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Transformation functions of banks

18–19 July 2012

A world without banks

Imagine a world without banks. Suppose someone in such a world, let’s call her Patricia, wants to buy a house, buy a car, or start a business. But she doesn’t have enough money for that.

She can talk to relatives, friends, neighbours, local business, etc. to see if they are willing to borrow her money.

Say she needs 200,000 dollars. Some people she knows may have some money to spare, but not that amount. So she will have to talk to many different lenders to get enough money together.

Some potential lenders (e.g. businesses) perhaps do have a lot of money, maybe more than Patricia needs, but they are not willing to lend it to her, because they don’t know her well and don’t trust her enough to take the risk.

Yet others may have money, e.g. because they saved it up to have a house built. But the actual building hasn’t started yet. Or it’s a company, who will build an extra factory next year, but not yet now. They have a temporary surplus of money, which they could lend out for six months of maybe one year, but probably not much longer. They don’t know exactly how things will develop, and not how fast.

But Patricia, who needs those 200,000 dollars for buying a house, would need the money for 20 or 30 years.

Perhaps if she could offer security, like a mortgage (the right to foreclosure in case of non-payment, i.e. the right to sell the collateral to collect all or part of the loan amount), her chances would improve. But how can she organise that with many different lenders and only one house?

Maybe she’ll eventually succeed in getting her money together and buy her house. But whatever way she does it, it will have involved a lot of fuss and hassle and required many difficult negotiations with many different parties.

Transformation functions

Introduction

Now that banks do exist, it’s all so much easier. Patricia can just go to one bank (or a couple, to see if some have better offers than others), and if the negotiations succeed, she’ll get the full amount for the required period at the agreed conditions. Much less hassle, less effort, less uncertainty.

That’s possible because banks perform various transformation functions, which largely eliminate the above-mentioned difficulties. The bank handles them instead of each borrower individually. The bank can do that, because of its size, number of clients and expertise.

That makes banks useful, even indispensible in modern society.

Now let’s look at each of those transformation functions in more detail.

Transformation of scales

A bank can combine 100 savings accounts with a balance of 100 dollars, 90 accounts with 1000 dollars on them, and two worth 50,000, to use as funding for a mortgage loan of 180,000 dollars. (Keeping 20,000 as cash reserve.)

The bank can do that because it has so many clients with savings accounts, large and small.

In the opposite direction a bank could turn an investment by a pension fund, worth 100 million, into 500 mortgage loans of 200,000 dollars each. Or into 400 of 200,000, 150 of 100,000 and 10 amounting to 500,000 dollars. Or any other combination, as required.

The bank can do that because it has so many clients who want mortgage loans.

Transformation of duration

A mortgage loan is long-term, like 20 or 30 years. Savings accounts may be long-term, but also shorter-term, and increasingly (in the Netherlands at least, where I live), they are withdrawable on demand.

Yet, a bank could use the money in them to finance mortgages. That’s because the bank has many different clients, and even if the money is withdrawable on demand, in practice most of it remains in the account for longer periods.

Less drastically, a bank can transfer money in savings accounts with a one-year maturity or notice period, into a five-year investment loan for a company. Etc. etc.

Transformation of availability

If you go to a bank and want to deposit some money there, you expect them to always accept it. They aren’t going to say “Sorry, we don’t know how to make useful use of that money right now, first we must find someone wanting to borrow this amount. Please try again next week.

Likewise, if you go to an ATM (Automatic Teller Machine) to get some cash, you don’t expect to see a message on the screen “We apologise for the inconvenience, but next week company X will redeem their loan, so we’ll probably have the cash available for you by then.

Without banks, if all lending were bilateral (directly from lender to borrower), you’d constantly run into such difficulties. Banks can avoid that, because they have many clients with differing behaviour, and large enough buffers.

Transformation of risks

In my example, I mentioned a local business, that has enough money for Patricia’s mortgage, but finds it too risky to lend it to her. But it probably is willing to deposit it in the bank, because the bank has a reputation of being trustworthy.

The bank, in turn, has known Patricia for many years, knows her payment performance, can create a mortgage on her house, so it will take the risk. Moreover, 200,000 dollars is a lot of money for Patricia and the local business, but a relatively small amount for a bank of some size.

Transformation risks

All such transformations, including the transformation of risks, themselves involve new risks. For example, if a bank funds long-term loans with short-term savings account money, they assume most depositors won’t soon withdraw their money and not all of it at the same time. However, if many savers do suddenly withdraw unexpected sums, the bank will have to deal with that. That’s a risk.

But the bank can usually handle those risks, because of its size, loan-loss reserves and expertise.

Banks are like supermarkets

The functioning of banks in modern society is quite similar to that of supermarkets.

You can of course buy your food directly from farmers and food-processing factories. But you’ll be confronted with many of the same sort of problems that I described in my example at the start of this article.

With a supermarket, you can simply go there and buy everything you need, leaving it to them where they get it from and how they organise that in terms of distance, price, quality and quantities.

Of course that comes at a price: the supermarket’s purchase prices are lower than what they make consumers pay. There is a price margin. Likewise, banks have an interest margin.

Banks are money supermarkets. And money wholesalers.

Stating the obvious

The supermarket analogy is quite trivial. While I was writing this article, I often wondered if I really needed to describe all these things that everybody already knows and understands.

But it is necessary, because judging from what I read here and there on the internet, quite a lot of people don’t get it about banks. They don’t see why banks are as useful as they are. Some even want all banks gone. That is very unwise. A step back into the past.


Copyright © 2012 R. Harmsen. All rights reserved.

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