In part one of our banking series, we scratched the surface on how complicated the sector is. Today we continue in that same vein by focusing explicitly on the fundamental issues of banking.
The Buck Stops with Banks
Banks are unique financial intermediaries. Remember, financial intermediaries are institutions that sit between lenders and borrowers, aiming to pay the least amount possible (to the lender) and charge the most possible (to the borrower). Banks are unique in that they sit between all ultimate lenders and borrowers, and all non-bank financial intermediaries. Non-bank financial intermediaries are not (you guessed it) banks. They do, however, offer financial services much like a bank, for example, a pension fund.
Banks provide all the means of payment and deposit for, well, every person and company. They’re fundamental to our social structure, and their failure would have an unimaginable impact on every aspect of society. Because of the risks banks carry, they’re subject to the highest level of regulation of all financial intermediaries.
How Do Banks Earn Cash?
Banks earn money by managing financial risks. This is essentially the profit gained from taking deposits (and paying as little as possible) and lending those deposits out (for maximum profit).
The biggest threat to the stability of banks is the securities market (stock exchanges, for example). Large companies no longer require banks to be their financial intermediary (therefore banks are not responsible for the risk), as they can generate investment via the stock market from other financial services providers or financial intermediaries. But a failure of those financial intermediaries, as we saw in the 2007 global financial crisis, can have enormous impacts that affect banks’ products.
Banks’ most unique function is their ability to create money. This is performed under guidance by a country’s central bank; the supply and demand of financial services are part of a wider set of influences that dictate interest rates.
Next time – the reason banks exist!