THE THEORY OF THE BANKING FIRM

AHAM  NZENWATA

                                                           

ABSTRACT

This research paper is on The Theory of the Banking Firm. For the purpose of the paper, we examined the nature, classification of financial intermediation role of banks in the economy. We also examined the place of banks in this process in addition and comparison to that of the capital market as financial intermediary. It is shown in the paper that in comparison to the capital market, the money market with special emphases on banks are the most important financial intermediation agents in the financial system. This is because the financial intermediation role of banks is more encompassing and inclusive than the capital markets whose role as a financial intermediary is a lot more the preserve of those segments of the society that more financially literate and elitist than the general populace. Secondly, banks perform some intermediation roles which they only are legally permitted to do. Finally, the paper shows that the problems associated with direct financing including: transaction costs, asymmetric information and counter party risk can only be comprehensively solved through the financial intermediation role of banks.

1        INTRODUCTION

In every economy, there exist some economic units who posses funds in excess of the amount they require. On the other hand, there also exist some units that have needs of far more funds than they posses. When this situation prevails, the process of financial intermediation play the very important role of providing the necessary mechanisms and institutions through which equilibrium in the demand and supply of funds can be achieved. According to Ezirim (2005), financial intermediation provides the economic system the allocative conduit through which scattered savings of the masses of society are first aggregated and then efficiently re-allocated among economic units.

There are numerous institutions through which financial intermediation is achieved in any market based economy. These are banks and other non-bank financial institutions including the stock market, insurance companies, discount houses etc. the onus is that through these institutions, savings or idle funds are aggregated and channeled into productive sectors of the economy.

A bank is a financial intermediary that creates credit by lending money to a borrower, thereby creating a corresponding deposit on the bank's balance sheet. Lending activities can be performed either directly or indirectly through capital markets. Due to their importance in the financial system and influence on national economies, banks are highly regulated in most countries. In this paper, we shall examine the numerous theories that seek to explain or justify why banks exist in society.

2        REVIEW OF RELATED LITERATURE

2.1     Conceptual and Theoretical Framework

Banks exist to broker the relationship between lenders and borrowers. They intervene to smoothen the flaws of direct finance. With the assistance of banks, lenders and borrowers need no longer transact directly as financial institutions act as a link between these units.

In an effort to explain the need for and existence of financial intermediaries, some arguments have been proposed by researchers. Three basic theories put forward to explain the need for financial intermediation include; (a)

Information Asymmetries (b) Transaction Cost Argument and (c) Need for Regulation, Production and use of Money.

First, and that used in most studies on financial intermediation, is the information asymmetries argument. These asymmetries can be of an ex ante nature, generating adverse selection, they can be interim, generating moral hazard, and they can be of an ex post nature, resulting in auditing or costly state verification and enforcement (Scholtens and Wensveen, 2003).

Second is the transaction costs approach (Fama, 1980). In contrast to the first, this approach does not contradict the assumption of complete markets. It is based on non-convexities in transaction technologies. Here, the financial intermediaries act as coalitions of individual lenders or borrowers who exploit economies of scale or scope in the transaction technology (Scholtens and Wensveen, 2003).

The third approach to explain the reasons for the existence of financial intermediaries is based on the regulation of monetary services production and of saving in and financing of the economy (Fama, 1980). Regulation affects solvency and liquidity with the financial institution.

Thus, to summarize, according to the modern theory of financial intermediation, financial intermediaries are active because market imperfections prevent savers and investors from trading directly with each other in an optimal way. The most important market imperfections are the informational asymmetries between savers and investors.

Financial intermediaries, banks specifically, fill (as agents and as delegated monitors) information gaps between ultimate savers and investors. This is because they have a comparative informational advantage over ultimate savers and investors. They screen and monitor investors on behalf of savers. This is their basic function, which justifies the transaction costs they charge to parties.

They also bridge the maturity mismatch between savers and investors and facilitate payments between economic parties by providing a payment, settlement and clearing system. Consequently, they engage in qualitative asset transformation activities. Finally, to ensure the sustainability of financial intermediation, safety and soundness regulation has to be put in place. Regulation also provides the basis for the intermediaries to enact in the production of their monetary services.

2.2     Functions banks as Financial Intermediaries

Wealth Function

For those who choose to save, the financial instruments sold in the money and capital markets provide an excellent way to store wealth until the funds are needed for spending. Although, it is possible to store wealth in other media e.g. like houses, automobiles, clothes etc), these items are subject to depreciation or risk. However, bonds, stocks and other financial instruments do not wear out over time and usually generate income; moreover, their risk of loss is much less than other forms of stored wealth (Ezrim 2005).

