Banks do so much for us that it’s almost impossible to imagine life without them. Banks are what we call fi nancial intermediaries because they stand between borrowers and lenders and help money go back and forth between the two. This might give you the impression that banks aren’t really necessary, but they aren’t simply passing the money from lenders to borrowers and back. They need to put in some serious effort to get money to fl ow from lenders to borrowers—and then fl ow safely back to the lenders again. In this lecture, you will learn how banks successfully do this.
Taking Deposits and Making Payments
The business of banking starts with taking deposits. In most countries, the defi nition of a bank centers on this activity. A bank deposit is, as its name suggests, a way for a person to store value by placing, or depositing, it in a bank. In the simplest deposit contract, the bank promises to keep the money safe and to return the money to the depositor whenever the depositor wishes.
The business of making payments—transferring money and other valuable items back and forth between people—is incredibly important to every economy. In fact, this job is important enough to be added to the list of fi nancial functions that you’ve been learning about in this course. The formal name of this fi fth function is clearing and settling payments.
There are two parts to making payments. The fi rst part, clearing, is about making sure the payment instruction gets to the right person or business. For example, if you pay your credit card bill by sending a check to the company’s payment processing center in Delaware, then the credit card company has to fi nd some way to present that check to your bank, which is located several states away.
Lecture 6: What Is Special about Banks?
Once the check comes to your bank, the bank verifi es that this is an authentic payment instruction. If the bank agrees that the check really did come from you, and you have enough funds in your checking account to cover the amount of the check, then the bank will proceed to the next phase of the payment process—settlement.
In settlement, the money is actually moved from your bank to the credit card company. Once the money reaches the credit card company, the settlement is declared fi nal—meaning that neither you nor your bank can change your minds about actually making the payment. Up to the time that the settlement is fi nal, you could technically stop the payment by giving an instruction to your bank to do that.
Needless to say, in the old days, clearing and settlement was a huge hassle. Companies and banks had to physically deliver payment instructions, such as checks, to the banks they were drawn against.
People use checks because it is both secure and convenient to have the bank hold your money and make payments for you.
© iStockphoto/Thinkstock.
Then, they had to take the money back to their own banks, which was costly and dangerous.
These expenses made people reluctant to accept payments from banks that were far away. In addition, people tried to cheat each other by presenting fake checks drawn on banks that didn’t even exist. This made people even more reluctant to accept payments from banks that were in another city.
To overcome these problems, banks in large towns started to meet regularly to pass payment instructions from each others’ depositors—
and money—back and forth. In the big cities, the banks had to meet daily to make these exchanges. The banks would all chip in to rent or buy a building where they could meet and make these exchanges daily, and these places became known as clearing houses.
Clearing houses are important because they’re the basic model for how our entire payment system works today. When global banks like HSBC and Citibank make billions of dollars of payments to each other, they use an arrangement that’s based on the basic clearing-house model—with some updates, of course.
These days, whenever you make a payment using some kind of payment instruction rather than cash, your payment is cleared through some kind of clearing house. There are private clearing houses, and one of the largest ones is operated by the Federal Reserve.
Over the years, information technology has made the process of clearing and settling payments faster, safer, and more convenient.
Today, in addition to using paper checks, many businesses and organizations accept electronic funds transfers (EFTs), which can be as simple as using a debit card at the grocery store.
A payment system failure often leads to long and painful recessions.
The Great Depression, for example, was so bad in part because of the failure of a large part of the payment system. And the reason why the fi nancial crisis in 2008 led to a recession was that it caused
Lecture 6: What Is Special about Banks?
big problems in the payment system that hadn’t been seen since the Great Depression.
Clearing and settling payments takes effort and resources. It costs money to move money from one person to another. When a bank makes and collects payments for you, it has to put a lot of resources into this activity. And this helps explain why banks often charge signifi cant fees on their checking accounts.
If you think that fees on your checking account are high, consider the alternative—living without a bank checking account. Not only would you have to fi gure out some way to store your cash safely, but you also face the expense of making and collecting payments in cash. If you can’t make your payment in cash, then you have to buy something to make the payment with.
Collecting payments from other people is also expensive. Although some stores will cash checks issued by well-known companies or banks if you make a signifi cant purchase there, generally you will have to use a specialized business called a check-cashing outlet.
These businesses charge fees based on the amount of the check cashed and the riskiness of the person or company who wrote the check.
