Day 197 The commercial banks

The commercial banks 

Obviously, commercial banks play the most essential role in the financial markets. It ensures the active flow of funds from surplus units to deficit units, so without commercial banks it is impossible to keep the wheel of commerce circulating. We can easily observe this effect through the economic equation of output, where money supply times velocity of money equals to price level times output. Therefore, the velocity of money, in other words, the flow of funds will be able to determine the output in an economy when the money supply and price level remain constant. In fact, as the most crucial participants, these commercial banks hold more than 50% of assets in the financial market. If we want to fully understand the mechanism of this market, the operation of banks is an important subject. 

Generally, there are two major parts of commercial banks’ business: those appear on the balance sheet and other off-balance sheet activities. Most of the commercial banks adopt liability management strategy, where the bank actively manages its sources of funds in order to meet future demand of loans. Although it leads to several prudential supervision problems and capital adequacy issue, this method still generates incredible liquidity to the financial market. For example, the deposits in different accounts, negotiable certificate of deposit, and debenture secured by the collateralized floating charge are typical sources of funds for commercial banks. On the other hand, these funds are used to finance loans to various parties. To illustrate, personal and housing finance instruments such as mortgage, investment loan and credit card take the most proportion of it. Interestingly, commercial banks prefer not holding these loans on hand, but sell them to trust in order to obtain funds for other loans. Then the trusts would issue securities and use these non-liquid assets as a guarantee. This process is named as securitization, which provides a common view of how did commercial banks operate. Other borrowers are companies and government, where treasury notes/bonds are often held by the banks as cash equivalent items. 

In addition to the activities recorded on the balance sheet, there is a substantial proportion of off-balance-sheet business. According to the statistics, these OBs create about seven times more than regular business. These activities are comprised of bank providing a guarantee of financial obligations (direct credit substitutes), promising financial compensation of non-performance of commercial contracts (trade and performance-related items), giving commitments like underwriting, and market rate-related contracts. This is because the commercial bank utilizes many derivative products to manage potential risks in the market. 

In conclusion, the banks are the pillars of our financial system, thus regulation and prudential supervision to them has become a critical issue for the government.