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theory of banking

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1. Introduction In this paper author review the traditional theory of banking and attempt to examine the theoretical reasons for why banks exist. As a financial intermediation, the natures of the banks are to provide financial services and conduct the intermediary functions in the whole financial system by accepting deposits and making loans. The question raised here are how they conduct these roles and why the borrowers and lenders do not come together without the banks for the saving of intermediation costs, why both of the two parties are ready to pay for their services and what's the value added by the banks? The paper proceeds as follows. Section 2 offers a traditional view of banks and describes the nature of them. By analyzing how the banks conduct their traditional function, there rises a question of why the borrowers and lenders do not choose direct deal with each other? Which leads to the consideration of the theoretical rational for the existence of banks. This analysis is presented in section 3, which have an intensive expatiation in the theories. In section 4, what are the problems if the direct deals between the borrowers and lenders happen, and how can banks solve those problems are presented therefore answer the question why individuals are willing to pay the intermediation costs. This is followed in section 5 by an analysis of the recent changes in the banking industry. With the development of the financial system, declining entry barriers and the deregulation of the banking industry make banks no longer the monopoly suppliers of banking services and reduce their comparative advantages which they usually hold in the past. Whether the reasons give rise to the existence of banks are still powerful will be examined here, while section 6 offers a way of considering whether banks are declining by looking at the value added by the banks. When the value added by banks is examined, banks are not a financial intermediation, which not only conduct the traditional services but also provide more diversified services. ...read more.


Tobin (19//) also highlights the advantages of using financial intermediation than individuals from four aspects: (1) convenience of denomination, (2) risk pooling, reduction and allocation. (3) Maturity shifting. (4) Transforming illiquid assets into liquid liabilities. As one form of the financial intermediation, banks have the same characteristics with the other intermediations; therefore those are all the advantages of using banks rather then deal individuals. In order to examine the reasons why the society is ready to pay the intermediation cost of banks more precisely, the author will discuss the advantages and problems of direct deals in detail, and how banks can solve those problem. 4.1 Advantages of direct deals. 4.1.1 Borrowers and lenders make direct contract, which can give rise to the external advantages such as trade credit in terms of business. By using banks as an intermediation, you cannot get this credit but just the loans. 4.1.2 In theory, direct deals can cut out the intermediation cost by bypassing banks. Both of them don't need to pay the high intermediation cost by dealing directly at a better interest rate. In fact, although the intermediation cost is saved, the other costs are raised. The most important parts are the information costs and also the other costs do exist. Now the author will explain each of them in turn and how can we use banks to solve those problems. 4.2 Problems of direct deals and how can banks solve them. 4.2.1 Search costs: Two parties have to obtain information, select, meet and negotiate with each other whenever there is a contract. Without the banks, search costs will be incurred. Banks can save these costs by pooling all the surplus of the depositors and offering loans to the borrowers. When the borrowers need money, they can go to banks directly without searching the counter party. 4.2.2 Portfolio preference: barter This is the problem we have known in barter. ...read more.


(Bert Scholtens & Dick van Wensveen, 2000), they also give a table to show the main theory of financial intermediation including the banks should be amended. The process of financial innovation and market differentiation should be included. When the value added by banks is examined, banks are not a financial intermediation, which not only conduct the traditional services but also provide more diversified services. Although the traditional theoretical rational for the existence of banks are becoming vulnerable, Banks themselves are continuously evolving. They provide new financial services to the markets; exploit new comparative advantages in the new areas. 7. Conclusion The traditional view of a bank is a financial intermediary, which accepts deposits with one set of characteristics and makes loans or acquires assets with a different set. The traditional rational for the existence of banks can be examined by looking at the roles of the banks in the economy. Banks can provide the banking services with lower costs than individuals for their monopoly positions and the comparative advantages in providing the banking services, therefore individuals are willing to pay the intermediation costs to banks for these costs are lower than the costs when they deal directly. In recently, the related pressures of competition, de-regulation, financial innovation, and technology have eliminated some of the comparative advantages of the banks in their traditional banking business. The traditional theoretical rational for the existence of banks are facing challenges. When the value added by the banks is examined, only an institutional perspective might conclude to disintermediation of the banking industry. The functional view, however, reveals that banking are of increasing importance to the modern economy. The traditional rational for the existence of banks are becoming less powerful in nowadays, but it doesn't mean that the banks will disappear in a near future. In facing the pressures, banks will adapt and the nature of banking business will continue to evolve. They will exploit new comparative advantages in the other areas; therefore, the definition and nature of banks should be changed continuously. ...read more.

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