Banks facilitate the use of money for transactions in the economy because people and firms can use bank accounts when selling or buying goods and services, when paying a worker or being paid, and when saving money or receiving a loan. In the financial capital market, banks are financial intermediaries; that is, they operate between savers who supply financial capital and borrowers who demand loans. A balance sheet (sometimes called a T-account) is an accounting tool which lists assets in one column and liabilities in another column. The liabilities of a bank are its deposits. The assets of a bank include its loans, its ownership of bonds, and its reserves (which are not loaned out). The net worth of a bank is calculated by subtracting the bank’s liabilities from its assets.
Banks run a risk of negative net worth if the value of their assets declines. The value of assets can decline because of an unexpectedly high number of defaults on loans, or if interest rates rise and the bank suffers an asset-liability time mismatch in which the bank is receiving a low rate of interest on its long-term loans but must pay the currently higher market rate of interest to attract depositors. Banks can protect themselves against these risks by choosing to diversify their loans or to hold a greater proportion of their assets in bonds and reserves. If banks hold only a fraction of their deposits as reserves, then the process of banks’ lending money, those loans being re-deposited in banks, and the banks making additional loans will create money in the economy.
A bank that is bankrupt will have a negative net worth, meaning its assets will be worth less than its liabilities. How can this happen? Again, looking at the balance sheet helps to explain.
A well-run bank will assume that a small percentage of borrowers will not repay their loans on time, or at all, and factor these missing payments into its planning. Remember, the calculations of the expenses of banks every year includes a factor for loans that are not repaid, and the value of a bank’s loans on its balance sheet assumes a certain level of riskiness because some loans will not be repaid. Even if a bank expects a certain number of loan defaults, it will suffer if the number of loan defaults is much greater than expected, as can happen during a recession. For example, if the Safe and Secure Bank in previous Figure experienced a wave of unexpected defaults, so that its loans declined in value from $5 million to $3 million, then the assets of the Safe and Secure Bank would decline so that the bank had negative net worth.
The risk of an unexpectedly high level of loan defaults can be especially difficult for banks because a bank’s liabilities, namely the deposits of its customers, can be withdrawn quickly, but many of the bank’s assets like loans and bonds will only be repaid over years or even decades.This asset-liability time mismatch—a bank’s liabilities can be withdrawn in the short term while its assets are repaid in the long term—can cause severe problems for a bank. For example, imagine a bank that has loaned a substantial amount of money at a certain interest rate, but then sees interest rates rise substantially. The bank can find itself in a precarious situation. If it does not raise the interest rate it pays to depositors, then deposits will flow to other institutions that offer the higher interest rates that are now prevailing. However, if the bank raises the interest rates that it pays to depositors, it may end up in a situation where it is paying a higher interest rate to depositors than it is collecting from those past loans that were made at lower interest rates. Clearly, the bank cannot survive in the long term if it is paying out more in interest to depositors than it is receiving from borrowers.
How can banks protect themselves against an unexpectedly high rate of loan defaults and against the risk of an asset-liability time mismatch? One strategy is for a bank to diversify its loans, which means lending to a variety of customers. For example, suppose a bank specialized in lending to a niche market—say, making a high proportion of its loans to construction companies that build offices in one downtown area. If that one area suffers an unexpected economic downturn, the bank will suffer large losses. However, if a bank loans both to consumers who are buying homes and cars and also to a wide range of firms in many industries and geographic areas, the bank is less exposed to risk. When a bank diversifies its loans, those categories of borrowers who have an unexpectedly large number of defaults will tend to be balanced out, according to random chance, by other borrowers who have an unexpectedly low number of defaults. Thus, diversification of loans can help banks to keep a positive net worth. However, if a widespread recession occurs that touches many industries and geographic areas, diversification will not help.
Along with diversifying their loans, banks have several other strategies to reduce the risk of an unexpectedly large number of loan defaults. For example, banks can sell some of the loans they make in the secondary loan market, as described earlier, and instead hold a greater share of assets in the form of government bonds or reserves. Nevertheless, in a lengthy recession, most banks will see their net worth decline because a higher share of loans will not be repaid in tough economic times.
A balance sheet is an accounting tool that lists assets and liabilities. An asset is something of value that is owned and can be used to produce something. For example, the cash you own can be used to pay your tuition. If you own a home, this is also considered an asset. A liability is a debt or something you owe. Many people borrow money to buy homes. In this case, a home is the asset, but the mortgage is the liability. The net worth is the asset value minus how much is owed (the liability). A bank’s balance sheet operates in much the same way. A bank’s net worth is also referred to as bank capital. A bank has assets such as cash held in its vaults, monies that the bank holds at the Federal Reserve bank (called “reserves”), loans that are made to customers, and bonds.
