Analysis of the Role of Bank in the Modern Financial System

Kong Lei

（Zhengzhou University of Light Industry， Zhengzhou， Henan， China，450002）

Abstract： In todays complex and more globalized world economy， the role of bank is more significant than ever before. Along with financial globalization， the existance of economic crisis also become a tough issue to both the business sector and governments. The liquidity and regulation of internatioanl banks therefore determine the financial environment. This paper will discuss the importance of financial intermediation and current issues involved to bank as financial intermediation.

Key words： financial intermediation， financial institution， liquidity， bank regulation

Introduction

There are so many financial activities involved in our everyday lives. Actually， it is quite easy for people to get use to shopping at the supermarkets or stores， apply for a student loan or pay-off the tuition fees； but it is somehow hardly for people to pay more attention on the question behind all of these activities—they all process through banks. With no doubt， one very important or fundamental element to the working of modern financial system is the provision of payment facilities. No economic transactions could be made without payment. Therefore， the importance of bank is fairly apparent， because this key function has traditionally been carried out by banks. （Bain， 1992） In fact， all modern banks act as intermediaries between borrowers and lenders， but they may proceed in different ways， from the traditional function of taking deposits and lending certain amount of them， to fee-based financial services. （Heffernan， 1996） Thus， there are some questions raised， such as why do banks exist， do they have other functions， and how they work within the financial system.

The main aim of this article is going to discuss the theoretical rationale of the existence of banks， with emphasis on the importance of borrowing and lending in economies， and how banks perform as intermediary in financial transactions. Furthermore， the question about ‘why banks are the most able actors would be addressed， with the discussion of advantages they have， and the significant role they play in financial systems.

Banks and Financial Intermediation：

The existence of banks

Market imperfections

It is difficult to discuss the question why bank exist with just recent literature， without taking the earlier approaches into account. Traditional theories saw bank as alternative to market transactions as a way of organizing activities， and as monitor and enforcer of the incentive structure. （Lewis， 1991） Some have seen banks major function is to provide loans to borrowers， and make deposits from the lenders， in order to make these procedures running.

It is clear that some of the new literatures are based on these traditional views， but with consideration of the banks function in an imperfect market， which described by Lewis in his paper as ‘perfect markets paradigm. （Lewis， 1991） This is to say that most of the assumptions about financial system are made under the condition of a perfect capital market， which all the economic decisions depend on nothing but the financial structure， because the information for investors are full and symmetric. In this ideal world， lenders and borrowers could deal with each other directly without any extra cost， and then there is no need for banks to operate as intermediaries because disputes and frictions do not exist during transaction， every financial activities will rely on the structure of the market. Yet this type of market never exists， as the importance of banks is apparent， because they perform like agents， who give responses to the imperfect market by providing the most information.

In fact， as Lewis argued， banks provide financial services that individuals find too costly to search out or to produce monitor by themselves. In order to do so， banks need some ‘real sources like offices and staff and also equipment to make this industry possible and efficient. （Lewis， 1991） These resources are building up to make connections with the consumers， so one of the important part of a modern banking is to provide service to them and collect information form these particular customers and their behaviour， for improvement of future services.

Importance of financial intermediation

Some would argue that in the context of the market imperfection， there are uncertainties about the financial transactions such as problems caused by the incompletion contract. In contrast with many commodity market transactions， which payment means the end of a contract and post-contract behaviour is irrelevant， financial contracts are often crucially dependent on the characteristics of the transactors. ‘The value of a promise to a potential lender depends upon the perceived character of the individual issuing the promise， together with expectations of how future events may influence the worth of that promise. （Lewis， 1991） This means borrowers might be irresponsible for their repayments， and it arise the problems of financing costs and risks.

There are two aspects of problems caused by lack of intermediation； the first one is information costs. In certain levels， risks are exist for both lending and borrowing， as long as the two parties are not stand for the same interests. Actually， without symmetric information， the lenders and borrowers may have different perception about the risks they would face， and the contingencies under that transaction. The lenders must analysis and assess which borrowers are most likely to make the repayment； the presence of information costs undermines the ability of a potential lender to find the most appropriate borrower， in the absence of intermediation. （Heffernan， 1996） Even there are fewer risks for the lenders to take because their benefits would not be affected by this； they sometimes still need to face the problems that can not find appropriate lenders by lack of information.

As Heffernan pointed， there are four types of information costs. The first one is search costs， and it will be in any contract with two parties. Potential transactors must search， select other potential parties for the transaction， and may need to meet or negotiate for the contract. Then there are verification costs， which is considered before the loans have been made， an evaluation of the potential borrowers should be made because the lenders need to choose the one with most like repayment. ‘Asymmetric information between borrower and lender will give rise to a problem of adverse selection， which will cause inefficient allocation in markets. （Heffernan， 1996） It is easy to understand that a borrower always holds more information about if he is going to repay the loan than the lender， and the character of a borrower determines the ability/willingness to make the repayment.

