What role does a Bank play in the economy.

_Mayday_

Hey:)

I'm trying to think of ways in which Banks play a role in the economy as a whole, and what you would gain in terms of experience in the field of finance.

I just wanted to know how those two areas of business are linked to Banking.

Thanks!

russ_watters

That post doesn't make a lot of sense to me. What two areas of business? And what do you mean by experience? You mean getting a job in finance?

The question in the title is pretty easy though: the primary purpose of a "normal" bank is simple: to store and lend money.

0xDEADBEEF

Put a bit more formally: The purpose of the banks is to provide the market with liquidity.
They fail horribly at that today, causing the economy to stall.

Evo

I think you are confusing banks with something else. As Russ said, the primary function of a bank is to store and lend money. They make make small loans, but a simple bank doesn't do much.

Perhaps you are thinking of financial institutions that primarily make their money on funding venture capital, large businesss loans, large mortgage holdings, large credit cards, etc...

marcus

Evo, Russ, I am trying to recall stuff from Econ 101, or even Freshman Econ IA. I have an inkling that OxBEEF is saying something that is standard economics. How ordinary retail banks like WellsFargo and BoA actually do increase the money supply---generate liquidity.

Of course we are using vague language here like "normal bank" and "a simple bank" and "small" loans.

But it's clear what we mean, I think----we aren't talking investment bank, or Wall Street. That's a separate category. We are talking Main Street, ordinary retail bank. Checking accounts. Loans to local business. Construction. Inventories. Payrolls.
I think these simple normal banks actually do generate liquidity. They don't actually STORE dollar bills in a vault that is equal to the numbers in everybody's checking account. They have claims on them, in a sense, for a lot more than they have stored. there is a certain percentage backing, but one of the principal things they do is CREATE money and keep it circulating at a brisk pace. I could be wrong, it's a long time, but I think that accounts at retail banks are part of the money supply.

Maybe someone else will step in. Or maybe OxBeef will clarify for us.

CRGreathouse

You're right, of course -- banks increase the (M1) money supply, up to the reciprocal of the reserve requirement (though never that high in practice).

I suspect that 3735928559 says that in this contraction, banks are providing less money supply than usual ('hoarding cash'), and as such failing to provide enough liquidity. I don't think the claim is that they provide no liquidity.

marcus

CR, thanks for clarifying! Your reference to 0x as a ten-digit decimal puzzled me until I realized that DEADBEEF could be read in hex. And I discovered that indeed when converted to decimal it is what you said! Namely 3735928559.
Then with google help I found out more---about various kinds of numbers instantly recognizable as words, which are nevertheless unlikely to occur in normal calculation and thus can be significant if a programmer spots one in a coredump.

This was educational for me. I learned about so-called magic numbers. Some of the lore is amusing as well as instructive. At one time a mathematician, now retired, I had somehow never learned about magic numbers.

To freely paraphrase, one cause of a depression could simply be that something spooks retail banks, and they, frozen in a spasm of dread, become reluctant to provide Mainstreet with short-term credit.

CRGreathouse

Sure.

An interesting question is to what degree the reluctance to loan is due to being spooked and what degree is to a new evaluation of the risk of credit. If it's all because of being surprised and not knowing how the government plan will work, then credit should go back to what it was; if banks have learned some kind of lesson from this crisis, credit shouldn't be as easy even once this is over.

Edit: And it's not just **** ****** that the banks won't lend to. The interbank rates are killer -- banks won't loan to anyone these days, it seems.

Evo

I guess I make a distinction between a bank and a financial institution.

Bank

http://en.wikipedia.org/wiki/Bank

Financial Institution

http://en.wikipedia.org/wiki/Financial_institution

So, yes, it's how you define bank and financial institution.

marcus

Evo, that Wikipedia article you cited is very helpful! We should have referred to it first thing, when the O.P. asked what banks do. Let me quote at greater length:
==quote Wikipedia on Banks==
A banker or bank is a financial institution whose primary activity is to act as a payment agent for customers and to borrow and lend money.

The first modern bank was founded in Italy in Genoa in 1406, its name was Banco di San Giorgio (Bank of St. George).

Many other financial activities were added over time. For example banks are important players in financial markets and offer financial services such as investment funds. In some countries such as Germany, banks are the primary owners of industrial corporations while in other countries such as the United States banks are prohibited from owning non-financial companies. In Japan, banks are usually the nexus of cross share holding entity known as zaibatsu. In France "Bancassurance" is highly present, as most banks offer insurance services (and now real estate services) to their clients.

...
...
Traditional banking activities

Banks act as payment agents by conducting checking or current accounts for customers, paying cheques drawn by customers on the bank, and collecting cheques deposited to customers' current accounts. Banks also enable customer payments via other payment methods such as telegraphic transfer, EFTPOS, and ATM.

Banks borrow money by accepting funds deposited on current account, accepting term deposits and by issuing debt securities such as banknotes and bonds. Banks lend money by making advances to customers on current account, by making installment loans, and by investing in marketable debt securities and other forms of money lending.

Banks provide almost all payment services, and a bank account is considered indispensable by most businesses, individuals and governments. Non-banks that provide payment services such as remittance companies are not normally considered an adequate substitute for having a bank account.

