FNCE 4102 Week 8 Bank Intermediation Analysis Example

Five Things a Bank Does That Savers and Borrowers Cannot Easily Do for Themselves: Size Transformation, Maturity Transformation, Credit Assessment, Risk Pooling and Payment Settlement, Worked Through One Hypothetical Branch

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Walden University

FNCE 4102: Financial Institutions and Markets

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Month Day, Year

Five Things a Bank Does That Savers and Borrowers Cannot Easily Do for Themselves: Size Transformation, Maturity Transformation, Credit Assessment, Risk Pooling and Payment Settlement, Worked Through One Hypothetical Branch

The Branch

Consider a hypothetical community bank branch in a town of 15,000 people. It holds 4,000 deposit accounts averaging $12,000, a total of $48 million, and has $40 million of loans outstanding: 120 home mortgages averaging $200,000, 80 small business loans averaging $125,000 and consumer loans making up the rest. The branch does five things that its depositors and borrowers could not easily do for themselves (Mishkin & Eakins, 2018).

1. Size Transformation

Deposits are small and loans are large. A $200,000 mortgage would require pooling the savings of about seventeen average depositors. Arranging that directly, and collecting monthly payments for each of them, would cost far more than the interest involved. The branch does it automatically: every deposit is part of every loan.

2. Maturity Transformation

Depositors can withdraw on demand; mortgages run for thirty years. The branch can lend long against short deposits because withdrawals are spread over time and largely offset by new deposits. On a normal day perhaps 1 percent of balances leave and a similar amount arrives. This is the function that creates value for savers, who get liquidity, and for borrowers, who get long-term money. It is also the function that every bank run exploits. Diamond and Dybvig (1983) showed that if depositors come to believe others will withdraw, each depositor does best by withdrawing early, and a sound bank can fail because it cannot sell long-term loans quickly enough. Deposit insurance and central bank lending exist mainly to prevent that outcome.

3. Credit Assessment

A small business owner asking for $125,000 knows far more about the business than any individual saver could learn. The branch's loan officers review tax returns, cash flow, collateral and the owner's history, and they often know the local market. This screening is costly, and no individual depositor would pay for it on a single loan. The branch spreads the cost across hundreds of loans and, because it holds most of them, has a strong incentive to screen well (Diamond, 1984).

4. Risk Pooling

If one of the 80 business loans defaults, the loss is spread across the whole portfolio and covered by the interest earned on the others. A saver who had lent directly to that business would lose everything. Suppose 2 percent of business loans default each year with a 50 percent loss on each: the expected loss is about $100,000 a year, or 1 percent of the $10 million business loan book, an amount the branch prices into its loan rates. Pooling turns an unpredictable individual loss into a predictable cost.

5. Payment Settlement

The branch also moves money: checks, debit cards, direct deposits and transfers. This function has changed the most. Many payments now move through card networks, mobile apps and, since 2023, the Federal Reserve's FedNow instant payment service, which banks access to settle transfers within seconds (Board of Governors of the Federal Reserve System, n.d.). Nonbank payment apps handle the customer side of many transactions, though most still settle through bank accounts in the end. Payment settlement remains a bank function at its core, but the bank is increasingly invisible to the customer.

What the Branch Earns for These Functions

The five functions are paid for through the spread between what the branch earns and what it pays. Suppose its $40 million of loans yield an average of 6.5 percent, or $2.6 million a year, and the remaining $8 million of deposits sits in securities and reserves earning 4 percent, another $0.32 million. If it pays an average of 1.5 percent on its $48 million of deposits, $0.72 million, net interest income is about $2.2 million. From that it covers the roughly $0.1 million of expected loan losses from the pooling example and perhaps $1.4 million of staff, premises and technology costs, leaving about $0.7 million before tax. Every function above shows up somewhere in those figures: screening in the low loss rate, maturity transformation in the gap between loan and deposit rates and payments in the fees and the deposits they attract.

Which Functions Are Most Secure

Credit assessment and maturity transformation remain hard for nonbanks to replicate at scale, because they rely on deposits and on holding loans. Size transformation and payments are the functions most open to competition from technology firms. The branch's future depends mainly on the functions that are hardest to copy.

References

Board of Governors of the Federal Reserve System. (n.d.). FedNow service. https://www.federalreserve.gov/paymentsystems/fednow_about.htm

Diamond, D. W. (1984). Financial intermediation and delegated monitoring. The Review of Economic Studies, 51(3), 393-414. https://doi.org/10.2307/2297430

Diamond, D. W., & Dybvig, P. H. (1983). Bank runs, deposit insurance, and liquidity. Journal of Political Economy, 91(3), 401-419. https://doi.org/10.1086/261155

Mishkin, F. S., & Eakins, S. G. (2018). Financial markets and institutions (9th ed.). Pearson.