Broad functions of banks

Introduction

In the previous section we discussed the basic underlying raison d'être of banks: information costs and asymmetry in liquidity preference. These may also be seen as the main functions of banks. Allied to these functions are a number of other functions, for example payments services (which are closely related with the taking of deposits). The longer list of the functions of banks is as follows:

• Facilitation of flow of funds (this is the obvious one).

• Efficient allocation of funds.

• Assistance in price discovery.

• Money creation.

• Enhanced liquidity.

• Price risk lessened for the ultimate lender.

• Improved diversification.

• Economies of scale.

• Payment system.

• Monetary policy function.

Facilitation of flow of funds

In essence, financial intermediaries facilitate the flow of funds from surplus economic units to deficit economic units. Without sound financial intermediaries, much of the savings of the ultimate lenders will not be available to the ultimate borrowers. There are numerous examples in underdeveloped countries where individuals keep their savings in the form of notes and coins as opposed to deposits with unsound banks.

Efficient allocation of funds

Banks (not all though) have the expertise to ensure that the flow of funds is allocated in the most efficient manner. As noted, they are aware of the existence of asymmetric information and its two by-products, the problems of adverse selection and moral hazard.6 Asymmetric information means that the potential borrower has more information than the bank does about his/her business.

As we have seen, the presence of asymmetric information leads to adverse selection and moral hazard problems. Adverse selection means that bad risk borrowers are more likely to want loans than good risk borrowers. Moral hazard purports that once a loan is granted the borrower may be inclined to take risks with the money that are not disclosed to the bank in the application. These are two of the many real-life risks faced by banks. They are keenly aware of them, and this ensures that available funds are allocated to borrowers that will utilize the funds prudently, which in turn will lead to an increase in economic activity.

Assistance in price discovery

Closely allied with efficient allocation of funds is price discovery. The banks are the professionals / experts in the financial system (after all, they also make up a large part of the system), and are therefore keenly involved in price discovery. They are actively involved in the pricing of financial services and securities.

It is notable, however, that the cue for interest rates, especially at the short end of the yield curve, emanates from the central bank. This is elucidated in the separate section on money creation.

Money creation

Also closely allied with the efficient allocation of funds is money creation. This function may also be termed the credit of loan function. Not only are existing funds allocated efficiently, but new money is also allocated efficiently by the banking sector. They have the unique ability to create money (their own deposits) by making new loans, i.e. literally by accounting entries. But, this takes place under the guidance of the central bank.

The banks may thus also be seen as the intermediaries that ease the constraint of income on expenditure, thereby enabling the consumer to spend in anticipation of income and the entrepreneur to acquire physical capital. These are of benefit to the overall welfare of the country. Money creation is covered more fully below.