ABSTRACT
This chapter introduces readers to the banking business model, the risks created by the extreme maturity mismatch of banks’ balance sheet, and the factors underlying the rise of the bank holding company structure and financial conglomerates. Understanding these business risks and the complexity of today’s financial institutions helps one in understanding regulatory expectations and how to design effective risk management and compliance systems that meet these expectations. The chapter describes banks’ central role in the economy – in extending credit, intermediating between savers and borrowers through liquidity transformation, and operating the payments system – which makes them such a highly regulated industry. FDIC deposit insurance and the broader federal safety net exacerbate the risks of banking by introducing moral hazard, reducing investor scrutiny of bank management and increasing its incentive to take on excessive risk. Taxpayers’ exposure to failing banks further heightens the need for close, ongoing regulatory scrutiny. The chapter gives a preview of the book by linking each of the economic roles of banks and the related risks to their corresponding areas of bank regulation. A section on securitization and its role in disintermediating banks’ role in liquidity transformation is key to understanding the credit and liquidity crisis of the financial crisis covered in Chapter 6.
