Principles of Islamic banking and finance/PIBF202/Key differences/What is a bank ?

A Bank

Although banks do many things, their primary role is to take in funds in terms of deposits from those who have surplus money with them, more than what they need for their current needs. Banks then pool them, and lend to those who need funds. Banks are thus intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money). The amount banks pay for deposits and the income they receive on their loans are both in terms of interest . For conventional banks, difference between the rates of interest that a bank charges to their customers (different rates for different types of customers depending on their credit worthiness) and the rates that it pays to its depositors (different rates based on the duration of deposits and the their amounts), is its income.

Benefits of banks

Banks, along with other depository institutions such as mutual funds, provide a number of benefits to an economy that are crucial for its smooth functioning. They are:

• Create liquidity
• Pool risk
• Lower the cost of borrowing
• Lower the cost of monitoring borrowers

Creation of liquidity

Banks create liquidity by granting loans to their clients. They need to keep a fraction of total deposits in terms of cash (by law) so that they are not short of it against withdrawals. The rest of the deposits amount can be used for making loans. Suppose you deposit today $ 10,000 in your bank. |If the bank was not holding any extra reserves, they must keep $1,000 cash against this deposit but allowed to make a new loans up to $9.000 by crediting the account of borrowers. This way the banks create liquidity or money). Remember that, in economics, money is not only currency and coins but also bank deposits. This newly created money increases economic activity in the economy and hence beneficial for the society.

Pooling of risk

As mentioned above, banks pool the deposits of thousands and millions of people, and give loans to the borrowers or invest in different types of bonds and securities. They excel in evaluating credit worthiness of borrowers as well as the probable performance of their businesses. Banks thus minimize the total risk but some of their loans will not perform well. However, as long as the number of non-performing loans and the corresponding amount involved, are not excessive (which is normally the case unless there is an economy wide severe financial crisis), the bank is sound and safe.

Imagine if each depositor (and borrower) has to find a suitable person to lend or borrow from, how much risk will be involved.

Lowering of cost of borrowing

You also need to think what may happen if there are no banks around and each lender and borrower has to find a suitable counter party to complete a loan agreement. The transaction costs would be enormous resulting in high costs of borrowing in decreased economic activities.

Lowering of cost of monitoring borrowers

Again think about what might happen if each individual learner has to monitor the borrower or user of the fund so that the chances of default on loans are minimized. Over the years banks have developed many techniques and mechanisms to monitor their borrowers and their businesses. After pooling the deposited amount banks choose worthy clients to advance loans many of whom borrow larger amounts. Thus the number of borrowers are substantially less than that of depositors, another cause of lowering the cost of monitoring.

Sources and uses of banks' funds

Sources

The main source of conventional commercial banks is different kinds of deposit accounts; checking or demand deposits, savings deposits and different kinds of time deposits of varying durations. On demand deposits most banks don't pay any interest and in case they pay, the rates are very low. They can even charge a monthly fee if the average balance remains lower than a minimum. "A checking account is designed for everyday money transactions. The money in a savings account, however, is not intended for daily use, but is instead meant to stay in the account — be saved in the account — so that it might earn interest over time. Savings accounts have higher interest rates than checking accounts, meaning it is better to let large sums of money (e.g., an emergency fund) sit in savings instead of checking."

Interest rate paid on time deposits are higher than savings deposits and the rate increases with the time duration of the account. The advantage for bank is that it can advance long term loans against these accounts not worrying much about withdrawals and can charge higher rates of interest, increasing with time duration.

The other source of banks' fund is the equity capital of the share holders / owners of the banks. They can also issue bonds of different maturity to generate funds that could be lent at higher rates than what they must pay to the bond holders.

Uses

Banks typically keep some cash to comply with the regulation for minimum cash balances. Their desired and actual minimum cash balance may exceed the regulatory minimum if they extra careful and prudent. The bulk of their assets consists of loans advanced for consumption or business expenditures of their customers. The rest is used for buying bonds issued by government and private firms.