27.3 The Role of Banks

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3 The Role of Banks – Principles of Economics
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PRINCIPLES OF ECONOMICS
CONTENTS
Chapter 27. Money and Banking
27.3 The Role of Banks
Learning Objectives
By the end of this section, you will be able to:
Explain how banks act as intermediaries between savers and borrowers
Evaluate the relationship between banks, savings and loans, and credit unions
Analyze the causes of bankruptcy and recessions
Previous: 27.2 Measuring Money: Currency, M1, and M2

Next: 27.4 How Banks Create Money
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10/2/21, 10:23 AM 27.3 The Role of Banks – Principles of Economics
The late bank robber named Willie Sutton was once asked 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 ma‐
jority 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 con‐
sequently, with the broader economy.
Banks make it far easier for a complex economy to carry out the extraordinary range of transac‐
tions that occur in goods, labor, and financial capital markets. Imagine for a moment what the
economy would be like if all payments had to be made in cash. When shopping for a large pur‐
chase 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 is called 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 that
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 to‐
gether. Along with making transactions much safer and easier, banks also play a key role in the
creation of money.
Banks as Financial Intermediaries
An “intermediary” is one who stands between two other parties. Banks are a financial intermedi‐
ary—that is, an institution that operates between a saver who deposits money in a bank and a bor‐
rower who receives a loan from that bank. Financial intermediaries include other institutions in
the financial market such as insurance companies and pension funds, but they will not be included
Previous:
in this 27.2 Measuring
discussion because Money: Currency,
they are M1, and M2to be depository institutions, which are insti‐
not considered
tutions that accept money deposits and then use these to make loans. All How
Next: 27.4 the funds
Banks deposited are
Create Money
mingled in one big pool, which is then loaned out. Figure 1 illustrates the position of banks as fin‐
ancial 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 un‐
able to repay.
Figure 1. Banks as Financial Intermediaries. Banks act as financial intermediaries

