Unit 5. The role of banks in theory

Banks are financial intermediaries, similar to credit unions, savings and loan associations, and other institutions selling financial services. The term financial intermediary simply means a business that interacts with two types of individuals or institutions in the economy: (1) deficit-spending individuals or institutions whose current expenditures for consumption and investment exceed their current receipts of income and who, therefore, need to raise funds externally by negotiating loans with and issuing securities to other units; and (2) surplus-spending individuals or institutions, whose current receipts of income exceed their current expenditures on goods and services so they have surplus funds to save and invest. Banks perform the indispensable task of intermediating between these two groups, offering convenient financial services to surplus-spending individuals and institutions in order to raise funds and then loaning those funds to deficit-spending individuals and institutions.

There is an ongoing debate in the theory of finance and economics about why banks exist. What essential services do banks provide that other businesses and individuals couldn't provide for themselves?

This may at first appear to be an easy question, but it has proven to be extremely difficult to answer. Why? Because research evidence has accumulated over many years showing that our financial system and financial markets are extremely efficient. Funds and information flow readily to both lenders and borrowers, and the prices of loans and securities seem to be determined in highly competitive markets. In a perfectly efficient financial system, in which pertinent information is readily available to all at negligible cost, in which the cost of carrying out financial transactions is negligible, and all loans and securities are available in denominations anyone can afford, why are banks needed at all?

Most current theories explain the existence of banks by pointing to imperfections in our financial system. For example, all loans and securities are not perfectly divisible into small denominations that everyone can afford. To take one well-known example, U.S. Treasury bills - probably the most popular short-term marketable security in the world - have a minimum denomination of $10,000, which is clearly beyond the reach of most small savers. Banks provide a valuable service in dividing up such instruments into smaller securities, in the form of deposits, that are readily affordable for

millions of people. In this instance a less-than-perfect financial system creates a role for banks in serving small savers and depositors.

Another contribution banks make is their willingness to accept risky loans from borrowers, while issuing low-risk securities to their depositors. In effect, banks engage in risky borrowing and lending activity across the financial markets by taking on risky financial claims from borrowers, while simultaneously issuing almost riskless claims to depositors.

Banks also satisfy the strqng need of many customers for liquidity. Financial instruments are liquid if they can be sold quickly in a ready market with little risk of loss to the seller. Many households and businesses, for example, demand large precautionary balances of liquid funds to cover expected future cash needs and to meet emergencies. Banks satisfy this need by offering high liquidity in the deposits they sell.

Still another reason banks have grown and prospered is their superior ability to evaluate information. Pertinent data on financial investments is both limited and costly. Some borrowers and lenders know more than others, and some individuals and institutions possess inside information that allows them to choose exceptionally profitable investments while avoiding the poorest ones. Banks have the expertise and experience to evaluate financial instruments and choose those with the most desirable risk-return features.

Moreover, the ability of banks to gather and analyze financial information has given rise to another view of why banks exist in modem society - the delegated monitoring theory. Most borrowers and depositors prefer to keep their financial records confidential, shielded especially from competitors and neighbors. Banks are able to attract borrowing customers, this theory suggests, because they pledge confidentiality. Even a bank's own depositors are not privileged to review the financial reports of its borrowing customers. Instead, the depositors hire a bank as delegated monitor to analyze the financial condition of prospective borrowers and to monitor those customers who do receive loans in order to ensure that the depositors will recover their funds. In return for bank monitoring services, depositors pay a fee that is probably less than the cost they would have incurred if they monitored the borrowers themselves.

By making a large volume of loans, banks as delegated monitors can diversify and reduce their risk exposure, resulting in increased deposit safety. Moreover, when a borrowing customer has received the bank's stamp of approval, it is easier and less costly for that customer to raise funds elsewhere. In addition, when a bank uses some of its owners' money as well as deposits to fund a loan, this signals the financial marketplace that the borrower is trustworthy and has a reasonable chance to be successful and repay its loans.

 

EXERCISES

Exercise 1. In each paragraph, find the sentences supporting the main idea of the text. What paragraph contains the most important information?

Exercise 2. Answer the questions.

1. What does the term "financial intermediary" mean?

2. Explain the meaning of the following terms "deficit-spending individuals" and "surplus-spending individuals".

3. What task do banks perform?

4. Why does bank exist?

Exercise 3. Complete the sentences.

Provide, banks, explain, popular, evaluate, debate, risk, market, afford, data, confidential, system, need.

