savers receive interest on their savings.
Very basically, banks earn money by charging more interest on loans than that they pay on savings.
Interest income is used to cover the costs involved in keeping interest-rate risk under control, to cover losses on loans that are not repaid or not repaid in full, and to pay the bank's overhead, such as wages.
Besides interest income, banks also make money from other transactions and services, such as providing financial advice and products to large corporations.