A bank is a financial institution that accepts deposits and uses the money for lending it individuals and/or businesses, directly or indirectly. It is basically a financial intermediary that connects customers that are in need of money with those who have surplus money and desire to earn from that surplus.
Since banks play an extremely important role in a country’s financial system and economy, they are among the most highly regulated institutions.
Almost all banks operate under fractional reserve banking system, which allows them to hold only a fraction of the money deposited with them as reserve and lend the rest for profit.For this reason, regulators insist that banks comply with declared minimum capital requirements, which are necessary for smooth functioning and also submit their activities for supervision. Minimum capital requirements are generally based on Basel Accords, the banking supervision recommendations issued by the Basel Committee.
Monte dei Paschi di Siena, a bank with its headquarters in Siena, Italy is the oldest bank that has been in business uninterruptedly since 1472.
The history of modern banking can be traced back to the medieval and early Renaissance Italy, particularly to the rich northern cities like Venice, Florence and Genoa. In 14th century Italy, banking was primarily controlled by the Bardi and Peruzzi families. The Medici Bank, established by Giovanni di Bicci de’ Medici in 1397was among the most famous banks in Italy. Bank of St. George (actually Banco di San Giorgio) set up in 1407 in Genoa, Italy, is the earliest known state deposit bank.
Etymology of the Word
The word bank originates from Middle French banque, from Old Italian banca, from Old High German banc, meaning bench or counter. During the Renaissance, the Florentine bankers used desks or counters covered by green tablecloths to transact their business, which eventually led to the use of the word banque, which was borrowed by Middle English.
The oldest pictorial representation of money-changing or banking activity is shown in a silver coin, a Greek drachm coin lying in the British Museum in London. The coin dates back to circa 350-325 BC and is from ancient Hellenic colony of Trapezus on the Black Sea, modern Trabzon. The coin depicts a banker’s table (trapeza) full of coins, whichis actually considered to be a pun of the name of the city. The word trapeze means both a table and a bank even today in Modern Greek.
The word bank may even have originated from the ancient Indian language Sanskrit. The two Sanskrit words for ‘expense’ and ‘calculation’ can be joined to form a word that sounds almost like bank. The word is still used in Modern Bangla, one of the many Indian languages derived from Sanskrit.
Expense calculations were among the biggest mathematical treatises written in 500 BC by Indian mathematicians.
Definition of Bank
Banking is specified under English Common Law as the business of conducting current accounts for clients, paying checks drawn on the banker and collecting checks for customers. However, the definition of a bank changes from one country to another.
In most Common Law jurisdictions there is a Bills of Exchange Act that sets the rules in relation to negotiable instruments (an unconditional order or promise to pay a sum of money) such as checks. The definitionof the term banker is found in this Act.
The term banker refers to a body of persons, incorporated or otherwise, carrying on the business of banking. It is a broad functional definition because it makes sure that the legal basis of banking business suchas payment and collection of checks is not dependent on the way a bank is organized or regulated.
In English Common Law countries where there is no statute for defining banking, the above definition is used for defining banking business. Other English Common Law jurisdictions that have a relevant statute, there are statutory definition of banks and banking business.
However, there may a vast disconnect with the general meaning of the term and the statutory definition. The statutory definition in most cases is however almost similar to the Common Law definition. Two examples of statutory definitions of banking business:
– (Banking Act (Singapore), Section 2, (Interpretation):
- “banking businessmeans the business of receiving money on current or deposit account, paying and collecting checks drawn by or paid in by customers, the making of advances to customers, and includes such other business as the Authority may prescribe for the purposes of this Act.”
– Banking Ordinance, Section 2, (Interpretation), (Hong Kong):
- “banking businessmeans the business of either or both of the following:
- receiving from the general public money on current, deposit, savings or other similar account repayable on demand or within less than [3 months] … or with a period of call or notice of less than that period;
- paying or collecting checks drawn by or paid in by customers”
It must however be noted that the check has lost its importance as a paying instrument in the modern day scenario. More transactions are carried through EFTPOS (Electronic Funds Transfer at Point Of Sale), credit and debit cards and Internet banking than by physical checks. This change has also been responsible for suggestions by some legal theorists that the check-based definition should now be broadened so as to reflect the changed realities. It is to say that the definition should include even those financial institutions that conduct current accounts but do not pay or collect checks but enable customers to pay or be paid througha third party/parties.