Banks borrow most funds from households and non-financial businesses, and lend most funds to households and non-financial businesses, but non-bank lenders provide a significant and in many cases adequate substitute for bank loans, and money market funds, cash management trusts and other non-bank financial institutions in many cases provide an adequate substitute to banks for lending savings to.
...
...
==endquote Wikipedia==

I think the gist here, relevant to the current credit crunch and possible depression, is that by definition a bank is a type of financial institution. And in our society it is probably the main type of financial institution* that is involved in lending and borrowing.

Banks also provide payment services, as the article says, but their traditional role in the credit market---their activity as lenders and borrowers---is the main way they affect the money supply. This, I guess, is why the banks play such an important role in society, and why their collective behavior has such a strong effect on economic conditions (employment, economic growth, etc.)

*not counting the government. It does a fair amount of lending and borrowing too!

marcus

This business about the reciprocal of the reserve requirement, and how banks create money, is the key to answering the O.P. question "What role does a Bank play in the economy?"

It is coming back to me in bits and pieces. But I wish you would explain. There is a mechanism by which banks create most, or a large portion, of the money supply in the country. The State regulates the reserve requirement----say at 25 percent.

That means a bank must maintain reserves of 25 percent of the claims on it. Correct me if I am wrong. That means that for every dollar in reserve currency (T-bills? Federal notes?) that it has in its vaults, or in its account with the Fed, it can lend out FOUR dollars.
The bank does not need actually money in order to lend. It can lend just by putting numbers into somebody's checking account. This sounds too simple. Please clarify if necessary.

So you say the banks create money up to the reciprocal of the reserve requirement. If the State stipulates 25 percent, then the reciprocal of that is 4. That means the banks can multiply by a factor of four the amount of money put in circulation by Fed in the form of reserve currency (some kind of bills, notes, central bank reserve tokens?)

Banks can lend out more money than they have because if they put numbers in someone's checking account that someone will normally use the money for business and spend it and it will go into somebody elses checking account, and continue circulating. Only very very rarely will anybody go to the bank and ask for what is in his checking account in the form of 100 dollar bills and twenties. So the bank does not have to sit on a big pile of currency commensurate with the amount of money it has created in the outside world.

The O.P should be happy, if they ever check back on this thread. We are finally visualizing the answer of what role a bank plays in our society's economy. At least I think so. Please confirm if this is on the right track.
======================

Maybe another way to look at the reserve requirement is as a limit on how much the bank can borrow from its customers. When you deposit money in a bank, in a checking or savings account, you are lending the bank money. The reserve requirement could say that it can have borrowed 4 times as much from its depositors (by accepting their deposits) as it actually has on hand in its reserve vault, in whatever form. So having borrowed that 4X sum it can turn around and lend it out to businesses and consumers etc. So either way the bottom line is it adds up to 4 dollars to the amount in circulation for every 1 dollar it has in reserve.
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Another thing is how regulation can change the semantic picture. Banks are licensed. Regulated. Different kinds of license, different entities, different terminology. The Government could legalize another category of things called "Zanks" that do some of the same things that what we now call Banks do. with different regulations. This would complicate our language and require effort to keep straight. Like what are Savings and Loans? How are they different from Banks, or Zanks? But I suspect the Wikipedia article is still pretty good on the overall picture.

After 1929 I believe that banks became somewhat more state-regulated than they were prior. there was probably a period during which it was a kind of boring straightlace business. Banks couldn't get too big because they were licensed to operate within a particular region or state, like California. Banking had some of the upright propriety of a state religion---like bankers faintly resembled Episcopalian (Anglican) clergy. Then without the rest of us taking much notice the industry became somewhat deregulated and a little more on the go-go side. I'm not sure when this happened.

Interesting topic. Compliments to MAYDAY!

russ_watters

Seems like splitting hairs to me, Evo - the very next paragraph after the one you quoted for "bank" is about lending: It also says in the first line of the article that a bank is a type of "financial institution". In fact, I'd say that "financial institution" is too broad and includes functions that banks don't necessarily have. Ie, you'd expect all banks to have checking accounts, but not necessarily have brokerage accounts. But brokerage house is also a type of "financial institution".

Anyway, I consider 0xDEADBEEF's post to basically be just another way of saying what I said.

Evo

A bank is just a small part of what a large financial institution would be involved in.

I have a friend that owns a bank, I have clients that are on the boards of financial institutions, different rules, different markets.

But if you guys think a bank does more than I do, who am I to argue?

marcus

Who are you to argue? Why you are our cherished Evo, whose good opinion we treasure beyond all measure.

I don't particularly care about what we call them. What I do find mildly interesting is that there are a lot of institutions out there who determine the supply of money apparently by a kind of squishy herd behavior not subject to much in the way of prediction or control.
I would like to understand what GC called the multiplier, which is the reciprocal of the reserve requirement. Whatever you call them, the things that do the myriads of of borrow and lend operations and whose collective mood has such an effect on the M1 money supply.
It would be nice to understand that better.

phynoob

a bank also creates money
a central bank will impose a reserve ratio on bank, for example 0.1 ( which mean for every 10 dollar deposited, 1 dollar must go to the reserve)
while doing that, they also create money in the process, the formula is 1xmultiplier.
formular of multiplier = 1/reserve ratio. This is provided that the money the bank load out is used to create accounts in the bank as well.

so, for a 10 dollar deposit, it actually creates 100 dollar.
correct me if im wrong.

AeroFunk

well the central bank also creates money, and no deposits required, just politics.