Role of Commercial Banks as Financial Intermediaries
Commercial banks play several roles as financial intermediaries. First, they repackage the deposits received from investors into loans that are provided to firms. In this way, small deposits by individual investors can be consolidated and channeled in the form of large loans to firms. Individual investors would have difficulty achieving this by themselves because they do not have adequate information about the firms that need funds.
Second, commercial banks employ credit analysts who have the ability to assess the creditworthiness of firms that wish to borrow funds. Investors who deposit funds in commercial banks are not normally capable of performing this task and would prefer that the bank play this role.
Third, commercial banks have so much money to lend that they can diversify loans across several borrowers. In this way, the commercial banks increase their ability to absorb individual defaulted loans by reducing the risk that a substantial portion of the loan portfolio will default. As the lenders, they accept the risk of default. Many individual investors would not be able to absorb the loss of their own deposited funds, so they prefer to let the bank serve in this capacity. Even if a commercial bank were to close because of an excessive amount of defaulted loans, the deposits of each investor are insured up to $100,000 by the FDIC. Thus the commercial bank is a means by which funds can be channeled from small investors to firms without the investors having to play the role of lender.
Fourth, some commercial banks have recently been authorized (since the late 1980s) to serve as financial intermediaries by placing the securities that are issued by firms. Such banks may facilitate the flow of funds to firms by finding investors who are willing to purchase the debt securities issued by the firms. Thus they enable firms to obtain borrowed funds even though they do not provide the funds themselves.
Regulation of Commercial Banks
The banking system is regulated by the Federal Reserve System (the Fed), which serves as the central bank of the United States. The Fed is responsible for controlling the amount of money in the financial system. It also imposes regulations on activities of banks, thereby influencing the operations that banks conduct. Some commercial banks are members of the Federal Reserve and are therefore subject to additional regulations.
Commercial banks are regulated by various regulatory agencies. First, they are regulated by the Federal Deposit Insurance Corporation, the insurer for depositors. Because the FDIC is responsible for covering deposits of banks, it wants to ensure that banks do not take excessive risk that could result in failure.
If several large banks failed, the FDIC would not be able to cover the deposits of all the depositors, which could result in a major banking crisis.
Those commercial banks that apply for a federal charter are referred to as national banks and are subject to regulations of the Comptroller of the Currency. They are also subject to Federal Reserve regulations, because all national banks are required to be members of the Federal Reserve. Alternatively, banks can apply for a state charter.
The general philosophy of regulators who monitor the banking system today is to promote competition among banks so that customers will be charged reasonable prices for the services that they obtain from banks. Regulators also attempt to limit the risk of banks in order to maintain the stability of the financial system.