1. There is an ongoing... in the theory of finance and economics about why banks exist.

2. What essential services do banks...?

3. Our financial... and financial markets are extremely efficient.

4. Most current theories... the existence of banks by pointing to imperfections in our financial system.

5. Loans and securities are not divisible into small denominations that everyone can...

6. U.S.Treasurybillsarethemost... short-term marketable security in the world.

7. Pertinent... on financial investments is limited and costly.

8. Banks satisfy the strong... of many customers for liquidity.

9. Financial instruments are liquid if they can be sold quickly in a ready... with little risk of loss to the seller.

10. Banks have the expertise and experience to... financial instruments and choose those with the most desirable risk-return features.

11.... can gather and analyze financial information.

12. People prefer to keep their financial records....

13. Banks can diversify and reduce their... exposure by making a large volume of loans.

Exercise 4. Write down the Russian equivalents.

Financial intermediary, savings, loan, to interact, deficit-spending individuals, surplus-spending individuals, current receipts of income, current expenditures, an ongoing debate, to provide, evidence, lenders and borrowers, a highly competitive markets, to afford, a less-than-perfect financial system, financial instruments, financial investments, profitable investments, trustworthy.

Exercise 5. Match the nouns and the verbs as they are used in the text.

1. 2.

3.

4.

5.

6.

7.

8. 9.

to perform to offer to provide to take to engage to satisfy to cover to meet to evaluate

10. to gather

11. to keep

12. to attract

13. to analyze

14. to pay

15. to make

16. to fund

A. the financial condition

B. emergencies

C. borrowing customers

D. a fee

E. information

F. services

G. in risky borrowing

H. expected cash needs

I. financial information

J. the indispensable task K. financial services L. an example M. the strong need N. a loan

O. a large volume of loans P. financial records confidential

 

UNIT 6. CENTRAL BANK

WHAT IS A CENTRAL BANK?

Just as a prudent driver keeps an eye on the road and a hand on the wheel, every country's central bank watches economic data carefully and adjusts the money supply in an effort to keep the economy headed in the right direction.

Instead of taking deposits and making loans as normal banks do, a central bank controls the economy by increasing or decreasing the country's supply of money. Cranking up the printing presses is not the only way for a central bank to increase the economy's supply of money. In fact, in most modern economies printed notes and coins are only a small percentage - often less than 10 percent-of the money supply. Central banks usually print only enough currency to satisfy the everyday needs of businesses and consumers.

Since most «money» is actually nothing more than a savings or checking account at a local bank, the most effective way for a central bank to control the economy is to increase or decrease bank lending and bank deposits. When banks have money to lend to their customers, the economy grows. When the banks are forced to cut back lending, the economy slows.

Once a customer deposits money in a local bank, it becomes available for further lending. A hundred dollars deposited at a bank in London, for example, doesn't lie idle for long. After setting aside a small amount of each deposit as a «reserve,» the bank can lend out the remainder, further increasing the money supply - without any new currency being printed. When these loans are redepositing in banks, more money becomes available for new loans, increasing the money supply even more. A bank's supply of money for lending is limited only by its deposits and its reserve requirements, which are determined by the central bank.

Central banks often use these reserve requirements to control the money supply. When a bank is required to keep a certain amount of its funds on reserve with the central bank -10 percent of deposits for example - it is unable to lend these funds back to customers. When a central bank decides to increase the money supply, it can reduce this reserve requirement, allowing banks to use more of their funds to lend to businesses and consumers. This increases the money supply quickly because of a multiplier effect: as the new loans enter the economy, deposits increase - and banks have even more money to lend, which generates further deposits providing more money for further loans.

Another way of controlling the money supply is to raise or lower interest rates. When a central bank decides that the economy is growing too slowly - or not growing at all - it can reduce the interest rate it charges on the bans to the country's banks. When banks are allowed to get cheaper money at the central bank, they can make cheaper loans to businesses and consumers, providing an important stimulus to economic growth. Alternatively, if the economy shows signs of growing too quickly, a centra! bank can increase the interest rate on its loans to banks, putting the brakes on economic growth.

Perhaps the most dramatic way of increasing or decreasing the money supply is through open market operations, where a central bank buys or sells large amounts of securities, such as government treasury bonds, in the open market By buying a large block of bonds, from a bank or a securities house for example, the central bank pumps money into the economy because it uses funds that previously were not part of the money supply. The money used to buy the bonds then becomes available for banks to lend out to consumers and businesses.

A central bank, unlike other players in the economy, does not have to secure funding from any other source. It can simply print more money or use its virtually unlimited credit with banks in the system. Once a central bank s payment enters the economy, it becomes part of the money supply, providing fuel for businesses and consumers to increase their economic activities. Likewise, when a central bank sells bonds in the open market, the payments from banks and securities houses disappear into the black hole of the central bank's vault, completely removed from the economy at large.