Primarily, banks are intermediaries that act as paying agents by administering current or checking accounts, paying and collecting checks drawn by or paid in by customers. Modern banks also make customer payments through wire or telegraphic transfers, automated clearing houses, EFTPOS and automated teller machine (ATMs).
Banks borrow money through different means. Most common among them is by accepting customer deposits in various types of account, current, savings and term deposits and by issuing banknotes and bonds. Banks lend money to customers through a credit line or installment loans and other forms of money lending including investments in tradable debt securities.
Payment services provided by banks are indispensable in modern society. Banks not only provide security of money but also provide third party evidence in case of a dispute.Financial institutions that provide payment services such as domestic and cross border remittances are normally not considered as banks.
Access to Banking Services
Customers can access banking services through different channels. While nearly every modern bank provides these channels, it is not a given.
– Brick and mortar bank branch
– Automated teller machines
– Mail and email – most banks accept check deposits through regular mail and also use mail and email to communicate with customers; for example sending statement of accounts
– Relationship managers –given a specific level of customer relationship, a bank will send an officer to homes or businesses
– Online banking – performing transaction over the Internet
– Video banking – available only to high net worth individuals or corporations, it is the use of an audio/video connectionfor the purpose of transacting banking business or for professional consultations with the banker. Video banking can also be through banking transaction ATM-like machines built specifically for the purpose.
There are different ways that banks can earn from. The three most common sources of generating income, in order of their potential,are interest, transaction fee and advise on financial matters. The main source is evidently from interest charged on moneys lent to customers. The bank’s profit is the difference between the average interest rate it pays on borrowings (deposits and other sources of funds) and the rate of interest it charges on loans to others.
This difference between cost of funds and interest rate on loans is known as spread. Historically, the spread is cyclical in nature and depends upon a number of variables such as the stage of economic cycle and need for loans. Interest income may form a bulk of a bank’s earnings, but transaction fees and financial advice are more stable, the reason why most banks focus on this revenue stream.
In the past two decades American banks have tried in many ways to maintain their profitability in the fast changing market environment.The first step in this direction was the enactment of the Gramm-Leach-Bliley Act, which permits banks to merge with insurance and investment companies. Merger with such financial institutions allows banks to provide all financial services from one point, something that customers find extremely convenient and banks hope will increase their profitability.
The other measure taken by banks to remain profitable has been the use of risk-based pricing. Risk-based pricing has been the norm in business loans. Banks have now expanded its use to consumer lending as well. Risk-based lending is a system where higher interest rate is charged on loans to customers with low credit ratingsas it means that the chance of default on loan is more. This works in to offset the loss from bad loans, offers credit to customers who would otherwise be denied loans and lowers the interest rate on loans to customers with good credit histories.
The third measure is that banks have tried to reduce the cost of the services provided by them. The issue of credit cards, smart cards and prepaid and debit cards greatly reduces the cost of processing payments to the public thus increasing the spread. Card products help banks in not only making money through fees and interest charged on consumer loans but also from transactions fee charged to merchants accepting these card payments.
At the same time, easy credit is accompanied by an increased risk of financial mismanagementby consumers, which in turn increases the risk of more loans turning bad.
Products: Retail Banking
Modern banks commonly offer the following products to retail customers:
- Current or checking account
- Several forms of Savings account
- Money market account
- Certificate of deposit (CD)
- Time deposits
- ATM Card
- Credit card
- Debit card
- Individual retirement account (IRA)
- Home and Home Equity loan
- Personal loan
- Mutual funds and Insurance products
Products: Business Banking
- Business loan
- Capital raising (Equity / Debt / Hybrids)
- Mezzanine capital
- Project finance
- Credit line or Revolving credit
- Risk management
- Term loan
- Cash Management Services
Capital Requirements and Risk
During the course of providing their services, banks face quite a few risks. How the bank manages these risks is the key to a bank’s profitability. Correlated to the risk issue is the matter of minimum required capital that is how much capital does a bank need to have for smooth functioning.
