Lesson Explainer: Banks Economics

In this explainer, we will learn how to identify the role of banks in the economy and the functions served by different types of banks.

A bank is primarily known in societies as a place to store money safely while earning interest at the same time. Indeed, this was the reason banks came to exist. When coins emerged to serve the function of money in societies, individuals were able to accumulate wealth in coins. But to achieve wealth, individuals needed a safe storage of coins, for which their homes were often insufficient. Banks emerged to satisfy this need to store money and to accumulate wealth. In ancient civilizations, such as Egypt, Greece, and Rome, the role of banks was fulfilled by temples, as the public trusted them to manage their coins ethically. Even today, we can see many banking buildings resembling ancient Greek temples, which serves both to remind us of the origin of banking and to strength the trust of the public in such institutions.

As more and more individuals deposited their coins in these early banks, or temples, the accumulated coin reserves grew to be large. While many different individuals deposited and withdrew from their accounts, the banks always had a large reserve of coins in storage. This is because individuals preferred to store their money in banks except for a small amount needed for purchases. This enabled the banks to utilize their coin reserves to make loans or investments. The money collected from various individuals from households, called savers, was loaned to the firms in the economy, called borrowers. In this sense, banks mediate between borrowers and savers in order to make such loans possible. In economics, we refer to such entities as financial intermediaries.

Hence, banks developed in societies as financial intermediaries, and they continue to serve this role today. Banks’ intermediary services are greatly beneficial for economic development, because they provide the firms with the ability to acquire the funds necessary to begin a new production process. Banks themselves profit from interest payments and fees when serving as intermediaries. Moreover, the depositing customers, whose fund is used to make these loans, share in the bank’s benefit by earning interest on their deposits. Since this is one of the main roles of the banks today, let us examine it in depth.

In economics, finance refers to the process of acquiring the money, or capital, needed for various expenses. In particular, firms often need financing in order to begin new production, and the borrowed funds are generally paid back to the lender with interest. Finance can be largely split into direct and indirect finance. Let us consider the difference between direct and indirect finance.

Direct finance refers to the flow of money directly between the lender and the borrower without going through a financial intermediary. Since the lenders and borrowers directly deal with each other in direct finance, the lender knows exactly who the money is going to and the borrower knows where the money is coming from. For instance, a wealthy individual can directly finance a firm’s project without going through the bank’s services. However, even when such financing is possible, it is rare to see large-scale direct financing, because the lender lacks the guarantee that the borrower will repay the loan. It is more typical to see direct finance in context of families, friends, and close acquaintances. Direct finance also applies to financing through stocks and bonds, which will be discussed in the next lesson.

Indirect finance refers to the flow of money between lenders and borrowers that goes through a financial intermediary. Here, the lenders and borrowers do not directly deal with each other, but both parties go through the financial intermediary, which is usually a bank. Generally, lenders do not know who the money is going to, and the borrowers do not know where the money is coming from. The financial intermediary ensures that money is delivered to the borrowers and also that the money is returned, often with interest, to the lenders.

In our first example, we will identify an example of indirect finance.

Today, banks have diversified into many different types, which we will discuss later in this explainer. Most countries have one centralized bank holding authority over other banks as well as national monetary issues. This bank is known as the nation’s central bank. Functions of a central bank may vary between nations; however, banks in these nations usually share many essential functions. For instance, the central bank is known as the “government’s bank” because it manages monetary affairs of the government, such as keeping its deposits, making payments, and making arrangements for loans. The central bank is also known as the “bank of banks” because it lends money to other banks. The central bank also ensures that banks can fulfill their obligations by requiring them to keep a safe level of money in their reserves.

The primary role of the central bank is to achieve economic growth and stability through a careful management of monetary policy. Monetary policy should be distinguished from fiscal policy, which refers to legislators’ decisions on the public expenditure and taxes. Monetary policy is conducted by the central bank, rather than the government. Main components of monetary policy are decisions on new banknote issuance, interest rates, and bank regulations. These are important decisions that impact the national economy. For instance, if the central bank issues too many banknotes when there is no respective increase in production in the economy, the purchasing power of money will decline, leading to inflation. Also, if lending interest rates are too high, it can stifle the economic growth, since the firms in the economy would face a high cost of borrowing and hence have difficulties in making new investments. As we can see here, the central bank holds a large responsibility toward the welfare of the national economy.

