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Discuss the reasons for the existence of banks

Discuss the reasons for the existence of banks and consider whether their future existence is assured.

In the first section of this essay I will outline some hypothetical situations to show how the Intermediary role of banks came to fruition and why they were needed. If we imagine an economy without money barter would be the only means of exchange. To convert endowments of goods and labour into a preferred package is an arduous task. Then there would have been a development into a form of commodity money. For example, gold or silver. Due to costs of holding, adding to and maintenance we see the evolution of paper money. Exchange can now take place at different times between parties. When paper money is introduced we see the deadlock between savings and investment break. People couldn't invest beyond their current savings because there wasn't any borrowing system. Money allows savings to occur through accumulation of balances and investment by depleting previous money balances. The ultimate borrower can issue 'primary securities'. These can then be purchased directly by the ultimate lenders. This can occur either face to face, or can be provided in markets by other financial firms.

In our previous model we saw that financial assets held promised to deliver gain at some point in the future. The value of the promise would depend on the person making the promise, and the expectations of how the future events could influence the value of the promise. There are also preferred habits of borrowers and lenders. It is likely the lender will want short-term returns, and it is likely that the borrower will only anticipate long-term returns to pay off the loan. Therefore there is a need for common ground and in the previous system this would have incurred search and/or transaction costs, which were involved in meeting/obtaining information on the other party. This meant these costs directly translated into the interest rate on the loan, thus reducing the number of mutually acceptable contracts. The ex ante problem will also occur in this model. There is imperfect information so lenders can't assess what the future prospects of a borrower could be. It is also likely that a borrower will be over optimistic about the future so as to procure the loan. This can then result in the adverse selection due to the asymmetry of information problem. Then an ex post cost occurs when monitoring the borrowers actions to make sure that they are in accordance with the contract. Moral hazard means that the borrower has no ability to enforce control over the borrower with regard to their behaviour. If the borrower can't keep to an initial agreement then there are further costs associated with lender and borrower having to arrange a different agreement.

Banks differ from other types of financial firms. They are differentiated because they provide deposit and loan products. The deposit products will pay out money on demand or after notice. Banks are in the managing liabilities business and by doing this they have the ability to lend out money to create bank assets. You could also argue however that banks were in the managing assets business. Assets are provided by deposits or other liabilities. This project from coursework.info

Banks can eliminate a large proportion of the costs that I have mentioned above. Banks act as intermediaries. They fulfill this function by allowing lenders (depositors) to offer loans with lower information costs than if they found a potential borrower individually. This means that lenders will seek out banks because of reduced costs. Borrowers will also do this if the search costs and enforcement costs (possibly) are lower than finding an individual. This is done by utilising economies of scope. The individual cannot do this. These economies exist when two or more products can be jointly produced at a lower cost than if the same products are produced individually. The bank can pool a portfolio of its assets, which have the same expected return, but a lower default risk than if the individuals had tried to lend funds directly. If the markets utilize information search in this field they suffer from the 'free rider problem'. Other market participants, competitors could mimic the lending decisions without the expense of performing the individual assessments. An example of this would be a bonds market. If one company carries out information search and as a result buys certain bonds then others can mimic their behaviour and benefit. Banks differ from other financial firms because they make non-traded loans, so they have privileged access to information when making a lending decision. They develop expertise in information production as they have access to transaction accounts of potential borrowers. No one else can benefit from this information. It is used internally to boost their loan portfolio. The ex ante problem is removed. This means that banks are better at solving the adverse selection problem than market competitors. Banks can introduce loan contracts to increase their chances of the loan being repaid. This could be in the form of collateral if the loan defaults which reduces the adverse selection problem. The bank contract may also contain restrictive covenants, which restricts the borrower's activities. This further reduces the problems of ex post and moral hazard. These covenants and contracts allow banks to do the monitoring and enforcing costs at a fraction of what it would cost an individual because they carry it out for so many people. They once again benefit from economies of scope. If a market firm did this we would see the emergence of the 'free rider' problem again as in the securities example I sited earlier. Firms are not going to put in large amounts of resources for others to obtain the benefits. Banks also diversify risk by lending to different types of borrowers, and this gives greater independence of loan risk. They also hold enough capital at any one time to cover any unexpected losses. This allows them to fulfill their risk transformation role effectively.

