Functions and Forms of Banking

Outline

What is a bank?
What do banks do for their customers?
Why do banks perform those services?
How do banks compare to other financial service organizations?
What factors have affected the operations of commercial banks
and other financial service organizations?
What are the principal sources and uses of funds for banks?

What is a bank?
In the U.S. a bank is defined by federal and state laws
and by bank regulators.
National Currency Act of 1863 created the OCC and said a
national bank will carry out the business of banking.
Bank Holding Company Act of 1956 changed the definition to
accepting deposits that can be withdrawn on demand and making
commercial loans.
Competitive Equality Banking Act of 1987 broadened definition to
accepting deposits and making loans.
Today a legal definition is that a bank makes loans, has insured
FDIC deposits, and has banking powers under state and federal
government laws.

What is a bank?
Types of banks:
Global, international banks or money center banks
Medium and large size banks that are full-service banks (but not
universal banks as in Europe and some other foreign countries)
Small and medium size banks that are retail or consumer banks
(which use correspondent banks and outsourcing)
Banks that focus on medium and large business firms or wholesale
banks (which also includes limited purpose banks that are further
specialized in terms of customer base)

What do banks do for their customers?

Payments
These services include coin and currency and financial
transactions, including checking accounts, credit cards, electronic
banking (CHIPS or Clearing House Interbank Payments System),
wire transfers (Fedwire), international payments (SWIFT or
Society for Worldwide Interbank Financial Telecommunication),
etc.
Retail payments system and large-dollar payments system for
business and government

What do banks do for their customers?

Financial intermediation:
Deposit function of offering savers a wide variety of
denominations, interest rates, and maturities, as well as risk-free
(FDIC insured) deposits and a high degree of liquidity.
Loan function of transferring or allocating savings to most
productive and profitable uses to provide growth and stability of
the economy.
Other financial services include off-balance sheet risk taking (from
financial derivatives and guarantees), insurance-related activities,
securities-related services, and trust services.

Why do banks perform those services?

Banks are private firms with a public purpose. They seek to
maximize shareholder wealth (represented by the market
value of bank stock and dividends paid).
Banking is the management of risk. By taking risks, they
earn a profit.
-- Credit risk -- Foreign exchange risk
-- Interest rate risk
-- Compliance risk
-- Liquidity risk
-- Strategic risk
-- Price risk -- Reputation risk

Various factors that affect banks include include market,

social, and legal and regulatory constraints.

How do banks compare to other financial

service organizations?
Banks are the dominant financial institution in the U.S.
based on the percentage of total assets (24%).
Federally related mortgage pools are second largest (12%).
Life insurance are third largest (11%).
Other significant organizations include savings
institutions, money market funds, mutual funds, and assetbacked security issuers.
However, commercial banks shrank from 34% in 1980 to
24% in 1997.

What factors have affected the operations

of commercial banks and other financial
service organizations?
Inflation and volatile interest rates:
Rising interest rates caused shorter-term deposit costs to rise faster
than longer-term loans. Also, as rates rose, the market value of
their assets declined and borrowers defaulted on loans with greater
frequency than normal.

Securitization:
Banks are pooling loans for various kinds and selling securities
with claims on these loans.

Technological advances:
Telecommunications and computers are increasing economies of
scale and economies of scope for banks.

What factors have affected the operations

of commercial banks and other financial
service organizations?
Consumers have become more sophisticated.
Capital markets have increased their competition with banks in
attracting firms seeking debt funds.
Deregulation:
The elimination of laws that placed geographic limits on banks, their
products and services, and the rates they can pay has stimulated bank
mergers and consolidation in the banking industry (e.g., 14,400 banks in
1985 compared to 8,500 banks in 2000).

Despecialization and competition among financial institutions with

one-stop shopping centers.
Global integration of financial markets is increasing competition
from foreign financial service firms.

What are the principal sources and uses

of funds for banks?
Assets
Loans
commercial and industrial (C&I) loans
real estate loans
consumer loans
Investments
short-term, liquid securities (e.g., U.S. Treasury securities)
long-term securities
Cash
Other assets
buildings, equipment, etc.

What are the principal sources and uses

of funds for banks?
Liabilities
Deposits
transactions deposits
nontransactions deposits

Nondeposit sources of funds

Equity
Relatively small compared to debt sources of funds. Highly
leveraged compared to nonfinancial firms.