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Finance & Development March 2012
Although banks do many things, their primary role is to take in fundscalled depositsfrom those with money, pool them, and lend them to those who need funds. Banks are intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money). The amount banks pay for deposits and the income they receive on their loans are both called interest.Depositors can be individuals and households, financial and nonfinancial firms, or national and local governments.Borrowers are, well, the same. Deposits can be available on demand (a checking account, for example) or with some restrictions (such as savings and time deposits).
Creating money
Banks also create money. They do this because they must hold on reserve, and not lend out, some portion of their deposits either in cash or in securities that can be quickly converted to cash. The amount of those reserves depends both on the banks assessment of its depositors need for cash and on the requirements of bank regulators, typically the central banka government institution that is at the center of a countrys monetary and banking system. Banks keep those required reserves on deposit with central banks, such as the U.S. Federal Reserve, the Bank of Japan, and the European Central Bank.
Banks create money when they lend the rest of the money depositors give them. This money can be used to purchase goods and services and can find its way back into the banking system as a deposit in another bank, which then can lend afraction of it. The process of relending can repeat itself a number of times in a phenomenon called the multiplier effect. The size of the multiplierthe amount of money created from an initial depositdepends on the amount of money banks must keep on reserve.
Banks also lend and recycle excess money within the financial system and create, distribute, and trade securities.
Banks have several ways of making money besides pocketing the difference (or spread) between the interest they pay on deposits and borrowed money and the interest they collect from borrowers or securities they hold. They can earn money from
income from securities they trade; and
fees for customer services, such as checking accounts, financial and investment banking, loan servicing, and the origination, distribution, and sale of other financial products,such as insurance and mutual funds.
Banks earn on average between 1 and 2 percent of their assets (loans and securities). This is commonly referred to as a banks return on assets.Transmitting monetary policy Banks also play a central role in the transmission of monetary policy, one of the governments most important tools for achieving economic growth without inflation.
The central bank controls the money supply at the national level, while banks facilitate the flow of money in the markets within which they operate. At the national level, central banks can shrink or expand the money supply by raising or lowering banks reserve requirements and by buying and selling securities on the open market with banks as key counterparties in the transactions. Banks can shrink the money supply by putting away more deposits as reserves at the central bank or by increasing their holdings of other forms of liquid assetsthose that can be easily converted to cash with little impact on their price. A sharp increase in bank reserves or liquid assetsfor any reasoncan lead to a credit crunch by reducing the amount of money banks have to lend, which can lead to higher borrowing costs as customers pay more for scarcer bank funds.A credit crunch can hurt economic growth.Banks can fail, just like other firms. But their failure can have broader ramificationshurting customers, other banks, the community, and the market as a whole. Customer deposits can be frozen, loan relationships can break down, and lines of credit that businesses draw on to make payrolls or pay suppliers may not be renewed. In addition, one bank failure can lead to other bank failures.\
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Banks vulnerabilities arise primarily from three sources:
a high proportion of short-term funding such as checking accounts and repos to total deposits. Most deposits are used to finance longer-term loans, which are hard to convert into cash quickly;
a low ratio of cash to assets; and
a low ratio of capital (assets minus liabilities) to assets.
Depositors and other creditors can demand payment on checking accounts and repos almost immediately. When a bank is perceivedrightly or wronglyto have problems, customers, fearing that they could lose their deposits,may withdraw their funds so fast that the small portion of liquid assets a bank holds becomes quickly exhausted.During such a run on deposits a bank may have to sell other longer-term and less liquid assets, often at a loss, to meet the withdrawal demands. If losses are sufficiently large, they may exceed the capital a bank maintains and drive it into insolvency.
Essentially,banking is about confidence or trustthe belief that the bank has the money to honor its obligations.Any crack in that confidence can trigger a run and potentially a bank failure, even bringing down solvent institutions.Many countries insure deposits in case of bank failure, and the recent crisis showed that banks greater use of market sources of funding has made them more vulnerable to runs driven by investor sentiment than to depositor runs.
New words
1.intermediaries between depositors -
2. Loans
3. individuals and households -
4. Restrictions
5. Creating money
6. converted to cash
7. Requirements
