Banking and its role in the economy

When someone uses the term banking, they are generally referring not only to commercial banks but to all the institutions that make up the financial system. Do you want to know what banking is and what its role is in the economy, what is the financial system, what are the types of banks or what are the main products offered by commercial banks? Keep reading.

The existence within the economy of agents with surplus financial resources and others with a shortage of these allows the exchange to cover these needs, which is carried out under certain pre-established norms and conditions. From this, relations between banking institutions and business entities are fostered, and financial systems are formed.

A financial system is the set of assets, institutions, and financial markets that work, develop, or trade in a country or a specific environment. In the financial system, the institutions that compose it perform the role of financial intermediaries. These are a set of institutions specialized in the mediation between the borrowers and the lenders of an economy.

Stiglitz (1998) also defines the financial system as the set of banks, other financial intermediaries, debt markets, and capital markets that solve three fundamental problems: the agglomeration of capital, its distribution in the most important uses and the monitoring of that these resources are used efficiently.

Within the financial system is the banking system, which can be defined as the set of entities or institutions that, within a given economy, help to connect savings and investment. This system has a very different typology and depends on the development of the financial system.

Banks are an institution that links savers and borrowers and contributes to the proper functioning of the economy; that is, they capture funds from people with money, agglomerate it, and lend to those who need it.

Types of banks

There are several criteria to classify banks due to their different typology. Responding to the type of operations that they perform from specialists in the subject, they can be classified as:

Central Bank

Controls the issuance of legal notes and coins and maintain the financial system. It exercises the function of bankers of other banks. In the countries, there is only one Central Bank.

Commercial Banks

They are companies that, through various products, receive money from the public (savers and investors) and lend it to the people or companies that need it and who meet the requirements to be credit subjects. Also supported by payment systems, they offer services such as payments (electricity, telephone, tuition, etc.), transfers, purchase and sale of dollars, and circulating gold and silver coins.

Development Banks

They are banks run by the federal government whose purpose is to develop specific sectors, solve financing problems.

Savings Bank

Its main objective is to promote savings, financing, and investments and offer financial services instruments among the members of the sector.

Investment Banks

They focus on advising clients seeking to make national and international investments. They play the role of intermediaries between investors and users of capital rather than an intermediary between depositors and borrowers. Among the bank’s operations is the purchase of shares, among others.

Mortgage Banks

Its activity is based on financing clients who wish to acquire homes, using their own homes as a credit guarantee.

However, since its inception, banks have played a significant role in the economic development of countries and, specifically, in the growth of the business sector. This statement is supported given the multiple functions they have, those that give dynamism to economic processes.

Bank Services

The basic services of banking entities reveal their significance and their impact on a country’s economy. Contemporary banking theory classifies banks’ services into four main categories: offering access to the payment system, transforming assets, managing various types of risks, and processing information, and monitoring debtors.

The transformation of assets occurs from the fact that banks accept deposits that are usually short-term and small amounts as liabilities. These are transformed into assets by placing them in the form of loans of generally larger dimensions, in the short and long term, a process that necessarily implies a risk, since the assets of the institutions become illiquid concerning their liabilities for which it charges an interest (active rate) and commissions. This process also leads to the transformation of savings into credits.

The savings management function takes place since the banks receive the money from the savers in the form of a deposit, thereby granting interest (passive rate). This function is based on the client’s trust when depositing in the bank.

The administration of the payment system allows the settlement of commercial operations. Banks play a strategic role in allowing the flow of financial resources throughout the country, distributing banknotes and coins, paying the checks that are issued, offering the service of payment with cards and bank transfers, and promoting the proper functioning of the systems of payment.

Another of its main services is to offer security to economic agents who deposit their money in said institution to protect them from losses and subtractions. It responds to the fact that the bank manages different risks such as credit, operational, and market risk, intending to reduce the threats that affect its results. Thus, it has the obligation and responsibility to monitor and follow up on all the credits it offers.