Risks faced by banks:
- Credit risk: This pertains to loss from bad loans
- Liquidity risk: Loss due to a financial instrument held by the bank not being easily tradable to prevent a loss
- Market risk: This pertains to the fall in the value of the bank’s portfolio of investments
- Operational risk: Risks arising from people, systems and processes through which a bank operates
- Reputational risk: Loss of reputation means people will not want to deposit their money with the bank
- Macroeconomic risk: This pertains to the risk related to the economy of the country the bank operates in
Minimum capital requirement of banks is a regulatory issue whereby the central authority of the country sets standards that a bank must adhere to while handling its capital.
Economic Functions of Banks
- The primary function of a commercial bank is to issue money. This may be in the form of banknotes or checking accounts on which payments are made on customer’s orders through checks or otherwise. Checks are negotiable instruments and payable on demand. Whereasbanknotes are transferable simply by delivery, checks drawn on a bank may be banked or cashed by the payee.
- Banks act as a collecting as well as payment intermediaries for customers. This is accomplished by participating in an interbank clearing house where payments are settled and netted. Since banks are collecting as well as making payments, outward and inward payments offset each other, which in turn enable banks to offset payment flows across geographical areas and reduce cost of settlement.
- Banks borrow money and then lend money on their own account thus acting as credit intermediaries.
- Banks improve and maintain credit quality. Banks are high quality borrowers but lend the borrowed money to ordinary business and personal borrowers. A bank’s credit improvement stems from the bank’s capital, particularly the quality of its assets that gives it the ability to absorb losses and at the same time to meet financial commitments to depositors. The problem however is that banknotes and deposits are generallyunsecured. If a bank faces difficulty and pledges its assets to raise funds it needs for continued operations, it puts depositors and note holders at risk.
- Banks’ borrowings are in the shape of short term debt or demand debt. In contrast, they provide long term loans.Banks accomplish this by aggregatinga number of issues. Typically, banks would accept deposits, issue banknotes, maintain cash reserves, invest in tradable financial instruments that can be readily cashed when needed and raise funding from wholesale cash markets.
- Banks create virtual money. Whenever a bank provides a loan within the fractional-reserve banking system, it actually creates virtual money.
Besides operational risks, banks also face many other risks that sometimes trigger a systemic crisis.The most dreadful of all is a liquidity crisis, a situation where depositors request withdrawals in excess of funds readily available with the bank. Sometimes, the credit risk, the chance that the bank will not get the money back from those who owe may get too big to handle. Another systemic crisis may be caused when a bank becomes unprofitable, a scenario that may arise if interest rate compel the bank to pay more on deposits than it receives on the loans.
Historically, such crisis have occurred and affected the banking sector as a whole. For example, the bank run during the Great Depression of 1929, the savings and loan crisis in USA in late 1980s and early 1990s and the Japanese crisis during the 1990s. The sub-prime mortgage crisis of 2000 is too recent to be forgotten.
Global Banking Industry
The assets of the top 1,000 banks in the world were US$ 96.4 trillion at the end of the 2008/2009 financial year, which amounted to an annual growth of 6.8%. The asset growth despite adverse market conditions was mainly due to recapitalization. Profits in the same year were to the tune of US$ 115 billion, a decline of 85%. EU banks accounted for the largest share of assets (56%) in 2008/2009, which was actually a fall from the previous year’s figure of 61%. The share of Asian banks increased from 12% to 14% in the same year and that of US banks from 11% to 13%. The global investment banking system generated fee revenue of US$ 66.3 billion in 2009, which was 12% more than the previous year.
USA had 7,085 banking institutions (82,000 branches) at the end of 2008, which was more than any other country in the world.The huge number of small and medium sized banking institutions is indicative of the geography and the regulatory structure of USA. The top 4 banks in China had more than 67,000 branches as of November 2009. The number of branches of the other smaller 140 banks in China is not known. Japan, on the other hand, had 129 banks with 12,000 countrywide branches. In 2004, France, Germany and Italy had more than 30,000 branches each, which is more than double the 15,000 branches in UK.
