The Banking System: Commercial Banking - Economic Concepts in Banking
  1. The Banking System: Introduction
  2. The Banking System: Commercial Banking - What Banks Do
  3. The Banking System: Commercial Banking - Economic Concepts in Banking
  4. The Banking System: Commercial Banking - How Banks Make Money
  5. The Banking System: Commercial Banking - Business Lending
  6. The Banking System: Commercial Banking - Operations
  7. The Banking System: Commercial Banking - How Banks Are Regulated
  8. The Banking System: Commercial Banking - Where Commercial Banks Are Vulnerable
  9. The Banking System: Commercial Banking - Bank Crises And Panics
  10. The Banking System: Commercial Banking - Key Ratios/Factors
  11. The Banking System: Federal Reserve System
  12. The Banking System: Non-Bank Financial Institutions
  13. The Banking System: Conclusion

The Banking System: Commercial Banking - Economic Concepts in Banking

ByStephen D. Simpson, CFA

Banks both create and issue money. While commercial banks no longer issue their own banknotes, they are effectively the distribution system for the notes printed, and the coins minted, by the U.S. Treasury. The Federal Reserve buys coins and paper money from the Treasury and distributes them through the banking system, as needed. Banks effectively buy currency from the Fed, or sell it back when they have excess amounts on hand. (To lean more, see How The Federal Reserve Was Formed.)

Settle Payments
Every day there are millions of financial transactions in the United States, some conducted with paper currency, but many more done with checks, wire transfers and various types of electronic payments. Banks play an invaluable role in the settling of these payments, making sure that the proper accounts are credited or debited, in the proper amounts and with relatively little delay.

Credit Intermediation
Banks play a major role as financial intermediaries. Banks collect money from depositors, essentially borrowing the money, and then simultaneously lend it out to other borrowers, forging a chain of debts. This is especially significant when asset values decline. As asset values decline, those assets are less able to service debt, which in turn makes it more difficult for borrowers to borrow, and reduces lending capacity. What follows, is a decrease in the flow of credit from savers to spenders and a decline in economic activity. At the same time, banks often find that they must raise capital, and their capital needs compete with those available savings.


Maturity Transformation
Maturity transformation is part and parcel of what banks do on a daily basis. Many investors are willing to invest on a very short term basis, but many projects require long-term financial commitments. What banks do, then, is borrow short-term, in the form of
demand deposits and short-term certificates of deposit, but lend long-term; mortgages, for instance, are frequently repaid over 30 years. By doing this, banks transform debts with very short maturities (deposits) into credits with very long maturities (loans), and collect the difference in the rates as profit. However, they are also exposed to the risk that short-term funding costs may rise much faster than they can recoup through lending.

Money Creation
One of the most vital roles of banks is in money creation. Importantly, money creation at the individual bank level is not the same thing as "printing money;" currency is just one type of money. Instead, banks create money through
fractional reserve banking. Fractional reserve banking is a key concept to understanding modern banking and money creation.

Fractional reserve banking refers to the fact that banks keep only a small portion of their deposits on hand. When a customer comes into the bank and deposits $100, perhaps $10 of that will be kept on hand in the form of cash or easily-liquidated securities. The remaining $90 will be lent out to customers as loans, or used to acquire the stock or bonds of other companies. This phenomenon is known as the money multiplier and can be expressed as the formula: m = 1 / reserve requirement. If the reserve requirement is 10% (or 0.1), every dollar deposited with a bank, can become $10 of new money.

This is a key concept, because this is how banks increase the money supply and effectively create money. If banks simply acted as storehouses or vaults for money, there would be far less money available to lend.

The Banking System: Commercial Banking - How Banks Make Money

  1. The Banking System: Introduction
  2. The Banking System: Commercial Banking - What Banks Do
  3. The Banking System: Commercial Banking - Economic Concepts in Banking
  4. The Banking System: Commercial Banking - How Banks Make Money
  5. The Banking System: Commercial Banking - Business Lending
  6. The Banking System: Commercial Banking - Operations
  7. The Banking System: Commercial Banking - How Banks Are Regulated
  8. The Banking System: Commercial Banking - Where Commercial Banks Are Vulnerable
  9. The Banking System: Commercial Banking - Bank Crises And Panics
  10. The Banking System: Commercial Banking - Key Ratios/Factors
  11. The Banking System: Federal Reserve System
  12. The Banking System: Non-Bank Financial Institutions
  13. The Banking System: Conclusion
RELATED TERMS
  1. Adjustment Credit

    A short-term loan made by a Federal Reserve Bank to a smaller ...
  2. Deposit Multiplier

    A function that describes the amount of money created in a bank's ...
  3. Multiplier Effect

    The expansion of a country's money supply that results from banks ...
  4. Bank Reserve

    Bank reserves are the currency deposits which are not lent out ...
  5. Federal Reserve Credit

    Refers to the process of the Federal Reserve lending funds on ...
  6. Net Free Reserves

    A statistic released in weekly Federal Reserve data showing the ...
RELATED FAQS
  1. How do commercial banks us the 'money multiplier' to create money?

    Find out how commercial banks can expand the supply of money in an economy through the fractional reserve system, otherwise ... Read Answer >>
  2. What impact does the Federal Reserve have on a bank's profitability?

    Learn how the Federal Reserve impacts a bank's profitability with its influence on the discount rate, federal funds rate ... Read Answer >>
  3. How does the deposit multiplier affect a bank's profitability?

    Find out how a deposit multiplier affects bank profitability, how it increases the supply of money in the economy and why ... Read Answer >>
  4. Why do commercial banks borrow from the Federal Reserve?

    Learn how commercial banks borrow from the Federal Reserve to meet minimum reserve requirements, and discover the pros and ... Read Answer >>
  5. How much does M1 enhance the multiplier effect of fractional reserve banking?

    Explore the impact of M1 on the economy and how the Federal Reserve uses it. Find out how the fractional banking system and ... Read Answer >>
  6. What are the implications of a high Federal Funds Rate?

    Learn the implications of a high federal funds rate, which include constriction of the money supply, a stronger dollar and ... Read Answer >>

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