# Money and Banking

## The Role of Banks

Somebody once asked the late bank robber named Willie Sutton why he robbed banks. He answered: “That’s where the money is.” While this may have been true at one time, from the perspective of modern economists, Sutton is both right and wrong. He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks, waiting for a robber to appear. Most money is in the form of bank accounts, which exist only as electronic records on computers. From a broader perspective, however, the bank robber was more right than he may have known. Banking is intimately interconnected with money and consequently, with the broader economy.
Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets. Imagine for a moment what the economy would be like if everybody had to make all payments in cash. When shopping for a large purchase or going on vacation you might need to carry hundreds of dollars in a pocket or purse. Even small businesses would need stockpiles of cash to pay workers and to purchase supplies. A bank allows people and businesses to store this money in either a checking account or savings account, for example, and then withdraw this money as needed through the use of a direct withdrawal, writing a check, or using a debit card.
Banks are a critical intermediary in what we call the payment system, which helps an economy exchange goods and services for money or other financial assets. Also, those with extra money that they would like to save can store their money in a bank rather than look for an individual who is willing to borrow it from them and then repay them at a later date. Those who want to borrow money can go directly to a bank rather than trying to find someone to lend them cash. Transaction costs are the costs associated with finding a lender or a borrower for this money. Thus, banks lower transactions costs and act as financial intermediaries—they bring savers and borrowers together. Along with making transactions much safer and easier, banks also play a key role in creating money.

### Banks as Financial Intermediaries

An “intermediary” is one who stands between two other parties. Banks are a financial intermediary—that is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. Financial intermediaries include other institutions in the financial market such as insurance companies and pension funds, but we will not include them in this discussion because they are not depository institutions, which are institutions that accept money deposits and then use these to make loans. All the deposited funds mingle in one big pool, which the financial institution then lends.  illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out. Of course, when banks make loans to firms, the banks will try to funnel financial capital to healthy businesses that have good prospects for repaying the loans, not to firms that are suffering losses and may be unable to repay.

### A Bank’s Balance Sheet

A balance sheet is an accounting tool that lists assets and liabilities. An asset is something of value that you own and you can use to produce something. For example, you can use the cash you own to pay your tuition. If you own a home, this is also an asset. A liability is a debt or something you owe. Many people borrow money to buy homes. In this case, a home is the asset, but the mortgage is the liability. The net worth is the asset value minus how much is owed (the liability). A bank’s balance sheet operates in much the same way. A bank’s net worth as bank capital. We also refer to a bank has assets such as cash held in its vaults, monies that the bank holds at the Federal Reserve bank (called “reserves”), loans that it makes to customers, and bonds.
 illustrates a hypothetical and simplified balance sheet for the Safe and Secure Bank. Because of the two-column format of the balance sheet, with the T-shape formed by the vertical line down the middle and the horizontal line under “Assets” and “Liabilities,” we sometimes call it a T-account.
The “T” in a T-account separates the assets of a firm, on the left, from its liabilities, on the right. All firms use T-accounts, though most are much more complex. For a bank, the assets are the financial instruments that either the bank is holding (its reserves) or those instruments where other parties owe money to the bank—like loans made by the bank and U.S. Government Securities, such as U.S. treasury bonds purchased by the bank. Liabilities are what the bank owes to others. Specifically, the bank owes any deposits made in the bank to those who have made them. The net worth of the bank is the total assets minus total liabilities. Net worth is included on the liabilities side to have the T account balance to zero. For a healthy business, net worth will be positive. For a bankrupt firm, net worth will be negative. In either case, on a bank’s T-account, assets will always equal liabilities plus net worth.
When bank customers deposit money into a checking account, savings account, or a certificate of deposit, the bank views these deposits as liabilities. After all, the bank owes these deposits to its customers, when the customers wish to withdraw their money. In the example in , the Safe and Secure Bank holds $10 million in deposits.
Loans are the first category of bank assets in . Say that a family takes out a 30-year mortgage loan to purchase a house, which means that the borrower will repay the loan over the next 30 years. This loan is clearly an asset from the bank’s perspective, because the borrower has a legal obligation to make payments to the bank over time. However, in practical terms, how can we measure the value of the mortgage loan that the borrower is paying over 30 years in the present? One way of measuring the value of something—whether a loan or anything else—is by estimating what another party in the market is willing to pay for it. Many banks issue home loans, and charge various handling and processing fees for doing so, but then sell the loans to other banks or financial institutions who collect the loan payments. We call the market where financial institutions make loans to borrowers the primary loan market, while the market in which financial institutions buy and sell these loans is the secondary loan market.
One key factor that affects what financial institutions are willing to pay for a loan, when they buy it in the secondary loan market, is the perceived riskiness of the loan: that is, given the borrower's characteristics, such as income level and whether the local economy is performing strongly, what proportion of loans of this type will the borrower repay? The greater the risk that a borrower will not repay loan, the less that any financial institution will pay to acquire the loan.
  Another key factor is to compare the interest rate the financial institution charged on the original loan with the current interest rate in the economy. If the original loan requires the borrower to pay a low interest rate, but current interest rates are relatively high, then a financial institution will pay less to acquire the loan. In contrast, if the original loan requires the borrower to pay a high interest rate, while current interest rates are relatively low, then a financial institution will pay more to acquire the loan. For the Safe and Secure Bank in this example, the total value of its loans if they sold them to other financial institutions in the secondary market is $5 million.
The second category of bank asset is bonds, which are a common mechanism for borrowing, used by the federal and local government, and also private companies, and nonprofit organizations. A bank takes some of the money it has received in deposits and uses the money to buy bonds—typically bonds issued that the U.S. government issues. Government bonds are low-risk because the government is virtually certain to pay off the bond, albeit at a low rate of interest. These bonds are an asset for banks in the same way that loans are an asset: The bank will receive a stream of payments in the future. In our example, the Safe and Secure Bank holds bonds worth a total value of $4 million.
The final entry under assets is reserves, which is money that the bank keeps on hand, and that it does not lend or invest in bonds—and thus does not lead to interest payments. The Federal Reserve requires that banks keep a certain percentage of depositors’ money on “reserve,” which means either in their vaults or at the Federal Reserve Bank. We call this a reserve requirement. (Monetary Policy and Bank Regulation will explain how the level of these required reserves are one policy tool that governments have to influence bank behavior.) Additionally, banks may also want to keep a certain amount of reserves on hand in excess of what is required. The Safe and Secure Bank is holding $2 million in reserves.
We define net worth of a bank as its total assets minus its total liabilities. For the Safe and Secure Bank in , net worth is equal to $1 million; that is, $11 million in assets minus $10 million in liabilities. For a financially healthy bank, the net worth will be positive. If a bank has negative net worth and depositors tried to withdraw their money, the bank would not be able to give all depositors their money.

