CHAPTER 1

FUNCTIONS & FORMS

OF BANKING
Dr. Abid Mahmood 1
 Contents
- Introduction
- Historical Background
- What is a bank?
- What do Banks do for their Customers?
- Types of Risks
- Major factors affecting Banking & Market Shares
- Role of Banks in the Economy
- Assets and Liabilities of a Commercial Bank

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 Introduction
Banks are the main source of finance & investment for the trade, commerce, and industry and
therefore recognized as the backbone of modern business world.

The development of any country is significantly influenced by the strength and resilience of its
banking system, as their operations directly impact the overall availability of loans and
investments.

Point to Ponder
• Banks are similar to other profit-making businesses; they are owned by investors who
expect favorable returns on their investments.
• They operate safely and profitably within a competitive market.
• Banks are the most regulated financial institutions.
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 Cont’d
Recognition as a bank is dependent on the satisfying of following conditions:

1. High reputation and standing in the financial community.

2. Providing of a wide range of banking services, e.g., current and deposit account facilities,
overdraft and loan facilities, foreign exchange, investment management & corporate
finance and so.

3. Satisfying the central authority concerned (mostly Central Banks) that the institution’s
business will be carried out with integrity, prudence and professional skills.

4. Maintenance of paid up capital, reserves and other financial resources as are considered
appropriate.
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 Historical Background
The creation of money led to the development of financial institutions* such as banks.

Western commercial banking started in around the 14th century in Florence (Italy) and became
more established in the 18th (1760 – 1840) century with the advent of the Industrial Revolution.
It was established by three groups of people and to this day conventional banking shows
traces of its ancestors.

1- Rich and Reputable Merchants 2- Money Lenders

3- Goldsmiths
Like a merchant the bank finances foreign Like money lenders the bank pools the savings
of the masses and lends it out to those with a Like a goldsmith the bank serves as a trustee of
trade, issues bills of exchange and provides
shortage of finances generating profit by customers’ valuables.
capital to new business ventures.
charging higher interest to the borrowers and
paying lower interest to the savers.

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 What is a Bank?

A bank is a financial institution whose primary activities include providing financial services to
customers while enriching its investors.

Banks accept deposits from customers who want the safety and convenience of deposit
services and the opportunity to earn interest on their excess funds.*

 In short, bank acts as a financial intermediary** that channels funds between savers and
borrowers.

 Thus, a bank is a financial intermediary for the safeguarding, transferring, exchanging, or

lending of money.

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 Banking
Banking refers to the activities and services provided by the bank to generate income.

Banks generate income through several methods. One key way is by putting money to work
when they lend it out.

Most of their income comes from the interest that people or businesses pay as they repay a
loan.

The difference between what a bank pays in interest and what it receives in interest is called
the spread, or net interest income.

The spread represents income or revenue, but it is not pure profit. Profit is what remains
after all costs have been deducted from the revenue.
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 Cont’d
To illustrate the traditional intermediary function of a i SL
bank, consider Figure 1.1, a simple model of the
deposit and credit markets. (Ref. pp.18,19 & 20)1 SD

The interest margin is equal to iL − iD and covers the iL

institution’s intermediation costs, the cost of capital, i*

the risk premium charged on loans, tax payments and
the institution’s profits.
iD
Market structure is also important: the greater the
DL
competition for loans and deposits, the more narrow
the interest margin.
0
T B Volume of Loans/Deposits

The Banking Firm – Intermediary (Fig. 1.1)

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 Cont’d
Other Sources of Income

In addition to interest income, banks have other sources of income.

They charge for various

services such as rental of safe-
deposit boxes, account
Banks make money on
maintenance fees for checking
investments.
accounts, fees for online bill
payments, and ATM
transaction fees.

Banks may have funds at their

disposal from stockholder
investments.

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 Cont’d
Economies of Scale
(given the large number of savings and deposit products
offered, the related transactions costs are either constant
or falling.)

