Banks: At the Heart of the Matter

Institutions that connect savers and borrowers assist to keep economies running smoothly.

You have $1,000 that you won’t need for a year and want to generate money with it till then. If you want to purchase a house, you’ll need to borrow $100,000 and pay it back over the course of 30 years.

It would be difficult, if not impossible, for a lone borrower to find a potential borrower who needs exactly $1,000 per year or a lender who can spare $100,000 for 30 years.

 

This is where banks come into play.

Although banks perform a variety of functions, their basic function is to accept monies—known as deposits—from individuals who have money, pool them, and lend them to others who want them. Banks act as go-betweens for depositors (those who lend money to the bank) and borrowers (to whom the bank lends money). The amount that banks pay for deposits and the money they get from loans are both referred to as interest.

Individuals and households, financial and non-financial companies, and national and local governments can all be depositors. Borrowers are, well, borrowers. Deposits can be made accessible on demand (like in a checking account) or with certain limits (such as savings and time deposits).

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Making loans

While some depositors want their funds at any given time, the majority do not. As a result, banks can use shorter-term deposits to fund longer-term loans. The maturity transformation process entails transforming short-term obligations (deposits) to long-term assets (loans). Banks pay depositors less than borrowers, and the differential accounts for the majority of bank income in most nations.

Creating money

Banks generate money as well. They do this because they must keep part of their deposits in reserve and not lend them out—either in cash or in securities that may be rapidly converted to cash. The size of those reserves is determined by the bank’s appraisal of its depositors’ demand for cash as well as the criteria of bank regulators, often the central bank—a government organization at the heart of a country’s monetary and banking system. 

The need for regulation

Bank Safety and soundness are key public policy concerns, and government interventions have been sought to limit bank collapses and the ensuing panic. Most nations need banks to get a charter in order to conduct banking activities and be eligible for government backup facilities such as emergency loans from the central bank and explicit guarantees to insure bank deposits up to a specific level. 

Banks are normally subject to frequent monitoring and are governed by the laws of their own nation. If a bank operates in another nation, it may be regulated by the host country as well. 

In general, regulations are intended to minimize banks’ exposure to credit, market, and liquidity risks, as well as total solvency risk. Banks are now required to keep more and higher-quality equity, such as retained profits and paid-in capital, to cushion losses than they were prior to the financial crisis. 

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