Bank

What Is a Bank?

A financial institution that provides services such as checking and savings accounts, lines of credit, term loans, credit cards, mortgages, and financial services.

It acts as an intermediary between two parties for arranging payments.

There are several kinds of them, each serving a different purpose. The nation’s central bank usually regulates them.

• If it services the general community, it is called a retail bank.
• If it serves enterprises, it is called a business/commercial/corporate bank, depending on the size of the client companies.
• For high-net-worth individuals, there are private banks.
• One that serves large corporations and governments is called an investment bank.

These companies often are public companies; their owners are their shareholders, and as such, their main goal is to earn profits. It achieves that by gaining a spread on its operations, such as loans and mortgages. 

In simple terms, the financial institution always earns more interest on those products than it pays on checking and savings accounts.

Apart from the spread they earn on operations, they often charge several fees to their customers. Usually, each product that is offered has a fee attached to it.

Their size can vary. It depends on a variety of things, such as the market it serves and the share of that market it accounts for. Usually, large conglomerates that join together retail and IB operations tend to be much larger than their peers.

The central banks are responsible for ensuring the financial system’s stability.

Essentially, these entities can be thought of as an entity that brings together lenders who have been able to save some cash and borrowers, who need cash. The institution intermediates the deal and earns a profit on top of it.

How do Banks work?

Financial institutions work by earning a spread on their operations. Therefore, the interest and fees they earn on loans must outweigh the interest and fees they pay consumers. This is the principle.

There are several kinds of services they may provide. In the case of a retail one, for instance:

• Checkings accounts
• Credit/Debit cards
• Savings accounts/term deposits
• Lines of credit
• Term loans
• Mortgages
• Insurance policies

Their operations are segmented into various departments for these processes to run smoothly. For example, client-facing roles are front-office, while data and numbers-focused jobs are called back-office. 

For corporations, depending on its size, a division serving it may be a business, commercial or corporate one. The main takeaway is that business financials serve small businesses, corporate serves large ones, and commercial division serves the ones in the middle.

The primary services in the corporation-oriented segment are:

• Credit for working capital needs and lines of credit
• Credit for equipment acquisition
• Business operating and savings accounts (similar to the ones offered to retail clients)
• Term loans
• Merchant services (assistance in dealing with card payments)

It is important to note that many large institutions have their own retail and commercial divisions, so it’s not uncommon for a corporate client to have its commercial and retail accounts at the same place.

For private and corporate divisions, on top of the services offered by its retail divisions:

• Wealth & estate planning
• Investment management & advice
• Credit Strategies
• Tax planning

Since they deal with high-net-worth clients, these segments offer tailored products. Also, the relationship between the customer and the institution is much closer.

An IB's main services are:

• Debt & equity issuance
• Initial Public Offering (IPO) advisory
• Sales & Trading
• Mergers & Acquisitions advisory
• Restructuring advisory

IBS serves as a bridge between its customers (corporations, government) and the public capital markets. 

Retail Banking products

The products offered by the institution differ based on its segment. The main products for retail are: 

Checking Accounts

Unsecured demand deposits that earn no interest. Its primary purpose is to serve a client’s day-to-day needs, such as paying the bills. Checking accounts are the most liquid type of product clients can be offered.

Saving accounts

Term deposits that earn interest, as the name implies, serve as a safe place for customers to keep the money they don’t need right away but may do in case an emergency arises.

Term Deposits, Certificates Of Deposit, And Fixed Deposits

Term deposits earn interest and only are available for withdrawal at a certain date. Since the money will be tied for longer, they offer a higher rate on these products. These are less liquid than savings accounts.

Debit & Credit Cards

Debit cards serve as an instrument for the client to interact with their checking account. For example, it can be used in ATM machines to withdraw cash to make purchases on debit - where the transaction value is discounted upfront.

Credit cards are credit instruments and work as a loans on demand. Every time customers use their credit cards, they effectively extract an amount from a line of credit. Credit cards are issued based on a customer’s creditworthiness and will have a limit based on that.

Consumer Finance & Mortgages

Loans and mortgages are among the most popular products in retail divisions. Term loans serve as a bridge between a customer’s means and the desired purchase, such as a car. At the same time, mortgages serve the same purpose but focus on housing. 

Both types are secured by the underlying asset and are repaid over a long period.

We have estate/tax planning, investment advisory, and credit strategies among the main private-oriented products.

Private Banking products

High-net-worth individuals can get private banking services from banks and other financial entities. Usually, it entails offering specialized services like financial planning, asset management, and investment guidance.

Private bankers serve high- and ultra-high-net-worth people while working for financial organizations. Managing clients' finances and making financial recommendations are among the main responsibilities. The majority of private bankers are licensed and hold at least a bachelor's degree.

