Principles of Islamic banking and finance/PIBF202/Key differences/What is 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.

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.