The commercial bank plays three primary roles in the financial market:
1. information processing;
2. risk sharing; and
3. money creation.
First, the bank collects and processes information.The bank collects information on both its depositors who provide funds and borrowers who represent investment opportunities for the deposit funds. The bank allows the depositors and the prospective borrowers to avoid the search cost of directly finding each other. Further, the bank’s specialized resources for screening loan candidates reduce the likelihood of default faced by the depositors on their own. Since the bank undertakes investments in specialized resources on its own account, depositors are able to share the default risk not only with one another but also with the shareholders of the bank. As a result, depositors are only concerned with the viability of the bank, and not of individual borrowing entities. Through this process, the bank fulfills its second role of risk sharing. Finally, a bank loan to a business reduces the information asymmetry for other investors through a signal regarding credit worthiness of this entity.
In order to sharpen the focus on the role played by a commercial bank, it is useful to consider two other financial intermediaries, investment banks and insurance companies. The investment bank engineers specific financial products that are tailored to suit the needs of their customers.To accomplish this task, it focuses on gathering and analyzing information pertaining to its customers’ needs. Because the prototype investment bank does not undertake investment activities on its own account, its customers bear the risk of investments on their own.Thus, the investment bank supplies its customers the information, but does not offer them an actuarial risk sharing function.
An insurance company, on the other hand, specializes in risk sharing. Unlike the investment bank, an insurance company (another major financial intermediary) does not gather information on customers’ investment needs; instead, it attracts a large number of customers who fund each other in the eventuality of a specific adversity such as a fire or a death. By collectively sharing each other’s risk, the insurance company’s customers minimize their individual loss in the event that the insured risk materializes.
First, the bank collects and processes information.The bank collects information on both its depositors who provide funds and borrowers who represent investment opportunities for the deposit funds. The bank allows the depositors and the prospective borrowers to avoid the search cost of directly finding each other. Further, the bank’s specialized resources for screening loan candidates reduce the likelihood of default faced by the depositors on their own. Since the bank undertakes investments in specialized resources on its own account, depositors are able to share the default risk not only with one another but also with the shareholders of the bank. As a result, depositors are only concerned with the viability of the bank, and not of individual borrowing entities. Through this process, the bank fulfills its second role of risk sharing. Finally, a bank loan to a business reduces the information asymmetry for other investors through a signal regarding credit worthiness of this entity.
In order to sharpen the focus on the role played by a commercial bank, it is useful to consider two other financial intermediaries, investment banks and insurance companies. The investment bank engineers specific financial products that are tailored to suit the needs of their customers.To accomplish this task, it focuses on gathering and analyzing information pertaining to its customers’ needs. Because the prototype investment bank does not undertake investment activities on its own account, its customers bear the risk of investments on their own.Thus, the investment bank supplies its customers the information, but does not offer them an actuarial risk sharing function.
An insurance company, on the other hand, specializes in risk sharing. Unlike the investment bank, an insurance company (another major financial intermediary) does not gather information on customers’ investment needs; instead, it attracts a large number of customers who fund each other in the eventuality of a specific adversity such as a fire or a death. By collectively sharing each other’s risk, the insurance company’s customers minimize their individual loss in the event that the insured risk materializes.
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