Liquidity Function

For wealth stored in financial instruments, the financial system provides a means of converting those instruments into cash with little risk of loss. Thus, the world’s financial markets provide liquidity (immediately spendable cash) for savers who hold financial instruments but are in need of money (see Jhingan, 2003). In modern societies, money consists mainly of deposits held in banks and is the only financial instrument, possessing perfect liquidity. Money can be spent as it is without the necessity of converting it into some other forms.

However, money generally earns the lowest rate of return of all assets traded in the financial system, and its purchasing power is seriously eroded by inflation. That is why savers generally minimize their holdings of money and hold other higher-yielding financial instruments until they really need spendable funds. Of course, money is not the only means of making purchases of goods and service. In many less developed economics around the world, the exchange of one good or service for another perform the same services as money.

Credit Function

In addition to providing liquidity and facilitating the flow of savings into investment, to build wealth, financial markets furnish credit to finance consumption and investment spending. Credit consists of loan of funds in return for a promise of future payment. Consumers need credit to buy daily needs, houses, repair the faulty automobiles and retrieve outstanding debts. Firms draw on their lines of credit to stockholders, governments borrow to construct buildings and other public facilities and to cover routine cash expenses until tax revenue flow in.

Payment Function

The financial system also provides a mechanism, for making payments for goods and services. Certain financial assets including current accounts and savings accounts, serve as a medium of exchange in making payments. Credit and debit cards issued by banks, credit unions etc are also widely accepted as a convenient means of payment. Plastic cards and electronic means of payment, including computer terminals in homes, offices and stores and digital cash, are likely to displace cheque and other pieces of paper as popular means of payment in the future. Indeed, electronic means of payment are in wide spread use today and are growing rapidly in the wider world especially in advanced economies.

Risk Protection Function

The financial market, offer its clients a safe and convenient way of storing and moving money from one productive activity to the other without having to deal with the risk of being dispossessed of such.

Policy Function

Finally in recent times, the financial markets have been the key channel through which government has carried out its policy of attempting to stabilize the economy and avoid inflation. By manipulating interest rates and the availability of credits, government can affect borrowing and spending plans of the public, which in turn, influence the growth of jobs, production, and prices.

2.3     Resolving the Problems of Direct Financing – The Role of Banks

As stated earlier, banks are the most well placed financial institutions to act as financial intermediates. They perform this role by resolving the problems that arise a result of direct financing.

The first problem which is identified is the difference in the requirement of lenders and borrowers. It is well noted that while lenders want low risk liquid assets, borrowers are interested in long-term liabilities. Bank as financial intermediaries resolve this problem through their asset transformation function. This, they do by transforming large denominations of financial assets into smaller units.

They are also able to transform the characteristics of the funds that pass through them. This it does by matching the maturity of the assets it holds with the maturity of the liabilities it issues. They borrow funds that are short-term (deposits) and lend them with long-term maturity (loans). Thus, a financial intermediary is able to hold high-risk, long-term claims issued by borrowers and finance this by issuing low-risk and short-term deposits. This is a process known as qualitative asset transformation (Saunders  & Cornett, 2006).

Diamond and Dybvig (1983) confirm this by stating that banks provide better risk sharing among agents who need to consume at different (random) times”. This liquidity to them provides the rationale for the existence of banks and by extension financial intermediation. Financial intermediaries address the risks associated with maturity transformation by diversifying funding sources. On the other hand, risk associated with transformation of default risk can be reduced by obtaining information on potential borrowers  and selecting those that have the highest repayment potentials. In this regard, Buckle & Thompson point out that banks have advantage over direct lender in obtaining useful information on potential borrowers since most of these borrowers use banks’ payment services.

Transaction costs were also cited as one of the problems that the existence of financial intermediaries solves. Mathews and Thompson (2008) explain that intermediaries are able to reduce search costs through their distribution channels. By spreading out their branches and adopting products like automated teller machine (ATM), internet banking and telephone banking, intermediaries reduce search costs by borrowers. Furthermore, Allen and Santomero (1977) point out that, intermediaries also reduce verification costs by developing expertise in certain business lines.

