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As we discussed earlier, enhanced liquidity is created for the depositor with a bank. If an individual purchases the securities of the ultimate lenders (such as making a loan to a company), liquidity is low or almost zero. Banks are in the business of purchasing less (or non-) marketable primary securities, and offering liquid investments to the ultimate lenders.
Price risk lessened for the ultimate lender
Flowing from the above is that banks take on price risk and offer products that have little or zero price risk. Banks have a diverse portfolio of non-marketable loans, bonds and share investments that carry price risk (also called market risk), and offer products that have zero price risk, such as fixed deposits.
Figure 7: risk & diversification
One of the central doctrines of portfolio theory (and practice) is that risk (defined as variability of return around the mean return) is reduced as the number of securities in a portfolio is increased, provided that the returns are not perfectly positively correlated. It may be said that part of the investment risk is "diversified away" as one increases the number of securities (assets) in a portfolio.7 This concept is illustrated as in Figure 7.
With investments, members of the household and (small and medium) corporate sectors can only achieve limited diversification compared to a bank which aggregates small amounts of deposits for investments in the securities (mainly NMD) of the ultimate borrowers. Thus, an investment with a bank is an indirect investment in a wide variety of assets (mainly NMD), achieving diversification and lessening risk. Earlier, we used the example of a father lending to his son. This is highly risky, because there is a fair probability of him receiving zero return and losing 100% of his investment. He lessens risk by lending to a number of individuals and companies via a bank deposit.
Economies of scale
This was touched upon earlier; however, there is no harm in elaborating. Because of the sheer scale of banks, a number of economies are achieved. The two main economies that are realised are: transactions costs and research (search) costs.
The largest benefit of financial intermediation is the reduction in transactions costs; in fact some intermediaries have been formed specifically because of transactions costs [e.g. securities unit trusts (SUTs) and exchange traded funds (ETFs). The obvious example is that the (transaction) cost involved in purchasing a small number of shares in a company via a broker-dealer is similar to the cost of purchasing many more shares. More important is payments system costs. The banking system, through the use of sophisticated technology, provides an efficient payments service (cheque clearing and electronic payments) that is relatively inexpensive. Individual participants in the financial system cannot achieve this reduction in transactions costs.
Research (search) costs
An example is the purchase by an ultimate lender of shares and bonds as opposed to holding bank deposits. S/he now has the task of monitoring the performance of each company, which involves economic analysis, industry analysis, ratio analysis, etc. Financial intermediaries have the resources to carry out research, which essentially benefits the holders of its products (deposits).
The banking sector provides the mechanism for the making of payments for anything that is purchased (goods, services, securities). Certain financial assets serve as a means of payments, and there are instruments of transfer, and purchases / payments are settled efficiently, assuming an efficient payments system (clearing and settlement). The financial assets / instruments of transfer that are accepted as payment include:
• Financial assets (money):
- Bank notes and coin (issued by the central bank in most cases).
- Bank deposits.
• Instruments of transfer:
- Credit, debit and smart cards.
- Electronic funds transfer (EFTs) facilities (such as internet banking facilities).
Monetary policy function
The banks are both the instruments of money creation and the mechanism for the implementation of monetary policy. The monetary authorities are able, through various means, to exert a powerful influence on the interest rates of banks, and, in turn, to influence consumption (C) and investment (I) spending. C + I = GDE (gross domestic expenditure), and GDE contributes over 60% to GDP (gross domestic product8) (and as high as 80% in some countries). GDP growth is a major input in the other objectives of policy: stable employment, balance of payments equilibrium and low inflation.