An error in judgment at the central bank has grave consequences for everyone in the economy. If a central bank allows the economy to expand too rapidly by keeping too much money in circulation, it may cause inflation. If it slows down the economy by removing too much money from circulation, an economic recession could result, bringing unemployment and reduced production. A central bank serves as a watchdog to supervise the banking system, in most cases acting independently of its government to provide a stabilizing influence on the country's economy.

The activities and responsibilities of central banks vary widely from country to country. For example, Britain's Bank of England is responsible for printing the money as well as supervising the banking system and coordinating monetary policy. In the United States, the duties of a central bank are divided among different agencies: the U.S. Treasury borrows the government's money through Treasury bond and note issues, while the Federal Reserve Board is put in charge of monetary policy and oversees the printing of money at the Bureau of Printing and Engraving.

The French central bank, the Banque de France, prints and issues the money, but the French treasury makes the decisions regarding monetary policy and bank supervision. In Germany, the central bank, called the Bundesbank, is noted for its active policy of strict monetary control, limiting money supply growth in order to control inflation at all costs.

The Bank of Japan, like many of the world's central banks, acts as banker to the government. This activity is a major source of revenue for the bank since fees are charged for issuing the government's checks.

EXERCISES

Exercise 1. Explain why it is useful to be able to estimate and describe character.

1. What are the main functions of a central bank?

2. In what way can a central bank control the economy?

3. How can central banks control the money supply?

4. What is the most dramatic way of increasing or decreasing the money supply?

5. Does a central bank have to secure funding from any other source? Why?

6. Do the activities and responsibilities of central banks vary from country to country? Give your examples.

 

Exercise 2. Translate the following sentences.

1. Don't bank on going abroad this summer, we may not have enough money.

2. The morning began fine, but now clouds are banking up.

3. I have always banked with the Royal Bank.

4. They have an access to huge banks of public data or library information.

5. The only way out is to ask your bank for a loan.

6. I am not sure if I should buy this suit - Come on! It won't break the bank.

7. Mr. Smith had bankrolled them when they had nothing.

Exercise 3. Match the term with its definition.

Discount house, deposit, loan, charter, lend, borrow, denomination, claim, installment, repository.

1. A place where you keep objects of a particular type.

2. A sum of money lent for an agreed period of time and at an agreed rate of interest

3. Demand or request for a thing considered one's due.

4. A document granting rights, issued by a legislature.

5. Any of several usually equal payments for something.

6. Money left with an organization for safe keeping or to earn interest.

7. Class of measurement of money.

8. Company or bank on the discount market that specializes in discounting bills of exchange.

9. Acquire temporarily, promising or intending to return.

10. Allow the use of money at interest.

Exercise 4. Study the following words and word combinations. Make your own sentences, using each of them. Translate the sentences into Russian.

Risk; riskless; risky; desirable risk-return features; risk-taker; low-risk securities; risk-exposure; riskiness; insurable risk; at risk; put at risk; ran a risk; take a risk; risk capital; calculated risk; risk on.

Exercise 5. Explain the difference between:

Risk - hazard - jeopardy - peril.

Give your own sentences to show you understand the difference.

Exercise 6. Think of the nouns that are most commonly used with the following adjectives:

Current, surplus, ongoing, efficient, competitive, negligible, profitable, trustworthy.

Exercise 7. Think of the nouns that are most commonly used with the following verbs.

Issue, sell, perform, save, cover, accumulate, flow, afford, meet, recover, incur, claim.

Exercise 8. Think of the verbs and adjectives that are most commonly used with the following nouns.

Fund, income, service, flow, deposit, borrower, claim, loan, fee.

Exercise 9. Make up your own sentences with any ten word- combinations from ex. 6, 7,8.

UNIT 7. FINANCE

The field of finance is broad and dynamic. It directly affects the lives of every person and every organization, financial and non-financial, private or public, large or small, profit-seeking or non-profit.

One of the primary considerations when going into business is money. Without sufficient funds a company cannot begin operations. The money needed to start and continue operating a business is known as capital. A new business needs capital not only for ongoing expenses but also for purchasing necessary assets. These assets - inventories, equipment, buildings, and property - represent an investment of capital in the new business.

Finance can be defined as the art and science of managing money. All individuals and organizations earn or raise money and spend or invest money. Finance is concerned with the process, institutions, markets, the instruments involved in the transfer of money among and between individuals, businesses and governments.

Finance can be defined at both the aggregate or macro level and the firm or micro level. Finance at the macro level is the study of financial institutions and financial markets and how they operate within the financial systems. Finance at the micro level is the study of financial planning, asset management, and fund raising for business firms and financial institutions.

Finance has its origin in the fields of economics and accounting. Economists use a supply-and-demand framework to explain how the prices and quantities of goods and services are set in a free-enterprise or market-driven economic system.

