Banks

Banks play an important role in economics. In this unit, the functions of both commercial banks and
central banks are explained. Two other types of banks are briefly explored, and the issue of independent
banks is discussed.

Banking

Banking is a major industry in a number of countries. It helps people to borrow and lend and carry out a
range of other financial activities. By doing this, it enables more efficient use of resources and
encourages the growth of output of economies.

commercial Banks

Commercial banks are also called joint stock banks, retail or high street banks. All four names tell us
something about them. Commercial indicates that they are business organizations which seek to make a
profit. Joint stock means that they have limited liability and are in the private sector. In most countries,
the majority of banks are public limited companies but there is usually a number of private limited banks
also. Retail suggests that they are selling the public something - in this case banking services. High street
tells us that these banks are found in most of the towns and cities. They are the banks we are most
familiar with.

Main Functions of Commercial Banks

The three main and traditional functions of commercial banks are to accept deposits, to lend and to
enable customers to make payments. The first function enables customers to keep their money in a safe
place. Deposits can be made into two types of bank accounts. One is a current account, sometimes
called a demand account. There is easy and immediate access to money in this type of account but
usually interest is not paid on money held in such an account. Customers use current accounts mainly to
receive and make payments. The other type of account is a deposit or time account. A period of notice
usually has to be given before money can be withdrawn from this account. Interest is paid on any money
held in a deposit account and customers use deposit accounts as a way of saving. Banks make most of
their profit by charging higher interest from borrowers than that paid on the money held with the
banks. There are two main ways of borrowing from a bank. One is in the form of an overdraft. This
enables a customer to spend more than what is in her or his account, up to an agreed limit. Interest is
charged on the amount borrowed. This can be a relatively expensive way of borrowing and is mainly
used to cover short term gaps between expenses and income. The other way of borrowing is by taking a
loan. This is usually for a particular purpose and for a particular period of time. Interest is charged on the
full amount of the loan but the rate of interest is likely to be lower than that on an overdraft. A
customer may be asked to provide some form of security, known as collateral, when taking a loan. This
is to ensure that if the loan is not repaid, the asset given as collateral can be sold and the money
recovered. In practice, though, banks try to avoid doing this by checking very carefully whether the
person seeking a loan will be able to repay it. In the case of a firm, this is likely to involve a scrutiny of
the firm's accounts and business plan.

The first two functions of banks, effectively borrowing from their customers and lending to them, means
that they act as financial intermediaries. They accept deposits from those with more money than they
currently want to spend and lend it to those with an immediate desire to spend more money than they
have at hand. In other words, they channel money from lenders to borrowers.

The third main function that banks carry out is to enable their customers receive and make payments.
This is referred to as acting as agents for payments and providing money transmission services. There is
now a range of ways in which people can receive money and make payments out of their accounts.
These include cheques, standing orders, direct debits, debit/credit cards and online banking.

Other Functions of Commercial Banks

Over a period of time, commercial banks have built up a range of other services that they offer their
customers. Most commercial banks now provide travelers cheques and change foreign currency.
Customers can leave important documents, such as house deeds and small valuables with their banks
and the banks are also likely to be willing to help with the administration of customers' wills. They can
provide advice and help with a number of financial matters, such as completion of tax forms and the
purchase and sale of shares. Many banks also now sell insurance and offer a wide variety of savings
accounts, with a range of conditions and interest rates. Some now offer mortgage loans, which are loans
to buy houses.

Aims of Commercial Banks

The key aim of a commercial bank is to make a profit for its shareholders. The main way it does this, is
by giving loans (which bankers often refer to as advances). Another aim which can conflict with the key
aim is what is known as liquidity. Banks have to ensure that they can meet their customers’ requests to
withdraw money from their accounts. To do this, banks have to keep a certain amount of, what are
called, liquid assets. These are items which can be turned into cash quickly and without incurring loss.
Banks earn most of the interest by giving long term loans. However, if they tie up all their money in such
loans, they would not be able to pay out cash to the customers requesting it. They have to balance
Profitability and liquidity — having some assets earning high interest but being illiquid and having others
earning low or no interest but being liquid.

Other Banks

Two other types of banks are investment banks (sometimes called merchant banks) and savings banks.
Merchant banks act as bankers, mainly to large firms. They accept deposits from them and lend to them.
They manage the issue of new shares and buy and sell shares and other financial securities on behalf of
their customers. They also give advice on, and help with, mergers and takeovers.

Savings banks are found across the world. As their name suggests, their aim is to encourage savings.
They particularly try to encourage people pith relatively low incomes to save. They make it easy to
withdraw with few penalties. A large proportion of the money lent savings banks goes to the
government.

Central Banks
A central bank is the single most important and influential bank in the country or, in the case of the
European Union, the region. The three most well-known central banks in the world are probably the
Federal Reserve Bank of USA (often called the Fed), the European central Bank (ECB) and the Bank of
England. Central banks are owned by governments and are responsible to them.

The Functions of a Central Bank

The functions of a central bank include:

 Acts as a banker to the government. Tax revenue is paid into the government’s account at the
central bank and payments by the government for goods and services are made out of this
account.
 Operates as a banker to the commercial banks. Holding accounts at the central bank enables
commercial banks to settle debts between each other and to draw out cash, if their own
customers are taking more cash from their branches than usual.
 Acts as a lender of last resort. This means it will lend to banks which are temporarily short of
cash.
 Manages the national debt. The national debt is the total amount the government owes. Over
time, government debt tends to build up. The central bank carries out borrowing on behalf of
the government by issuing government securities, for instance government bonds, pays interest
on these and repays them when they fall due.
 Holds the country’s reserves of foreign currency and gold. The central bank keeps foreign
currency and gold to influence the exchange rate.
 Issues bank notes. The central bank is responsible for printing notes and destroying notes
which are no longer suitable for circulation. It also authorises the minting of coins.
 Implements the government’s monetary policy with the prime aim of keeping inflation low
and steady. This involves controlling the money supply and influencing interest rates
throughout the economy, by changing the interest rate it charges on its loans. The government
may instruct the central bank to increase or decrease the money supply. In some cases, central
banks implements interest rate changes decided by their respective governments. In other
cases, central banks have been given the responsibility to set interest rates.
 Controls the banking system. Many central banks play a key role in regulating and supervising
the banking system.
 Represents the government at meetings with other central banks and international
organisations such as the World Bank and the International Monetary Fund.

Indespendence of Central Banks

A number of governments have given their central banks the authority to decide the rate of
interest. The governments still decide the aims of their central banks and give them a target for
inflation. The Bank of England, for instance, is instructed to use the rate of interest to achieve
an inflation target of 2%. If it thinks that there is a danger that the price level will increase by
more than 2%, it will raise the rate of interest whereas if it thinks it will fall below 2%, it will
lower the rate of interest.
There are a number of advantages in allowing the central bank to decide the rate of interest for
banking. Unlike a national government, a central bank is unlikely to be tempted to lower the
rate of interest to win public support. Most central banks also have extensive knowledge of the
banking system and the appropriate rate of interest to set.