The Liquidity Risk Management Guide: From Policy to Pitfalls

2 Primer in Banking

Although this book focuses on liquidity management and liquidity risk it is useful before embarking on that tour to take a top-down look at the role banks play in the real economy and the risk associated with being a service provider of funds. This will provide a better understanding of the embedded risk in banking.

The central role of a bank is one of being a financial intermediary. As other intermediaries it buys goods and services from producers and sells them to the final user (consumer). This analogy might seem alien to banking, but a clear example would be the trading and brokering services banks provide and where their role is one of being the middleman. As further expanded later, a retail bank is also an intermediary when it takes deposits from depositors and lends onwards. Here the flow of services or products might be the opposite from the usual definitions; that is in retail banking we have the consumer providing the products (deposits) and the final user or beneficiary can be a producer (a firm).

Why does the economy need a middleman? The answer has certainly changed over the centuries as banks have evolved from a place of safekeeping to more active business partners and risk takers. In today's technologically advanced economy, there are surely markets that could link the fund provider with the user, but apart from the obvious transaction cost and the difficulty of matching the two interested parties, there are other fundamental reasons why banking ...