Banks are the backbone of our financial system, connecting savers with borrowers and keeping money flowing. They accept deposits, make loans, and create liquidity, helping to allocate resources efficiently and drive economic growth.

From commercial banks to credit unions, different types of financial institutions serve various needs. Understanding how banks work and their role in the economy is crucial, as bank failures can lead to economic downturns and require careful regulation.

The Role of Banks in the Financial System

Banks as financial intermediaries

• Act as intermediaries by connecting savers and borrowers
  • Accept deposits from savers providing a safe place to store money and earn interest (checking and savings accounts)
  • Use deposited funds to make loans to borrowers enabling financing for investments or consumption (mortgages, business loans)
• Transform the maturity of funds
  • Accept short-term deposits (checking and savings accounts)
  • Provide long-term loans (mortgages, business loans)
• Pool and diversify risk
  • Collect funds from many savers allowing larger loans than any individual saver could provide
  • Spread the risk of loan defaults across many depositors and borrowers (diversification)
• Create liquidity in the economy
  • Allow depositors to withdraw funds on demand while providing long-term loans to borrowers
  • Enable efficient allocation of resources by channeling funds from savers to productive investments (capital formation)
• Engage in credit creation through fractional reserve banking
  • Maintain only a fraction of deposits as reserves, lending out the rest to create new money

Types of financial institutions

• Commercial banks
  • Primary role is accepting deposits and making loans to individuals and businesses
  • Offer a wide range of financial services (checking and savings accounts, CDs, credit cards)
• Investment banks
  • Focus on helping companies and governments raise capital by underwriting and selling securities (stocks, bonds)
  • Provide advisory services for mergers, acquisitions, and other corporate financial transactions (M&A, IPOs)
• Credit unions
  • Non-profit financial cooperatives owned by their members
  • Offer similar services to commercial banks but often have lower fees and better interest rates due to non-profit status
• Savings and loan associations (S&Ls)
  • Specialize in accepting savings deposits and making mortgage loans
  • Historically focused on residential mortgages but have expanded services over time
• Insurance companies
  • Provide financial protection against risks (death, disability, property damage, health issues)
  • Invest premiums collected from policyholders in various financial assets contributing to capital formation

Bank failures and economic downturns

• Bank failures can lead to a contraction in the money supply
  • When banks fail, money created through lending is destroyed reducing overall money supply
  • A decrease in money supply can lead to deflation and a decline in economic activity (Great Depression)
• Bank failures can disrupt the flow of credit
  • As banks fail, they stop lending making it harder for businesses and individuals to access credit
  • Reduced access to credit can lead to a decline in investment and consumption contributing to economic downturn
• Bank failures can erode consumer and business confidence
  • Failure of one or more banks can create uncertainty and panic among depositors and investors
  • Loss of confidence can lead to bank runs where depositors rush to withdraw funds potentially causing more bank failures
• Systemic banking crises can amplify economic downturns
  • When multiple banks fail simultaneously it can cause a systemic banking crisis
  • Systemic crises can severely disrupt the financial system leading to deep and prolonged recession (2008 global financial crisis)
• Government intervention and regulation aim to mitigate the impact of bank failures
  • Central banks (Federal Reserve) can provide liquidity to troubled banks to prevent failures
  • Deposit insurance (FDIC) helps maintain consumer confidence and prevent bank runs
  • Stricter banking regulations (Dodd-Frank Act) aim to reduce the risk of bank failures and systemic crises

Central Bank and Banking System

• Central banks implement monetary policy to influence the economy
  • Use tools like interest rates and open market operations to control money supply
• Act as lender of last resort to prevent bank failures
  • Provide emergency loans to banks facing liquidity crises
• Oversee bank regulation to ensure stability of the financial system
  • Establish capital requirements and conduct regular bank examinations
• Facilitate interbank lending to maintain liquidity in the banking system
  • Oversee overnight lending markets where banks lend excess reserves to each other