Banks

1. Banks You will be able to describe the functions of commercial banks and central banks

2. Financial Institutions • In a modern economy, people, firms and government need somewhere they can keep their money safely and help them make payments to others. • They may also want to borrow money, make investments and exchange the money used in their country for the currency used in another. • Business organizations that specialize in providing these services are called financial institutions. • Therefore we can say that finance deals with….

3. Banking • Banks allow people to borrow and lend and carry out a range of other financial activities. They are like any other business except the product they supply is money. • Banks have existed since the first civilizations. The first banks did not store money like they do today. • What item do you think banks stored? • Agricultural products were stored in granaries that were run by the government. The government would keep track of deposits and withdrawals.

4. Commercial Banks • Commercial banks are also called retail banks. They are businesses that seek to make a profit. They are called retail banks because they are selling to the public. • Basic activities of a commercial bank: • Keeping money safe • Lending • Loans • Credit Cards • Mortgages

5. Commercial banks as financial intermediaries • Where does a bank get money to make loans? • How does a bank make a profit from making loans? • What do you think the time horizon is on profits for banks? Savers and depositors save and deposit money Banks act as intermediaries Lend money to households and businesses They charge interest on the money they lend, which is an additional amount that the borrower must pay back. A long, long time. Loans are paid back over a large number of years.

6. How commercial banks work How much money does the single $100 deposit add to the money supply? Why do banks need to keep a reserve?

7. Why save in commercial banks? Banks pay interest as a reward to savers. Money saved in a bank is often insured to prevent the loss of money during a financial panic. It can easily be stolen in your house. It could easily be destroyed (fire or other disaster). Banks provide convenient access to money in the form of checks and debit cards.

8. Loan Interest • Interest is simply a percentage of the money that you borrow that must be paid back to the bank in addition to the value that was borrowed. • So, a $10,000 loan with 5% interest will be repaid to the bank in the amount of $10,500. Interest will depend on how risky the loan is. Banks want to be sure that you will be able to pay back the money that you borrow. For example, a big loan over 10 years to a new, small business may be charged a higher rate of interest than a smaller loan to be repaid over 2 years to an established business. Often a loan is secured by the property that the loan is used to purchase. So if a person gets a mortgage to buy the house, its actually the bank that owns the home.

9. How might a bank treat the following borrowers? • An unknown musician wants $100,000 loan to pay back in 10 years so they can make a record. • A famous and critically acclaimed author needs $50,000, to be paid back in a year, to act as expenses while he writes his next book. • A start-up technology company, with a promising but not proven breakthrough, needs a 1 million dollar loan to build a new testing facility. They are looking to pay back the loan over 15 years. • A person who recently recovered from a bankruptcy wants an $800,000 mortgage to buy a new house. They are looking for a 25 year payback period.

10. Why we need commercial banks • Digital Dreams is a small but rapidly expanding company manufacturing video equipment. It has recently received a $200,000 loan repayable over 20 years to buy new business premises. • Digital Dreams sells much of its equipment online to customers who use credit and debit cards and so it accepts all these forms of payment. It also accepts checks from customers. (What’s the difference between a debit and credit card?) • The company keeps most of its sales revenues in a deposit account. The balance is kept in a current account to pay wages to employees and other costs, including electricity, gas and local taxes, by direct debit. • If there were no banks: • 1. How would the company have to make and receive payments? • 2. Where would it have to store sales revenues? • 3. How would it have to pay for its new business premises? • 4. What would happen to the costs of having to run the company?

11. Central Bank • A central bank is often the only one of its kind in a country. • A central bank has authority over all of the commercial banks that operate in its country, and is owned and operated by the government. The most well-known and influential central bank in the world is the Federal Reserve Bank of the USA (often abbreviated Fed). Other well known central banks are the European Central Bank and the Bank of England. These banks provide services to commercial banks and the government.

12. The purpose of central banks • A central bank has many functions but was originally envisioned as a way to help regulate the economy of a country. • The ups and downs of an economy look a lot like waves: There are highs and there are lows. It is the job of the central bank to make sure the highs and lows aren’t too extreme. • It does this through monetary policy. Monetary means having to do with money. The biggest goal of monetary policy is to keep inflation low. • Central banks can influence inflation by changing the rates that it charges commercial banks to borrow money or even set the rate that banks can charge to its customers. • How much money do you think the Fed needs to have control over to be able to influence an economy the size of the US?

13. What causes inflation? • DEMAND • Inflation is the natural result of increased demand for products. • People’s demand for goods increases when they have more money. When people have more money they are willing to pay more for a product and hence prices rise. • If this happens too quickly and abruptly it means that wages might not keep up with the rising cost of goods and many people will be left unable to afford certain things.

14. Other functions • The central bank also has the following functions: • Acts as banker to the govt. • Operates as a banker to the commercial banks (facilitates transactions between banks) • Acts as a lender of last resort (provides liquidity) • Manages the national debt (countries owe money too!) • Hold’s a country’s reserves of gold and FX. • Issues bank notes and coins – they print money! • Controls the banking system – regulation, supervision

15. National Debt • Governments act as borrowers through the central bank. They need to raise funds to pay for the services they provide to their citizens (health care, military, etc.). Taxes aren’t enough! • The central bank issues IOUs called bonds (a promise to repay money) to rich investors, other governments, or financial institutions which get paid back over a period of time. • Most lenders consider governments to be less risky than other borrowers. • But is this always true?

16. How does a central bank work • The head of the central bank holds regular meetings with officials of commercial banks and outlines its policies for lending money. • If there is too much spending in an economy, which can lead to rising prices (this is called what?), the government might ask banks to lend less money. • If there is too little spending, which could lead to a recession, the government might ask banks to lend more. • Additionally, the central bank has tools to force banks to do as it wants as well.

17. How does the central bank work • The Tools • Central banks control lending through interest rates and regulation. These controls, which affect the flow of money in an entire country represent monetary policy. • Interest rates: the Fed charges interest to banks to borrow its money. If interest rates go down what are banks more likely to do? • Regulations might include: • Controlling how much a bank can lend • Controlling how much a bank must keep in its reserves • Controlling the interest rates that banks can charge to customers or each other