The Principles of Banking, 2nd Edition

CHAPTER 1Banking, Bank Business and Financial Statements¹

Abstract

A bank is an entity that provides loan and deposit products to its customer base. The traditional and still current banking business model uses borrowed funds in the form of customer deposits to leverage its own equity base (“capital”) on the balance sheet in order to fund loans; because loans are generally of a longer contractual maturity than deposits, this maturity transformation process is a key undertaking of banks and one that generates the other main tenet of the banking business model, the assumption of continuous liquidity provision. Managing liquidity risk, together with the risk associated with a customer not repaying a loan, which is capital risk, are the two main risk exposures that are very important for a bank. The difference between the interest received on loans and the interest paid on deposits, known as the net interest income, is the primary performance measure for banks, and managing this and the related measure of net interest margin are also important for a bank. Banks are part of the global money markets, the interconnected market for short-term wholesale borrowing and lending.

This chapter was originally intended for newcomers to the market, junior bankers and finance students, but in fact everyone else may wish to read it as a form of refresher course. The purpose of this primer is to introduce all the basics of banking necessary to gain a strategic overview of what banks do and ...