Why Banks Are Special: Their Role in Transformation
A simplistic definition of a bank is “a financial intermediary that offers loans and deposits and payment services. These constitute the bank’s distinguishing features. It acts as an intermediary in channeling funds from savers to borrowers”. Hence, the core activity of a bank is to collect deposits from savers, and out of these, provide loans to borrowers. Borrowers can also be called Deficit Units, which means that they spend more than they earn. The difference between spending and income is the deficit, which must be covered by debt. On the other hand, savers can be referred to as Surplus Units, which means that they earn more than they spend, and thus have funds left over which can be lent to the Deficit Units.
The borrower of the saver’s fund would have a financial liability towards the saver, which is the duty to pay back the amount borrowed, whereas the lender would have a financial asset, referring to fund which are yet to be collected. Applying this to banks, which intermediate between the surplus units and the deficit units, the bank assets are made up of loans provided to clients, and the bank’s liabilities on the Bank’s Statement of Financial Position are made up of deposits received from clients.
Different requirements of lenders and borrowers
The period of time of the loan/deposit is one key difference in the requirements of surplus units (lenders) and deficit units (borrowers). Borrowers seek long term loans, while savers would be willing to lend their funds for a short period of time. An example is a client seeking a home loan of €80000 to be paid back in 30 years (borrower – long term), when nearly no individual lender would be willing to tie their funds for so long and generally seek liquidity (lender – short term).
Lenders want the highest possible return on their savings (high interest), while borrowers seek to minimise the cost of borrowing (low interest). Banks serve a very important function in bridging the incompatible requirements of lenders and borrowers, as they undertake transformation in three aspects.
The role of banks in Transformation
Banks fulfill the role of bridging the gap between the needs of deficit units and the needs of surplus units. Deficit units seek large-sized loans, for a long period and have a higher risk of defaulting in their repayment. Surplus units, on the contrary, save small-sized amounts, seek liquidity (short term deposits), and have a low risk of not getting their money back. The three-pronged transformation carried out by banks involves Size, Maturity and Risk.
- Size transformation refers to joining several small deposits by different surplus units to issue loans of large amounts to deficit units. For example, 1000 surplus units deposit €1000 each with the bank, which in theory is able to issue a loan of €1000000 to a company to finance the purchase of machinery equipment.
- Maturity transformation refers to the short term nature of continuously incoming client deposits being converted in longer-period loans to deficit units. For example, demand deposits such as savings and current accounts can be converted in Home Loans for 25 years.
- Risk transformation means minimising the risk of the funds deposited by savers and lent to borrowers (credit risk). Banks do this by diversifying their investment funds, pooling risks, screening and monitoring borrowers, and holding capital and reserves to be able to make up for unexpected losses without affecting the savers badly.