What do banks do? We know that most banks serve to accept deposits and make loans. They act as safe stores of wealth for savers and as predictable sources of loans for borrowers. In this way, the major business of banks is that of a financial intermediary between savers and borrowers. The bank simplifies this process by eliminating the need for savers to find the right borrowers and the right time to directly make a loan.
Banks are generally trusted by the public. When people put their savings into banks, they receive little more than a paper receipt in return. There are two organizations in place to ensure that banks are trustworthy with individuals' money and reasonable in the loans that they make. The Federal Deposit Insurance Corporation guarantees that deposits, up to $100,000 per account, will be returned to the depositor, even if the bank fails. Individual banks also have a board of directors to regulate the sizes and interest rates of loans the bank makes. This board is charged with ensuring that the bank is taking reasonable risks with its depositors' money.
Banks serve another important role. When you look at a check or a debit card you will usually see the name of a bank. Individual banks serve as the issuing and regulating bodies for many financial services often employed by consumers. In this way, banks are able to give depositors access to their money while also maintaining a large number of loans.
What happens when you deposit money into a bank? First, the money is recorded (usually by computer) and added to your account. It is then placed into the vault. At various times during the day, money is removed from the vault and taken to a second bank. This bank, unlike the first, does not serve individuals. It is a "banks' bank," usually a branch of the Federal Reserve. The first bank is able to make deposits, withdrawals, and take out loans from the second bank.
When you walk into a bank to withdraw money or to take out a loan, the reverse of the process outlined above occurs. If the first bank does not have enough money in the vault to cover the withdrawal or the loan, the first bank goes to the second bank and withdraws money. If the first bank does not have enough money in its account at the second bank, then it must take out a loan at a lower rate of interest than the loan that it will eventually give to the individual borrower. In this way, a bank is able to accept deposits, honor withdrawals, and make loans without having to maintain all of the deposited cash on hand in the vault.
How do banks make money? As financial intermediaries, they earn enough to support their activities by the difference between the interest rate paid to savers and the interest rate charged on loans. When customers make deposits in a savings account, they earn interest on the principle. Similarly, when customers take out loans, they pay interest on the principle. By charging the borrower a slightly higher interest rate than that which is given to the depositor, a bank is able to cover its expenses.
Banks serve another very important purpose involving the creation of money. To begin, let's go to a simplified world where banks only serve as a safe place to store money. They do not make loans and do not pay interest. Also, let's say that the money supply is only $1000. In this case, if a bank held $100 in deposits, the money supply would simply be $900 since the $100 in the bank would no longer be in circulation. When the depositor withdrew the $100 deposit and spent it, the money supply would again increase to $1000. This system is called a 100\% reserve banking system because a bank holds 100% of all of the deposits made.
In the real world though, banks are required to hold significantly less than 100% of the deposits in reserve. A bank can make loans, which are then redeposited, and can then be loaned out again; this, in essence, creates money. In this way, any banking system with less than 100% required reserves effectively increases the money supply. This system is called fractional reserve banking because banks hold less than 100% or a fraction of the deposits in reserve.
For example, let's say that an economy has a money supply equal to $1000 and that there is a reserve requirement of 50%. If all $1000 is deposited into a bank, half of this amount must be held as reserves to cover withdrawals and half of this amount can be used to make loans. Say the bank gives out $500 in loans. The money is spent and eventually redeposited in the bank. Now, the bank has $1500 deposited. Only $1000 of this amount is in currency. The other $500 is owed to the bank and exists in a form known as a paper balance. The bank has $1500 in deposits, and since it is required to keep half in reserves, it must keep $750 in currency. This leaves only $250 in currency available for loan seekers. This process continues and real balances are replaced by paper balances until the bank can no longer make loans because all of its currency must be kept in real balances.
This action by banks can also be illustrated using a balance sheet procedure. A balance sheet is an accounting tool that lists assets and liabilities. For a bank, reserves and loans serve as assets because they are money that the bank has, or has coming. Deposits, on the other hand, are liabilities; they are money that the bank owes. When creating a balance sheet, the assets are listed on the left and the liabilities are listed on the right.
We can model the example of fractional reserve banking presented above using a balance sheet procedure. This is done in figure 1. To begin, list the assets and the liabilities of the bank after $1000 is deposited and $500 is loaned out. Remember that the reserve rate is 50%, so $500 must be held back in reserves and the rest may be loaned out. Given that this money is deposited into the bank again rather than stored in a mattress, the liability of deposits increases by $500 to $1500 while the reserves increase by $250 to $750. The bank now has $250 with which to make loans. Given that it loans out the entire amount, which is then deposited again, the liability of deposits increases by $250 to $1750. Furthermore, the assets of loans increase to $750 and the assets of reserves increase to $875. This process continues until the reserve amount is equal to the total amount of the money supply. Until that time, each loan that is made and redeposited increases the money supply.
The process of money creation by banks continues until no more loans can be made due to reserve requirements. Each time a loan is made and redeposited, the possible amount of next loan shrinks. There is an easy way to determine the total money supply created by an initial deposit. Simply multiply the initial deposit by one over the reserve rate. Then, to find the amount of money created by the bank, simply subtract the initial deposit from this figure.
For example, say that $2000 is initially deposited into a bank and the reserve requirement is 20%. What is the change in the money supply created by this deposit? First multiply the initial deposit by one over the reserve rate. This gives $2000 * (1 / .2) = $10,000. Then, subtract the initial deposit: $10,000 - $2000 = $8000. Thus, a $2000 deposit yielded an $8000 change in the money supply.
Clearly, there are many jobs and purposes for banks. By creating money, banks serve to facilitate many transactions with a relatively small initial money supply. By holding deposits and making loans, banks fulfill the needs of consumers and producers. In this way, banks are more than just financial intermediaries. Banks are in fact crucial to the functioning of the economy.