Economics » Money and Banking » The Role of Banks

Key Concepts and Summary

Key Concepts and Summary

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.

Glossary

asset

item of value owned by a firm or an individual

asset–liability time mismatch

a bank’s liabilities can be withdrawn in the short term while its assets are repaid in the long term

balance sheet

an accounting tool that lists assets and liabilities

bank capital

a bank’s net worth

depository institution

institution that accepts money deposits and then uses these to make loans

diversify

making loans or investments with a variety of firms, to reduce the risk of being adversely affected by events at one or a few firms

financial intermediary

an institution that operates between a saver with financial assets to invest and an entity who will borrow those assets and pay a rate of return

liability

any amount or debt owed by a firm or an individual

net worth

the excess of the asset value over and above the amount of the liability; total assets minus total liabilities

payment system

helps an economy exchange goods and services for money or other financial assets

reserves

funds that a bank keeps on hand and that are not loaned out or invested in bonds

T-account

a balance sheet with a two-column format, with the T-shape formed by the vertical line down the middle and the horizontal line under the column headings for “Assets” and “Liabilities”

transaction costs

the costs associated with finding a lender or a borrower for money

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