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Banking

Banking

Have you ever put money in your bank account? Do you ever wonder what it actually does there? Your first thought might be that it sits in a large vault with guards standing by protecting it at all costs! In actuality, it's not as cool as that. However, banks serve a critical role in our financial system and economy. Continue reading to learn more about the bank's paramount role in our everyday lives!

Bank Definition and Functions

Let's go over the definition and functions of a bank. A bank is a financial intermediary that uses deposits to finance investments of other borrowers. That's right, the money that's in your bank account is financing other people's loans! But how can banks do this without failing to give back money to depositors?

Banks do not hold on to the entire deposit from individuals. Generally, most individuals will deposit some amount into their bank account, and only use a portion of it every day, week, or month. Therefore, a bank can utilize a portion of all deposits to loan out to other consumers, spurring investments!

But what if a bank lends out too much of an individual's deposit? Banks have a reserve requirement that they cannot exceed. A reserve requirement is the amount of money that a bank must store to make sure it can meet the needs of individuals who want to take out large portions of their deposits. The central bank sets this requirement to ensure individuals can withdraw their entire deposit if they wanted to.

As you can see, a bank's role and function are NOT simply to store money in a large vault! Taking deposits, holding on to a required amount, and loaning/investing the rest of the deposit is a bank's role and function.

Let's say, Mike, Sally, and Marley are depositing and borrowing money from the same bank; the bank also has a 10% reserve requirement. Mike deposits $100 at the bank. The bank will store a portion of that money, $10, and loan out the rest of it to someone else — Sally. The bank holds on to the $10 from Mike in reserves due to the reserve requirement. Sally actually owes Marley money, so Sally will pay Marley the $90 that was given to her as a loan. Marley will now deposit the $90 to the bank and the bank will keep $9 in its reserves (10%) and loan out the $81 to someone else.

Banks are financial intermediaries that use deposits to finance loans and investments of other borrowers.

Reserve Requirement is the amount of money that a bank must hold on to in its reserves.

Banking Money StudySmarterFig. 1 - Money.

Importance of Banking

You might be thinking to yourself, what's the importance of banking? Do we really need some institution that just transfers money from saver to borrower? The answer is a resounding yes! Let's go over why banks are important to our everyday function.

Recall that banks are financial intermediaries that take money from savers and loan it to other borrowers. Borrowers will either spend the loan or use it for their own investments. Investments are crucial to growing an economy, and banks aid in making this process easy for borrowers. Without banks, there would be fewer investments being made, and as such, the economy would grow at a slower rate.

Banks also allow millions of people to store and utilize their money at a safe and secure institution. You might not think this is all that special, but think about what the alternative would be without banks. You would not be able to efficiently store your money, take out your money, and use it to buy goods and services this quickly. Much of a bank's importance we take for granted, but imagine if just for one hour, all banks stopped functioning and no one could deposit or withdraw their money — chaos would ensue!

Types of Banking

Let's go over the two main types of banking systems we see today. Those banking systems are known as commercial banks and investment banks, respectively.

Types of Banking: Commercial Banks

Commercial banks are financial intermediaries that accept deposits from individuals and are later used to make loans for other individuals. In fact, the process of issuing loans from savers to borrowers is how commercial banks are profitable. Commercial banks will pay low interest on deposits and charge high interest on their loans to other individuals and businesses. This ensures that commercial banks can incentivize individuals to make loans at their institution, and profit from borrowers with higher interest rates. Apart from the financial intermediary services commercial banks provide, commercial banks also provide financial advice to their users.

Examples of common commercial banks are Bank of America, Wells Fargo, and CitiBank.

The Federal Deposit Insurance Corporation (FDIC) provides a safety net for individuals who deposit their money at a commercial bank. In the occurrence of a bank run or bank failure, the FDIC will insure depositors' checking and savings accounts up to $250,000. This provides stability and security in the commercial banking system.

Commercial banks are financial intermediaries that accept deposits from individuals and are later used to make loans for other individuals.

Banking Debit Card StudySmarterFig. 2 - Debit Card.

Types of Banking: Investment Banks

Investment banks are financial intermediaries that help large firms and governments raise money by trading financial assets such as stocks and bonds. Unlike commercial banks, Investment banks do not take deposits from individuals — the focus is on making wise investment decisions. Investment banks will buy securities and sell them to other investors. Investment banks charge a fee for this exchange of financial assets; the entire process is known as underwriting. The returns can be lucrative for investment banks; however, they can also be risky as well, given that investment banks will work with incredibly large institutions and investors.

Examples of common investment banks are Goldman Sachs, J.P. Morgan, and Morgan Stanley.

Investment banks also provide financial advice — similar to commercial banks — for corporate mergers and acquisitions. Investment banks also make money off financial advice services, but the returns are much greater from trading financial assets.