because they stand between savers and borrowers. Savers place deposits with banks, and
then receive interest payments and withdraw money. Borrowers receive loans from banks
and repay the loans with interest. In turn, banks return money to savers in the form of
withdrawals, which also include interest payments from banks to savers.
How are banks, savings and loans, and credit unions related?
Banks have a couple of close cousins: savings institutions and credit unions. Banks,
as explained, receive deposits from individuals and businesses and make loans with
the money.
Savings institutions are also sometimes called “savings and loans” or “thrifts.” They
also take loans and make deposits. However, from the 1930s until the 1980s, federal
law limited how much interest savings institutions were allowed to pay to depositors.
They were also required to make most of their loans in the form of housing-related
loans, either to homebuyers or to real-estate developers and builders.
A credit union is a nonprofit financial institution that its members own and run.
Members of each credit union decide who is eligible to be a member. Usually, poten‐
tial members would be everyone in a certain community, or Next: 27.4 How
groups Banks Createor
of employees, Money
members of a certain organization. The credit union accepts deposits from members
and focuses on making loans back to its members. While there are more credit unions
than banks and more banks than savings and loans, the total assets of credit unions are
growing.
In 2008, there were 7,085 banks. Due to the bank failures of 2007–2009 and bank
mergers, there were 5,571 banks in the United States at the end of the fourth quarter
in 2014. According to the Credit Union National Association, as of December 2014
there were 6,535 credit unions with assets totaling $1.1 billion. A day of “Transfer
Your Money” took place in 2009 out of general public disgust with big bank bailouts.
People were encouraged to transfer their deposits to credit unions. This has grown
into the ongoing Move Your Money Project. Consequently, some now hold deposits
as large as $50 billion. However, as of 2013, the 12 largest banks (0.2%) controlled 69
percent of all banking assets, according to the Dallas Federal Reserve.
A Bank’s Balance Sheet
A balance sheet is an accounting tool that lists assets and liabilities. An asset is something of
value that is owned and can be used to produce something. For example, the cash you own can be
used to pay your tuition. If you own a home, this is also considered 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 as‐
set, 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 is also
referred to as bank capital. 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 are made to customers, and
bonds.
Figure 2 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,” it is sometimes
called a T-account.
Figure 2. A Balance Sheet for the Safe and Secure Bank.
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 fin‐
ancial 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 al‐
ways 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 shown in Figure 2,
the Safe and Secure Bank holds $10 million in deposits.
Loans are the first category of bank assets shown in Figure 2. 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. But in practical terms, how can the
value of the mortgage loan that is being paid over 30 years be measured in the present? One way
of measuring the value of something—whether a loan or anything else—is by estimating what an‐
other party in the market is willing to pay for it. Many banks issue home loans, and charge vari‐
ous handling and processing fees for doing so, but then sell the loans to other banks or financial
institutions who collect the loan payments. The market where loans are made to borrowers is
called the primary loan market, while the market in which these loans are bought and sold by
financial institutions 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 character‐
istics of the borrower, such as income level and whether the local economy is performing
strongly, what proportion of loans of this type will be repaid? The greater
Next: theBanks
27.4 How risk that a loan
Create will
Money
not be repaid, the less that any financial institution will pay to acquire the loan. Another key
factor is to compare the interest rate charged on the original loan with the current interest rate in
the economy. If the original loan made at some point in the past 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 ac‐
quire the loan. For the Safe and Secure Bank in this example, the total value of its loans if they
were sold 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—typ‐
ically bonds issued by the U.S. government. Government bonds are low-risk because the govern‐
ment is virtually certain to pay off the bond, albeit at a low rate of interest. These bonds are an as‐
set 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 is
not loaned out or invested 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 kept at the Federal Reserve Bank. This is called a reserve require‐
ment. (Monetary Policy and Bank Regulation will explain how the level of these required re‐
serves 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.
The net worth of a bank is defined as its total assets minus its total liabilities. For the Safe and
Secure Bank shown in Figure 2, 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.
For some concrete examples of what banks do, watch this video from Paul Solman’s
“Making Sense of Financial News.”
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 expenses of banks every year includes a factor for loans that are not repaid, and the value of a
bank’s loans on its balance sheet assumes a certain level of riskiness because some loans will not
be repaid. 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 Figure 2 experienced a wave of unexpected defaults, so that its loans de‐
clined 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.
What led to the financial crisis of 2008–2009?
Many banks make mortgage loans so that people can buy a home, but then do not
keep the loans on their books as an asset. Instead, the bank sells the loan. These loans
are “securitized,” which means that they are bundled together into a financial security
that is sold to investors. Investors in these mortgage-backed securities receive a rate
of return based on the level of payments that people make on all the mortgages that
stand behind the security.
Previous: 27.2 Measuring