Commercial banks require a special license and in most countries are regulated by government bodies. For the purpose of regulation, the definition of banking business includes acceptance of deposits even if the institution does not allow regular withdrawals of money through checks or other customer’s order; money lending is however generally not included in the definition.
Certain financial institutions, although performing functions similar to a bank, may be wholly or partly excluded from licensing requirements. These include but not limited to building societies and credit unions.
Nevertheless, banking regulation is a bit different from regulation of other industries because the regulator, a private or publicly governed central, is also a market participant. Central banks typically have a monopoly on issuing banknotes. However, some countries such as UK have as different system. In UK, instead of the Bank of England (UK’s central bank), the licensing authority is the Financial Services Authority. In addition, the Bank of Scotland issues banknotes along with those issued by the Bank of England.
Banking law primarily implies rights and obligations into the relationship between a bank and the customer who opens an account with it.
– The balance in a bank account reflects the financial relationship between the bank and the customer. If the balance is in credit, the bank holds that much money on behalf of the customer and is liable to pay according to the terms and conditions under which the amount was deposited.Similarly, when the balance is in debit, the customer owes the balance to the bank.
– The bank must pay according to customer’s order (checks or otherwise) the amount standing to the credit of the account holder plus any overdraft as agreed upon.
– The bank cannot pay any amount from the account holder’s account to a third party without specific written instructions from the account holder.
– The bank agrees to act as the customer’s agent for promptly collecting whatever checks are deposited by the customer and credit the proceeds to the customer’s account.
– The bank reserves the right to combine the accounts if a customer were to hold more than one account as each account is perceived as part of the same relationship.
– Each check deposited for collection by the customer is under lien to the bank to the extent of moneys owed by the customer to the bank.
– The bank must not reveal the details of the account to any third party without the consent of the customer, unless it in the interest of the bank to disclose it or the bank is required by law to disclose.
– The bank can close a customer’s account only after a reasonable notice period because checks issued by the account holder take several days to be cleared.
The above are some of the implied conditions, which may be altered by an agreement between the customer and the bank. The above terms may be modified or new rights and obligations may be created by the regulatory authority or through legislation.
Requirements for a bank license may differ between jurisdictions but they typically include the following:
- Minimum capital requirement
- Minimum capital ratio
- Bank’s owners, directors and senior officer must have above reproach credentials
- Bank’s business plan must be approved as being sufficiently prudent and apparently reasonable
Types of Banks
Banks are classified according to the type of service they render and the targeted segment. Retail banking deals directly with individuals and small businesses, business banking deals with medium sized businesses and corporate banking with large businesses and corporate entities. Private banking provided wealth management services and investment banking is directed at activities relating to financial markets. As a general rule, banks are in the business for making profits but some government owned bank have a social motive and may offer products that are commercial unavailable.
Commercial Banks: It is an all encompassing term used for a normal bank. A commercial bank is not an investment bank. The term originated after the Great Depression of 1929 when the US Congress required that the banks engaged in normal banking activities be segregated from those dealing with capital markets.
Community Banks: These are financial institutions, operating at the local level, that allow employees to take local decisions for serving customers and partners.
Community Development Banks: These are regulated banks providing financial and banking services and credit to markets and populations not served by bigger banks.
Credit Unions: These are non-profit cooperative banks owned by members who are also depositors. Credit unions are motivated by the social good and often offer better interest rates as compared to commercial banks. Usually, the membership is restricted to a particular group of people.
Postal Savings Banks: Banking services, often limited only to deposits, offered by the national postal services.
Private Banks: Banks that manage wealth of HNIs (high net worth individuals). Private Banks in USA normally require a minimum of US$ 1 million for opening an account. However, in recent times, some have lowered the limit to US$ 250,000.
Offshore Banks: Banks located in countries having less regulation and low taxation rates.