Investment banks are financial intermediaries that help large firms and governments raise money by trading financial assets such as stocks and bonds.

2008 Financial Crisis

A big component of the 2008 financial crisis dealt with actions from investment and commercial banks. Commercial banks were giving mortgages and loans to individuals who were unlikely to pay those loans — subprime mortgages. Commercial banks sold these subprime mortgages to investment banks, and then investment banks sold the same subprime mortgages to investors. Since the housing market was booming, everyone was happy! People had mortgages, commercial banks gave out a glut of loans, investment banks sold those same loans to investors, and investors profited off the booming housing market. However, eventually, the asset bubble popped which left individuals unable to pay their mortgages — the same mortgages that were sold to investment banks and private investors. This banking system collapsed, causing the economy to take a massive downturn.

Role of Banks in the Economy

Let's go over the role of banks in the economy. First, we must review the function of banks and the definition of the economy. Banks are financial intermediaries that take deposits and use them to make loans to other individuals and businesses. The economy is the management and use of resources to produce and consume resources in a given region. Given the distinctions between the two, we can go deeper into the role of banks in the economy.

Banks provide the foundation of a working economy. An economy requires consumers and producers to interact in the market to grow the economy. Consumers purchase goods from producers, and producers continue making and expanding their facilities to foster growth. Without banks, this relationship does not occur. How would consumers store money and take it out to purchase goods? How would producers get the investments needed to begin and expand their firms? Banks act as a "middle-man" between consumers and producers; without banks, the economy would not run as efficiently as it does now.

Economics of Banking

The economics of banking is predicated on the relationship between savers and borrowers. Recall that economics is about managing resources effectively and efficiently. In this instance, banks have to manage money effectively between savers and borrowers. If banks were ineffective at this, then consumers would not be able to purchase anything in the market, and producers would not be able to get the loans needed to make goods.

The management of resources comes from the bank's own actions as well as external regulations. For example, a bank can choose who to lend money to ensure they receive monthly payments from customers. Banks can examine a customer's credit history and other information to make this decision. In contrast, The Federal Reserve regulates banks by setting the reserve requirement; this ensures that banks do not lend out too much of their deposits in the chance of a bank run.

In tandem, internal and external regulations help banks maintain an efficient method of transferring money from savers to borrowers to stimulate the economy.

Banking - Key takeaways

  • Banks are a financial intermediary that uses deposits to finance loans and investments of other borrowers.
  • The two types of banking systems are commercial and investment banks.
  • Banks provide the foundation of a working economy by utilizing saver's money to loan out to other individuals and businesses.
  • The banking system, by making loans and investing in businesses, assists in economic growth.
  • Banks require internal and external regulation to manage their resources efficiently.

Frequently Asked Questions about Banking

Banking is a system where a financial intermediary takes money from savers and loans it to borrowers in a secure way.

The two types of banking systems are commercial and investment banking.

The importance of banking is that it provides a safe and secure way of spurring investments from savers to borrowers; it also helps provide stability to the economy by storing and withdrawing money from millions of people at a time.

Banking deals more with savings and loans, whereas finance deals more with investments.

The four main functions of a bank are taking deposits, storing deposits, making loans, and giving financial advice.

Economics relies on proper management of resources; banks have to properly manage their own reserves to ensure depositors get their money back, and borrowers can have loans to buy capital goods.

Final Banking Quiz

Question

What is a bank?

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Answer

A financial intermediary that uses deposits to finance loans and investments of other borrowers.

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What is a commercial bank?

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Answer

Financial intermediaries that accept deposits from individuals and are later used to make loans for other individuals.

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What is an investment bank?

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Answer

Financial intermediaries that help large firms and governments raise money by trading financial assets such as stocks and bonds.

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Question

What are the two types of banking systems?

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Answer

Commercial and investment banks.

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Question

Banks help foster economic growth when they give out _________ to borrowers.

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Answer

loans.

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Banks take money from _______ and loan it to borrowers.

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Answer

savers.

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Who/what regulates the amount that banks MUST hold in reserves?

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Answer

The Federal Reserve.

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The FDIC insures depositors up to ________

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Answer

$250,000.

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True or False: Investment banking can also be described as a "high-risk high reward."

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True.

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True or False: Investment banks take deposits.

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False.

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True or False: Commercial banks primarily trade securities.

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False.

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True or False: Commercial banks can set their reserve requirement to anything they want.

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False.

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Which of the following is an example of a commercial bank?

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Answer

Bank of America.

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True or False: Commercial banks buy and sell securities.

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False.

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Ideally, commercial banks will pay _______ interest rates to depositors and charge ______ interest rates to borrowers.

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Answer

low; high.

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