Estate/Tax Planning

PB clients have a large net worth. And one big area of concern for them is what to do with that wealth in a generation transition. That is where PB service comes in. Usually, the banker is a very experienced professional in tailored high-end products.

Tax planning consists of finding the most efficient way for the customer to organize taxes. Usually, this type of client has a lot of assets in several jurisdictions, which can translate into different interpretations and applicability of tax law.

The private banker comes in to assist the client in developing an efficient method.

Investment And Wealth Planning

To further assist the client in managing its finances, this division also provides investment advice, which can be discretionary. Depending on the client’s needs, it may be more or less similar to an asset management service.

Since it is very much up to the client how the service will be provided, it must have professionals prepared to effectively manage a client’s investments or just provide an opinion.

In wealth and investment planning, it is the entity’s role to be clear to the client about the risks and possible returns of all investments. Not only making it clear but also explaining how the investments work is an excellent way to be transparent and have a good relationship with the client.

The institution may also provide insight into where the client’s funds will come from if it’s more advantageous to withdraw for a savings account or to dump an equity position, for instance.

Regarding risk, not only should the client be made aware of how much money they might be risking, but also the different types of risk since it provides a deep understanding of where the problems may come from. For example, explaining the difference between country and interest rate risk is helpful in this case.

Investment Banking services and products

Various IB services and products are:

1. Initial Public Offering (IPO) Underwriting: IBS bridges a company that wants to go public and the capital markets. They underwrite the shares, form a customer base, and also look to ensure the price doesn’t oscillate too much immediately after issuance.
2. DCM/ECM (Debt/Equity Capital Markets): Apart from IPOs, companies also issue shares when they are publicly traded. Additional issuance of stock is called follow-on. This type of financial institution also provides this service and serves as the underwriter of these securities.
   • Companies, countries, and government entities all issue bonds. Underwrite these debt instruments into the market and make a profit by earning fees.
3. M&A and restructuring advisory: When companies decide to engage in M&A activity, they need external advisory. IBs provide that advisory and effectively carry out the transaction by issuing debt or shares from the company to fund the deal. In the restructuring, IBs come to the rescue.
   • Companies that are distressed financially or even in default are the main customers here, and usually, what takes place is an overhaul in the capital structure of the business.
4. Sales & Trading (S&T): These institutions trade for clients. Sales & trading deals primarily with buy-side investors such as investment and hedge funds, institutional investors, and insurance companies.
   • IBS is essentially a sell-side institution; they are market makers. On the other end, we’ve got potential buyers- buy-side investors. The bankers pitch the clients their investment ideas.
5. Research: Research works along with Sales and Trading. This area is concerned with examining the companies’ financials and finding investment opportunities, which it then passes on to S&T for them to pitch to clients.

Banking Regulation

Each country’s Central Bank usually oversees financial regulation. Those entities’ main attributions are ensuring stability in the financial system and others oriented toward monetary policy, such as full employment and price stability.

In the wake of crises and crunches in the markets, governments have grown increasingly concerned about financial regulation. For example, after the GFC, U.S. Congress. passed the Dodd-Frank Act, a regulation targeting risk in the financial system by addressing capital requirements for them and financial institutions.

Regulators assess the firm’s risky operations by running stress tests. Stress tests are simulations designed to understand how something would behave in certain conditions, in this case, financial institutions.

Suppose there is a spike in unemployment in the overall economy, and a pandemic breaks out suddenly. One area of concern for regulators would be whether the financial institutions would be able to endure runs and stress tests would be run.

Another situation, which is reminiscent of recent crises, is to assess how much leverage those entities are currently running. 

Regulators would conduct stress tests to see how they would behave if credit events (defaults) were to ripple across the economy and would try and measure their exposure.

For that matter, one may think that the Basel III rules already address it. But in reality, that framework only lays out guidelines for how much leverage financial institutions can take in and not precisely what that leverage may be comprised of.

Let me be more explicit. These Institutions must always maintain a specific rate of equity to risk-weighted assets. The framework only instructs how much that number should be but does not discuss what Banking Institutions can do with it.

Suppose a large U.S. Banking Institution trying to earn bigger yields enters into a large trade of sovereign debt of an emerging country that is very likely to default but simultaneously manages to keep its Basel rates below the hurdle. Also, suppose all other large U.S. Financial Institutions also have exposure to our business.

If that country defaults on its debt, the institution would be in trouble, so large is the operation. It managed to dodge the regulation by entering only this operation. Being this is only a risky asset, it can take a large enough position and still be under the radar.

Stress tests seek to address exactly that, and if it were to be in trouble, how much would be at stake?

As far as deposit security goes, in the U.S., there is the FDIC, a governmental agency whose role is to ensure customers’ deposits and savings of up to 250,000 dollars.

Researched and Authored by Lucas

Free Resources

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