A nation’s central bank is responsible for issuing new banknotes, for which it is known as the “bank of issue.” To understand how the central bank became the bank of issue today, let us briefly discuss the history of banks, which parallels the development of money.

Before paper money, or banknotes, emerged, banks were used as safe storage for coins. Consumers would need to withdraw their coins from the banks when they wanted to use them for purchases. But this process changed with the emergence of banknotes. Instead of paying with coins, consumers provided the merchants with written notes from their banks with a written guarantee for physical coins. Since banks were trustworthy, their guarantees were as good as physical coins for many merchants. Unlike transactions using coins, banks became an essential part of each transaction, since the value of paper money relied on the banks. Hence, banknotes overtook the marketplace, and banks began to take the center stage in economic activities.

In the early days of banknotes, any bank could issue banknotes as long as it was able to deliver the amount of coins it guaranteed. A failure to deliver the guaranteed coins would be disastrous for the reputation of the bank, so banks tried to keep a safe level of coin reserve in storage. However, the banks were not regulated in how much coin reserve they should maintain, regardless of how many banknotes they had issued. The absence of accountability allowed banks to issue paper money in far excess of the amount of deposits. This led to an arbitrary increase in money supply in circulation, as if a large amount of gold coins had suddenly entered the marketplace.

The increase in money supply while the production of goods and services remains at the same level leads to an increase in their prices. This is because the availability of money increases the demand in the marketplace, while the supply remains the same. Then, the prices of goods and services will increase by the supply and demand mechanism. The increase in the average price level in the economy is known as inflation. Inflation leads to a decreasing purchasing power of money since the same amount of money will not be enough to purchase a certain amount of goods and services.

Increased supply of money, when the level of production remained the same, led to a decrease of money’s general purchasing power, since more common money would be less valuable. Since money’s value decreased, while the values of everyday goods and services remained the same, the prices of these goods and services increased. The increased prices of everyday goods and services is known as inflation.

To better manage the supply of money in circulation, the governments intervened to limit the issuance of banknotes to one bank only, which later became the central bank. The central bank is not immune to the error of excessive issuance of banknotes. In fact, central banks in many countries made this error, especially to overcome large national debts simply by issuing more banknotes. However, such excessive issuance causes the value of the national currency to sharply decline as well as inflating the prices of commodities within the country. Hence, these nations experienced harsh economic instability and came to the realization that the issuance of banknotes should be limited. To avoid this pitfall, central banks around the world collectively decided to limit the issuance of banknotes in accordance with the nation’s stock of gold reserves. In this way, gold will always have the same price in the national currency, and the value of banknotes will be tied to that of gold, which is a scarce resource. This method of restricting issuance of banknotes is known as the gold standard.

With the gold standard, the ability to issue new banknotes solely relies on the supply of gold. While the gold standard was helpful in preventing economic stability created by overissuance of banknotes, it severely limited the government’s ability to supply money when the nation’s economy was in distress. This was exaggerated during the early 1900s, when most of the world experienced a severe economic recession known as the Great Depression. The Great Depression surprised economists since the world had not known this level of economic tumult. Governments around the world needed to dramatically increase the money supply to alleviate the effects of the Great Depression. For this reason, the gold standard no longer served its purpose, and it was abandoned altogether.

Rather than using the gold standard to measure the value of a currency, governments used their legal authorities to enforce monetary value in banknotes. This led to the emergence of legal tender, which is money that is backed solely by a nation’s legal authority. Today, banknotes issued by central banks are legal tender within the nation’s economy, and all merchants within the nation are legally obliged to accept it as payment. Since these banknotes are not backed by physical assets such as gold, it is also known as fiat money.

In our next example, we will consider the roles of central banks.

We have discussed the history of banks, leading up to today’s banking and monetary system. The development of the Central Bank of Egypt (CBE) followed similar stages, while some details differ from the general history. Let us look in more detail at how the CBE was established.

