Written by Nicolas Costa
In its purest definition, banking entails the matching of lenders and borrowers. Banks do this in several distinct ways and with a wide variety of clients. Two of the most common forms of financing are debt and equity financing. Debt financing comes in the form of loans; it involves the loaning of money to an individual or group in exchange for repayment with interest over time. Equity financing involves the selling of shares of stock, which offer the owner partial ownership of a company. Individuals give a corporation money in exchange for equity (stocks) which entitles them to a proportional share of the company’s profits in the form of revenue. The stock market is largely made up of equity financing.
Debt and equity financing both have their pros and cons. In debt financing, the lender is contractually guaranteed, given no default, to receive more money in return than was lent out, but the yield is capped and determined by the supply and demand of loanable funds. In the case of default, the borrower can declare their inability to repay the loan (usually through bankruptcy), leading the lender to either get no repayment or seize assets worth up to the repayment amount, though usually the seizure amounts to less. With these two different types of financing comes independent levels of risk that must be considered by investors before committing to the purchase of a particular asset. Debt financing is usually seen as a lower risk, lower return investment. In contrast, equity financing entails higher risk and higher return. In equity financing, an investor bets on the performance of the firm. If the firm does well, the investor has the possibility of making a significantly higher return than they would with debt financing. However, if the company under performs, investors lose money with no contractual repayment.
The banking industry is mostly divided between commercial banking, investment banking, and asset management.
Commercial banking is the form of banking most individuals interact with. Commercial banks, such as Wells Fargo, Chase, and Bank of America, make their money from lending out the money of their depositors. People put their money in a bank for safekeeping, and the banks lend out a portion of this pooled money in the form of mortgages and business loans, among others. Commercial banks make money mostly from the interest they earn from lending their deposits out. They also are involved in debt financing at the local level and serve depositors and borrowers that are relatively small in scale.
In addition, commercial banks often do not provide high interest rates to their depositors. Rather, depositors use commercial banks as a convenient means to store their money, oftentimes depositing money into the bank and spending it with debit cards so they do not have to carry money around. Furthermore, people often use credit cards issued by commercial banks as it allows them to spend money more conveniently and repay their expenses within certain time frames.
Investment banking deals with larger societal actors such as corporations, governments, and wealthy individuals, serving as financial intermediaries and advisors to these entities in their attempt to raise financing. The most famous investment banks include Goldman Sachs, JP Morgan, and Morgan Stanley. Investment banking deals with both debt and equity financing and has a variety of means of assisting these institutions in raising money. Investment bankers may assist these institutions in entering the stock market to raise equity financing. They also may directly seek lenders for large institutions through their sales and trading branches. Investment bankers may assist governments and corporations in issuing bonds to raise debt financing. Investment bankers may assist in mergers and acquisitions between companies, usually involving the purchasing of equity. Investment banks do not take deposits and are intended to be an intermediary in the high financing process, making money through fees and commission. All in all, investment bankers serve a similar role to commercial bankers in the connecting of lenders and borrowers but serve more as advisors to larger clients.
Asset Management (and Wealth Management) entails the strategic investment of money from high-net-worth individuals, mutual funds, and institutions. Individuals and groups hire asset managers to invest fortunes in the stock market in order to maximally grow their wealth. Asset managers look for financing opportunities that will yield the highest possible return while minimizing the risk of default. This is usually done through utilizing equity researchers to determine which companies are more likely to grow and investing client’s money into these companies while keeping their portfolios diversified. Asset managers make money by charging fees in proportion to the returns they make for their clients. In essence, asset managers can be thought of as commercial bankers for wealthy clients and, in some cases, large institutions.
While not usually considered “banks,” the buy-side of the financial system plays a similar role in the economy as asset managers. These include private equity firms and hedge funds. These firms essentially do the same thing as asset managers, but almost exclusively for high-net-worth individuals. Hedge funds tend to be riskier than asset managers but tend to make higher returns.
Central banks are the last notable type of bank. These banks are state-owned-and-operated and are responsible for monetary policy. Central banks can increase or decrease the money supply through printing money and the government bond market. The bond market, in turn, can be used to raise money for the federal government. Because these banks have a monopoly on currency printing, they are some of the most powerful state institutions. They are often used to indirectly raise interest rates, stimulate the economy, and decrease unemployment, among other things.
Risk is the primary driver of the banking industry. In all of their operations, banks are lending out money with the risk of default. Typically, higher-risk investments have higher earning potential while lower-risk investments have a lower earning potential. Oftentimes, these two types of investments are balanced out in a bank’s transactions in order to maximize return on investment while minimizing the risk of losing money in their lending practices.
The banking industry has been rightfully scrutinized by many in instances of poor behavior. The 2008 financial crisis was largely caused by the poor lending practices of large banks, causing the American taxpayers to have to pay for the damages. The crisis caused Washington to tighten Wall Street regulations to ensure that banks were responsible for their lending practices. This led many banks to make better lending decisions and to insure against the negative effects of subprime (i.e., “bad”) lending. JPMorgan Chase, the largest bank in the country, set aside billions of dollars during the onset of the COVID-19 pandemic to provide security should any of their loans turn out to be subprime. Now that the economy seems to be coming back together, JPMorgan Chase is reaping the benefits of having the money set aside become freed up (McCaffrey, Wall Street Journal).
Banks have also proved useful to society at many points. Banks have often served as financiers of military operations – notably the Second World War. Banks across the United States provided loans to allied militaries in order to win the war. In other areas, banks have financed leading technological, medical, and residential advancements, among others.
Though, like any industry, the banking industry has not always behaved well, at large it is the driving engine of an economy. Regulations and responsibility have proved to be great ways to reap maximal societal benefit from the industry. Banks use the savings of the economy to stimulate economic growth, while making a profit in the process. Without the banking industry, it would be near impossible for people to buy a home, car, or start a small business. If the banking industry is behaving properly, it serves as an efficient way for society to invest their money in the future of the economy, creating a win-win for everyone involved.
Works Cited
McCaffrey, Orla. “JPMorgan Profit Soars to Record After Bank Releases Reserves for Bad Loans.” The Wall Street Journal, Dow Jones & Company, 14 Apr. 2021, www.wsj.com/articles/jpmorgan-profit-soars-after-bank-releases-reserves-for-bad-loans-11618398726.