Role of banks in the economy
Sanderson Abel Business Correspondent
Banks accept deposits and make loans and derive a profit from the difference in the interest rates paid and charged to depositors and borrowers respectively. The process performed by banks of taking in funds from a depositor and then lending them out to a borrower is known as financial intermediation.
Through the process of financial intermediation, certain assets are transformed into different assets or liabilities. As such, financial intermediaries channel funds from people who have extra money or surplus savings (savers) to those who do not have enough money to carry out a desired activity (borrowers).
Banking thrive on the financial intermediation abilities of financial institutions that allow them to lend out money and receiving money on deposit. The bank is the most important financial intermediary in the economy as it connects surplus and deficit economic agents.
When you deposit your money in the bank, your money goes into a big pool along with everyone else’s, and your account is credited with the amount of your deposit. The role of the bank is to provide a safe place to keep your money and sometimes the opportunity to earn interest on your deposits.
Services like current and savings accounts provide convenient ways for you to pay your bills without the hustle of using cash. At the same time, when you run short of liquidity, the bank is able to give you some advance to cover up for your shortfall through other depositors funds.
In the absence of banks; where would you go to borrow money? What would you do with your savings? Would you be able to borrow (save) as much as you need, when you need it, in a form that would be convenient for you? What risks might you face as a saver (borrower)?
Because of the power of financial intermediation of the banks, these puzzles are resolved through the banking system hence they cease to be your problem but the banks problem.
Banks are vital institutions in any society as they significantly contribute to the development of an economy through facilitation of business. Banks also facilitate the development of saving plans and are instruments of the government’s monetary strategy among others.
Credit provision — Credit fuels economic activity by allowing businesses to invest beyond their cash on hand, households to purchase homes without saving the entire cost in advance, and governments to smooth out their spending by mitigating the cyclical pattern of tax revenues and to invest in infrastructure projects.
Liquidity provision — Businesses and households need to have protection against unexpected needs for cash. Banks are the main direct providers of liquidity, both through offering demand deposits that can be withdrawn any time and by offering lines of credit. Further, banks and their affiliates are at the core of the financial markets, offering to buy and sell securities and related products at need, in large volumes, with relatively modest transaction costs.
Risk management services — Banks allow businesses and households to pool their risks from exposures to financial and commodity markets. Much of this is provided by banks through derivatives instruments transactions. Banks also enable individuals and businesses to take part in the global foreign exchange and commodity markets indirectly. It would be very difficult for example for a small company needing only a few million Japanese yen to import a vehicle from Japan to get onto the global currency markets without the aid of a bank.
Remittance of Money — Cash can be transferred easily from one place to another and from one country to another by the help of a bank. It has facilitated transactions in distant places. This, in turn, has expanded the internal and external trade and market. The men have become free of the risks of carrying cash, gold, silver etc. The credit instruments issued by banks such as cheque, draft, Real time gross settlement, credit cards have facilitated the transfer of money.
Rapid Economic Development — The banks make available loans of different periods to agriculture, industry and trade. They make direct investments in industrial sectors. They provide industrial, agricultural and commercial consultancy hence facilitating the process of economic development.
Promotion of Entrepreneurship — The role of private sector is crucial in accelerating the pace of economic growth. The banks increase the participation of the private sector in economic development by making available the loans easily on reasonable rate of interest. The expansion of financial sector encourages entrepreneurs to make investments by promoting entrepreneurship.
- Sanderson Abel is an economist. He writes in his capacity as senior economist for the Bankers Association of Zimbabwe. He can be contacted on [email protected] or on 04-774686, 0772463008