In-depth knowledge of clients and their businesses by intermediaries make verification quicker, more effective and cheaper.  Monitoring a borrower refers to “information collection before and after a loan is granted”, including screening of loan applications, examining the borrowers ongoing credit worthiness and ensuring that the borrower adheres to the terms of the contract.  This implies enormous costs in monitoring and enforcement. Since banks’ possess privileged information regarding the borrowers’ current account and can observethe flows of income and expenditure, these costs can be ameliorated (Diamond, 1984)

The third and final problem of direct financing that banks resolve is information asymmetry. The information asymmetry problem arises because borrowers usually possess insider information about investment projects that lenders may be unaware of. According to Claus and Grimes (2003) information asymmetry can occur “ex ante” or “ex post”. It is ex ante when lenders can not differentiate between borrowers with different credit risks before providing loans leading to adverse selection problem. On the other hand, ex post information asymmetry arises when only borrowers, but not lenders, can observe actual returns after project completion.

This gives rise to moral hazard problems, where borrowers engage in activities that increase the likelihood of default. To resolve these problems, information is needed. Unfortunately information is a “public good”. Even when privately produced at great cost there is a tendency that other agents could access it at lower costs. That is the “free rider problem”.

This discourages the direct financier from investing in “publicly optimal information” (Hirschleifer & Riley, 1979). Financial intermediaries, on the other hand, can obtain information at lower cost than individual lenders because they avoid duplication in production of information.

Leland and Pyle (1977) buttress this by showing that banks can communicate information to investors about potential borrowers at lower cost than can individual borrowers. To mitigate the moral hazard problem, banks introduce restrictive covenants which restrict the borrowers’ activity and increase the probability of repayment. It can also be said to encourage borrowers to undertake desirable behaviour, for example, mortgage loans requiring the borrower to obtain life assurance (Buckle & Thompson, 2008).

Fhese roles of banks as enumerated above in most cannot be performed optimally by other financial intermediaries.

3        SUMMARY AND CONCLUSION

This research paper is on The Theory of the Banking Firm. For the purpose of the paper, we examined the nature, classification of financial intermediation role of banks in the economy. We also examined the place of banks in this process in addition and comparison to that of the capital market as financial intermediary. It is shown in the paper that in comparison to the capital market, the money market with special emphases on banks are the most important financial intermediation agents in the financial system.

This is because the financial intermediation role of banks is more encompassing and inclusive than the capital markets whose role as a financial intermediary is a lot more the preserve of those segments of the society that more financially literate and elitist than the general populace. Secondly, banks perform some intermediation roles which they only are legally permitted to do. Finally, the paper shows that the problems associated with direct financing including: transaction costs, asymmetric information and counter party risk can only be comprehensively solved through the financial intermediation role of banks.

REFERENCE

Acha, I. A. (2011). Does Bank Financial Intermediation Cause Growth in Developing Economies: The Nigerian Experience, International Business and Management, Vol. 3, No. 1, 2011, pp.156-161, ISSN 1923-8428[Online] www.cscanada.net

Allen, F., & Santomero, A. M. (1977). The Theory of Financial Intermediation. Journal of Banking and Finance, 21(11&12), 1461-1485.

Claus, I. & Grimes A. (2003, September). Asymmetric Information Financial Intermediation and Monetary Transmission Mechanism: A Critical Review. New Zealand Treasury Working Paper, 03/19 , 5-10.

Diamond, D. W. (1984). Financial Intermediation and Delegated Monitoring. Review of Economic Studies, 51 (3), 393-414

Diamond, D. W. & Dybvig, P. (1983). Bank Runs, Deposit Insurance and Liquidity. Journal of Political Economy, 91 (3), 401-419.

Ezirim CB (2005). Finance Dynamics, Principles Techniques and Application. Port Harcourt: Markowitz Centre for Research.

Fama, E.F. (1980). Banking in the theory of finance, Journal of Monetary Economics 10, 10-19

Hirschleifer, J. & Riley, J. G. (1979). The Analytics of Uncertainty and Information: An Expository Survey. Journal of Economic Literature, 17, 1375-1421.

Leland, H. E. and Pyle, D. H. (1997). Information Asymmetries, Financial Structure and Financial Intermediation. Journal of Finance, 32 , 371-387.

Mathews, K. & Thompson, J. (2008). The Economics of Banking . Chichester: Wiley.

Saunders, A. & Cornett, M. M. (2006). Financial Institutions Management: A Risk Management Approach . New-York: McGraw Hill.

Scholtens and van Wensveen (2003). The Theory of Financial Intermediation: An Essay On What It Does (Not) Explain, The European Money and Finance Forum (SUERF) Vienna Austria, 2003.

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