Principles of Banking

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Principles Of Banking & Finance

Chapter 2 : Financial Systems

Economic function: Channeling funds from units who have saved surplus funds to units who have a shortage of funds.

Lenders-Savers : Units who have saved can lend funds.
Borrower-Spenders : Units with a shortage of funds must borrow funds to finance their spending.

Channelling of funds are important because,
- Lender-savers have excess of available funds but do not frequently have profitable investment opportunities, while borrower-spenders have investment opportunities but lack of funds. - Borrower-spenders may want to invest in excess of their current income or to adjust the composition of their wealth.

Direct Finance : Borrower-Spenders borrow funds directly from lenders in the financial markets by selling them securities.
Indirect Finance : A financial intermediary helps to transfer funds from one to another. (Most Important)

Monetary function: Enables savers/spenders to separate the act of sale from the act of purchase and enables them to overcome the main problem of barter. (“The Double Coincidence of Wants”)

Financial Markets: - Markets in which funds are moved from Lenders-Savers to Borrower-Spenders.
- Where securities are being traded.
- Have direct effect on personal wealth and behaviours of businesses and consumers.
- Contribute to increase the production and efficiency in the economy.

Securities: - Financial claims on issuer’s future income or assets.
- Represents financial assets (buyer) and financial liabilities (seller).
- Governments and corporations raise funds to finance their activities by issuing debt and equity instruments.
- Bonds: Securities that promise to make periodic payments of a sum of money for a specified period of time.
- Shares: Securities that represent ownership in the issuing firm.

Financial Intermediaries: - Economic agents who specialize in the activities of buying and selling financial contracts and securities.
- Financial Securities: Easily marketable and sold.
- Financial Contracts: Not easily marketable and sold.

Financial Institution: - Banks are the largest financial institution in the economy.
- Accepts deposits and makes loans.
- Borrows deposits from people who have saved and in turn make loans to others.
- Mutual funds, pension funds, insurance companies and investment banks have been growing at the expense of banks.

Taxonomy of Financial Intermediaries

Depository Institutions
- Intermediaries with a significant proportion of their funds derived from customer deposits.

1. Commercial Banks
- Accepts deposits (liabilities) to make loans (assets) and to buy government securities. - Deposits: Checkable, Savings and Time deposits
- Loans: Consumer, Commercial and Mortgages
- Largest group of financial intermediaries in USA.
- Industry has experienced a consolidation as a result of mergers and acquisitions.

2. Savings & Loan Associations
- In the past, S&L and thrift institutions form the 2nd largest group of financial intermediaries, concentrating mostly on residential mortgages.
- Acquiring funds primarily through savings deposits.

1950 & 1960 - Grew much rapidly than Commercial Banks.
1979 & 1982 - Change in monetary policy causes a dramatic surge in interest rates.
- S&L had negative interest spreads in funding the fixed-rate long-term residential mortgages. - Had to pay more competitive interest rates on savings deposits as FED limited the interest rates payable on deposits by S&Ls. (Regulation Q) Early 1980s - Congress passed acts allowing S&Ls to expand their deposit-taking (Offer checking a/c)...