Commercial banks play an important role in the financial system and the economy. As a key component of the financial system, banks allocate funds from savers to borrowers in an efficient manner. They provide specialized financial services, which reduce the cost of obtaining information about both savings and borrowing opportunities. These financial services help to make the overall economy more efficient.

Imagine a World Without Banks!

One way to answer your question is to imagine, for a moment, a world without banking institutions, and then to ask yourself a few questions. This is not just an academic exercise; many former eastern-block nations began facing this question when they began to create financial markets and develop market-oriented banks and other financial institutions.

If there were no banks…

• Where would you go to borrow money?
• What would you do with your savings?
• Would you be able to borrow (save) as much as you need, when you need it, in a form that would be convenient for you?
• What risks might you face as a saver (borrower)?

How Banks Work?

Banks operate by borrowing funds-usually by accepting deposits or by borrowing in the money markets. Banks borrow from individuals, businesses, financial institutions, and governments with surplus funds (savings). They then use those deposits and borrowed funds (liabilities of the bank) to make loans or to purchase securities (assets of the bank). Banks make these loans to businesses, other financial institutions, individuals, and governments (that need the funds for investments or other purposes). Interest rates provide the price signals for borrowers, lenders, and banks.

Through the process of taking deposits, making loans, and responding to interest rate signals, the banking system helps channel funds from savers to borrowers in an efficient manner. Savers range from an individual with a $1,000 certificate of deposit to a corporation with millions of dollars in temporary savings. Banks also service a wide array of borrowers, from an individual who takes a loan of $100 on a credit card to a major corporation financing a billion-dollar corporate merger.

Banking Matters: Why banks are resented, and why they're needed?

It's probably fair to say that banks are mostly unloved. They make money with your deposits in exchange for minimal interest. They charge high fees for what are very basic services, and customer service is something they pay lip service to but oftentimes have yet to master. Even the chief executive of a big Spanish bank, during a recent interview, called banks "a necessary evil." He did not want to be identified, for obvious reasons.

But while unpopular on a personal level, in the global context, banks are crucial. Economies would screech to a halt without them because they perform a series of functions - including facilitating payments and granting credits - that grease the wheels of commerce. A functioning, efficient financial system drives growth and promotes development.

Banks are even more critical for emerging economies. In such countries, financing from both local and international banks plays a much larger role for corporations, because local capital markets are often still developing, and international capital markets prove to be expensive and difficult to gain access to for all but the largest companies.

That is part of the reason banks, unlike other businesses; attract such close scrutiny - and regulation - from governments. For the authorities, stability is the watchword.

In today's globalized, networked world, the failure of a bank in one country will generally have repercussions beyond those borders. BCCI, for instance, an international bank whose main regulator was in Luxembourg, was closed down in 1991 for fraud, causing losses for thousands of British depositors and small businesses.

And regulators don't want to stifle the banking business, but neither can they keep quiet when, say, they feel banks are overexposed to a specific sector like property or an emerging country, where major losses may occur due to a speculative bubble. Generally, they don't want to see banks endangering themselves.

Most regulators in the developed world are concerned about derivatives and, of these, credit default swaps, a market in which multinational banks are heavily involved. The banks insist these instruments disperse risk in the financial system by ensuring that no single bank has too much exposure to a specific company.

Regulators, however, worry that banks do not thoroughly understand the possible effects of an upheaval and are too reliant on their risk-control systems.

Ultimately, supervisors argue, a large crisis could have unintended consequences, far larger than the BCCI failure. The great fear is what they call a "systemic failure," the possibility of a domino-like collapse of banks across borders.

That is not how the banks see it. From their perspective, too much regulation is the greatest risk facing the financial sector, according to the 2006 Banking Banana Skins survey, carried out by the London group CSFI in association with PricewaterhouseCoopers.

Bankers argue that the cost burden and distractions of what they call regulatory overkill has become a net negative. Among their biggest bugbears are anti- money-laundering rules, which they say consume too many form-filling hours for staff, anger clients and, to cap it all, don't capture the large money launderers involved in the drugs and illegal arms trades.

Despite their complaints, though, banks are raking in profits as they benefit from the benign conditions in the world economy since the early 1990s, despite the Asian financial crisis of 1997 and the fallout after the bursting of the dot-com bubble.

The yearly ranking of the Top 1,000 World Banks for 2006 compiled by The Banker, a trade publication, shows that pretax profits for 2005 set a record for the third consecutive year.

Aggregate profits for all the banks rose 18.6 percent to reach $645.1 billion, while an important measure of profitability - pretax profits to Tier I capital - broke through the benchmark of 20 percent return on capital for the first time, reaching 22.7 percent.

Thus, on a global scale, even if economic conditions deteriorate, banks generally are well-capitalized and should be able to weather possible storms. They can even do well in what might look like adverse circumstances.

And this came despite the leftist, anti-capitalist rhetoric of some leaders and the nationalization of important industries in countries like Venezuela and Bolivia. Even there, banks matter.