Figure illustrates a hypothetical and simplified balance sheet for the Safe and Secure Bank. Because of the two-column format of the balance sheet, with the T-shape formed by the vertical line down the middle and the horizontal line under “Assets” and “Liabilities,” it is sometimes called a T-account.
Figure . A Balance Sheet for the Safe and Secure Bank.
The “T” in a T-account separates the assets of a firm, on the left, from its liabilities, on the right. All firms use T-accounts, though most are much more complex. For a bank, the assets are the financial instruments that either the bank is holding (its reserves) or those instruments where other parties owe money to the bank—like loans made by the bank and U.S. Government Securities, such as U.S. treasury bonds purchased by the bank. Liabilities are what the bank owes to others. Specifically, the bank owes any deposits made in the bank to those who have made them. The net worth of the bank is the total assets minus total liabilities. Net worth is included on the liabilities side to have the T account balance to zero. For a healthy business, net worth will be positive. For a bankrupt firm, net worth will be negative. In either case, on a bank’s T-account, assets will always equal liabilities plus net worth.
When bank customers deposit money into a checking account, savings account, or a certificate of deposit, the bank views these deposits as liabilities. After all, the bank owes these deposits to its customers, when the customers wish to withdraw their money. In the example shown in Figure , the Safe and Secure Bank holds $10 million in deposits.
Loans are the first category of bank assets shown in Figure. Say that a family takes out a 30-year mortgage loan to purchase a house, which means that the borrower will repay the loan over the next 30 years. This loan is clearly an asset from the bank’s perspective, because the borrower has a legal obligation to make payments to the bank over time. But in practical terms, how can the value of the mortgage loan that is being paid over 30 years be measured in the present? One way of measuring the value of something—whether a loan or anything else—is by estimating what another party in the market is willing to pay for it. Many banks issue home loans, and charge various handling and processing fees for doing so, but then sell the loans to other banks or financial institutions who collect the loan payments. The market where loans are made to borrowers is called the primary loan market, while the market in which these loans are bought and sold by financial institutions is the secondary loan market.
One key factor that affects what financial institutions are willing to pay for a loan, when they buy it in the secondary loan market, is the perceived riskiness of the loan: that is, given the characteristics of the borrower, such as income level and whether the local economy is performing strongly, what proportion of loans of this type will be repaid? The greater the risk that a loan will not be repaid, the less that any financial institution will pay to acquire the loan. Another key factor is to compare the interest rate charged on the original loan with the current interest rate in the economy. If the original loan made at some point in the past requires the borrower to pay a low interest rate, but current interest rates are relatively high, then a financial institution will pay less to acquire the loan. In contrast, if the original loan requires the borrower to pay a high interest rate, while current interest rates are relatively low, then a financial institution will pay more to acquire the loan. For the Safe and Secure Bank in this example, the total value of its loans if they were sold to other financial institutions in the secondary market is $5 million.
The second category of bank asset is bonds, which are a common mechanism for borrowing, used by the federal and local government, and also private companies, and nonprofit organizations. A bank takes some of the money it has received in deposits and uses the money to buy bonds—typically bonds issued by the U.S. government. Government bonds are low-risk because the government is virtually certain to pay off the bond, albeit at a low rate of interest. These bonds are an asset for banks in the same way that loans are an asset: The bank will receive a stream of payments in the future. In our example, the Safe and Secure Bank holds bonds worth a total value of $4 million.
The final entry under assets is reserves, which is money that the bank keeps on hand, and that is not loaned out or invested in bonds—and thus does not lead to interest payments. The Federal Reserve requires that banks keep a certain percentage of depositors’ money on “reserve,” which means either in their vaults or kept at the Federal Reserve Bank. This is called a reserve requirement. (Monetary Policy and Bank Regulation will explain how the level of these required reserves are one policy tool that governments have to influence bank behavior.) Additionally, banks may also want to keep a certain amount of reserves on hand in excess of what is required. The Safe and Secure Bank is holding $2 million in reserves.
The net worth of a bank is defined as its total assets minus its total liabilities. For the Safe and Secure Bank shown in Figure, net worth is equal to $1 million; that is, $11 million in assets minus $10 million in liabilities. For a financially healthy bank, the net worth will be positive. If a bank has negative net worth and depositors tried to withdraw their money, the bank would not be able to give all depositors their money.
An “intermediary” is one who stands between two other parties. Banks are a financial intermediary—that is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. Financial intermediaries include other institutions in the financial market such as insurance companies and pension funds, but they will not be included in this discussion because they are not considered to be depository institutions, which are institutions that accept money deposits and then use these to make loans. All the funds deposited are mingled in one big pool, which is then loaned out. Figure illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out. Of course, when banks make loans to firms, the banks will try to funnel financial capital to healthy businesses that have good prospects for repaying the loans, not to firms that are suffering losses and may be unable to repay.
