Imagine a world without banks. Where would you borrow money? Would you be able to save as much as you need and when you need it? What risks would you face?
This explanation will help you understand the banking system and the purpose of banks in your economic life. You will also learn about the different types of banks and alternative forms of financial institutions and finally understand certain terms you come across every day.
The economic importance of banks
Banks have a very important role in an economy as they provide both individuals and companies with a range of financial services. Routine banking activities such as deposits or withdrawals may be carried out using a range of account types, such as checking or savings accounts.
But in addition, banks provide personal and business borrowers access to credit. Deposits made by individuals are used to lend long-term debt, such as credit cards and mortgages.
A bank’s ultimate purpose, like that of every other company, is to maximise its profit. Banks achieve this by charging borrowers higher interest rates on loans and other debt compared to the interest paid on deposits.
Shareholders of a bank that pays 2% interest on deposits and 6% on loans make a 4% gross profit for the company.
Banking is very important for the UK economy. It’s a sector that expands beyond the UK borders. Three UK based banks - HSBC, Barclays and Lloyds Banking group- are not only the largest but also rank among the top ten banks in Europe in terms of market capitalisation. The leading three banks have a market capitalisation of approximately $30 billion while the largest among these is HSBC with a market share of over $107 billion.
A bank is a financial institution that is involved in borrowing and lending money.
Categories of banks
Banks can be grouped into two main groups: commercial and investment banks. One of the main differences between the two is that commercial banks take deposits from their customers, whereas investment banks do not take deposits. Investment banks’ main role is to help companies and governments to gather funds by issuing securities.
Commercial banks
Commercial banks or high street banks are financial institutions that cater to individuals and businesses and offer services such as accepting deposits, loans, checking accounts, and other basic banking services.
A few examples of commercial banks in the UK are Barclays, HSBC, and Lloyds bank.
Commercial banks have multiple networks of branches mostly located in prime locations such as a city’s high street or near shopping centres. However, with the development of electronic banking, these banks now operate mostly online.
These types of banks play an important role in the economy. They provide funding for individuals and enterprises in case one wants to buy a house or expand a company. This then leads to an increase in transactions in the economy which contributes to economic growth.
Government agencies and central banks closely monitor commercial banks’ activities. If large commercial banks were to go bankrupt, it would trigger a severe economic crisis.
Keep in mind that these banks hold the majority of your savings and if not managed properly, you could end up losing your entire wealth.
To learn more about the different functions of a commercial bank check our explanation on Commercial Banks.
Investment banks
As we said before, investment banks serve different roles than commercial banks. One of the main roles of an investment bank is to intermediate sophisticated transactions for large companies or governments.
When Apple first went public in 1980, it hired Morgan Stanley, a global investment bank, to help them with their initial public offering (IPO).
Other roles investment banks play also include mergers and acquisitions, offering advice to their clients such as pension funds. Some of the largest and most well-known investment banks are Goldman Sachs, JP Morgan Chase, and Citigroup.
Many of these banks also offer storefront community banking and have divisions that cater to the investment needs of high-net-worth individuals.
Functions of banks
There are multiple functions of banks. The most important ones include:
- Safety deposits: banks are a relatively secure place to deposit money and safeguard assets while earning some interest on these deposits.
- Interest on deposits: commercial banks pay interest on deposits that differ based on the type of account. For current accounts, this rate may be significantly lower compared to savings accounts. During inflation, interest rates are very important for maintaining the real value of your savings. For example, a 4% inflation rate will decrease the value of you savings. However, if banks are paying an interest rate of 6% then the real value of your savings will increase.
- Loans: lending money is an important source of banks’ profit. Banks use the deposits to lend money to worthy individuals and businesses for investment or expansion. For example, if a bank pays 4% on deposits but lends money at 8%, the difference makes up the profit for the bank. Banks need to keep sufficient liquidity to meet the demands of the customers to withdraw their money.
- Credit creation: banks can regulate money supply or create credit with the deposits of the customers by advancing them as loans while adhering to some regulatory requirements.
- Other services: banks also provide miscellaneous services to customers: ATMs, advice on financial matters, international money transfers, and a range of other services, insurance and safety lockers for keeping tangible assets such as jewellery, important documents, etc.
Banking regulations in the UK
The central bank of the United Kingdom is deeply concerned with maintaining a sound and stable financial system. Besides ensuring that individuals' savings are protected, their goal is to also create an efficient and trust-based financial system.
Imagine not being able to withdraw funds from your checking accounts due to credit card payments being declined as a result of the bank’s bankruptcy.
One of the main goals of banking regulation is to prevent banks from taking huge risks. Reserve requirements and limits on the investment a bank may undertake are some examples. Banks must retain a minimum proportion of their deposits in reserves to support depositor requests for withdrawals.
The difference between a bank’s assets and liabilities, known as bank capital, is also another tool that financial regulators use to keep banks in check. To avoid bankruptcy, a bank has to have a positive net value; otherwise, it would be unable to pay the depositors back. Banks are required by law to maintain a certain level of net worth in order to safeguard their customers and other creditors.
One of the main regulatory bodies in the UK is the Financial Conduct Authority (FCA). It ensures that financial institutions in the UK comply with rules and regulations that create an efficient financial ecosystem.
To learn more about how banks are regulated check our explanation on the Regulation of Financial System.
Profitability, liquidity and risk in banks
Liquidity is the ability of banks to turn reserve assets into cash. Liabilities are payable on demand, and to maintain profitability banks must have cash and liquid assets. However, banks are often met with the problem of either maintaining liquidity or focusing on making profits. This is because higher liquidity yields lesser profits. Hence, it is important to strike a balance between the two objectives.
Assets in commercial banks are liquid to different extents. Cash is the most liquid asset, followed by deposits. Loans and long term bonds are the least liquid assets. If banks can borrow easily and cheaply, they are likely to keep fewer liquid assets. The more expensive and difficult it is to get a loan, the more liquid assets are likely to be kept.
Banks need to maintain profitability to pay their depositors interest on their money, wages, and to keep working capital for the bank. Holding funds in cash means profitability is limited. However, banks usually must prioritise liquidity and safety over profits, and it is considered a supplement for the survival of the bank.
Banks - Key takeaways
- A bank is a financial institution that is involved in borrowing and lending money.
- Banks play a critical role in the economy by providing both individuals and companies with a range of important financial services.
- Government agencies and central banks closely monitor commercial banks' activities due to the important role they play in an economy.
- There are two main types of banks: commercial and investment banks.
- Commercial banks or high street banks are financial institutions that cater to individuals and businesses and offer services such as accepting deposits, loans, checking accounts, and other basic banking services.
- One of the main roles of an investment bank is to intermediate sophisticated transactions for large companies or governments.
- One of the main goals of banking regulation is to prevent banks from taking huge risks.
- Liquidity is the ability of banks to turn reserve assets into cash. Banks need to maintain profitability to pay their depositors interest on their money, wages and keep working capital for the bank.
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