Basics of Banking

Gerald Klein of University of London explains “bank” as “a body, corporate or not, that has been recognized by Bank of England under the Banking Act, 1987, to accept deposits as defined by that Act. In UK there is no statutory definition of a “bank or “banker”. Banks are called “financial intermediaries” because they invest or lend funds of depositors who themselves are unable to lend their funds, due to risk and other factors involved in direct lending. Banks assume the credit risk involved in direct lending to those who needs funds. They have expertise and abilities to manage such risks.

As per this principle, a bank must keep a certain portion of its deposit liabilities in liquid form so as to be able to repay the same on demand or maturity dates to the depositors. The acceptance of deposits and lending these funds to borrowers in a manner such that the bank would be able to arrange for the funds demanded by its depositors at any point of time. It is called “liquidity management” or “asset liability management”.

Interest income, which represents the interest differential between its loans and deposits rates, is the main source of profit for a bank. Interest income along with non-interest or fee-based income contributes to the bulk of a bank’s profits. Solvency connotes long term financial soundness of a bank, achieved by adherence to prudent policies in lending, retention of some part of profits for business growth, implementation of professional management systems and following the mandatory rules and procedures in day-to-day operations.

The trust that customers – existing and potential-repose in a bank is its hallmark as it connotes dependability in the opinion of its customers. Trustworthiness is a function of a bank’s good track record over a fairly long period of time, in terms of liquidity, profitability, financial soundness and its record of meeting its commitments to all concerned parties. A bank accepts money from its customers and keeps the funds in non-interest bearing accounts or interest-bearing accounts as per the choice of customer while opening the account. Deposits constitute the largest portion of a bank’s funds, apart from its own capital. Deposits are repayable on demand or on specific maturity dates.