In addition to the previous ones, the function of promoting the healthy development of the financial system, assuring a positive impact on the economic development of the economic actors, on social equity and environmental management, becomes relevant.

These functions allow the economic development of a country, especially state-owned companies, by guaranteeing access to a well-functioning payment system and facilitating local and international economic transactions. Hence, the existence of banks is justified because these entities allow a better allocation of financial resources, benefiting claimants and fund providers, favoring investments, and issuing specific liabilities more efficiently than would be done by savers and investors privately. (Barrios, 2004; Sicilia, 2010).

The financial intermediation of commercial banks also allows promoting capital formation by accepting deposits from individuals and companies and then making these funds available to other agents. The granting of credits that it commits allows investment in new companies and the adoption of novel production methods. Hence it supports the productive capacity of the economies. It is also noteworthy, mainly in developing countries, its contribution to the increase in agricultural productivity and farmers’ incomes since commercial banks finance the development of agriculture and small industries in rural areas in these countries.

Looking inside companies and businesses, in many cases, they do not have conditions to finance their investments or working capital with their own resources, it is not even convenient to use them in their entirety if they had these. Therefore, as previously mentioned, they receive the financial resources necessary for their development from the commercial banks.

Based on the above, the use of financing by companies with a considerable level of debt provides advantages such as the reduced cost of this type of source, the financial savings of their fixed financial charges, as well as the multiplier effect of profits that the latter provoke. In this sense, they must ensure that the return generated by the assets of the companies is higher than what was had before contracting the debt, so as not to present liquidity and insolvency problems.

Products and services of commercial banking

Financial intermediaries are responsible for facilitating the flow of money through the economy through the products and services they offer.

According to the banks’ services, the financing products and services that commercial banking offers to companies and businesses mainly allow an understanding of the role they play in the development of the country’s economy, and their use establishes the credit relationships between them. Among its leading products and services are:

Bank loan

It is the financial operation where the bank makes available to the client an amount of money where its use is in the medium and long term for investments and the short term for working capital. The company receives all the capital loaned when the transaction is formalized and can immediately amount to this amount.

Credit line

Operation through a contract so that the client has financial resources up to a certain amount may be partially or totally available to cover the cash needs during the established period, generally one year. In short-term financing for liquidity needs, it gives the possibility of covering possible liquidity gaps at the same time that they occur. In long-term funding, it gives the possibility of using credit by parties when the client requires payment to different providers at different times.

Revolving line of credit

It is a line of credit in which the total or partial repayments release the authorized credit limit. Companies obtain this type of short-term financing for current needs, and it is highly operational. It can be used partially or totally.

Syndicated credit

Resources contributed by various financial institutions (trustees) are in favor of an entity controlled by a financial institution (agent).

Bank discount or commercial discount

In this operation, the bank anticipates the payment of a credit not yet expired. It is short-term financing for current needs. It is a means that avoids waiting until the expiration date of the effects to obtain the amount of the sales made or the payment for the services rendered, which makes it essential to finance the working capital of the companies.


The factoring is a transaction by which a company engages in a commercial transfer of its portfolio effects sales charge for loans to a third company or bank. In this way, the company is advancing its collections and consequently receiving financing. The bureaucratic and collection management work is eliminated, thereby decongesting the administration of the company. The expenses associated with the operation are tax-deductible.


The lease is a finance lease of an asset, with the option to purchase it at the agreed term’s expiration. Forces the lessee to make fixed payments for the use of physical assets such as equipment and land. There is some flexibility because the company benefiting from the leasing contract can adapt the contract’s duration to the life of the equipment, using it during the period in which its productivity is highest.

Confirming or Confirmation of payments

The confirming is a financial transaction whereby the confirming authority is responsible for the payment of invoices the client company owes to its suppliers, as long as the due payment is deferred in time.

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Ahmed Ismail

I'm a Civil Engineer. I like reading everything related to Business so I decided to launch the "Fast Grow Company" website to help Entrepreneurs in their business journey. Keep updated and follow us.

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