Figure. Banks as Financial Intermediaries. Banks act as financial intermediaries because they stand between savers and borrowers. Savers place deposits with banks, and then receive interest payments and withdraw money. Borrowers receive loans from banks and repay the loans with interest. In turn, banks return money to savers in the form of withdrawals, which also include interest payments from banks to savers.
The late bank robber named Willie Sutton was once asked why he robbed banks. He answered: “That’s where the money is.” While this may have been true at one time, from the perspective of modern economists, Sutton is both right and wrong. He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks, waiting for a robber to appear. Most money is in the form of bank accounts, which exist only as electronic records on computers. From a broader perspective, however, the bank robber was more right than he may have known. Banking is intimately interconnected with money and consequently, with the broader economy.
Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets. Imagine for a moment what the economy would be like if all payments had to be made in cash. When shopping for a large purchase or going on vacation you might need to carry hundreds of dollars in a pocket or purse. Even small businesses would need stockpiles of cash to pay workers and to purchase supplies. A bank allows people and businesses to store this money in either a checking account or savings account, for example, and then withdraw this money as needed through the use of a direct withdrawal, writing a check, or using a debit card.
Banks are a critical intermediary in what is called the payment system, which helps an economy exchange goods and services for money or other financial assets. Also, those with extra money that they would like to save can store their money in a bank rather than look for an individual that is willing to borrow it from them and then repay them at a later date. Those who want to borrow money can go directly to a bank rather than trying to find someone to lend them cash Transaction costs are the costs associated with finding a lender or a borrower for this money. Thus, banks lower transactions costs and act as financial intermediaries—they bring savers and borrowers together. Along with making transactions much safer and easier, banks also play a key role in the creation of money.
Looking after your money, lending money and helping you pay for things are the main ways that people use banks in their daily lives.
Banks do other things too. Most investment banks, for example, trade shares, foreign currencies and commodities (like oil or gold) in financial markets on behalf of their clients.
Banks provide debit and credit cards so you can pay for things in the shops and online.Over 9 in 10 adults make payments using a debit card at least once a month.
Source: UK Payments Markets 2016
When you use a card to buy, say, food, the money is transferred from your bank account to the bank account of the shop. Exactly the same thing happens when you pay for things using your debit or credit card online.
When you add to this the payments for much bigger items, like houses, and all the financial activity between banks and other financial situations, over £500 billion moves between bank accounts every single day. That’s over £5 million every second.
The stakes are very high: if these payments stopped working, then the entire economy would grind to a halt. This is why the Bank of England oversees these payments – to make sure they operate smoothly every day.
Banks don’t just look after your money. They also lend money to those who need it.
Banks provide loans for many things, whether you’re a family looking to buy a house or a business seeking to expand, hire and grow. In this way, the flow of lending can help the economy as a whole to thrive.
Lending money is a risky business, though. Banks can lose out if someone they have lent money to doesn’t pay it back.
Banks know this, so they try to make sure they earn enough profit by charging more interest for lending money than they pay out in interest on people’s savings.
Of course, some loans are riskier than others – and banks will charge higher interest rates to reflect this.
But no-one can predict the future perfectly. Inevitably, banks sometimes get it wrong: sometimes a large number of loans will not be repaid. So the Bank of England makes sure that banks hold sufficient financial resources in case they face larger losses than they expect. That is part of ensuring banks operate in a safe and sound way.
High Street Banks providing services to the general public. In the UK The Big Five banks are HSBC, Halifax, Lloyds TSB, Natwest and Alliance & Leicester.
Business Banking. Many high street banks provide specialised services for businesses. They operate similar to ordinary accounts but usually have more services and more fees.
Investment Banking. These are financial institutions who invest money on behalf of investment trusts, pension funds and high street Banks. They look for the best way to invest money through knowledge of different bond markets, exchange rate markets and the stock market.
Central Banks. Underpinning most modern banking systems is the Central Bank. Usually a quasi-government organisation, Central Banks have various tasks such as ensuring sufficient liquidity, acting as lender of last resort and in some cases setting Monetary Policy. In the UK, The Bank of England is responsible for Monetary Policy.
Loans are essentials to enable firms to invest and expand. However, banks are not the only source of finance. Firms may turn to private investors, stockmarket, government grants or personal savings.
In times of recession or shortage of funds, banks may not be willing to lend when firms need it most.
Bank lending is profitable for banks and can incur significant costs for the firm.
Consumers increasingly need banks to pay for bills electronically.
Bank loans and mortgages provide an opportunity to purchase very expensive items and pay back over a long period – e.g. house, car.
The poorest consumers often don’t have access to bank account and bank loans, causing the poorest to look outside traditional banking to more exploitative loans, such as payday loans and money sharks.
Some insurance services are not necessary, for example, insuring electronic goods is expensive compared to the cost of replacing them.
Low-income consumers may feel they cannot afford insurance payments and put themselves at risk.
