Banks and Money

Question 1

Learn the Difference between Commercial and Investment banks: Commercial Banks

Answer 1

1. Commercial Banks (e.g. TSB and NatWest) have these main roles:
   - To accept savings
   - To lend to individuals and firms
   - To be financial intermediaries
   - To allow payments from one person or firm to another
2. Commercial banks also provide other financial services to customers, such as insurance and financial advice.
3. Commercial banking is split into two areas:
   - Retail banking - providing services for individuals and smaller firms. Retail banks are often called ‘High Street Banks’
   - Wholesale banking - dealing with larger firms’ banking needs.
4. Commercial banks help firms grow by providing loans and financial advice, and by facilitating overseas trade.

Question 2

Learn the difference between Commercial and Investment banks

Answer 2

Investment Banks:

1. Investment banks don’t take deposits from customers. Instead, their role is to:
   - Arrange share and bond issues.
   - Offer advice on raising finance, and on mergers and acquisitions.
   - Buy and sell securities (e.g. shares and bonds) on behalf of their clients.
   - Act as market makers to make trading in securities easier
2. Investment banks also engage in high risk (but potentially very profitable) activities. E.g. propietary trading involves a bank buying and selling shares using its own money.
   - Many large banks operate as both commercial and investment banks (e.g. Barclays and HSBC).
   - Allowing banks to operate as both commercial banks and investment banks creates a systematic risk (i.e. a risk the whole market or financial system might collapse), because banks may wish to use deposits from the commercial banking side of their business to fund investment banking activity. If they lose money in bad investments then their depositors’ money could be at risk.

Question 3

Banks aren’t the only financial institution

Answer 3

There are other financial institutions operating in the global financial markets - its not just banks. e.g.

• Pension funds = collect ppl’s pension savings and invest them in securities. When a client retires, the pension fund pays out their savings and the returns they’ve generated. Pension funds also provide long-term, large-scale investment in companies.
• Insurance firms = firms that charge customers fees to provide insurance cover against all kinds of risk. This is important for the economy - e.g. businesses can insure against the risk of customers not paying (which encourages trade)
• Hedge funds = firms that invest pooled funds from different contributions in the hope of recieving high returns. They usually invest in a number of different markets, but the desire for high returns can => risks for the contributiors, and for the wider economy.
• Private equity firms - these invest in businesses (e.g. by buying equity) and then try to make the maximum return. This could mean helping a business become successful so that it can be sold for a profit. However, they’re often criticised for asset-stripping and cutting jobs.

Question 4

What is the Shadow Banking System?

Answer 4

• The shadow banking system includes unregulated financial intermediaries and the unregulated activities of otherwise regulated financial institutions. The shadow banking system has become much larger in recent years.
• Hedge funds and private equity firms are often considered part of the shadow banking system
• The shadow banking system supplies an increasing amount of credit.
• But the lack of regulation, the absence of the sort of emergency support available to normal banks, and its large size add to the risk of the shadow banking system helping to cause a financial crisis.

Question 5

Money has different levels of liquidity

Answer 5

1. Any financial instrument that satisfies the four main functions of money, and that’s also portable, widely accepted, difficult to forge and durable can be classified as money and counted as part of the money supply.
2. Different types of moeny (and other assets) have different levels of liquidity. Liquidity refers to how easily something can be spent - e.g. notes and coins are very liquid because they can be spent easily, but shares (and houses) are less liquid because they need to be converted into cash before they can be used to buy things.
3. Economists have ‘narrow’ and ‘broad’ definitions of money, based on the liquidity of the different forms.
   - Narrow money refers to the notes and coins in circulation, plus balances held at a central bank. In other words, narrow money consists of financial instruments that are very liquid.
   - Broad money includes assets that are less liquid, as well as all of the things that make up narrow money.

Question 6

Banks have to Balance Profitability and Liquidity

Answer 6

1. Banks are businesses, and one of their aims is to maximise profits for the benefit of their shareholders.
2. The rate of return on illiquid assets (e.g. corporate bonds) is generally higher than that on more liquid assets. So banks don’t want to have too many liquid assets.
3. However, banks need to have a certain amount of liquid assets available. This is because banks tend to lend money over a long term - i.e. they’re paid back over a long period of time. But depositors who give their money to banks expect to be able to withdraw their savings immediately.
4. So banks need enough liquidity to be able to repay depositors when asked, but not too much liquidity, or they might become unprofitable. This means they have to calculate very carefully the amount of liquid reserves they hold.
5. Banks actually rely on depositors not all wanting to withdraw their savings at the same time. If too many depositors want to withdraw their money at short notice, a bank may not have the liquidity to be able to repay them (and it can’t immediately demand money back that it’s lent out long term).
6. This usually won’t be a problem, as its very unlikely everyone would suddenly decide to withdraw their savings at the same time.
7. However, if ppl thought withdraw their savings very quickly, and the bank could quite quickly run out of liquid assets.
8. This is why it’s really important that ppl trust the banking system with their savings. It’s also why a central bank is needed to act as an emergency lender of last resort.

Question 7

Risk if Profitable but… Risky

Answer 7

1. Risk is a key idea in finance. All other things being equal, risky investments will usually generate a higher return than less risky ones. Investors will want high rewards for risking their money. This is why different interest rates are charged in different money markets - the more secure an investment is, the lower the rate of interest that will be earned.
2. All investors must balance the security of an investment against its profitability.
3. This is esp important if an investor is using someone elses’ money, or if the firm they’re working for is particularly important to the stability of the financial system.