Banks and Financial
Background to Banking
International Money and Banking: The FED
Banking Crises and their Consequences
Why start with banks?
Banks play a key role in the financial system and in
And, as we will see, monetary policy works largely
through the influence that it has on the banking
The banking sector played a key role in the
financial market turmoil that generated the severe
global recession of 2008-2009.
Banking problems have also played a key role in
the economic problems that continue to afflict the
So, we will start by explaining how banks emerged,
how they work and the important role they play in
Some History: Early Banking
Once coin and paper money replaced barter (more on this
later) the question arose of where people stored their money. You could keep it all at home (perhaps under the mattress)
but this would not be very safe.
Banks began as safe depositories for cash: You had your own
separate locker in the bank’s vaults for your cash.
And you could go to the bank when you needed to get out
But why waste your time going yourself? Why not pay your
bills with a special piece of paper (clearly identifiable as coming from you) that says the
◦ bearer is entitled to payment of cash from your account? And so the cheque was born!
After a while, most people that you were paying with a
cheque weren’t exchanging it for cash but instead instructing the bank to move cash from your locker to theirs.
History: Bank Clearing House
• Suppose Bank A’s depositors look to have their accounts credited by €10 million by presenting cheques from Bank
B’s depositors. At the same time, Bank B’s depositors look to be credited €9 million from Bank A depositors.
• We could send €19 million in cash around town to the
• But the couriers could get held up by bandits!
• Better idea: Settle accounts at a clearinghouse bank. At end of the day, the clearinghouse orders the transfer of
€1 million from B’s vaults to A’s. Actually, you could mingle all the cash together and the clearinghouse just
deducts €1 million from the ledger entry for Bank B’s
account and adds it Bank A’s. But all deposits are still
fully backed up by cash in the vaults.
• These clearinghouses were the forerunners of today’s
Financial Intermediaries: Why do
we need them?
Question To Consider: Why can’t those with savings just lend them directly to those who want to borrow?
Many savers deposit small amounts. Someone looking for
a big loan can get it from a bank rather than having to look for a saver with the correct amount of funds.
2. Risk Diversification
Savers lending their funds to an individual borrower face idiosyncratic risk. If that borrower fails to pay back, they lose everything. The bank can lend to many borrowers, take its cut, and pass a safe return back to the saver.
3. Maturity Transformation
If I want to have my savings back when I want them, I won’t lend the money for one year or more, as borrowers may want. Banks can make these long-term loans, knowing that (hopefully) each period, only some of its depositors will want their money back.
4. Information Processing
Banks can specialize in screening borrowers, processing and sharing information, and in writing sophisticated debt contracts.
Intermediaries help you do
There are other financial intermediaries apart from banks and insurance companies. Pension funds, mutual funds and private equity funds are three examples that play important roles in the economy.
Financial intermediation plays a crucial role in modern economies. 1 Buying a House: Without financial intermediation, you could only obtain the money to buy a house by saving all the...
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