Banks Necessity: Your Empowering Catalyst for Thriving Financially

Introduction:

Banking history is, in effect history of private bankers, who, through their social, political, economic, and inherited clout, governed the flow of capital in advanced societies. Early goldsmiths, English bankers, French financiers, and American financial pioneers rode the financial tide of imperialism, industrialisation, and war economies. They played a key role in shaping the “wealth of nations” and the ability of states to finance militarisation, build infrastructure, and finance imperialism. Nevertheless, it was the emergence of commercial banking during the 1950s that paved for the bank for many, not the few. However, these very banks also led to the mass destruction of wealth during the financial crises of the 1980s and 2009. Hence, one wonders why we need banks and why, now and then, banks have been complicit in alleged misconduct and violations, but their necessity in our economy cannot be denied. The answer to this question lies in understanding the multifaceted role of banks in our economies.

Role of banks:

Banks are crucial agents in the economy that help in: 

1. Transmission of the monetary policy: Through open market operations and interest rates, central banks regulate the money supply in an economy. It helps a country to manage its inflation business cycle and control government, firms, and citizens’ spending and saving behaviour.  
2. Minimise Information Asymmetry: In indirect exchange of capital, where one party (investors) have limited information about the other party (firms and their management), we need a third party to verify the data used by investees to get finance (Rajan and Zingales, 1995). Banks, through their close relationships with firms and management (James (1988) and James and Wier (1988)) act as a verifier of a borrower’s quality in the financial markets. Banks, through their investment in firms and underwriting stocks issued by firms, may signal that these firms are good quality investments. Furthermore, these institutions may also verify the creditworthiness of individuals through verifying their income and expenses. As personal bankers of citizens, they act as the best judge to confirm whether a mortgage borrower or loan seeker is likely to pay back.
3.  Reduce transaction costs and increase economies of scale: Imagine if you, as an individual or a firm, need to raise capital from the financial markets. You need to meet regulatory requirements, establish a proper communication channel between you and your investors and seek approval from authorities to launch your IOU papers or stocks. Moreover, as a new borrower, firm, or start-up, an investor would view you as a risky investment. There’s no track record of your financial history, nor can investors verify your financial position. As a result, they may ask higher rate of return or interest rate to offer you investment. This is also a result of information asymmetry. Banks, as Ministers of information asymmetry, can help you lower your cost of capital and interest rates and help you minimise information asymmetry between you and your investors. By lending you money or investing in your firm, they can signal to the market that you are a good quality borrower and firm. By signalling your credit quality, they can indicate to investors that you are not a high-risk borrower or stock and may result in investors demanding lower premiums and interest rates for their investment.
4. Allocative Efficiency:  Banks must ensure that capital is allocated to the best alternatives that minimise risks and maximise return. This principle is a simple objective of investment that allows for every £1 invested, the rate of return (dividend, interest, or capital gain) is highest, and the relative risk is lowest. Banks, through their position as market makers, are ideally placed to ensure that capital is allocated to appropriate places. Further, as they relate to the centre of finance in any country, they know which industry or sector needs money now. Therefore, through their accumulation of capital and economies of scale in borrowing and raising capital, banks can provide the cheapest source of financing for growth sectors. This helps an economy grow and ensures that savings earn decent yields, and savers and investors are rewarded for their capital investments.  
5. Time Intermediation: Banks are perpetual structures in our societies. Banks often outlive their customers, and one may notice that some banks have been established for centuries. The longevity of banks enables them to gain the trust of generations, become a source of wealth and transition from one generation to the next. As a custodian of our national wealth, they keep our deposits safe, grow them, and ensure that returns are re-invested to build infrastructure for the next generations.
6. International Flows of Capitals: Banks also enable international investors to invest in different countries and currencies. Banks do so by allowing foreign investors to exchange and transfer their capital from one country to another. Then, they do so by repatriating yields on foreign investment back to foreign investors’ home countries.
7. Help in international trade: Banks play a central role in facilitating international trade. They open letters of credit, write insurance and bearer cheques, and finance the working capital of firms to manufacture in one part of the world and sell in the other. They also enable importers to pay for their purchases of foreign goods and exporters to receive payments for their foreign sales on time.

Covering what banks do in one article is too big a topic to be covered. However, banks are crucial because of their activities, not because they are banks. The real question is whether they can be replaced in the 21^st century and their alternatives.

References

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