### How Banks Go Bankrupt

A bank that is bankrupt will have a negative net worth, meaning its assets will be worth less than its liabilities. How can this happen? Again, looking at the balance sheet helps to explain.
A well-run bank will assume that a small percentage of borrowers will not repay their loans on time, or at all, and factor these missing payments into its planning. Remember, the calculations of the banks' expenses every year include a factor for loans that borrowers do not repay, and the value of a bank’s loans on its balance sheet assumes a certain level of riskiness because some customers will not repay loans. Even if a bank expects a certain number of loan defaults, it will suffer if the number of loan defaults is much greater than expected, as can happen during a recession. For example, if the Safe and Secure Bank in  experienced a wave of unexpected defaults, so that its loans declined in value from $5 million to $3 million, then the assets of the Safe and Secure Bank would decline so that the bank had negative net worth.
The risk of an unexpectedly high level of loan defaults can be especially difficult for banks because a bank’s liabilities, namely it customers' deposits. Customers can withdraw funds quickly but many of the bank’s assets like loans and bonds will only be repaid over years or even decades. This asset-liability time mismatch—the ability for customers to withdraw bank’s liabilities in the short term while customers repay its assets in the long term—can cause severe problems for a bank. For example, imagine a bank that has loaned a substantial amount of money at a certain interest rate, but then sees interest rates rise substantially. The bank can find itself in a precarious situation. If it does not raise the interest rate it pays to depositors, then deposits will flow to other institutions that offer the higher interest rates that are now prevailing. However, if the bank raises the interest rates that it pays to depositors, it may end up in a situation where it is paying a higher interest rate to depositors than it is collecting from those past loans that it at lower interest rates. Clearly, the bank cannot survive in the long term if it is paying out more in interest to depositors than it is receiving from borrowers.
How can banks protect themselves against an unexpectedly high rate of loan defaults and against the risk of an asset-liability time mismatch? One strategy is for a bank to diversify its loans, which means lending to a variety of customers. For example, suppose a bank specialized in lending to a niche market—say, making a high proportion of its loans to construction companies that build offices in one downtown area. If that one area suffers an unexpected economic downturn, the bank will suffer large losses. However, if a bank loans both to consumers who are buying homes and cars and also to a wide range of firms in many industries and geographic areas, the bank is less exposed to risk. When a bank diversifies its loans, those categories of borrowers who have an unexpectedly large number of defaults will tend to be balanced out, according to random chance, by other borrowers who have an unexpectedly low number of defaults. Thus, diversification of loans can help banks to keep a positive net worth. However, if a widespread recession occurs that touches many industries and geographic areas, diversification will not help.
Along with diversifying their loans, banks have several other strategies to reduce the risk of an unexpectedly large number of loan defaults. For example, banks can sell some of the loans they make in the secondary loan market, as we described earlier, and instead hold a greater share of assets in the form of government bonds or reserves. Nevertheless, in a lengthy recession, most banks will see their net worth decline because customers will not repay a higher share of loans in tough economic times.

### Key Concepts and Summary

Banks facilitate using 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 receiving payment, 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. The bank's liabilities are its deposits. The bank's assets include its loans, its ownership of bonds, and its reserves (which it does not loan out). We calculate a bank's net worth by subtracting its 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 interest rate on its long-term loans but must pay the currently higher market interest rate 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, re-depositing those loans in banks, and the banks making additional loans will create money in the economy.

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### References

Credit Union National Association. 2014. "Monthly Credit Union Estimates." Last accessed March 4, 2015. http://www.cuna.org/Research-And-Strategy/Credit-Union-Data-And-Statistics/. 
Dallas Federal Reserve. 2013. "Ending `Too Big To Fail': A Proposal for Reform Before It's Too Late". Accessed March 4, 2015.  http://www.dallasfed.org/news/speeches/fisher/2013/fs130116.cfm.
Richard W. Fisher. “Ending 'Too Big to Fail': A Proposal for Reform Before It's Too Late (With Reference to Patrick Henry, Complexity and Reality) Remarks before the Committee for the Republic, Washington, D.C. Dallas Federal Reserve. January 16, 2013.
“Commercial Banks in the U.S.” Federal Reserve Bank of St. Louis. Accessed November 2013. http://research.stlouisfed.org/fred2/series/USNUM.