1.2 Banks Function And Role As Financia Intermediaries

Question 1

Banks perform three core functions for their customers

Answer 1

Operating payment mechanisms
Accepting deposits
Making loans

Question 2

Operating payments mechanisms

Answer 2

Goods and services are exchanges for a sum of money, mutually agreed between buyer and seller.
Allowed customer to make and receive payments

Non bank companies = Worldpay

Question 3

Accepting deposits

Answer 3

To keep money safe and secure and to be able to access it quickly and easily when you need it.

Accept deposits to make people’s savings work for as they earn interest and bank also use this money to lend to others

Question 4

Making loans

Answer 4

For people who need to borrow
Helps fund peoples expensive (directly providers employment)
Charger higher rate of interest then what they pay to savers

Question 5

Financial intermediation

Answer 5

Assets and liabilities - two main section on balance sheet

Question 6

Assets

Answer 6

Loans that a bank make to its borrowers

This is what the borrowers owe to the bank

Question 7

Liabilities

Answer 7

Deposits they accept from saves

Bank owe money to the deposits

Question 8

Lenders

Answer 8

Savers are those who lend money to the bank and this may be surplus money for them.

Effectively giving money to the bank

Question 9

Borrowers

Answer 9

People who have money shortfall or in deficit

Borrow from the bank in overdrafts, loans and mortgages

Question 10

Financial intermediation

Answer 10

Process by which money deposited by a bank (by savers) is lent to those who want to borrow money.

Accepting deposits from savers and using it to make loans to borrowers

Question 11

What is the major financial intermediary

Answer 11

Commercial banks

Main providers of credit to businesses and ie virals

Question 12

Main role of financial intermediary

Answer 12

Provides a mean of transferring and allocating money to places it can be used

Question 13

Savers want banks to perform two main services

Answer 13

1. Make payments - allows customers to have instant access to their money
   (the quicker they have access when drawing their money- more liquidity)
2. Keep customers money safe - banks need to reduce the risk of savers not receiving their income

Question 14

Lending responsibly

Answer 14

The banks duty
E.g. restrict the loan amount to what the customer can afford to repay

Reduces the risk of customers getting into financial difficulty and increases the likelihood of receiving the money back with interest

Question 15

Three types of transformation

Answer 15

Size (aggregation)
Maturity
Risk

Question 16

Size transformation

Answer 16

Collecting large numbers of small deposits from savers and repackaging them into larger size loans

Question 17

Maturity transformation

Answer 17

Medium long term loans to borrowers and at the same time allowing savers to have instant access to their money

Short term deposits are used to finance longer term loans

Question 18

Risk transformation

Answer 18

Bank can make large number of loans to customers and can afford it small borrowers default.

Advanced systems for screening (banks use to identify potential risk characteristics)

Question 19

Savers

Answer 19

Reduced risk as the bank pool its funds and is responsible for paying them out.

Banks hold its own capital (own funds)

Can receive a return on their surplus money as they can access their money quick and easy

Question 20

Borrowers

Answer 20

Large amount of money
Long periods (25-30 year mortgage)
likely to be granted a loan when needed

Question 21

Savers + borrowers

Answer 21

Both benefit from lower transaction costs

(Cost and money spent searching for counterparty - other party in transaction)

Question 22

Profitability

Answer 22

Maximise returns for its shareholders (owners)

Question 23

Commercial bank make profit in 3 ways

Answer 23

1. Pay depositors a lower ROI on their savings
2. Charging fee on some products
3. Purchasing shares and bonds in other companies

Question 24

Profit margin

Answer 24

Difference between interest rate it pay to its savers and interest it charges to its borrowers

Question 25

Liquidity

Answer 25

Turning an asset into cash easily and quickly without losing value

Question 26

Commercial banks can access liquidity from:

Answer 26

1. Deposits made by savers
2. Loans and interest payments by borrowers
3. Loans from other banks in the wholesale markets

Question 27

‘Run on the bank’

Answer 27

Bank is running out of money

Bank must meet customers demand for cash when they need it

If not less confidence

Customers will then demand their money back simultaneously- can cause bank to fail

Question 28

Relationship between profitability and liquidity

Answer 28

Balancing making profit from lending and investments and ensuring the bank has enough cash in reserve to pay its depositors money.

On the other hand, to hold enough cash readily available to meet customers immediate demands and towards profitability by making enough loans and generate profit.

Both these must achieve a balance so that there is safe level of liquidity

Question 29

Money supply in a country and credit creation

Answer 29

Money supply = all currency and other liquid assets

Money supply tends to grow due to inflation and economic growth

Banks deposits is majority of the supply

Question 30

Credit creation multiplier

Answer 30

Use new deposits from customers to make new loans to other customers.

• Bank receives a new deposit
• Bank keeps aside some of the money (keep in reserve) as they can’t lend it all out
• bank lends the rest to a borrower
• borrowers spends the borrowed money
• sellers pay the money into a bank account

All called ‘fractional reserve banking’

Question 31

For fractional reserve banking to operate, various protections put in place

Answer 31

• depositors protection scheme = the scheme guarantees repayment or customers deposit up to a certain amount in the event of a bank failure
• hold reserves = in case of occasional periods of usually high withdrawals
• repayment = bank needs to have sufficient reserves to absorb any losses made in loans not being repaid

Question 32

Disintermediation

Answer 32

Parties transacting in financial products deal directly with each other instead of using a bank or third party as an intermediary

Question 33

Two examples of disintermediation

Answer 33

1. Peer to peer lending (P2P) - deal directly through online platform (fintech)
2. Pension fund = buying company bonds directly in the financial markets
3. Crowdfunding

Question 34

Benefits of disintermediation

Answer 34

• greater returns for investors as dealing directly (benefit from reduced costs)
• alternative source of finance for those with poor credit score
• provides more diverse and cost efficient sources of credit for borrowers

Question 35

Cons of disintermediation

Answer 35

• increase risk of making a wrong choice
  Investing money directly in the FM, requires expertise and skills. Have to make decisions on your own without the help of an experienced intermediary.
• loans can be made to more risky borrowers
  Due to lack of information about borrower
• act less prudently (risers for those dealing directly with each other)