Savings Bank: Essentially banks meant for providing easily accessible savings products to all classes of the population. Savings banks were founded in Europe in the 19th century. In some countries public initiatives were responsible for creation of savings banks while in others, the necessary infrastructure was put in place by foundations. Savings bank so Europe have now taken on the role of retail banks providing savings products, payments, credit and insurances to individuals and small and medium businesses. They differ from commercial banks in more ways than one. For one, they have a decentralized distribution network that focuses on local and regional areas. Secondly, their approach towards business and society is socially responsible.
Ethical Banks: Banks that focus on transparency of all operations and make only what they consider to be socially responsible investments.
Internet-Only Banks: Online banks that operate over the Internet without brick and mortar branches.
Types of Investment Banks
Investment Banks: A typical investment bank insures (the actual term is ‘underwrites’)stock and bond issues, make markets, render advice to corporations on mergers and acquisitions and other activities associated with capital markets.
Merchant Banks: Historically, merchant banks performed the function of supporting international trade by way of documentation and other means such as providing letters of credit and/or advancing funds on the basis of a trade contract. Modern merchant banks however provide finance to corporations by way of shares rather than direct loans. They are different from venture capital firms as they tend not to invest in start-ups.
Universal Banks: These are multifaceted banks that provide a whole suite of financial services. As such, they are better known as financial service institutions. Actually, these are large banks, actually part of a diversified group of companies that also sell insurance with subsidiaries offering capital market services.
Central Banks: A central bank is basically a quasi-regulatory body empowered by government of the country. Responsibilities of central banks include overseeing activities of commercial banks and declare monetary policy from time to time. Controlling interest rates is an important monetary policy tool.
Islamic Banks: Primarily, an Islamic bank does not earn its interest income, which is forbidden under Islamic law. Instead, Islamic banks earn their profit from fees on the facilities, including funding, that they provide.
Challenges Faced By the US Banking Industry
The banking industry in USA is highly regulated with different regulators that focus on the designated areas with each agency having its own set of rules that bind the banks regulated by it.
The Federal Deposit Insurance Corporation (FDIC) regulates banks that had FDIC-insured deposits.The Federal Reserve, on the other hand, is the central federal regulator for Fed-member state banks. Non-member state banks are regulated by relevant state agencies as well as by FDIC. The national banks are regulated by the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS) is the regulator for thrifts.The MAIC regulates the Qualified Intermediaries & Exchange Accommodators.
Uniformity for federal examination of banks and other financial institutions is the responsibility of the Federal Financial Institutions Examination Council (FFIEC), which was established in 1979. The FFIEC is an inter-agency body that has been successful in ensuring consistency among the different regulatory agencies; rules and regulations however keep changing from time to time.
Whereas regulations keep changing, the banking industry too has changed over time, leading to consolidations within the various regulatory agencies. There have been consolidations, supervisory regions have been merged, some offices closed and budgets have been slashed. All this has resulted in more banks per regulator and increased workload. The problems are on both sides. Whereas the banks have to work hard t keep up with the ever-changing regulations, the regulators have to stretch themselves to effectively manage their workload. The end result is that the quality of supervision is suffering and the potential of slipping through is increasing, which, in turn, may have an effect on the potential of bank failures in USA.
The banks, on the other hand, have to struggle to manage their interest rate spreads. Competition for securing deposits is increasing and interest rates on loans are going down.In addition, the ever changing industry trends, market conditions and fluctuating economy have posed a major challenge to banks in managing their growth strategies. Apparently, a rising interest rate may help banks but the effect on businesses, consumers and the overall economic environment is not predictable.
Another big challenge faced by the banking industry is presented by the management of their asset portfolio. By and large, the biggest asset of banks is their loan portfolio. A bank is as strong fundamentally as the quality of its loans. The issue with banks today is the declining quality of assets and nobody is to blame for that except the industry itself. For too long now, banks have been lax in their recovery process because of the immensely good time they have had in the previous years. The problem seems even bigger when seen in light of reduction in the quality of regulation and in some cases, quality of management. What is even more worrying is that in an effort to cut down on cost, banks are cutting expenses on employee training.