Making Loans
In the fractional reserve banking system, the money the bank has on hand to pay back depositors—that is, the reserves—are only a fraction of the deposits. Most of the deposits are loaned out at any given time. The lender is trying to lend successfully so that he or she can keep the interest on the loan as profi t. But some of the deposits are always on hand, so that when people come back to take some or all of their deposits out, the bank has enough cash to meet this demand for withdrawals.
Providing payment services is important, but it’s not really a big source of profi ts for banks. The real profi ts are in borrowing money from the depositors and lending the money out to
households and businesses. That’s why we say that banks are fi nancial intermediaries; they stand between the ultimate borrowers and lenders.
Banks borrow from their depositors in two main types of accounts:
demand deposits and time deposits. A demand deposit is a deposit that may be withdrawn at any time—that is, on demand. One type of demand deposit is a checking account, which is often also called a current account. These demand deposits may not only be withdrawn at any time, but they also can be used to make payments, through checks or EFTs. There are other simple demand deposits without the ability to make payments: savings accounts.
A time deposit is a deposit contract in which the depositor explicitly agrees to leave the deposit in the bank for a minimum amount of time. Needless to say, these accounts can’t be used to make payments. It is possible, however, for someone to withdraw their time deposit before the time is up. But if you do, the bank will reduce the amount of interest you get dramatically, and in some cases, it will actually give you back less money than you deposited.
This is the so-called penalty for early withdrawal.
The bank pays interest on all of these different deposits. Generally, the longer the bank can count on you to leave your deposit in the bank, the higher the interest the account pays. In the case of current accounts, the interest is often paid in kind, instead of in cash. That is, if you have a so-called free checking account, then the bank is paying you interest in the form of payment services. But because payment services are fairly expensive, banks usually require depositors to hold a minimum amount in their checking accounts at all times in order to earn free checking.
On the other side, the bank earns interest on the loans that it makes. We often distinguish between loans according to whom the bank is lending to. Banks lend to businesses, including to other banks, which is often called commercial and industrial lending, or
Lecture 6: What Is Special about Banks?
wholesale lending. Banks also lend to individuals, which is called retail lending.
In addition to regular loans, banks also provide lines of credit to both businesses and individuals. A line of credit is preapproval to take out a loan, up to a certain amount, that the borrower can use whenever they like. Borrowers like the fl exibility, and the bank earns a monthly or annual fee just for holding the credit line open for the borrower. And when the borrower actually taps the line of credit by borrowing, the bank earns interest on the resulting loan.
When we add all the interest that the bank earns on the various loans that it makes, and add all the interest on all the deposits that the bank takes, we can compare these numbers and get a very important measure of a bank’s profi tability called its net interest margin, which is the difference between two ratios.
The fi rst ratio is formed by taking the total amount of interest earned and dividing it by the total amount of all the interest-earning assets the bank holds, which gives us the average interest rate the bank is earning on its loans. The second ratio is formed by taking the total amount of interest paid out by the bank and dividing it by the total amount of borrowing the bank does. This gives us a measure of the average interest rate a bank pays on its deposits. The difference between the two is called the net interest margin.
The Advantage of Banks
There is an explanation for why banks have played such a dominant role in the fi nancial markets throughout history—and continue to do so in most economies today. Banks are simply better at the business of lending than other institutions.
First, banks can make better-quality loans than other potential lenders because they have better information about the potential borrowers. Second, even when a loan does go bad and the borrower can’t pay, the bank has a better ability to recover at least some
money from the borrower. Both of these advantages come from the fact that banks take deposits.
Cecchetti and Schoenholz, “Depository Institutions: Banks and Bank Management,” Chapter 12 in Money, Banking, and Financial Markets.
Rajan and Zingales, “Which Capitalism?”
1. Do you carry a credit card that pays you cash back, frequent-fl yer miles, or other bonuses based on your transactions? How do the credit card companies manage to pay you these bonuses? Have you calculated what these bonuses are really worth?
2. One of the other advantages that banks have as lenders that we didn’t have the chance to cover in this lecture is that banks can diversify risk by lending to many different borrowers. Consider this: In the 1930s, the United States experienced thousands of bank failures. The United States had thousands of small banks, and generally each bank served a single town. Meanwhile, in Canada, there were almost no bank failures during this time. There were only about 10 banks in Canada, but they were allowed to have branches all over the country. What role did diversifi cation play in this story?
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Questions to Consider