Commercial banks seem like an economic curse during a financial crisis, although during an economic boom they seem too good to be true. By accepting deposits and then loaning out money, banks are an integral part of the financial system because they essentially create money. Using economic equations, we can calculate the effects of different reserve requirements and see this principle in action. Fundamentally, commercial banks’ function is to collect savings and to provide capital for new investment, although this is a strategy not without risk.
Banking activities have been occurring since the rise of humanity at the most basic level, although it is generally the 12th and 13th century Tuscan/Italian merchants that are given credit for developing the financial instruments of modern banking, especially bills of exchange, as Edwin Hunt and James Murray detail in “A History of Business in Medieval Europe, 1200-1550.” The origin of the word “bank” comes from the Italian for the desks used by Florentine bankers, although word lineage can be traced back further to ancient Rome. Moneylenders would set up stalls on long benches called
The main idea behind banks is the idea of “cost of capital.” Theoretically, economists attach a productive price to each unit that might be considered capital, or something that can be invested to create a product, sometimes described as a percentage annual yield. For example, with one unit of stock on the stock market, the average annual return might be 8 percent. This means that since the rate of return for capital has the potential of being 8 percent, this is also the “opportunity cost” associated with letting your money sit around and do nothing. Banks are designed to accept deposits and pay out less than the cost of capital. (Savings accounts typically earn less than 2 percent a year, which loses out to inflation, more in the range of 2 percent to 6 percent normally, while loans typically go out for interest rates higher than this.)
The bank aggregates deposits and lends out money because it is interested in the bottom line–it can make money by using small deposits to make large loans because of the different prices associated with each activity. For the consumer, though, this might not be a bad deal. Free market economists believe that all voluntary transactions are beneficial, and this can be debated, but there is an economic advantage to being able to get loans. Loans mean that money can flow to where it is going to do the most good. People’s savings can come together and be used to finance business activities for a start-up, for example, rather than just sitting under people’s mattresses, which is good for the savers (deposit interest) and the business owner (gets the capital he needed).
Part of the complexity with this is that banks, when they take savings and lend them out as loans, actually create money. An example is most useful to understand this principle. When you lend $1,000 to the bank as a deposit in a savings account, it keeps only a portion of it actually at the bank–not everyone who has deposited in the bank is going to draw his money out at the same time (usually: bank runs are what develop when that occurs). A common reserve requirement is 10 percent of the deposit, so a typical bank might loan out $900 of that $1,000. This means, though, that now there is a total of $1900 in the entire system. In other words, the bank has increased the amount of cash actually in the rotation in the money supply.
Economists take this idea further and use the reserve requirement to calculate the theoretical money multiplier, the number by which bank activities multiply the money supply. Using the equation 1/r = M where r is the reserve requirement expressed as a percentage and M is the money multiplier, a 10 percent reserve requirement theoretically means that the money multiplier will be 10. In other words, if banks hold about 10 percent of the funds that you give them to deal with everyday banking activities such as withdrawals from savings and expenditures from your checking account, they increased the money supply by 10 times. The function of banks, then, is multifaceted. To banks, the goal is to earn profits by aggregating savings and making loans; to the rest of us, the function of banks is to aggregate capital by this leverage of money creation and loaning.