The banks have the advantage of:

Economies of Information
(the bank enjoys information economies of scope in
lending decisions because of access to privileged
information on current and potential borrowers with
accounts at the bank.)
Point to Ponder
 The banks with lowest possible costs will have advantage over others.
 Provision of loan at higher costs to the firms will single out them as firms can go for
issuing bonds.
 Firms do take loans from banks because it shows their creditworthiness.
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 What do Banks do for their
Customers?
Some of the fundamental principles of banking that are universally recognized across all banking
systems include:

As a financial intermediary bank performs two major functions:

Financial Intermediation* 1. Deposit Function (Deposit Creation)
2. Loan Function (Lending)

1. Banks are the core of the payments system.

2. Movement of funds via credit cards, electronic banking, wire
transfers etc.
Payments 3. Retail payment system is for individual level transactions including
utilities and receiving or payment of funds.
4. Large payment system is for bank-to-bank transactions.

1. Off-balance sheet Activities

• Earning from Financial Derivatives
Other Financial Services • Issuance of L/C
• Guarantees
2. Insurance and Securities Related Services

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 Banking Business Lines

The Basel Committee divides banking

business activities into eight business
lines.

1. Corporate 4. Commercial 5. Payments and 6. Agency 7. Asset 8. Retail

2. Trading & Sales 3. Retail Banking
Finance Banking Settlements Services Management Brokerage

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 Types of Risks
Banks are exposed to a wide range of risks due to their complex operations and the diverse nature
of financial markets.

1. Credit Risk*

Credit risk is the risk to a bank’s earnings and capital that an obligor (counterparty) may fail to
meet the contractual obligations, leading to a financial loss for the bank.
 Banks don’t make bad loans (NPL), however, they may make loans that go bad (bad debt/non-
performing loans).
 Initially, the decision seems correct however, unforeseen changes in economic conditions and
other factors such as interest rate shocks, changes in tax law etc. have resulted in credit
problems.
 Credit Risk is the primary cause of bank’s failure.

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 Types of Risks (Cont’d)
2. Liquidity Risk
Liquidity risk arises when a bank lacks enough liquid assets (cash or easily convertible assets) to cover
its short-term obligations, such as deposit withdrawals, loan disbursements, or other financial
commitments.*
The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans
makes them inherently vulnerable to liquidity risk.

Depositors, borrowers, and lenders have different liquidity preferences.

If the bank cannot quickly raise funds by selling assets (asset-based reason) or borrowing at reasonable
terms (liability-based reason), it may incur unacceptable losses by selling assets at a discount or
facing financial distress.
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 Cont’d
3. Market Risk*

Market risk is the risk of loss in the value of a bank’s financial instruments due to changes in market
conditions, leading to adverse movements in market prices, such as interest rates, equity prices, foreign
exchange rates, and commodity prices.
a) Interest Rate Risk
Interest rate risk is the risk arising from the unfavorable change in market rates of interest. For example, the
Banks’ value of assets (debt securities) fall with increase in interest rate. Similarly, cost of borrowed funds are
affected.
b) Foreign Exchange Rate Risk
Exposure to fluctuations in in foreign exchange rates.
c) Equity Price Risk
Equity Price risk is the exposure of a bank’s earnings and financial condition to adverse movements in equity
indices and individual equity prices. There are two main aspects of equity price risk—systematic risk and non-
systematic risk.
d) Commodity Price Risk
Commodity price risk is the exposure of a bank’s earnings and financial condition to fluctuations in
commodity** prices.
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 Types of Risks (Cont’d)
4. Reputation Risk
The risk of damage to the bank's reputation, which can affect customer trust, stock prices, and overall
business. Examples: Scandals, negative media coverage, regulatory fines etc.

5. Operational Risk

Operational or transaction risk is the risk to earnings and capital arising from problems associated with
the delivery or services of a product. It includes failure of management information system, inefficient
personnel, regulatory compliance, external and internal frauds, and lawsuits etc.
Sources of
Definition Examples
ORs
People risk is the risk that people do not follow the organization’s procedures,
• Operational losses due to human errors
People practices and/or rules. It is the risk that people deviate from expected
• Employee fraud
behaviours.
• Inadequate segregation of duties
Process risk is the risk from faulty overall design and application of business
Process • Absence of internal controls
processes
• Erroneous legal documentation
• IT system breakdown resulting in losses for the
Systems risk is the risk of failure arising from deficiencies in the bank’s
Systems bank
infrastructure and information technology systems
• Power outage
• Natural calamities
External events risk is the risk associated with events outside the bank’s
External Events • Wars
control. 16
• Terrorist attacks
 Cont’d
CONSTRAINTS
Bank management must balance risk and return in seeking sustainability and to maximize shareholder
wealth. However, such decisions are exposed to constraints by many factors:
1. Market Constraints
 Bank’s growth and profitability is directly proportional to growth rate of the economy.
 Secondly, there is competition with other banks e.g., Bank A charges 25% rate and Bank B is charging
28% to cover its credit risk. Bank B has a market constraint.

