 Ask
Dr. Econ
July 2001
What Is the Economic Function of a Bank?
Commercial banks play an important role in the financial system and the
economy. As a key component of the financial system, banks allocate funds
from savers to borrowers in an efficient manner. They provide specialized
financial services, which reduce the cost of obtaining information about
both savings and borrowing opportunities. These financial services help
to make the overall economy more efficient.
Imagine a World Without Banks
One way to answer your question is to imagine, for a moment, a world
without banking institutions, and then to ask yourself a few questions.
This is not just an academic exercise; many former eastern-block nations
began facing this question when they began to create financial markets
and develop market-oriented banks and other financial institutions.
If there were no banks…
- Where would you go to borrow money?
- What would you do with your savings?
- Would you be able to borrow (save) as much as you need, when you need
it, in a form that would be convenient for you?
- What risks might you face as a saver (borrower)?
How Banks Work
Banks operate by borrowing funds-usually by accepting deposits or by
borrowing in the money markets. Banks borrow from individuals, businesses,
financial institutions, and governments with surplus funds (savings).
They then use those deposits and borrowed funds (liabilities of the bank)
to make loans or to purchase securities (assets of the bank). Banks make
these loans to businesses, other financial institutions, individuals,
and governments (that need the funds for investments or other purposes).
Interest rates provide the price signals for borrowers, lenders, and banks.
Through the process of taking deposits, making loans, and responding
to interest rate signals, the banking system helps channel funds from
savers to borrowers in an efficient manner. Savers range from an individual
with a $1,000 certificate of deposit to a corporation with millions of
dollars in temporary savings. Banks also service a wide array of borrowers,
from an individual who takes a loan of $100 on a credit card to a major
corporation financing a billion-dollar corporate merger.
The table below provides a June 2001 snapshot of the balance sheet for
the entire U.S. commercial banking industry. It shows that the bulk of
banks' sources of funds comes from deposits - checking, savings, money
market deposit accounts, and time certificates. The most common uses of
these funds are to make real estate and commercial and industrial loans.
Individual banks' asset and liability composition may vary widely from
the industry figures, because some institutions provide specialized or
limited banking services.
Banks Are Only One Type of Financial Intermediary
Finally, the U.S. financial services industry and financial markets are
highly developed. In recent decades, many new products and services have
been created, as well as new financial instruments and institutions. Today,
in addition to banks, there are several other important types of financial
intermediaries. These include savings institutions, credit unions, insurance
companies, mutual funds, pension funds, finance companies, and real estate
investment trusts (REITS).
Banks' assets have grown in recent decades in absolute terms; however,
banks have tended to lose market share to even faster growing intermediaries
such as pension funds and mutual funds. Still, banks continue to account
for a significant share-over 23 percent-of the assets of all financial
intermediaries at the end of year 2000, as the chart below shows.
Let me also suggest some more advanced reading materials:
What's Different about Banks--Still? Milton Marquis.
Federal Reserve Bank of San Francisco. FRBSF Economic Letter. No. 2001-09.
Apr. 6, 2001. (8-22-01)
http://www.frbsf.org/publications/economics/letter/2001/el2001-09.html
Are Banks Special? A Revisitation. E. Gerald Corrigan.
Federal Reserve Bank of Minneapolis. The Region. No. v. 14, no 1. Mar,
2000 , p. 14-17. (8-22-01)
http://www.minneapolisfed.org/pubs/region/00-03/corrigan.cfm
Personal Financial
Education, FederalReserveEducation.org, 2003
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