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Financial System                                The Theoretical Rational For the Existence of Banks

1. Introduction

In this paper author review the traditional theory of banking and attempt to examine the theoretical reasons for why banks exist. As a financial intermediation, the natures of the banks are to provide financial services and conduct the intermediary functions in the whole financial system by accepting deposits and making loans. The question raised here are how they conduct these roles and why the borrowers and lenders do not come together without the banks for the saving of intermediation costs, why both of the two parties are ready to pay for their services and what’s the value added by the banks?

The paper proceeds as follows. Section 2 offers a traditional view of banks and describes the nature of them. By analyzing how the banks conduct their traditional function, there rises a question of why the borrowers and lenders do not choose direct deal with each other? Which leads to the consideration of the theoretical rational for the existence of banks. This analysis is presented in section 3, which have an intensive expatiation in the theories.

In section 4, what are the problems if the direct deals between the borrowers and lenders happen, and how can banks solve those problems are presented therefore answer the question why individuals are willing to pay the intermediation costs. This is followed in section 5 by an analysis of the recent changes in the banking industry. With the development of the financial system, declining entry barriers and the deregulation of the banking industry make banks no longer the monopoly suppliers of banking services and reduce their comparative advantages which they usually hold in the past. Whether the reasons give rise to the existence of banks are still powerful will be examined here, while section 6 offers a way of considering whether banks are declining by looking at the value added by the banks. When the value added by banks is examined, banks are not a financial intermediation, which not only conduct the traditional services but also provide more diversified services. Banks themselves are continuously evolving. Therefore, although the traditional factors that give rise to the existence of banks are become less powerful; banks are still survive in a different way.  Finally, section 7 contains concluding remarks.

2. The definition and natures of banks

To begin the analysis of the theoretical rational of the existence of banks, let’s first look at the definition of bank. “They perform an intermediary role in an economy, by accepting deposits and making loans.” (Shelagh A Heffernan,1996) David T Llewellyn (1999) gives the nature of banks: “The traditional view of a bank is that of a financial intermediary: an institution which accepts deposits with one set of characteristics and makes loans or acquire assets with a different set”

To illustrate the traditional intermediary function of a bank, David T Llewellyn (1999) uses a chart of deposits supply and loans demand to describe it. As shown in the figure, Sd is the supply curve of deposit, but bank’s supply of loans is Sl, for banks take the deposit in a lower interest rate and make loans at a higher rate, the difference between the two interest rate is the interest margin that is the intermediation cost paid by the society. The margin i1i0 must cover bank’s non-deposit costs, such as the cost of capital, the risk premium charged on loans, tax payments and the institution’s profits. (Shelagh A Heffernan, 1996)

i        Sl

        i1        

        i2                Sd

        

        i0

        D

        

        O        A        Q

Figure 1

From this figure, it is easy to find out that by direct dealing between the lenders and borrowers, both parties can save most of the intermediation cost by bypassing banks if they choose to transact at the interest rate of i2 for a given volume of OA. In fact, the existence of banks indicates that direct deals are not costless than the intermediation costs paid to the banks. Why using banks is a more cheap way than individuals and why the society wants to pay for their services. In order to answer those questions we need to examine the economic rational for the existence of banks,

3. The existence of banks

David T.Llewellyn. (1999) States that as with any firms, banks exist for one of two generic reasons:

  • They possess certain monopoly powers to do what other firms cannot do.
  • They have the comparative advantages in providing the services, which can also be provided by the others.

The traditional theory of the banking firm emphasizes on eight factors that is given by David T.Llewellyn. (1999)

  • Information advantages.
  • Imperfect markets.
  • The theory of delegated monitoring.
  • Control.
  • The insurance role of banks.
  • Commitment theories.
  • Regulatory subsidies.
  • The special role of banks in the payment system.

The author will explain each of them in turn.

3.1 Information advantages

Information is very important in the financial system. Banks have comparative advantages in getting information than the other parties because banks hold account of their customers. When the firm doesn’t want to disclose their information to the public, by holding and managing the customer accounts, banks can gain valuable information from them conveniently.

3.2 Imperfect markets

Current intermediation theory states that in the traditional Arrow-Debreu model of resource allocation, firms and households interact through markets and financial intermediaries play no role. “When markets are perfect and complete, the allocation of resources is Pareto efficient and there is no scope for intermediaries to improve welfare.”(Franklin& Anthony, 1996) Gurley and Shaw (1960) also pointed out in the absence of market imperfections; there would be little need for financial intermediaries. “As long as there are market imperfections, there are intermediaries;

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As soon as markets are perfect, intermediaries are redundant: they lose their function as soon as savers and investors have the perfect information to find each other directly, immediately and without any impediments, so without costs.” therefore the imperfect of the market give rise to the existence of the banks.

3.3 Delegated monitoring

Banks play a role of delegated monitoring to solve the contracting problem between the borrowers and lenders. Because of the asymmetric information, moral hazard of borrowers will be caused after the contract, for the lenders will never know what’s the real incentive of the borrowers, who ...

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