Securitization Money:
offers Currency,
certain M1, andIfM2
advantages. a bank
makes most of its loans in a local
area, then the bank may be financially vulnerable if the local economy
Next: declines,
27.4 How Banks so Money
Create
that many people are unable to make their payments. But if a bank sells its local
loans, and then buys a mortgage-backed security based on home loans in many parts
of the country, it can avoid being exposed to local financial risks. (In the simple ex‐
ample in the text, banks just own “bonds.” In reality, banks can own a number of fin‐
ancial instruments, as long as these financial investments are safe enough to satisfy
the government bank regulators.) From the standpoint of a local homebuyer, securitiz‐
ation offers the benefit that a local bank does not need to have lots of extra funds to
make a loan, because the bank is only planning to hold that loan for a short time, be‐
fore selling the loan so that it can be pooled into a financial security.
But securitization also offers one potentially large disadvantage. If a bank is going to
hold a mortgage loan as an asset, the bank has an incentive to scrutinize the borrower
carefully to ensure that the loan is likely to be repaid. However, a bank that is going to
sell the loan may be less careful in making the loan in the first place. The bank will be
more willing to make what are called “subprime loans,” which are loans that have
characteristics like low or zero down-payment, little scrutiny of whether the borrower
has a reliable income, and sometimes low payments for the first year or two that will
be followed by much higher payments after that. Some subprime loans made in the
mid-2000s were later dubbed NINJA loans: loans made even though the borrower had
demonstrated No Income, No Job, or Assets.
These subprime loans were typically sold and turned into financial securities—but
with a twist. The idea was that if losses occurred on these mortgage-backed securities,
certain investors would agree to take the first, say, 5% of such losses. Other investors
would agree to take, say, the next 5% of losses. By this approach, still other investors
would not need to take any losses unless these mortgage-backed financial securities
lost 25% or 30% or more of their total value. These complex securities, along with
other economic factors, encouraged a large expansion of subprime loans in the mid-
2000s.
The economic stage was now set for a banking crisis. Banks thought they were buy‐
ing only ultra-safe securities, because even though the securities were ultimately
backed by risky subprime mortgages, the banks only invested in the part of those se‐
curities where they were protected from small or moderate levels of losses. But as
housing prices fell after 2007, and the deepening recession made it harder for many
people to make their mortgage payments, many banks found that their mortgage-
backed financial assets could end up being worth much less than
Next: 27.4they
Howhad expected—
Banks Create Money
and so the banks were staring bankruptcy in the face. In the 2008–2011 period, 318
banks failed in the United States.
The risk of an unexpectedly high level of loan defaults can be especially difficult for banks be‐
cause a bank’s liabilities, namely the deposits of its customers, can be withdrawn 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—a bank’s liabilities can be withdrawn in the short
term while its assets are repaid in the long term—can cause severe problems for a bank. For ex‐
ample, 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 were made 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 lend‐
ing 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, diversifica‐
tion of loans can help banks to keep a positive net worth. However, if a widespread recession oc‐
curs 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 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 a higher share of loans will not be repaid in tough eco‐
nomic times.
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 finan‐
cial intermediaries; that is, they operate between savers who supply financial capital and borrow‐
ers 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 be‐
ing re-deposited in banks, and the banks making additional loans will create money in the
economy.
Self-Check Questions
Explain why the money listed under assets on a bank balance sheet may not actually be in
the bank?
Review Questions
1. Why
Previous: 27.2isMeasuring
a bank called a Currency,
Money: financialM1,
intermediary?
and M2
2. What does a balance sheet show? Next: 27.4 How Banks Create Money
3. What are the assets of a bank? What are its liabilities?

4. How do you calculate the net worth of a bank?
5. How can a bank end up with negative net worth?

6. What is the asset-liability time mismatch that all banks face?
7. What is the risk if a bank does not diversify its loans?
Critical Thinking Questions
Explain the difference between how you would characterize bank deposits and loans as as‐
sets and liabilities on your own personal balance sheet and how a bank would characterize
deposits and loans as assets and liabilities on its balance sheet.
Problems
A bank has deposits of $400. It holds reserves of $50. It has purchased government bonds
worth $70. It has made loans of $500. Set up a T-account balance sheet for the bank, with as‐
sets and liabilities, and calculate the bank’s net worth.
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
Previous: 27.2Reserve. 2013.
Measuring “Ending
Money: `Too
Currency, BigM2
M1, and 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.
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 af‐
fected 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
Solutions
Answers to Self-Check Questions
A bank’s assets include cash held in their vaults, but assets also include monies that the bank
holds at the Federal Reserve Bank (called “reserves”), loans that are made to customers, and
bonds.
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10/2/21, 10:23 AM 27.

3 The Role of Banks – Principles of Economics

Home Read Sign in

Chapter 27. Money and Banking

By the end of this section, you will be able to:

Explain how banks act as intermediaries between savers and borrowers

Previous: 27.2 Measuring Money: Currency, M1, and M2

Banks as Financial Intermediaries

Figure 1. Banks as Financial Intermediaries. Banks act as financial intermediaries

A Bank’s Balance Sheet

Previous: 27.2 Measuring Money: Currency, M1, and M2

Next: 27.4 How Banks Create Money

Figure 2. A Balance Sheet for the Safe and Secure Bank.

How Banks Go Bankrupt

What led to the financial crisis of 2008–2009?

Previous: 27.2 Measuring

Key Concepts and Summary

3. What are the assets of a bank? What are its liabilities?

5. How can a bank end up with negative net worth?

7. What is the risk if a bank does not diversify its loans?

Critical Thinking Questions

Next: 27.4 How Banks Create Money

Late”. Accessed March 4, 2015.

asset–liability time mismatch

Answers to Self-Check Questions

Previous: 27.2 Measuring Money: Currency, M1, and M2

Next: 27.4 How Banks Create Money

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Principles of Economics by Rice

Guides and Tutorials | Contact

Previous: 27.2 Measuring Money: Currency, M1, and M2

Next: 27.4 How Banks Create Money

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