The third point is monitoring costs. These are created when a loan is going to be made， the actions of borrower must be monitored with the terms of the contract that ensure the delivery in due date. That means any failed repayments would have a genuine/legitimate reason. Therefore， the point of moral hazard refers to the problems which may flow form the inability of lenders to certain control over the behaviour of borrowers （Lewis， 1991）， in order to protect the lenders interests. Finally， there are enforcement costs. When a loan has been made， it is possible that the borrower would break the contract and unable to meet the commitments， then a solution should be made to enforce the contract， or to compensate the lender. There could be many reasons the borrower would break the contract， most commonly unable to meet the repayment date or have insufficient funds. ‘If it is not possible to renegotiate the loan conditions， the lender will have to take action to recover the loan. （Heffernan， 1996）

The second aspect caused by lack of intermediation is that borrowers and lenders have different liquidity preferences， as ‘posted by the longevity of physical investment and unexpected consumption demands. （Lewis， 1991） It is typical that lenders from the business or investment sectors would like to borrow funds that allow them to repay either by stages in a long period， or to make the repayment in once but by a longer term； but there might be unexpected market factors occur to delay the return of profit. For lenders， when the loans have been made they know that means to give up the present consumptions and expected to receive more profit some day in the future， sometime might be longer period. Either lenders or borrowers might change their mind with some unexpected reasons. Therefore， a pool of large amount of funds with various contract periods could solve this problem， because both borrowers and lenders would be satisfied with the flexibility and liquidity of these funds to meet their own demands. （Chant， 1992）

Lewis （Lewis， 1991） argued that in financial markets， information and liquidity problems could be overcome either by organised markets， where contracts and trading are relatively standardised， or by informal markets which are created by or exist within financial firms. Good example of the formal market is the stock market， where funds are operated in certain stock； but more commonly， borrowers and lenders would go to banks to make loans and deposits， and these processes are within the banks organization. Thus， it is necessary to discuss the role of banks in financial transactions， as they provide contracts with more flexibility and liquidity than formal markets， and produce enough information to meet the market demands.

Role of banks

Advantages of banks：

In the earlier chapters， the importance of financial intermediation in informal markets was considered， and banks work as deposit-taking institutions have largely taken these responsibilities. Some have seen banks as producing loans form inputs of deposits， and others as creating deposits from loans granted （Lewis， 1991）； actually， banks may have some advantages to do so than other financial institutions.

1. Information advantages

As mentioned above， both lenders and borrowers may face the asymmetric information problem， when they are going to perform in the market. It is too risky and costly for any individual transactor to take time and effort on identify the appropriate source. Banks have a comparative advantage over capital markets when this information is not transparent or difficult to get， by collecting and organising information from customers accounts. ‘The information rationale for financial intermediation is that banks can solve adverse selection and moral hazard contracting problems more efficiently than can be done either directly between ultimate borrowers and lenders， or through market. （Llewellyn， 1999）

2. Monitoring & enforcement

There are other problems raised once an investment is verified， because of the incomplete contract. How can the borrower ensure that the funds will be used on the agreed purpose， or who can guarantee the repayment is going to be made on time？ Thus， the behaviours of borrowers need to be monitored to reduce the possibility they break the contract. Banks therefore become the best agent for delegating the monitoring role， because they have comparative advantages in the area： banks as financial intermediaries are the most efficient methods， and banks can reduce the cost of monitoring by diversification. Relatively， banks is in a better position to solve the problem of the later question， as to deal with the moral hazard problems on loan transactions through superior control mechanisms. Just as Llewellyn pointed in his paper， banks are more able to exercise control by setting conditions and restrictive covenants into the contract， and may seek ‘insurance against unforeseen development in the form of security against the loan. Banks may also enforce repayment by sending signals of publicize any unexpected behaviour of investors， to make them feel very uneconomic to do. After receive all these sanctions from regulations to moral， the borrowers are less likely to break the contract but more likely to behave in the interests of the banks. （Llewellyn， 1999）

3. Liquidity insurer

One important aspect of financial transactions is the different liquid demands of borrowers and lenders， and this could be solved by the insurance role of banks. Banks can transform illiquid assets into liquid funds. If link this to the idea of control， banks can be seen as buy securities from the borrowers of funds and offer them to lenders of funds with an insurance policy added. （Lewis， 1991） This insurance is provided against the chances that lenders may change their idea of the contract， and want their money back in advance. This is guaranteed by the banks as part of the service， which insurance companies can not provide. Banks are able to do so by pooling large number of deposits together， and prepare to meet the lenders liquidity needs. The greater the number of depositors the more predictable is the liquidity requirement， and banks would be able to assess the minimum costs. In general， banks achieve to reduce the risks of a loan portfolio by pooling risks， and this enable banks to hold non-marketable assets.

