Understanding the banking sector

The banking sector is defined as a devoted economy for holding specific types of financial assets using methods that will make said assets grow financially over a period of time. Banking sectors are governed by rules imposed by governments or similar bodies.

Renowned author and financial consultantStephen Valdez described in his work, Introduction to Global Financial Markets (please visit https://www.macmillanihe.com/companion/Valdez-Introduction-To-Global-Financial-Markets-8th-Edition/about-this-book/), the different types of banking in the global financial markets. These are commercial banking, investment banking, securities firms, asset management, insurance, and shadow banking.

These types of banking are required to fulfill the needs of a wide variety of customers, ranging from large organizations to individual customers. The following is a description of these various types of banking based on the needs of customers:

• Commercial bankingcan be retail (serving consumers) or wholesale (serving companies). Essentially, banks focus on taking deposits from savers and lending them to borrowers by charging interest. Commercial banks thrive on their ability to assess the riskiness of the loan extended to borrowers. Any failure to accurately assess the risk can lead to bankruptcy due to the failure to return money to the depositors. Many banks have failed in financial crises, including Washington Mutual in the US.
• Investment bankingincludes advisory businesses and security trading businesses. Advisory businesses deal with the buying and selling of companies, also known asmergers and acquisitions(M&A), debt and equity capital raising (for example, listing companies on the New York Stock Exchange), and security trading businesses. The security trading businesses deal with the trading of stocks, fixed income, commodities, and currencies. Securities trading involves a buyer who is willing to buy a security, a seller who is willing to sell a security, and a broker who facilitates the buying and selling of a security.

The advisory businesses hinge on creating value for companies by combining or spinning off businesses. This process optimizes the organizational performance for M&A activities. It also optimizes the cost of capital for clients into a standardized borrowing structure (such as bonds). The clients can do more investment by issuing new shares or canceling existing company shares (equity) to financial market participants.

All of the aforementioned activities create value with the correct evaluation of the companies given by the participants of the markets, which are driven by moods and more rational concerns.

• Asset managementincludes funds of all kinds—mutual funds, exchange-traded funds, hedge funds, private equity, and more. Asset management companies invest in various types of financial assets and the various life stages of a corporation using different investment strategies (a combination of buying and selling decisions). A critical decision made in this industry also falls under the umbrella of proper valuation, with regard to an investment's future values.

Asset management participants have a hunger for generating returns to meet various purposes, from the protection of asset values to appreciation. They are typically referred to as the buy side, which represents the asset owners, while the banking services that help the buy side are referred to as the sell side, which typically includes securities sales (client-facing, gathering orders), trading (executing the orders), and research (evaluating the securities).

• Insuranceincludes general insurance and life insurance. Life insurance protects buyers from mortality risks (consequences of death), and non-life insurance covers everything else, such as loss due to disasters, the loss of luggage, the loss of rockets (for example, Elon Musk's SpaceX loss) and vessels, system breaches due to hacking or viruses, and more.

The core function of insurance is to estimate the risk profile of borrowers. On the other hand, the ability to generate investment returns to cover losses can be important as well. The stronger the investment performance of the insurer, the more aggressive the pricing of insurance it can offer and the more competitive it becomes. That's one of thereasons why Berkshire Hathaway can provide competitive insurance pricing—due to its superior investment performance.

• Consumer banking isrepresented by the asset size of consumer debts,which focuses on the mortgage, auto, and personal loans, and credit card businesses that we might need at various points in our life.
• Shadow bankingis a lending settlement involving activities outside the regular banking system. It refers to alternative investment funds, such as bitcoin investment funds, broker-dealers in securities, and consumer and mortgage finance companies that provide lending to consumers.

The size of banking relative tothe world's economies

By comparing the sheer size of the finance industry with the world's annual income from production, we get a fair sense of how the world uses banking services to support itself. However, it is rather abstract to only show the statistics. Let's say the world is a person. How does finance fit into this person's life? The following is a list of points to consider:

• Annual income:The productivity and, therefore, income of the global economy as gauged by the World Bank was $86 trillion in 2018. Roughly, one-fifth (19%) of the annual income comes from trading across borders (where export trade volume is at $15 trillion).
• Wealth:The global person has approximately 4.4 years equivalent of annual income (annual GDP). A breakdown of the annual GDP can be found in the table at the end of this section. The information on annual income has been derived from various sources by comparing the activities with the size of the GDP. These 4.6 years can be bifurcated as follows:
• 0.9 years has been with the asset manager.
• 0.9 years has been deposited in banks.
• 0.8 years has been in the stock markets.
• 2.3 years has been funded by credit/borrowing (1.17 through debts, 1.0 through bank loans, 0.5 through shadow banks, and 0.03 through consumer credits).

Of course, this is a simplified treatment of global wealth; some figures could be double-counted, and the stock market figure could include deposits placed by listed companies that are accounted for by bank liabilities. However, given that we want to understand the relative size of various financial activities and their importance, we've just taken a shortcut to show the figures as they are.

• Insurance:To protect against any kind of undesirable risks derived from productive or investment activities,6% of the global person's annual income was spent on the insurance that covers 1.45 times their equivalent income. The premium will be used to buy the underlying financial assets to generate income to offset any undesirable risks.

• Derivatives:As a risk-protection instrument, besides buying insurance, banks can also offer derivatives as a financial instrument to offer risk protection. The termderivativesrefer to the agreement between two parties to pay or receive economic benefits under certain conditions of underlying assets. The underlying assets vary fromfixed income and currency to commodities (FICC).

Fixed income includes the interestrate and credit derivatives. Currency refers to foreign exchange derivatives, and commodities refer to commodity derivatives. Foreign exchange came in second with $87 trillion of outstanding exposure, which is roughly equal to the world's GDP. Commodity, credit, and equity derivatives have smaller shares, with each at around 2% to 9% equivalent of GDP. When accounting for derivatives as a risk-protection instrument,we exclude a form of derivatives called the interest rate over-the-counter (OTC), which is equal to 6 times the annual income—this is far more than the annual income that our wealth requires for protection. Indeed, some investors take the interest rate OTC as an investment. We carve out this instrument for our overall understanding of insurance. OTC refers to the bilateral agreements between banks and bank customers.

Another form of agreement can be exchange-traded agreements, referring to bank customers buying and selling products via a centralized exchange. I did not include too many exchange-traded figures, but the figures mentioned in this point for foreign exchange, commodity, credit and equity, and so on, serve the purpose of showing the relative size of the sectors.

The following table lists the GDP figures:

Customers in banking

Customers in the finance industry include depositors and borrowers engaged in saving and lending activities. When engaging in commercial banking activities, such as cross-border payment or trade finance, they are calledapplicants(senders of funds) andbeneficiaries(receivers of funds).

If customers are engaged in investment banking, securities, and asset management activities, they are calledinvestorsor, generally,clients. To protect buyers of insurance products from potential risks, the personbuying is called theproposer,and the item is called aninsured item. In cases where risk occurs and if/when compensation is required from the insurers, the person to be compensated is called abeneficiary.

Non-financial corporations are the real corporate clients of all financial activities and should be considered the real players of economics. They save excess cash and produce goods and services for consumers.