In Egypt, locally issued gold and silver coins were widely circulated in the marketplace, which lacked regulations and uniformity. These government-issued coins became legal tender accepted by all merchants in Egypt. In 1834, the Egyptian government took control of the issuance of gold and silver coins to create a national currency known as the Egyptian pound, denoted LE. In 1898, the National Bank of Egypt (NBE) was established and was given the authority to issue banknotes. Using banknotes was optional in the beginning. Moreover, the banknotes were convertible into gold coins during this time. With this newfound convenience, banknotes began to overtake the marketplace.

In 1914, a decree was made by the Egyptian government that made the NBE-issued banknotes legal tender, without any physical asset backing the currency. Through this decree, the banknotes were no longer convertible to gold, which meant that these banknotes were also fiat money. An Egyptian pound banknote carried the same monetary value as the government-issued gold coin with the same denomination. From this point, gold coins ceased to circulate in the marketplace in Egypt.

As the bank of issue, the NBE served a function of the central bank in Egypt, but it did not hold the regulatory power over other banks. In 1957, the NBE assumed this role of a central bank, by making each bank in Egypt under NBE’s regulatory authority. In 1961, the NBE was split into a commercial division and a governmental division. While the former division still functions today under the name NBE, the latter division of the National Bank of Egypt was officially given the name the Central Bank of Egypt, or CBE. Since then, CBE has held the sole legal authority to issue Egyptian banknotes.

This history is summarized in the following timeline.

In the next example, we will consider the history of development of the Central Bank of Egypt.

While a nation’s central bank serves important functions to achieve economic stability, it does not deal with individual customers to receive their deposits or to lend them money. These roles are reserved for smaller, and often privately owned, banks known as commercial banks. Commercial banks use accumulated funds from the customers’ deposits to invest in firms in the economy by lending them money. Commercial banks assess risks involved in the firms before making loans to them, because they have the responsibility to recover the loaned amount from these firms. According to the level of perceived risk in each firm, commercial banks can determine an appropriate interest rate for the loan. Firms with higher perceived risks, or loans with longer terms, have higher interest rates.

Why would the firms want to borrow money from banks, who require interest payments in addition to the borrowed amount? Firms, especially smaller or starting firms, need a lot of money to invest in fixed capital goods, such as factory machinery, to acquire new productive capabilities. These investments often require much more than what the individuals, who are owners of the firms, can afford. Without the ability to borrow money, these firms cannot even begin to produce goods and services. On the other hand, once the firms successfully begin the production, they believe their profits will exceed the required interest payments. Since the owners of the firms will still make profits even after paying interest, they are motivated to take loans from commercial banks.

As commercial banks help promote investment through providing loans to firms and therefore encouraging production, the overall economy benefits. Profits of these firms are returned to individuals in households, who then deposit more money to banks. Furthermore, firms who have received bank loans are required to repay the borrowed amount with interest. These interest payments are returned as profits for the deposit holders as well as the commercial banks, hence creating additional benefits to the economy. For deposit holders, this profit is gained without accompanying risks, since deposited amounts as well as interest payments are generally insured by the national government even when the firms fail to make their repayments.

While commercial banks can make loans using the customers’ deposits, they still have obligations to return the customer’s full deposit amount when demanded. If commercial banks failed to fulfill this obligation, the public’s trust in the banking system would decline and individuals would cease to make deposits to the banks. To ensure that this failure does not occur, the central bank supervises commercial banks and requires them to maintain a certain level of cash reserve proportionate to their liabilities. In the worst-case scenario, when commercial banks default in their liabilities, the central bank fulfills their obligations for them.

As commercial banks grew more trustworthy in societies, credit money became a popular medium of transaction in the marketplace. Recall that credit money is not a physical form of money, but it is the monetary value created by a bank’s liability to the deposit holders. Payments using credit money are made with checks or debit cards, which transfer the bank’s liability to another individual. In bookkeeping, transactions using checks are recorded as a transfer of the bank’s debt from one customer to another customer, or to another bank. Since physical money is not used during transactions, the utility of credit money in place of cash gives a greater flexibility to commercial banks to be able to use a larger portion of its cash reserve as loans. But, while the convenience of credit money means that less banknotes circulate in the marketplace, banknotes are still used for transactions. Unlike banknotes, credit money is not a legal tender, meaning that merchants are not obligated to accept it as payment.

In the next example, we will consider the functions and characteristics of commercial banks.

