ECON3610

Money and Banking

Lecture Topic 7
(Updated)

Economics of Banking
Readings: RH (Ch. 1)
JS (Ch 2: 26-31, 40-44;
Ch 3: 71-78)
Handout and Notes

Summary
Powerful Forces Reshaping the Industry
What Is a Bank?
The Financial System and Competing FinancialService Institutions
Old and New Services Offered to the Public
Key Trends Affecting All Financial-Service Firms
Appendix: Career Opportunities in Banking and
Financial Services

1-4

Introduction
Banks are the principal source of credit (loanable funds)
for millions of individuals and families and for many
units of government

Worldwide banks grant more installment loans to

consumers (individuals and families) than any other
financial-service provider
The assets held by U.S. banks represent about one-fifth
of the total assets
In other nations banks hold half or more of all assets in the
financial system

1-5

What Is a Bank?
A bank can be defined in terms of:
1. The economic functions it performs
2. The services it offers its customers
3. The legal basis for its existence

Historically, banks have been recognized for the great

range of financial services they offer
Bank service menus are expanding rapidly today to include
investment banking, insurance protection, financial
planning, advice for merging companies, the sale of riskmanagement services to businesses and consumers, and
numerous other innovative financial products

Theory of Banking Industry

Why do Banks Exist?

Qualitative Asset Transformation

(QAT) Liabilities issues and their
function in a monetary economy
Two-sided nature of financial firms
Brokerage

Theory of Banking Industry

Qualitative Asset Transformation (QAT)

a) Asset Diversification
Transformation of largedenomination financial assets into
smaller units

Theory of Banking Industry

b ) Asset Evaluation
Bank is fundamentally and evaluator of
credit risk.
Banks function as a filter to evaluate
signals in a financial environment with
limited information.
Due to imperfect information,
participants may not evaluate the
quality of signals.
Hence, financial intermediation.

Theory of Banking Industry

The Two-Sided Nature of the Financial Firms
Banks profit maximization depends
on the spread between the loan rate
and deposit rate (both uncertain).
Covariance between the two rates
encourages financial intermediation.

Theory of Banking Industry

Banking As A Firm
Banks operate similar to a firm and try to
maximize an objective function subject to
some control variables such as asset
quantities or prices. Other constraints
that may enter in the system are regulatory
constraints imposed by the authorities.

Theory of Banking Industry

The difference:
a) expected utility maximiser
b) risk behaviour

1-12

The Financial System and Competing

Financial-Service Institutions
Roles of the Financial System
The primary purpose of the financial system is to encourage
saving and to transfer those savings to individuals and
institutions planning to invest and needing credit to do so
This process of encouraging savings and transforming
savings into investment spending causes the economy to
grow, new jobs to be created, and living standards to rise
The financial system also provides a variety of supporting
services:
Payment services
Risk protection services
Liquidity services

THE FUNCTIONS OF A FINANCIAL

SYSTEM: Do Banks Do It?
Clear and settle payments to facilitate trade and commerce
Aggregate and disaggregate wealth and flows of funds so
that both large-scale and small-scale projects can be
financed
Transfer economic resources over time, space, and
industries
Accumulate, process, and disseminate information for
decision-making purposes
Provide ways for managing uncertainty and controlling
risk
Provide ways for dealing with incentive and asymmetricinformation problems that arise in financial contracting

Judging the Efficiency of Financial

System
Allocative efficiency (AE)
Moving funds to investment projects with highest
returns for a given level of risk
Operational efficiency (OE)
Minimize transaction cost thus increasing volume of
financial transactions leading to high growth
Informational/Price efficiency (IE)
How quickly and accurately security prices reflect
existing and new information Efficiency Market
Hypothesis

HOW THE FINANCIAL SECTOR

AFFECTS THE REAL SECTOR
Credit Screening Activities
Credit Rationing
Creating Liquidity
Facilitate Trade and Investment Activities
Debt Restructurings
Feedback Role

The Different Kinds of Financial Service

Firms Calling Themselves Banks

Commercial Banks
Savings Banks
Cooperative Banks
Mortgage Banks
Community Banks
Money Center Banks
Investment Banks
Merchant Banks
International Banks
Wholesale Banks
Retail Banks

Limited Purpose Banks

Bankers Banks
Minority Banks
National Banks
State Banks
Insured Banks
Member Banks
Affiliated Banks
Virtual Banks
Fringe Banks
Universal Banks

The Financial Service Competitors of Banks

Savings Associations
Savings Banks
Credit Unions
Money Market Funds
Mutual Funds (Investment Companies)
Hedge Funds
Security Brokers and Dealers
Investment Banks
Finance Companies
Financial Holding Companies
Life and Property-Casualty Insurance Companies

1-18

TABLE 11 The Many Different Roles Banks and Their

Closest Competitors Play in Todays Economy

Modern Banking

Traditional Services Offered By Banks

Carrying Out Currency Exchange
Discounting Commercial Notes and Making
Business Loans
Offering Savings Deposits
Safekeeping of Valuables
Supporting Government Activities with Credit
Offering Checking Accounts
Offering Trust Services

Recent Services of Banks

Granting Consumer Loans
Providing Financial Advice
Managing Cash
Offering Equipment Leasing
Making Venture Capital Loans
Selling Insurance Policies
Selling Retirement Plans

Offering Security Brokerage and

Investment Banking Services
Underwriting Securities
Offering Mutual Funds and Annuities
Offering Merchant Banking Services
Offering Risk Management and Hedging
Services

Trends Affecting Banks and Other

Financial Service Firms Today
Service Proliferation
Rising Competition
Government Deregulation
Increased Interest Rate Sensitivity
Technological Change and Automation
Consolidation and Geographic Expansion
E-Banking and E-Commerce
Convergence
Globalisation