What is the role of the financial sector in the economy?

The banks’ core business consists in intermediating between those who have financial means at their disposal, and those who are in need of funds.
The first category of people lends money to the bank, which in its turn will use it for the funding of the second category.

How?

Customers (private persons/households, companies) can give their money to the bank ‘as a deposit’. In this way, they are lending their money to the bank so to speak, and in return, they receive interest. There are several types of deposit, such as call deposits, savings deposits, term deposits and certificates of deposit.

Banks will then transform these deposits into credit for the funding of the needs of private persons and households, companies and the public authorities.

Anyone who borrows money from a bank, will have to pay interest , because the bank offers a service by putting at his disposal a certain amount of money during a certain period of time.

This kind of banking business allows for an optimal use of all funds, since the offer will meet the demand, and so it adds to the efficient organisation of the economy. However, a situation in which there is a perfect match between deposits and credits, is exceptional of course. So, this implies a transformation of deposits before they will become credits.

How?

  • By a change of scale: small deposits will be grouped together for the purpose of offering ‘big’ credit amounts. The funds provided by the thousands of savers in Belgium, taken separately, have no economic usefulness whatsoever. By putting those savings together, the bank will be able to transform them into credits and to provide funds to those who are in need of money.
  • By a transformation over time: short-term deposits are transformed into medium and long-term credit.
  • By a change of currency: in some cases, deposits labelled into a particular currency will be transformed into credits labelled in an other currency.

The transformation of deposits into credit implies some costs for the banks. First, there is the cost of operating, which includes among other things the employees, the IT-systems and the distribution network.

Then, there is the cost inherent of the risks implied in the transformation process. There are three risk categories:

  • Credit risk: the borrower may go bankrupt and lose his ability to reimburse. In some cases, it will be impossible for the bank to recover the whole of the credit amount.
  • Liquidity risk: depending on the characteristics of their deposits, savers have the possibility to ask for their money at a particular point in time. However, at that moment, the bank must make sure that it will be able to reimburse its creditors.
  • Interest rate risk: a bank has a certain interest rate margin it must try to keep at a positive level. This margin corresponds with the split between the yield generated by the credit interest rates and the cost of deposit interest rates. Anyone who borrows money, may opt for a fixed credit and hence for a fixed reimbursement amount all through the credit term. If the interest rate on deposits goes up however, banks cannot put the cost of this on the borrowers. So, the bank’s interest rate margin may become negative.

A bank may opt to take the risks on itself. It will make sure that there is sufficient capital adequacy or a sufficiently high level of liquidity margin (i.e. the extent to which it can meet its short-term payment obligations).

In addition, the bank can opt for risk hedging, for instance by means of a swap transaction, such as an interest rate swap. This implies several transactions aimed at transforming the fixed interest rate into a variable interest rate, and thus an elimination of the interest rate risk. It goes without saying that this risk hedging also generates costs.