Accountants provide the record-keeping mechanism for showing ownership of the financial instruments used to facilitate the flow of financial funds between savers and borrowers. Accountants also record revenues, expenses, and profitability of organizations involved in the production and exchange of goods and services.

Large-scale production and a high degree of specialization of labor can function only if there exists an effective means of paying for productive resources and final products. Business can obtain the money it needs to buy capital goods such as machinery and equipment only if the institutions and markets have been established for making savings available for such investment. Similarly, the federal government and other governmental units can carry out their wide range of activities only if efficient means exist for raising money, for making payments, and for borrowing.

Financial markets, institutions or intermediaries, and business financial management are basic elements of well-developed financial systems. Financial markets provide the mechanism for carrying out the allocation of financial resources or funds from savers to borrowers. Financial institutions such as banks and insurance companies, along with other financial intermediaries, facilitate the flow of funds from savers to borrowers. Business financial management involves the efficient use of financial capita! in the production and exchange of goods and services. The goal of the financial manager in a profit- seeking organization is to maximize the owners' wealth through effective financial planning and analysis, asset management, and of financial capital. The same financial management functions must be performed by financial managers in not-for-profit organizations, such as governmental units or hospitals, in order to provide the desired level of service at acceptable costs.

EXERCISES

Exercise 1. Answer the questions.

1. What is finance?

2. Where does finance have its origin?

3. What are the basic elements of financial system?

Exercise 2. Ask ten questions on the text.

Exercise 3. Insert the correct word from the list.

Goods, elements, accountants, not-for-profit, finance, capital, goal, art, investment, field, institutions, business, funds.

1. The... of finance affects the lives of every person.

2. People go into... to earn money.

3. Without sufficient... nobody can start business.

4. The money needed to start a business is called....

5. We can call inventories, equipment, buildings, and property an... of capital in the business.

6. We can call finance the... and science of managing money

7.... has its origin in the fields of economics and accounting.

8.... record revenues, expenses, and profitability.

9. Financial markets, institutions or intermediaries, and business financial management are basic... of well-developed financial systems.

10. Financial... such as banks and insurance companies facilitate the flow of funds from savers to borrowers.

11. Business financial management involves the efficient use of financial capital in the production and exchange of... and services.

12. The... of the financial manager is to maximize the owners' wealth through effective financial planning.

13. The financial manager in a... organization can use the effective financial planning and analysis in order to provide the desired level of service at acceptable costs.

Exercise 4. Match the definitions with the words given below.

Fee, executive, insure, skill, capacity, profile, applicant, charisma, ensure, guideline, superior.

1. Ability to do something well.

2. Short biographical or character sketch.

3. Payment made for professional advice or services.

4. Person or body with managerial or administrative responsibility.

5. Make certain.

6. Secure compensation in the event of loss or damage by advance regular payments.

7. In a higher position; of a higher rank.

8. Principle directing action.

9. Power to certain, receive, experience, or produce.

10. The ability to attract, influences, and inspire people by your personal qualities.

11. Someone who formally asks to be given something, such as a job or a place at a college or university.

Exercise 5. Read the text once again and explain, in your own words, the meaning of the following terms:

1. profit-seeking organization, non-profit organization, financial organization, rion-financial organization, private organization, public organization.

2. money, funds, capital, investment, finance, economics, accounting.

3. managing money, to earn money, to raise money, to spend money, to invest money.

4. finance at the macro level, finance at the micro level.

Exercise 6. Match the word with its definition.

Finance house (company), financial institution, financier, finance, financial year, financial instrument, financial, financial futures, financial capital, financial intermediary, financial accountant.

1. capital involved in a project loan of money for a particular purpose.

2. organization providing finance for hire-purchase agreements.

3. accountant whose primary responsibility is the management of the finances of an organization and the preparation of its annual accounts. Financial adviser.

4. the liquid as opposed to physical assets of a company.

5. futures contract in currencies or interest rates.

6. an organization that collects funds from-individuals, other organizations or government agencies and invest these funds or lends them on to borrowers.

7. formal financial document.

8. bank, building, society, finance house, insurance, company, investment trust etc. that holds funds borrowed from lenders in order to make loans to borrowers; sometimes you can call so an organization that sells insurance but is not directly employed by an insurance company.

9. any year connected with finance, e.g. a company's accounting period or a year for which budgets are made up; it is a specific period relating to corporation tax.

10. ratios between particular groups of the assets or liabilities of an enterprise and corresponding totals of assets or liabilities; or between assets and liabilities and flows like turnover or revenue.

11. person who uses his one money to finance a business deal or venture or who makes arrangements for such a deal.