Showing posts with label Role of banks. Show all posts
Showing posts with label Role of banks. Show all posts
Commercial banks
Commercial banking relates to deposit-taking and lending. They provide services to corporate and individual customers.
Some commercial banks have investment banking arms e.g. Bank of America Merrill Lynch
Commercial banks make their profits by taking small, short-term, relatively liquid deposits from retail savers and transforming these into larger, longer maturity loans e.g. in the form of business loans and mortgages
Other services of commercial banks include providing debit and credit cards, private banking, money custody and guarantees, cash management and settlement e.g. through cheque accounts, as well as trade finance.
Main functions of a commercial bank
- Commercial banks provide retail banking services to household and business customers
- They are licensed deposit-takers – providing a range of savings accounts
- They are licensed to lend money (and thereby “create” money e.g. in the form of bank loans, overdrafts and mortgages
- Commercial banks are profit-seeking
- A commercial bank’s business model relies on receiving a higher interest rate on the loans (or other assets) than the rate it pays out on its deposits (or other liabilities)
- This “spread” on their assets and liabilities is used to pay the operating expenses of a bank and also to make a profit
Objectives of a Commercial Bank
- Commercial banks are profit-seeking businesses
- Their main objective is to achieve a profit by earning more from the interest charged on loans than the interest paid to depositors
- Commercial banks can also make profits from providing other services such as deposit security, currency trading, business advice, cheque and credit-card processing
- Most commercial banks are privately owned but some in the UK are part or majority-owned by the UK government
- The UK government owns 73% of Royal Bank of Scotland
- It also owns a 10% minority stake in Lloyds Banking Group
Creating credit
The Old Textbook View of Banks and Credit Creation
- Banks take deposits of money from savers and lend it to borrowers
- Banks then lend money to businesses, thus allocating funds between alternative investment projects
How Modern Commercial Banks Create Credit
- Banks create credit by extending loans to businesses and households – pure and simple!
- They do not need to attract deposits from savers to do this
- When a bank makes a loan, for example to someone taking out a mortgage to buy a house, or a business taking out a loan to finance their expansion it credits their bank account with a bank deposit of the size of the loan/mortgage.
At that moment, new money is created!
“Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy.”
(Source: Bank of England)
Quantitative Easing
Most of the money in our economy is created by banks when they make loans. But in the aftermath of the financial crisis, banks stopped lending, and so stopped creating new money.
At the same time, people were still repaying their loans, meaning money was being ‘destroyed‘ and the total amount of money in the economy was shrinking. To counter this and to ‘replace’ the money that banks were destroying, the Bank of England created £375 billion of new money through a scheme called Quantitative Easing (QE). As the Governor of the Bank of England said at the time:
“[A] damaged banking system means that today banks aren’t creating enough money. We have to do it for them.”
- Sir Mervyn King, then-Governor of the Bank of England, speaking in 2012
How does Quantitative Easing work?
In the press, QE was generally presented as “The Bank of England prints money and lends this to banks so that they can increase their lending into the economy”, but this is completely inaccurate.
In reality, through QE the Bank of England purchased financial assets – almost exclusively government bonds – from pension funds and insurance companies. It paid for these bonds by creating new central bank reserves – the type of money that bank use to pay each other. The pension funds would sell the bonds to the Bank of England and in exchange, they would receive deposits (money) in an account at one of the major banks, say RBS. RBS would end up with the new deposit (a liability from it to the pension fund), and a new asset – central bank reserves at the Bank of England.
Quantitative Easing therefore simultaneously increased a) the amount of central bank money, which is used in the system that banks use to pay each other, and b) the amount of commercial bank money (deposits in the bank accounts of people and companies). Only the deposits can actually be spent in the real economy, as central bank reserves are just for internal use between banks and the Bank of England.
(See the further reading section below for a more in-depth explanation of the process).
Why was Quantitative Easing ineffective in boosting GDP?
The problem was that the money created through QE was used to buy government bonds from the financial markets (pension funds and insurance companies). The newly created money therefore went directly into the financial markets, boosting bond and stock markets nearly to their highest level in history. The Bank of England itself estimates that QE boosted bond and share prices by around 20% (Source). In theory, this should make people feel wealthier so that they spend more. However, 40% of the stock market is owned by the wealthiest 5% of the population, so while most families saw no benefit from Quantitative Easing, the richest 5% of households would have each been up to £128,000 better off (according to Strategic Quantitative Easing, p28, by the New Economics Foundation).
Very little of the money created through QE boosted the real (non-financial) economy. The Bank of England estimates that the £375 billion of QE led to 1.5-2% growth in GDP. In other words, through QE it takes £375 billion of new money just to create £23-28bn billion of extra spending in the real economy. It’s incredibly ineffective, because it relies on boosting the wealth of the already-wealthy and hoping that they increase their spending. In other words, it relies on a ‘trickle down’ theory of wealth.
A far more effective way to boost the economy would have been for the Bank of England to create money, grant it directly to the government, and allow the government to spend it directly into the real economy. This is the approach we have advocated in our paper “Sovereign Money: Paving the Way for a Sustainable Recovery“, and pound for pound of stimulus, it would be many times more effective than Quantitative Easing.
How central banks create money
Let’s start by seeing how the Bank of England creates the electronic money that banks use to make payments to other banks. Central bank reserves are one of the three types of money, and are created by the central bank in order to facilitate payments between commercial banks.
In the following example we will show how the central bank creates central bank reserves for use by a commercial bank, in this case RBS. Initially the bank of England’s balance sheet appears as so (this is a simplified example where we’ve ignored everything except this particular transaction):
How money is destroyed
As we have seen, when banks make loans, new money (in the form of numbers in somebody’s bank account) is created. What happens when these loans are repaid? Exactly the opposite – money is destroyed.
