How do banks work?

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Banks play a large role in the economy. This post will shed some light on banks and the role of central banks in the economy and how they could create major economic problems with monetary policy.

First, let’s start with the basics. A bank is a corporation that accepts deposits from customers and uses these funds to give loans. Banks offer interest to account owners and charge interest on loans and the difference between the amount of interest they get from loans and what they pay to account owners will be the bank profit.

Fractional Reserve Banking

A bank should keep a certain percentage of its deposits as a reserve so if a bank has total deposits of 10 billion dollars and the reserve requirement is 10% then a bank can keep 1 billion as a reserve and lend the 9 billion out. The people who receive these loans will eventually deposit them in banks as well and these banks will follow the same rule so every dollar in deposit equals 10 dollars in circulation assuming 10% reserve ratio. This system is called fractional reserve banking and the reserve requirement is set in each country by the central bank in that country. In the United States, the Federal Reserve is the central bank and it sets the reserve requirements.

Every bank should keep the reserve requirement every day, so at the end of the day if a bank is short of the reserve requirement it has to borrow the required funds from another bank overnight. Banks pay interest on overnight loans, and the central bank sets the interest rate on these loans. This is the main interest rate controlled by the central bank and is called the federal fund rate in the United States.

An interesting scenario happens if a bank got withdrawal requests that exceed its reserves, in this case, the central bank intervenes as the lender of last resort and provides liquidity to the bank in trouble.

The role of the central bank

As we have seen the central bank is the lender of last resort and it regulates the reserve requirements and the interest rate on loans between banks. The central bank plays a major role in the monetary policy of country through its ability to create and destroy money. Banks should have the reserve requirement as either cash in their vaults or deposits at the central bank. When the central bank decides to create money it buys financial assets, usually government bonds, from the open market. When it pays for those bonds it deposits funds into different banks central bank accounts; these deposits increase the reserve for those banks allowing them to lend more money. For example in the United States, if the reserve requirement is 10% and the Federal Reserve bought 10 billion dollars of bonds, then the reserves of the banks will increase by 10 billion dollars giving the banks the ability to lend up to 90 billion dollars causing credit expansion. If the central bank decides to remove money from the market it sells some of its bond holdings and deducts the price from the banks’ reserves forcing them to cut the outstanding loan balance.

The interest rate is the price a bank is willing to pay for deposits. When the central bank keeps the interest rates low this encourages the banks to lend with a little interest rate as well and this encourages more people to take loans even if they shouldn’t and so encourages more consumption and risk taking.

Keynesian economists, in reference to the economist John Maynard Keynes, who advocated the government role in stimulating demand think that central banks stimulate demand and stabilize the economy, but the history of central banks  demonstrates the failure of this theory. The cycle usually goes through a phase of credit expansion that causes the money to flow to stimulate buying of some types of assets such as stocks, houses or starting new companies, but because the interest rates are low a lot of people take loans to buy stocks, houses or start businesses without solid business plans. The credit expansion eventually results in inflation causing the central bank to start a phase of credit contraction to limit the money supply and limit inflation. When the credit supply dries out a lot of people who purchased assets through loans end up selling these assets quickly to pay their loans or default on their loans causing the asset price bubble created the expansion to pop causing the prices to plummet forcing the central bank to start a new phase of credit expansion to get the prices back up and so on.

Resources:

To learn more about banks check Murray Rothbard’s Mystery of BankingA free ebook version could be downloaded from the Mises institute.