4. Regulatory subsidy and payment advantages

Actually， banks have privilege of receiving subsidies through various forms of protective regulation， such as deposit insurance and limited competition. These regulations may insure banks of less competitive pressures and sustaining restrictive practices. （Llewellyn， 1999） Furthermore， banks have payment advantages as they are within the system as part of it， there is no transactions could be made without banks.

Organisational structure of a bank

When discussing the existence of bank， it is necessary to address its organisational structure as alternative to capital market. The intermediary and liquidity functions of a bank are more efficiently carried out by a command organisational structure， rather than rely on the adjustment of market prices. It is because the loans and deposits are internal to a bank. （Heffernan， 1996） This structure of bank is efficient in monitoring both parties， and creating incentives during the financial transaction. At the same time， a principal-agent problem arises when one party （lender） to a transaction engages another party （bank） to act on his behalf when the principal （lender） has less information than the agent （bank） about the agents characteristics， and the agent has its self interests to presume. This problem could be seen caused by asymmetric information that give rise to the problem of adverse selection and moral hazard.

Incentives problems could be solved by relational contract between the lender and borrower， as to build up an understanding of the characteristics of both parties. A relational contract improves information exchange， and allows the lender go gain specific knowledge about the borrower， in order to reinforce the relationship of both parties to insure they all stick to the terms of the contract. （Llewellyn， 1999）

Diversification of banking activities

Diversification is normally pursued by banks that want to make loans and deposit across different types of customers and economic activities， so that their loans and deposits would not concentrated too much on one area or one type. There are several types of banking activities will be introduced below：

First， international and multinational banking are most commonly used by many banks， because of the risk shifting purpose. Second， financial conglomerates are increasingly exist in both informal and organised financial markets， banks are like to expand into other like many profit-maximising organizations. Third， as discussed earlier， banks not only provide loans and deposits， but also provide financial services such as intermediary and liquidity services， helping customers to overcome asymmetric information and other financial difficulties. Fourth， there are two important types of banking： wholesale and retail banking. Generally， wholesale banking is targeting small number of large customers like governments or large corporations； whereas retail banking is involved number of small customers like individuals or small business. Then comes universal banking， which refer to the provision of most financial services under a single， largely unified banking structure. Finally， there is off-balance sheet banking， which are contingent commitments or contracts that generate income for a bank but do not appear as assets or liabilities on the traditional bank balance sheet. （Heffernan， 1996） These banking activities will help the development of the banks and their services， in order to meet the various demands of customers.

Conclusion

Recently， some people argue that the importance of banking firms to the whole economy will decline， or even be instead of new financial instruments and technology. The traditional advantages banks used to have are largely challenged. For example， new technology developments have reduced the cost of acquiring and accessing information of the market， and rating agencies also help to make information available and more accessible. （Llewellyn， 1999） Some even see the risk-pooling role of banks will be taking over by individuals， as more and more people is getting use to make purchase through internet. E-commerce and e-cash seem have the possibility to deal with the liquidity demands from customers， and make the transactions 24/7. Yet， this could become true even if these agents are able to arrange loans， deposits， and payments facilities with each other cheaper than banks can. （Heffernan， 1996） Actually， the traditional products banks offer is not going to disappear， or not in a long time. However， bank managers realised these challenges， and decide to expand to non-bank financial services as way of keeping the lead.

Apparently， the existence of banks has various reasons. This paper looked at the traditional view of bank as alternative to market transactions in borrowing and lending， combined with the new literature of market imperfections and importance of financial intermediation. At the same time， the banks role as intermediary in providing information and insure liquidity to the customers is addressed， together with introduce of the organizational structure and diversified activities， in order to understand the ability of banks to operate as market-maker in the informal financial markets.

Bibliography

[1]Bain， A.D. （1992）， ‘The Economics of the Financial System （Second Ed）， UK： Basil Blackwell Ltd. （p176-182）

[2]Chant， J. （1992）， ‘The New Theory of Financial Intermediation in Dowd， K. and Lewis， M. ‘Current Issues in Monetary Analysis and Policy， UK： Macmillan Edu Ltd. （p43-65）

[3]Heffernan， S. （1996）， ‘Modern Banking in Theory and Practice， England： John Wiley & Sons Ltd. （p18-30）

[4]Lewis， M. （1991）， ‘Theory and Practice of the Banking Firm in Llewellyn， D.T. and Green， C. ‘Surveys in Monetary Economics， Vol2. UK & USA： Basil Blackwell Ltd. （p116-135）

[5]Llewellyn， D.T. （1999）， ‘The New Economics of Banking， Amsterdam： SUERF. （p12-17）