The Role of the Financial Sector

The Role of the Financial Sector

Banks are important financial intermediaries at the heart of credit creation, and thus the economy.

To mobilise savings for lending – credit creation/financial intermediaries

  • Individuals borrow to fund property purchases; businesses borrow to fund investment and for working capital.

  • People and businesses save in order to have funds for emergencies and to spend in the future.

  • Savings usually need to be safe and secure; too much risk would defeat the purpose of saving.

  • Banks take in savings deposits and pay a fairly reliable, if often low, rate of interest.

  • They provide safety and channel the funds towards businesses that want to invest, charging a higher rate of interest than they give to savers.

  • The difference between the two rewards the banks for carrying risks and covers the costs of banking processes.

To lend to businesses for investment/WC – investment banks

  • Businesses need working capital to cover the gap between paying for the costs of production and receiving payment from the customer.

  • Some businesses pay their customers 60 days after delivery – TRADE CREDIT

  • Banks are a major source of loans and overdrafts for working capital.

To lend to individuals – retail banks/building societies/pension funds

  • Consumers need to borrow in order to buy expensive items; they need mortgages in order to buy their homes.

  • Banks provide loans and overdrafts to reliable individual customers

The Role of the Financial Sector, figure 1

How a bank facilitates the exchange of goods and services

  • Any kind of trade requires payment mechanisms.

  • Banks provide these for both domestic and international trade.

How a bank assesses creditor risk

  • Banks would not be able to carry risks unless they could evaluate the probability of a loan not being repaid.

  • Investigating the level of risk can be costly but makes it possible for banks to act as intermediaries between savers and borrowers.

  • However, mistakes can be made in the estimation of risks, which was one cause of the financial crisis – the ‘subprime housing market’ in the USA!

Comprehend how a bank provides a ‘forward market’ for currencies and commodities

  • Banks can help businesses that need to arrange purchases ahead of the time they are needed, i.e. in the forward market.

  • For example, they draw up contracts for future deliveries of raw materials or for buying foreign exchange on a specific date.

  • For the business, this reduces the risks associated with price or exchange rate changes.

Outline how a bank provides a market for equities (shares)

  • Until 1987, only specialist stockbrokers could buy and sell equities (shares) to the general public.

  • Most banks now provide this facility; many stockbrokers have been taken over by banks.

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