Banks also solve the problem of liquidity preferences. They can transform illiquid assets into liquid liabilities. Businesses will typically want to repay a loan in line with their investment, and this may not be realised for several years. When a saver lends money they are giving up present consumption for future consumption. If banks can pool a large number of savers and borrowers both parties are going to be satisfied, because the bank has the necessary liquidity to cater for both. If a bank can offer liquidity at a lower cost than it would be in its absence borrowers and lenders will come to the bank for its liquidity services. Market firms are unlikely to be able to compete with banks here because they will not have a financial pool large enough to reduce interest rates for borrowers below the banks rates.

Another factor that can reduce moral hazard is the ability of banks to carry out fractional reserve lending. It lends out surplus funds at a higher rate of interest than it pays to its account holders. This means that bank intermediation and payments services are inextricably linked. The money can then be leant out because more savers will hold their accounts in surplus than not, because there is no point in just holding an account to cover payments costs as it is not financially viable. This means that customer only want a fraction of their deposits at any one time. The maturity transformation problem is solved. Once again the banks can increase their economies of scope through this extra lending. This means the unit cost of lending falls even more and banks can attract more customers.coff ffr seffffw orff ffk inff foff ff.

Potential borrowers are also more likely to hold accounts at a bank if they think it is less likely that they will be credit rationed upon requesting a loan. If a company goes to a bank for a loan it also proves their credit worthiness, which may allow that company to get cheaper sources of funds from other sources. Quite simply if a firm is given a bank loan it acts as a signal that the company will stay in business. This all reduces search and transaction costs due to increasing the pool. This also relies on the reputation that banks have for assessing risk. Other financial firms in a market are unlikely to have this kind of reputation, as their search costs will be reduced by the 'free rider' problem.

I will now refer to the diamond model (Financial Intermediation as Delegated Monitoring: A Simple Example-Douglas W Diamond). Diamond observes that diversification in a financial intermediary allows delegated monitoring to function by reducing the cost of liquidation and therefore giving the banks an incentive to repay small investors. Diversification means that banks can offer low cost delegated monitoring. The law of numbers would mean that as a banks independent loan portfolio becomes more diverse then the chance of it defaulting on its deposits gets arbitrarily close to zero. This also means that the control costs to monitor also approach zero. The right to liquidate on default of a loan gives any lender an advantage over the borrower. The power is limited by the borrowers ability to repay the debt and therefore remove the liquidation rights of the lender if the lender cannot monitor the business of the borrower then it is in the lenders interests to liquidate whenever there is default regardless of the cause. If the lender can monitor then it is in their interests to take a small concession from the borrower and can thus provide power over the lender without using inefficient liquidation. Banks can centralise monitoring costs, and this means they can eliminate the costly duplication of effort, which is problematic in the monitoring of borrowers by small investors. They monitor loan contracts and issue unmonitored debt in the form of deposit contracts. To see the benefits of monitoring we can set up a simple model. We use 'K' as the cost of monitoring, and 'S' as the savings from monitoring. If there are multiple lenders, then either each must be able to monitor additional information directly, which would incur a cost of m*k where m represents the number of lenders per borrower or the monitoring must be delegated to someone. We now find ourselves in a situation where the monitoring causes the private information problems. The person doing the monitoring has private information. This could lead to delegating costs. Let D represent the delegation costs per borrower. Therefore a complete financial intermediary theory based on contracting cost of borrowing will model the delegation costs and show why intermediation will lead to a better offer of contracts.