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Debt
The Problem
1. Banks create new money when people go into debt
When you take out a loan, new money is created. As people borrow more, more new money comes into the economy. All the extra spending this newly created money funds gives people the impression the economy is doing well, which encourages them to borrow even more. As the debt goes up, so does the amount of money.
2. For every pound of money, there’s a pound of debt
Because banks create money when people borrow, for every pound of money in the economy there will be a pound of debt. If there’s £100 in your bank account, someone else must be £100 in debt. Across the whole economy there will be as much debt as money.1
3. If we want more money in the economy, we have to go further into debt
If we need to get more money into the economy – for example, during a recession – then we have to go further into debt to the banks. This is why the government is desperate to get banks lending again: if banks start lending more, they’ll create more new money in the process, and the people who borrowed will spend this new money.
But if the financial crisis was caused by people having too much debt, how can the solution be for people to take on more debt?
4. If we try to pay off debt, then money disappears
When you pay down your debts, the money that leaves your bank account doesn’t go to anyone else – it just disappears. This is because loan repayments are just the opposite process to money creation: banks create money when they make new loans, and effectively ‘destroy’ money when they repay loans.
So when lots of people try to pay down their debts at the same time, money disappears from the economy. As a result of there being less money and less new lending spending slows down. When this happens, it’s like draining the oil from the engine of a car: pretty soon, everything stops working.
This means that it’s almost impossible to reduce our debts without causing a recession. And you personally can only pay off your debts using money that was created when someone else went into debt. This creates a debt trap, where over time the level of personal debt in the economy has to keep growing.
Creating money
Now lets look at how ‘commercial’ or high-street banks create the type of money that appears in your bank account
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How banks create money
Most of the money in our economy is created by banks, in the form of bank deposits – the numbers that appear in your account. Banks create new money whenever they make loans. 97% of the money in the economy today is created by banks, whilst just 3% is created by the government. This short video explains:
Watch these important videos
Watch these important videos
The role of banks in the economy
The bank is able to take the deposits, which start out as liabilities, and turn them into assets. This is accomplished by the banks investing the money that is deposited in a way that gains them higher returns than what is being paid to the depositor's account when they receive interest. This allows the banks to loan money and still have the funding to cover any withdrawals that an account holder may make
Also read this article
Also read this article
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.
Central banks - key terms
Central banks - key terms
Central bank
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The monetary authority and major regulatory bank in a country. Its functions include issuing and managing the country's currency
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Central bank intervention
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When a central bank enters the foreign exchange market to buy or sell currency in order to influence exchange rates
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Base rate
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The rate of interest set by the Bank of England, being in effect the lowest rate that lenders will charge interest at.
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Basis point
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One hundred basis points make up a percentage point, so an interest rate cut of 25 basis points might take the rate from 0.5% to 0.25%
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Inflation target
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The target set for the annual rate of consumer price inflation – for the UK the target is CPI inflation of 2%
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Base Money
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Currency (banknotes and coins) in circulation plus minimum reserves credit institutions are required/choose to hold with the central bank
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Bond Market
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The market for interest-bearing securities (with either a fixed or a floating rate and with a maturity of at least one year) that companies and governments issue to raise capital for investment.
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Financial stability
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The condition in which the financial system – comprising financial intermediaries, markets and market infrastructures – is capable of withstanding shocks and the unravelling of financial imbalances
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Central banks
Main functions of a central bank
- Monetary policy function
- Setting of the main monetary policy interest rate
- Quantitative easing
- Exchange rate intervention (managed/fixed currency systems)
- Financial stability & regulatory function
- Supervision of the wider financial system
- Prudential policies designed to maintain financial stability
- Policy operation functions
- Lender of last resort to the banking system
- Managing liquidity in the commercial banking system
- Financial infrastructure provision function
- Overseeing the payments systems used by banks / retailers / credit card companies
- Debt management
- Handling the issue and redemption of issues of government debt
Current objectives of UK monetary policy
Monetary stability means stable prices and confidence in the currency. Stable prices are defined by the Government's inflation target, which the Bank seeks to meet through the decisions taken by the Monetary Policy Committee (MPC).
The Bank of England has been independent of the UK government since May 1997. The current governor is Mark Carney.
An Era of Extraordinary Monetary Policy
Central Banks of many advanced countries have made extraordinary sustained use of expansionary monetary policy in recent years:
Policy interest rates approaching the zero bound and remaining there (e.g. 0.5% in the UK and in the USA)
Negative policy rates in some countries (e.g. Japan, Sweden, Denmark and Switzerland)
Huge rise in the scale of quantitative easing (QE) designed to increase the base supply of money
Increasing use of exchange rate (currency) intervention as an instrument of monetary policy (i.e. a move towards managed floating)
Banking profitability
Major UK commercial banks’ profitability has fallen quite significantly since the global financial crisis.
Low profitability reduces the ability of commercial banks to generate fresh capital internally and reduces their resilience to future domestic and external shocks.
Key factors:
- Significant rise in regulatory costs
- Lower interest rates on loans has reduced trading incomes – for example, a steep fall in mortgage rates
- Financial cost of previous misconduct - UK banks put side another £15 billion relating to past misconduct in their 2015 results, reducing pre-tax profits by around 50%. This includes the costs of miss-selling PPI
- Commercial banks are now making less money from investment banking services such as currency & commodities trading. Retail banking is traditionally less profitable than the higher risk investment banking side
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