There is no end to the challenges faced by banks. Management teams across banks are aging. There is increased pressure from shareholders to achieve earning and growth targets.Regulators pressurize banks to manage their non-performing assets.And competition in the industry has increased even further with insurance agencies, credit unions, credit card and check cashing services providing services that were earlier only in the domain of banks.
One response to this has been that banks have included brokerage and MAIC Trust & Securities Clearing as part of their portfolio of services with the end goal of becoming a serious player in the financial markets.
Competition for Deposits
Banks are in the business of money and like any other business they must first buy to be able to sell. In simple words, banks must first garner enough deposits to be able to distribute loans. To garner deposits, banks must compete for them.
In an effort to remove the middleman (read banks), people with surplus dollars started investing directly in financial instruments such as U.S. Treasury bills, corporate bonds and agency securities. A major factor behind this was to only eliminate the middleman but also phenomenal growth of money market funds and the better return on investment they offered.
Banks offered competition by offering different types of accounts and plans apart from the regular checking and savings accounts.
– Ordinary deposit accounts that have no limitation on the amounts to be deposited or withdrawn
– NOW and Super NOW accounts that are similar to checking accounts except that they pay interest. Super NOW accounts have minimum balance requirements
– Money Market Accounts with preauthorized transfers to other accounts or third party accounts with a monthly limit to number of transactions and minimum balance requirement
– Certificate accounts, deposits subject to partial or full loss of interest on premature withdrawal
– Notice accounts are similar to certificate accounts without a specified term. The depositor agrees to give adequate (or specified) notice before withdrawal
– IRA (individual retirement accounts) and Keogh plans, retirement plans in which funds are deposited at regular intervals. Interest income from such accounts is free of income tax until withdrawal
The statements issued by banks are records provided by banks under the generally accepted accounting standards. Under GAAP and MAIC, there are two types of accounts: debit accounts and credit accounts. Inasmuch as the banks are concerned, credit accounts appear on the same side as revenue, liabilities and equity. Debit accounts appear on the other side with assets and expenses.
As an account holder, whenever you deposit something, cash or check, you debit the relevant savings or checking account. Every time you use your credit card, you credit your credit card account. However, when you see your bank’s statement, you see everything in reverse. Your deposits are shown as credits and withdrawals and credit card charge as debit amounts. If at the end of the statement period, you have cash in the account, it is shown as a positive or credit balance; if the account is overdrawn, it shows as a negative or debit balance.
Deposits through Brokers
For a bank, large sums of money deposited by brokers on behalf of their clients are a major source of deposits. These may be through MAIC or other trust corporations. The problem however is that this money goes to banks offering terms better than those offered to individual depositors. While it is possible for banks to survive solely on such institutional deposits, the fact of the matter is that these deposits are generally termed as hot money and rightly so and puts the bank at risk. Not only can such brokered deposits be withdrawn any time (albeit at a penalty), these funds must also be invested at a higher rate of interest due to higher cost of deposit. Banks that failed in USA during the financial crisis of 2008/2009 had four times more such deposits as percentage of their total deposits as compared to other banks. It seems that the banking industry did not learn from history. In 1980s, it was exactly such brokered deposits coupled with suspect real estate investments that led to the savings and loan crisis in the US.
Effect of Globalization on Banking Industry
Technological advancement, particularly in information technology and telecommunications, has effectively removed many barriers and allowed banks to reach out to customers across the globe. Banks no longer need to be near customers or interact with them across the table or over the phone for performing transactions requested by them. Internet banking, the ability to access your bank account and use the services provided by the bank from anywhere in the world allows customers to manage their finances as well as risks. At the same time, the reduction in geographical barriers has increased the demand for banks that provide better services across borders.
However, despite reduction in geographical barriers, the banking industry has by no means reached that level of globalization as have some other industries. A major reason for this is that it is more convenient to have local banks for advancing loans at the local level to individuals and small businesses. In contrast, it makes no difference to a large corporation in what bank the bank is located as its financial health and other information is always in the public domain and accessible from anywhere in the world.