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Banks: what do they do?

Functions of Banks

Main activities of banks
–      Financial intermediaries
–      Source of funds
ð  Through active liability management
–      Use of funds is through
ð  The provision of loans to customers
ð  The investment in securities
–      provide a range of other financial services and off-balance sheet (OBS) business

Sources of funds (Bank Deposits)

Banks offer a range of deposit and investment products that very by risk, return, liquidity and cash flow timing
Bank’s liabilities (sources of funds) may be categorised as
–      Current deposits
–      Fixed term deposits
–      Other deposits
–      Certificates of deposit

Current deposits
–      Fund deposited in cheque accounts
–      Highly liquid funds
–      May be interest bearing of non-interest bearing

Fixed term deposits
–      Offer a choice of terms of investment
–      Loss of liquidity
–      Higher rates of return
–      Generally a fixed interest rate

Other deposits
–      Example: savings deposits
–      Interest bearing accounts
–      Passbook, investment or statement accounts
–      Statement accounts may be accessed through ATMs and EFTPOS

Certificates of deposit
–      Paper issued by a bank in its own name
–      Issued at a discount to face value
–      Specifies repayment of the face value of the CD at maturity
–      Highly negotiable security
–      Short term (30 to 185 days)
Sources of funds – Non-deposit

Decline in importance of deposits as a source of funds due to removal of restrictions on foreign exchange and deregulation of product controls by banks
Non-deposit sources of funds include
–      1.Bills acceptance
–      2.Foreing currency liabilities

Bills acceptance
–      Banks accepts the primary liability for repayment of the face value of a bill of exchange at its maturity date
–      Bank effectively guarantees funding for a customer
–      Bank, however is not the provider of the funds under an acceptance facility

Foreign currency liabilities
–      Deregulation of the foreign exchange market
–      Allows diversification of funding sources into international markets
–      Allows matching of foreign exchange denominated assets
–      Large source of demand for foreign banks
–      Meet demand of corporate customers for foreign exchange products

Use of funds

Appear as an asset on the balance sheet
Recent trend in use of funds
–      Out of government securities and into foreign exchange
–      Change in composition of loans and advances
The main use of funds for banks are
–      Lending to government
–      Commercial lending
–      Personal finance
–      Other bank assets

Lending to governments
–      Banks required to hold a portion of their assets in government securities by Liquid Government  Securities (LGS) convention
–      LGS replaced by Prime assets requirement in May 1985
–      The proportion of prime assets held by each bank is determined by Governing financial Authority

Commercial lending
–      Loans to business sector and other financial institutions
–      Examples include
ð  Fixed term loans
ð  Overdraft
ð  Commercial bills
ð  Lease finance

Personal finance
–      Categorised into
ð  Owner-occupied housing finance
ð  Other housing finance
ð  Fixed loan
ð  Overdrafts
ð  Credit cards

Other bank assets
–      Two types
ð  (A) Premises
v  investment by banks into physical infrastructure
ð  (B) Foreign currency assets
v  level of foreign currency assets depends upon foreign bank representation in Australia and the level of foreign operations of domestic banks
Off-Balance Sheet (OBS)

OBS transactions are a significant part of a bank’s business
OBS transactions include
–      Direct credit substitutes
–      Trade and performance related items
–      Commitments
–      Market-rate related transactions

Direct credit substitutes
–      The bank acts as a guarantor on behalf of a client for a fee
–      Client has financial obligation to pay to a third party
–      Bank is only required to make payment of the client defaults on payment to a third party

Trade and performance related items
–      Banks acts as guarantor
–      Client has non-financial obligation to a third party
–      Bank pays compensation if client fails to fulfil the obligation

Commitments
–      Bank undertakes to advance funds, or make a purchase of assets at some time in the future
–      Examples include
–      Forward purchases
–      Underwriting

Market-rate related transactions
–      Examples include
ð  Futures
ð  Options
ð  Swaps
ð  Foreign exchange
ð  Forward rate agreements (FRAs)
–      Used for speculating or hedging