K+D <=min[S,m*K]. K+D represents the cost of using an intermediary, S shows the cost without any monitoring and m*K is the cost of direct monitoring. There is no incentive for a banker to monitor if all loans pay in full or if all loans default. The increase in the banker's returns come from increasing the return when just one loan defaults. Monitoring must increase the bank's expected payment by a certain percentage to make it profitable. If a loan that is monitored defaults and the other one does not (in a simple two loan situation) then the banker will receive an ex post increase return because of monitoring. In the simple two-loan banking situation the banker needs to make a small profit in excess of the cost of monitoring. Due to limited liability and limited wealth the banker will never make deposit payments in excess of loan repayments. This project from coursework.info

The traditional role of banks as already outlined is that of an intermediary which offers payment functions. Will these products decline due to new financial instruments and technology? Non-banking firms can now purchase off sheet balance products and securitisation services. The most important question is whether the new technology will let the global risk-pooling role played by the banks be taken over by individuals? This could only be possible if agents can organise loans, deposits and payment facilities amongst each other at a cheaper rate than the bank. This seems very unlikely. Even with very advanced technology, the time and cost of collecting the data to make the decision about where the best place for a deposit would be (pool with other depositors), or to try and find the most suitable loan or loans is likely to be too expensive. However computer systems have reduced the transaction cost advantage that banks hold. Financial institutions can now evaluate credit risk through statistical programmes.

A conflicting view of this was put out recently by David Birch (Director of Consult Hyperion) " The very existence of banks as we know them is under threat". Under threat perhaps, but I feel that they have already managed to stave off many dangers and should continue to do so into the future. A counter quote exemplifies my position " It is a healthy species capable of changing as the environment changes" (Hugh Kingdon- Barclaycard). We have seen banks change quite significantly over the last five years. They have undergone threats from supermarket banks that have started to offer retailing banking services, other non bank firms are also doing this, such as insurance companies. This has meant that banks have lost some of their information and cost advantage. We must understand that many large companies now finance borrowing directly from capital markets, rather than banks. Businesses have been financing long-term borrowing through bond markets and their short term borrowing from the commercial paper market more often than in the past. In the US commercial banks sourced 35% of funds to non-financial borrowers in 1974, this figure was down to 22% by 1995. Total non-financial commercial paper outstanding (as a percentage of commercial and industrial bank loans) rose from 5% in 1970 to above 20% in 1995, once again reducing a banks ability to diversify its pool of funds. However this has not eliminated intermediation, and is unlikely to in the near future. Banks are now involved in security market issues. They obtain fees through arranging and underwriting bond issues. They also undertake derivative transactions related to issues. Fees have been obtained through aiding mergers and acquisitions and banks have pursued off balance sheet activities, particularly in OTC (Over The Counter) derivatives. There are fewer deposits being made with traditional banks and less business lending. Banks have started to turn to more non-traditional activities to maintain themselves as financial intermediaries. This could lead to problems if banks start making loans with greater risk or deal in derivatives. However fee gathering through these types of activities will form a large part of banks income into the future.

Banks have grown in strength through out the Internet revolution. Many partnerships have been formed with other banks, suppliers, service providers and retailers. They have established trust and confidence over the years with their customers and have very high loyalty rates. This has maintained their informational advantage. Banks have so far carried themselves through the technology revolution well. They need to continue to adapt. To succeed in the future in this medium they will need to deliver consistent, dynamic services every day of the week. Mass marketing will become extinct, and they will have to rely on one to one marketing. The Internet may be a very valuable method for achieving this target. Visit coursework ae in ae fo ae for ae more project ae Do ae not ae redistribute

Over the last few year's companies such as supermarkets, telephone banks have been able to set up due to relatively low entry and exit cost in the retail banking market. Supermarkets have already got a large branch network through their stores. Telephone banking companies have only costs of staffing and setting up call centres. Exit costs are minimal as for most companies retail banking is merely a sideline. These businesses now have access to the economies of scope that I mentioned earlier in the essay. They obtain these at relatively low fixed cost because they only focus on their core competencies, and can then subcontract out other aspects of the business to companies with inherent comparative advantage with regard to those skills. Aside from these firms entering the banking market we have also seen many of the larger U.K building societies becoming banks. Halifax and the Abbey National have already become banks and Nationwide is continuing to ask its shareholders to vote on its position. It is likely they too will follow eventually. They have moved into retail banking and expect to start to sell products such as insurance to the personal sector. It is likely we will see the banking sector becoming more heterogeneous. The other firms mentioned above have diminished intermediation by banks.

