Saving and Borrowing

When you look at how we use money, you will find that we sometimes act as savers by depositing money in a bank account or by investing money in the financial markets, for example, by buying equity shares of a company. Other times, we act as borrowers by leveraging our requirements by borrowing money from financial intermediaries like banks.

Importance of Saving and Borrowing

In the modern world, these activities of saving and borrowing are performed by all companies to keep daily operations running and to plan for future growth. These activities are as essential as the blood in our veins.

Borrowing by Companies

• Small companies borrow from their banks.

• Large enterprises borrow from the capital markets through the issuance of debt securities.

• They invest their surplus cash in money markets, bonds, or equities.

Borrowing by Governments

• Most governments of developing nations are the biggest borrowers in the country.

• They borrow money from international financial institutions or foreign investors such as the World Bank.

• They invest their money in the country's growth by developing infrastructure, power projects, Medicare, etc.

• Developing nations with surplus cash could also invest in the financial system.

Role of Financial Intermediaries

Whether you are a government, a company, or an individual, you are both a saver and a borrower almost simultaneously. We require financial intermediaries to support these saving, investing, and borrowing activities. For a long time, the most popular destinations for savers to invest their money and for borrowers to borrow money have been through financial intermediaries known as banks. There are other financial intermediaries like insurance companies and pension funds. In the US, we have savings and loan institutions and so on.

Financial Intermediaries and Their Roles

Typically, financial intermediaries are institutions that act as middlemen between two parties to facilitate a financial transaction, usually in the most risk-free manner possible. Banks practice indirect finance, while other intermediaries in the financial market practice direct finance.

Indirect Finance by Banks

• The risk of losses is almost entirely carried by the banks.

• For example, when you deposit your money in a bank, the bank may lend your money to another customer.

• Even if the customer defaults and cannot pay the money back, you would still get the money from the bank.

• Bank deposits are usually insured.

Direct Finance by Financial Markets

• The saver or investor wholly takes the risk of losses.

• For example, when you buy shares of a company in the financial market, the risk of losses by the price of the shares falling would be compensated by your money.

What Exactly is a Bank?

When you think of a bank, what image comes to your mind? Most people assume that a bank is just a financial middleman or venue where a group of individuals who want to lend money or a separate group of people who want to borrow money are brought together and banks just act as an intermediary between these groups of people. This is not an accurate way of thinking about banking. Banks facilitate the movement of money through the economy by borrowing and lending, but they do not precisely act as middlemen or agents.

Core Activities of Banks

What differentiates banks from other financial intermediaries is that when banks borrow, the money acts as principal for their own accounts, and while lending, they risk losing the money. Other than intermediation borrowing and lending, banks' core activities include asset transformation, payments, and proprietary trading. The Board of Directors of a bank is entirely responsible for deciding what operations or a mix of activities the banks will focus on.

Asset Transformation

This refers to the process by which banks convert large quantities of short-term, low-risk, and liquid deposits into a small number of long-term, high-risk, and illiquid loans. This is how most banks generate the majority of their profits by converting assets to fulfill the mismatched requirements of borrowers and savers at the same time.

Example of Asset Transformation

Suppose a few customers make deposits in a bank. The bank may use a portion of their individual deposits to provide a mortgage loan to another customer for a specific period. In this case, the bank has transformed the financial assets (customers' deposits) into a real asset (the house for which the other customer has acquired a mortgage loan).

Risks Involved in Asset Transformation

There are a few risks involved in this approach that banks need to keep in mind. If many small, short-term deposits fund the bank, it may experience problems meeting depositors' demand if large numbers decide to withdraw their deposits. In this situation, the mismatch between the terms of depositors and borrowers is parabolic, as the loans may not be redeemable in a short time. This creates liquidity issues, meaning there may not be enough cash immediately available to allow depositors to withdraw their savings.

Mitigating Risks

Banks need to address these risks, which are referred to as mismatch transformation and risk transformation.

Mismatch Transformation

This involves maturity and value mismatch. Banks mitigate these issues by:

• Closely monitoring borrowers

• Investing money when there is surplus money with the bank

• Borrowing money from money markets or selling investments when there is a shortage of money

Risk Transformation

This refers to credit risk, liquidity risk, and market risk. It involves:

• Diversifying investment venues

• Sharing risks

• Screening and monitoring borrowers

• Creating and keeping enough levels of capital and reserves to absorb unexpected losses that may affect depositors

Payment Services

Banks also provide payment services by assisting individuals and businesses in accepting online payments, debit and credit cards, remittance services, personal checks, etc. These are vital services as a bank would be considered useless if it could not process payments on behalf of its customers.

Proprietary Trading

Proprietary trading is when a bank trades stocks, derivatives, bonds, commodities, or other financial instruments in its own account with its own money rather than with its clients' money. This allows the company to obtain the entire profit from a trade rather than just the commission from executing trades for clients. This activity involves high risks. Therefore, bank regulators have introduced the Volcker Rule in the Dodd-Frank Act, limiting banks from indulging in heavy proprietary trading.

Summary:

• This text provides an introduction to global banking, explaining the importance of saving and borrowing for individuals, companies, and governments. It also discusses the role of financial intermediaries, with a focus on banks. The text highlights the key activities of banks, including asset transformation, payments, and proprietary trading.

  Highlights

  • 💰 Saving and borrowing are essential for individuals, companies, and governments to support daily operations and future growth.

  • 🏦 Banks are the most popular financial intermediaries, practicing indirect finance where they assume the risk of losses.

  • 🔄 Banks transform short-term, low-risk deposits into long-term, high-risk loans to meet the needs of borrowers and savers.

  • 🏠 Through asset transformation, banks convert deposits into tangible assets like mortgage loans for customers.

  • 📉 Banks face risks such as liquidity issues and credit, liquidity, and market risks, which they manage through diversification and monitoring.

  • 💳 In addition to lending and borrowing, banks provide payment services to facilitate online payments, debit and credit cards, and more.

  • 💼 Proprietary trading is a high-risk activity where banks trade financial instruments with their own money, allowing them to keep the entire profit.

  Definitions

  • Financial intermediaries: Institutions that act as middlemen between two parties to facilitate financial transactions, usually in a risk-free manner.

  • Indirect finance: A practice where banks assume the risk of losses when lending money, providing added security to depositors.

  • Asset transformation: The process of converting short-term, low-risk deposits into long-term, high-risk loans to meet the needs of borrowers and savers.

  • Liquidity issues: Situations where there is not enough cash immediately available for depositors to withdraw their savings.

  • Credit risk: The risk that borrowers may default on their loans, leading to financial losses for the bank.

  • Liquidity risk: The risk of not having enough cash or liquid assets to meet the demands of depositors.

  • Market risk: The risk of financial losses due to changes in market conditions or factors affecting the value of investments.

  • Proprietary trading: The practice of a bank trading financial instruments using its own money rather than clients' money, with the aim of generating profits.