The economic functions of banks

The main economic role of a bank is to transfer financial resources (i.e. money) from those who have a surplus to those who are in need of funds - a function known as financial intermediation. The bank acts as a counterparty to both sides, collecting funds from savers and lending them to businesses and households for investment or consumption purposes.

In an economy without financial intermediaries, a business needing funding for an investment project would have to raise money directly from a large number of individual savers—something that would involve high costs for the business. Similarly, savers who might want to invest their money directly, without using a financial intermediary, would need to individually assess the likelihood of the project's success and the borrower's ability to repay the loan (known as creditworthiness), as well as monitor the progress of the investment and ensure timely payments of interest and repayment of capital.

Moreover, when a borrower also has a current account with the bank, this can gain valuable insights into their financial behaviour by analysing transactions on the account. Once a credit line is granted, the relationship between the bank and the customer continues to generate further information that the bank can use when deciding whether to extend or renew credit. For businesses that struggle to access capital markets directly, this close relationship with a bank makes it easier to obtain credit, as the bank can draw on the rich pool of information gathered from its customer relationships.

This intermediation process also involves what is known as 'maturity transformation'. Banks typically collect funds in the form of deposits that can be withdrawn 'on demand', and convert them into less liquid financial assets, such as loans, which are usually repaid over a longer period (often more than a year). Because not all depositors withdraw their funds at the same time, banks can use a portion of the money collected to finance longer-term lending, such as business loans or mortgages for households, while still allowing savers to access their money whenever needed.

Compared to individual savers, banks are better positioned to diversify risk. Savers with limited funds may be reluctant to lend all their money to a single business due to the risk involved. Banks, however, have the size and scale to spread their lending across a large number of borrowers from different sectors and locations, reducing the likelihood that all borrowers will encounter difficulties at the same time. In addition to providing loans to businesses and households, banks also invest in a wide range of financial assets: they hold securities, engage in interbank operations, and lend to other financial institutions.

These activities—reducing information and liquidity management costs, and diversifying risk—help increase the amount of financial resources available to the wider economy. Comparative international studies have shown that more efficient and developed financial systems tend to support stronger economic growth.