There are three alternative courses of action for a political economist to take when a crisis blows up in an area that is far from his speciality or range of interest, such as banking in my case. The first is to stay silent. The second is to bone up as quickly as possible on the new area and to talk plausibly about Basel I, Basel II, the looming Basel III, first and second tier capital and so on. The third is not to bluff one's way into the technical discussion but to use the crisis to think about a few fundamentals. The third is the course that appeals to me.
Let us start with the question of why we need banks. They are first and foremost depositary institutions. Without them we would have to keep whatever we use as money under the mattress or in corporate storerooms. Following closely from this depositary function is the role of banks for transmission and clearing of payments. Instead of having to withdraw money every time we make a payment and depositing all our receipts as they come in, it is obviously convenient to use documents such as cheques or transfers which the banks can net out, and also to net out payments and receipts from different banks to each other according to the flow of their customers' business.
There is however a third function. Large corporations derive most of their investment funds from retained profits or issues on the capital market. Many small and medium-sized businesses need more for their investment needs than they can find from retained profits, but do not have easy access to the capital market. Their best course is to borrow directly from savers. And even major corporations may have short-term financing needs that do not justify a new issue. Moreover, the availability of banks is highly useful for small savers who can effortlessly spread their savings among many borrowers and who do not have to put all their eggs into one or two baskets. Bankers will say that their function is to bring such savers and companies, who need funds for physical investment (including stock building), together.