Banks in the UK and US are increasingly focusing on their core competencies. This allows them to develop a depth of knowledge about their customers that competition will not be able to match. New advantages will be obtained through in depth knowledge of their particular market, thus creating barriers to entry. Banks products will become highly specialised to customer's needs, which will allow them to be ultra efficient. We see in America the 'Bank Of New York' now focuses on communications and the 'Nations Bank' focuses on energy. This will also allow them to keep low transactionary costs because they will be dealing with large numbers of customers in specific markets. However there is risk here. Whereas the traditional banks had a broad focus to reduce risk the newer systems will become more focused, potentially exposing them to risk. For example the 'Bank Of New York' will be lending primarily to communications companies. If there is a fall in the value of this sector or there is large default on loans (presently companies such as CISCO Systems are in financial difficulty) the 'Bank Of New York' could be at great risk due to a fall in liquidity. The risk pool mentioned earlier has diminished. Banks of the new age will have to sell their products well. They will need to be customer orientated. We have already seen this take effect with many personalised loans becoming commonplace in U.K banks. They will have to manage risk, current and future through diversification. Risk assessment policy may have to evolve to take account of the increasing focus on core competencies. There is a huge need to develop people, and this will come about through strong/focused corporate culture, motivation, training, and retention. The workforces of banks in the future could well be the comparative advantage that one bank holds over another firm. This project from coursework.info

Within this essay I have shown that banks came into existence because of a variety of factors, which prevented optimal lending and borrowing. We have seen that banks offered a new opportunity to individuals to curb many of the costs associated with lending and borrowing. As such banks have provided a huge service, and I have also outlined how these original factors will continue to be of importance in the future to a new world of banking. It is however likely that in the next few years we will see new regulatory policy, which will allow banks to continue their role. This legislation must allow them to strengthen themselves competitively and expand. It must also guard against excessive risk taking. It is probable that banks will have to increase their holdings of capital. This will mean that there will be less risk of failure due to liquidity problems and less incentive to take risk. Moral hazard problems could be reduced by this method as well. Banks will not become obsolete. The big banks around the world are vital. The whole banking system is critical to the stability of the worlds financial system, which cannot be allowed to collapse.

Bibliography Visit coursework ff in ff fo ff for ff more cours ff Do ff not ff redistribute

· M.K Lewis & K.T Davis, 'Domestic and International Banking'

· Shelagh Hefferman, 'Modern Banking in Theory and Practise'

· 'The Decline of Traditional Banking: Implications for Financial Stability and Regulatory Policy', New York Federal Reserve Bank, Economic Policy Review, July 1995, Volume 1, Number 2.

· Buckle and Thompson, 'UK Financial System' 1998

· D.Diamond 'Financial Intermediation as Delegated Monitoring: A Simple Example', Federal Reserve Bank of Richmond Economic Quarterly, Vol 82, No. 3, Summer 1996.

· 'Banks Have no Future in Banking', Credit Control, 2000, Vol.21 Issue 5, p23

· 'The Future of Banking', America's Community Banker, Dec 1999, Vol. 8 Issue 12, p16

· 'The World Wide Web is the Future of Banking', Computing Canada, 15/06/1998, Vol. 24 Issue 23, p4

· 'The Future of Banking', American Banker, 28/04/1997, Vol. 162 Issue 80, p5

· 'The Future of Banking: The strategies that won the game yesterday will win the game tomorrow', Consumer Interests Annual, 1996 Issue 42, p387

· 'The Future of Banking Supervision',Economic Commentary, 1/4/1996, p1

· 'Banks and Banking', Bankers Magazine, Mar/April; 1996, Vol. 179 Issue 2, p29

· www.bis.org/publ/



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