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Discuss The Role Of Banks In Economic Development?

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James Harden Profile
James Harden answered
To effectively address this question, it is first necessary to establish an operational definition of a bank, which for the purposes of my answer will be "an institution whose current operations consist in granting loans and receiving deposits from the public" which is the definition used by regulators when deciding whether a financial intermediary has to conform to banking regulation. For purposes of this answer, the term "public" will mean households or firms which are independent from the government or state.

Historically, the job of a bank was to change money from what members of the public had either in material wealth or earnings into a currency that could be traded. In medieval times when banks first started "changing money", their part played in economic growth was very significant. If it was determined the exact quantity of a precious metal in a coin, then it would be much easier to define the value of a particular coin. This lead to a large expansion of trade within Europe, as people were able to participate in deals and understand exactly what the value of their trade was. This arguably caused the rapid economic development of the European continent during the medieval period.

The first ever banks to offer loans were based in Florence and other Italian cities. The banks in these cities would limit any lending to financing a harvest, and would only supply funding for a harvest after visiting the fields to be harvested and approving the crops quality. This increase in funding for harvesting crops meant that more crops could be harvested in a given time, by hiring more workers to work the land. This would lead to higher revenue for the farmer and could therefore produce more crops the next year. This is an example of investment that is what modern economic development is founded upon.
Modern economic development has a variety of definitions, foremost there is a simple definition "an increase in the rate of increase in GDP causing higher standards of living for a nation's population", where GDP can be defined as the total spending within an economy. However to answer this question, a more complex definition is more apt "an increase in the productive potential of the economy, graphically represented by an outwards shift of the Production Possibility Frontier or an increase in the rate of the rightwards shift of the Long Run Aggregate Supply Curve (LRAS) which will have an effect in either the short run or the long run on the standards of living of a nation's population" what this means is that economic growth is defined as an economy being able to produce more goods and services for the same price. This increase in output of an economy will mean that households are able to demand more for the same price or better quality objects for the same price, thus increasing their standards of living.

Our definition of a bank stated that the institution must grant loans. These loans, in a perfect market would solely be spent on increasing either the quality and or quantity of the factors of production within an economy. (The factors of production are defined as land & natural resources; labour & workforce; capital; and entrepreneurship). Each of these factors of production can be increased in both quality and quantity through different methods. To increase the quality of land & natural resources, money borrowed from banks must be used to increase the potential of the land; this could be through irrigation, which will make the land more productive (output per unit land per unit time). To increase the quantity of land is obviously quite difficult, so here money must be spent on finding and exploiting new stored of natural resources, such as oil or gas. Each of the other factors of production can be increased through spending money. As the money to increase the quality and quantity of the factors of production is more often than not supplied by a bank, banks it would seem, play a vital part in economic development.

However, not all bank loans lead to economic growth, a large proportion of bank loans are loans to households who use the loan to purchase a house. Individuals purchasing houses does not directly lead to economic growth and therefore could be seen as inefficient allocation of the bank's resources.
As well as loans given to households, due to the decreasing awareness of risk upon loans to businesses, many banks are happy to grant loans without any collateral, and increasingly without proof of need for the loan. This means that frequently, money that could be used for economic growth and development is being spent on projects that have no positive impact on the economy.

To conclude, historically it seems that banks are very capable of promoting economic growth and development. This is seen in their formations in the medieval European trade, where the intervention by banks caused the growth, and without such institutions the growth is likely to have been much slower. However in recent years, due to the relaxing of banking regulation and the increasing lack of care by investment bankers and mortgage bankers economic growth is much less governed by banks and is often only implemented when governments introduce supply side policies which could involve manipulating banks to help in the economic development.
References: Microeconomics of Banking [Second Edition] - Xavier Freixas and Jean-Charles Rochet
Ady Mat Profile
Ady Mat answered
They lend loans and credits to the industry, agricultural,service sectors of the economy.

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