Dear Reader,
“It troubles me, deeply, that many of us will never fully understand the banking system, especially as banks have such a tremendous influence on the financial lives of almost every person on earth.”
As a result, in order to help solve this major problem, I regularly encourage others to read books like ‘Introduction to Banking.’
THE PROBLEM
Most of us are bound to use a bank at some point in our lives. Whether we apply for a loan, a current account (with overdraft facility), a savings account, a residential mortgage or a credit card; the monetary system (at least within advanced nations) is setup in such a way that it becomes virtually impossible to function daily without some sort of financial relationship with a bank. But why? Why is the system designed so that if we have too much money, or need to borrow funds, our only real option is to use the services of a bank? Additionally, other equally important questions may be asked such as:
- Where do banks come from and who owns them?
- How do banks make profit?
- What are the differences between good and bad banks?
- How does a government control banks?
Ultimately, if due to a lack of knowledge we fail to provide adequate answers to these questions then how can we be sure that:
- We are making our best financial decisions?
- We are not being grossly exploited by banks when we use their services?
- Politicians and business leaders are telling us the truth when they talk about the banking system?
- Financially we will be secure whilst there are major economic problems in society?
In short, an insufficient understanding of the banking system or a failure to provide answers to the above questions is, or will be for many of us, an extremely serious and detrimental problem (especially within our financial lives).
THE SOLUTION
To answer all of the above questions, including many others, it is essential that we gain an advanced understanding of the banking system. In light of this, I encourage you to read the book: ‘Introduction to Banking,’ as it was written by university academics (Barbara Casu, et al.) in order to be a comprehensive and accessible textbook, dealing with a broad spectrum of introductory banking issues
This book provides sufficient coverage of the theoretical and institutional details of banks and it was the authors’ intention, at the least, to offer us an interesting and enjoyable insight into the business of banking. Within this review, I will focus specifically on how this text explains:
- The special role that banks play at the heart of the financial system
- How general trends over the last 20 years, within the banking industry, have caused banks and the financial markets to become increasingly complex
WHAT IS SPECIAL ABOUT BANKS?
Banks are financial intermediaries. Their main function is to collect deposits from savers (lenders) and provide loans to borrowers. Simply put, they collect money from those who have too much and transfer the funds to those who need more. In this respect, they act as financial middlemen:
- Lenders – Financial Intermediaries – Borrowers
Arguably, the majority of lenders and borrowers do not need banks or any other financial intermediaries to act as their middlemen and may deal with each other directly (direct finance). However, various barriers that exist may make it difficult, if not impossible, for borrowers and lenders to cut financial intermediaries (the banks) out of their transactions, especially as they (borrowers and lenders) usually have conflicting interests. For example:
- Transaction costs – without banks, lenders would incur costs trying to find appropriate borrowers who match their respective needs, and visa-versa. For instance, there would be a cost for obtaining information about the other party; a cost of negotiating a contract; a cost for the monitoring of borrowers to ensure they are complying with their agreements; and a cost for enforcement if the borrowers fail to fulfil their contractual obligations.
- Asymmetric Information – without banks, before agreeing to provide funds for a project, lenders face the problem that borrowers are more likely to have better information about the risks and likely profits associated with a potential investment.
- Conflicting Interest – most lenders desire to lend their funds for short periods of time, and for the highest possible return (e.g. high interest rate). Whereas the majority of borrowers want to acquire funds with the lowest rates of interest (cheap), and for long periods of time (e.g. 25 years mortgages).
Transaction costs, information asymmetries, and conflicting interests are all clear examples of obstacles that can prevent lenders from directly providing funds to borrowers, which in turn would further prevent the efficient functioning of a financial market. In other words, within an economy, these obstacles can stop those with too much money being able to transfer funds to those who need more.
As a solution to these types of barriers, banks and other financial intermediaries have beneficially bridged the gap between lenders and borrowers by performing a transformation function:
- Size Transformation – Banks collect small-size deposits from savers, and convert and repackage them into larger size loans. They are able to perform this transformation process because of their unique access to a large number of depositors (enabling them to exploit their economies of scale).
- Maturity Transformation – Banks transform the money they receive for short periods of time from depositors into medium and long-term loans for borrowers (e.g. 25 years residential mortgages). It is again due to their economies of scale that banks are able to provide this type of lending.
- Risk Transformation – Banks are able to minimise the risk of non-repayment of loans by screening and monitoring those who borrow. They also diversify their investments, pool their risks, and hold capital and reserves as a buffer against any unexpected losses.
In conclusion, banks have been extremely beneficial to society, as they have created lower risks and costs for lenders and borrowers. As a result, this has further increased the efficient functioning of the financial markets, as lower risks and costs have caused a higher level of borrowing and lending to be undertaken within the economy. Moreover, by holding reserve capital, banks have been able to improve the availability of money to higher-risk ventures or projects. Providing funds for these types of projects is considered extremely important, as it is believed that they create the basis of future prosperity for a country’s economy.
Nonetheless, because of the general trends over the last 20 years,within the banking sector (e.g. deregulation) banks have also had a negative impact in society.
DEREGULATION
Essentially, there are two forms of deregulation:
- Financial Deregulation – is essentially the removal of controls and rules that, in the past, were used to protect financial organisation
- Structural Deregulation – the opening up of financial markets to allow institutions to compete against each other
In most countries, before deregulation, banks were under a relatively high level of government control and restriction in order to prevent a banking crisis and ensure stability within the banking system (e.g. interest rate restrictions, capital controls, branch restrictions, etc.). However, after regulatory change, such as that caused by the Gramm-Leach-Bliley Act of 1999 in the US (deregulation), banks were now free to perform additional roles in most advanced nations like providing pension and insurance, and various investment products (e.g. buying and selling stocks and bonds for clients). Moreover, due to structural deregulation, banks were now expected to set the prices they charge for their services in competition with other banks (domestic and foreign) and non-bank financial intermediaries. The result is that, within recent times, the competitive pressure on banks had increased considerably and they had to respond by trying to adopt strategies that improved their efficiency, expand their output, and increase the range of services that they can offer.
As a result, as banks have sought to become more and more profitable (competing within highly competitive financial market), they have in turn become increasingly complex institutions, offering a range of complicated investment products to their clients. Exacerbating their complexity, banks typically have clients who are also complex financial organisations such as other banks, companies, and governments. Unfortunately, what inevitably flowed from this increasingly complex and competitive banking environment was the global financial crisis which started in 2007. After studying this subject, I learnt that the crisis was caused, primarily, because of international banks, which were creating complicated investment products that lacked any real substance or value. Subsequently, these banks caused financial failure on an unprecedented scale, leading to the near collapse of many economies throughout the world.
CONCLUSION
As shown by the authors’ explanation of banks (i.e. their special transformation functions and growing complexity due to deregulation)
Reading this book will enable many of us to acquire an advanced understanding of the banking system.
It is important to bear in mind that the ‘Introduction to Banking’ is a textbook which provides a solid background reading for postgraduate students and banking professionals. As a result, it was not possible for me to explore (within this review) many of the significant theories and complex subject areas that form an important part of discussions about the banking industry. In spite of this, for many of us this book will:
- Drastically enhance our knowledge about the global banking system
- Allow us to fully understand the hidden monetary forces that exist within society
- Enable us to anticipate any future changes that are highly likely to take place in the financial system
‘It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning. Henry Ford (p. xviiii)
As always, if you have any comments, queries, or require additional information, please feel free to contact me. In the meantime, for those who know
“Let them know what we’re about!”
Truly yours,
Tom