So far, we have discussed in detail the roles of central and commercial banks, which are the two most predominant types of banks today. These banks serve important roles in achieving economic growth and stability. While the central bank acts on a large scale with regard to the national economy, commercial banks are more numerous and act as financial intermediaries between individual households and firms in local economies.

As the national economy is complex, there are areas of financial need that these two banks are not able to fill. Since commercial banks are, for the most part, driven by profits achieved through making loans, their priority is to ensure the recovery of the full amounts of the loans plus interest from borrowers. In other words, commercial banks need to carefully manage the default risk, which refers to the possibility that borrowers would not be able to fulfill their debt obligations.

Commercial banks can manage this risk by charging higher interest rates, so that a portion of interest payments can fill in the gap created by defaulted loans. In addition, commercial banks can decrease default risk associated with specific sectors by distributing their loans to a wide variety of sectors. This process is known as diversification. To see how diversification lowers default risk for commercial banks, let us consider a simple scenario where all borrowers work in agriculture. In this case, one hailstorm can destroy that year’s harvest in the vast majority of farms, which means that this single incident significantly raises the default risk for commercial banks. On the other hand, if the bank had diversified their borrowers, the effect of this hailstorm for commercial banks would not be as significant.

Since commercial banks need to diversify their borrowers, it is difficult to expect that these banks will help boost a specific sector of production. Hence, specialized banks emerged to provide financial loans for specific types of economic activities. Specialized banks are generally owned or subsidized by the government with the intention of helping the production of specific types of goods and services that will benefit the overall economic growth. Since it is supported by the government, lending interest rates for specialized banks are usually lower than those of commercial banks. For instance, specialized banks limit their borrowers to firms working on a specific sector such as agriculture, industry, and real estate. In many developing economies, activities of specialized banks have increased in recent years, reflecting the governments’ efforts to spur growth in specific sectors.

Investment banks are different from the previous types of banks in that they do not receive deposits or make loans. Instead, they serve purely as intermediaries between investors and firms in the financial market. The financial market is a marketplace where a firm’s securities such as stocks and bonds are traded. These securities are used by the firms to raise the necessary funds to invest in projects. Investment banks help the firms create these securities through the underwriting process, where the values and risks of securities are evaluated. These banks also act as brokers for individuals, or investors, by purchasing these securities on their behalf. These roles will be discussed in greater detail in a future lesson.

These functions of investment banks resemble those of commercial banks. While commercial banks receive deposits from savers, which are used to make loans to borrowers, investment banks help firms to obtain money directly from investors in the form of securities in the financial market. In this sense, both commercial and investment banks serve as financial intermediaries between savers (or investors) and borrowers. However, in case of investment banks, the money does not go through the banks.

Another distinction of investment banks is that, unlike savers in commercial banks, investors bear the full risk of the loans, and the return of their investment is usually not guaranteed. On the other hand, if the firms are successful in their projects, investors can earn higher rates of return on their investment compared to commercial banks. In addition to serving as financial intermediaries, investment banks also advise firms and investors on financial asset management. Investment banks are widespread in countries with advanced financial systems, such as the United States and England, and they play an important role in achieving economic growth.

Banks can serve in multiple capacities, rather than limiting their roles to those of commercial banks or of investment banks. These banks are known as universal banks. Universal banks serve both as commercial banks, by collecting deposits from savers and making loans to borrowers, and as investment banks, by advising firms and acting as intermediaries in the financial market. Since customers can satisfy many aspects of their financial needs in universal banks, these banks are becoming increasingly popular. Universal banks tend to be large international banks that are not bound to specific countries. In fact, most of the large international banks in the world, such as Deutsche Bank, UBS, and Citigroup, are universal banks.

With the development of technology, electronic banks, also known as virtual banks or online banks, emerged due to their convenience. Electronic banks perform all of their activities on the Internet, and they do not have physical buildings for customers to walk into. Rather than waiting in line in banks, customers can satisfy their financial needs at the comfort of their homes. As money is continuing to evolve into its electronic form, electronic banks are becoming more popular. Because they do not require physical buildings or cash reserve, the costs of running electronic banks are significantly lower. For this reason, they are often able to offer higher interest rates for savers, which makes them more appealing to customers.

Let us consider the roles of different types of banks in the next example.

Let us consider a final example on the functions of different types of banks.

Let us finish by recapping a few important concepts from this explainer.