2. Social Constraints
 Social constraints stems from the Bank’s historical position.
 They are expected to provide deposits and credit services to the community they serve.
 The economic health of the community affects the bank’s position.

3. Legal Constraints
a) Constraints on balance sheet position, including prohibition on holding equity securities, and
capital requirements.
b) Constraints on customer relationship, including a large number of consumer protection laws.

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 Major factors affecting Banking & Market
Shares
1. Inflation and Volatile Interest Rates
◦ Higher inflation causes interest rate to soar.

◦ Banks may suffer if they have transformed the short-term liabilities (deposits) into long-term fixed
assets (financing).
◦ Increase in interest rate devalues the assets (credit securities) of the bank.

◦ Higher interest rate may cause the borrowers to default.

2. Securitization
◦ Securitization is the issuance of debt instrument in which the promised payments are derived from
revenues generated by a defined pool of loans.
◦ In US, the market share of such assets are larger than the overall assets of commercial banks.

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 Cont’d
3. Technological Advancements
◦ Improved economies of scale with the introduction of technological advancements accessing large
number of customers and lowering the personnel costs.
◦ Economies of scope* improved as the services that were traditionally provided by two different
departments could now be performed through one electronic platform.
◦ Banks with UpToDate tech (e.g. fintech, smart contracts, blockchain etc.) can have greater market
share.

4. Consumers
◦ More-sophisticated consumers have played a major role in the changing structure of the financial
services industry.
◦ Rise in the education in personal money management, as well as high returns on the financial
assets in some periods and losses in others, have affected the fund flow in the banks more volatile.
◦ Technological advancement and use by the customers make the transfer of funds easy, but on the
other hand, makes the funds flow volatile.

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 Cont’d
5. Deregulations
◦ Deregulations have affected the operations of commercial banks to a great extent.
◦ Elimination of geographical limits, innovation in products and services have affected the decision
making of the banks in achieving greater market shares.

6. De-specialization and Competition

◦ De-specialization of financial institution has been an important force in changing the structure of
the financial service industry.
◦ The trend is for banks to become a one-stop shopping center for all financial services.
◦ Increased competition among the banks to provide vast facilities to the customers at lower cost.

7. Globalization
◦ Globalization of financial service organizations has affected the operations and structure of many
financial service organizations.
◦ The results of this global integration of financial markets is growing competition among financial
services firms.

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 Role of Banks in the Economy
Banks and other financial institutions play a critical role in performing services that
are essential to the functioning of an economy.
 Keeping your money safe
 Spreading wealth
 Transferring money (between banks, individuals, industry and governments)
 Lending (to individuals, businesses, and governments)
 Evaluating Creditworthiness (essential for a secure financial environment)
 Guaranteeing the money (to make sure that the money supply is adequate,
appropriate and trustworthy)*

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 Liabilities & Assets of a Commercial Bank

A. Liabilities of a Commercial Bank

◦ The liabilities of the bank are the items which are to be paid by the bank- either to its
shareholders or to the depositors.
◦ Every commercial bank gets funds mainly in three ways viz. Share Capital, Reserve Fund and
Deposits from the general public.
◦ Share capital is the contribution made by the shareholders of the bank.

◦ Reserve fund is the amount accumulated over the years out of undistributed profits. It actually belongs
to the shareholders. Share capital and reserve fund are liabilities of the bank , as they have to be paid to
the shareholders.

◦ The deposits from the general public constitute the biggest proportion of the bank’s working funds.
These funds are liabilities of the bank as they have to be returned to their owners viz. deposit holders.
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 Cont’d
B. Assets of a Commercial Bank
◦ The assets of the bank are those items from which the bank hopes to get an income, the
assets include all the amounts owned by others to the bank.
◦ The main items of a bank’s assets are as follows: (They are listed in descending order of
liquidity but ascending order of profitability)
1. Cash Balances

2. Money at Call and Short Notice

3. Short- term bills

4. Investments

5. Loans and Advances

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