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Economic Functions
The economic
functions of banks include:
1.Issue of money, in the form of banknotes and current accounts subject to
cheque or payment at the customer's order. These claims on banks can act as
money because they are negotiable or repayable on demand, and hence valued
at par. They are effectively transferable by mere delivery, in the case of
banknotes, or by drawing a cheque that the payee may bank or cash.
2.Netting and settlement of payments – banks act as both collection and
paying agents for customers, participating in interbank clearing and
settlement systems to collect, present, be presented with, and pay payment
instruments. This enables banks to economise on reserves held for settlement
of payments, since inward and outward payments offset each other. It also
enables the offsetting of payment flows between geographical areas, reducing
the cost of settlement between them.
3.Credit intermediation – banks borrow and lend back-to-back on their own
account as middle men.
4.Credit quality improvement – banks lend money to ordinary commercial and
personal borrowers (ordinary credit quality), but are high quality
borrowers. The improvement comes from diversification of the bank's assets
and capital which provides a buffer to absorb losses without defaulting on
its obligations. However, banknotes and deposits are generally unsecured; if
the bank gets into difficulty and pledges assets as security, to raise the
funding it needs to continue to operate, this puts the note holders and
depositors in an economically subordinated position.
5.Maturity transformation – banks borrow more on demand debt and short term
debt, but provide more long term loans. In other words, they borrow short
and lend long. With a stronger credit quality than most other borrowers,
banks can do this by aggregating issues (e.g. accepting deposits and issuing
banknotes) and redemptions (e.g. withdrawals and redemptions of banknotes),
maintaining reserves of cash, investing in marketable securities that can be
readily converted to cash if needed, and raising replacement funding as
needed from various sources (e.g. wholesale cash markets and securities
markets).
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