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Dictionary of Economics

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This is "What Do Banks Do?" from our Principles of Economics: Macroeconomics course.

Some people want to save and invest, others want to borrow. Sometimes, savers and borrowers link up directly. But most times, they don’t know each other. So they rely on institutions that bridge them together. These bridges are called financial intermediaries, and this video will show you one kind—banks.

How do banks operate?

On the savings side, they attract depositors by paying interest on deposits. On the borrowing side, banks make loans, for which they charge interest. The key to a bank’s profit is in charging a higher interest for loans than the interest paid out to depositors. Of course, to make sure that loans are as productive as possible, banks have specialized staff and systems for evaluating loan applications.

That sort of due diligence, and specialization is central to what a bank does. Not only does a bank coordinate the savings of many, but it also undertakes the task of studying borrowers in order to determine the most qualified. And then, to further minimize risk, a bank will spread its money out across a whole portfolio of loans. Thus, if one loan goes bad, the bank won’t go bankrupt.

In this way, you can see how banks provide valuable services—they allow you to earn interest on your savings, while also turning those savings into loans, which help economic growth.

Notice though, that as a depositor, your savings won’t just rest in a vault. But then, what happens when you decide to make a withdrawal? Banks account for that by having reserves. Banks keep an eye on their reserves so they can cover the withdrawals of various depositors. Predictably, problems arise, when there aren’t enough reserves to cover withdrawals. In the words of our previous video, that’s one kind of failed intermediation.

Teacher Resources


Some people want to save and invest; others want to borrow. Sometimes these people -- they interact directly -- say, you borrow money from your parents. But typically, savers and borrowers -- they don't even know one another. So, a variety of institutions act as bridges to link savers to borrowers. In this video, we'll cover banks.


Banks attract savings from many different depositors by paying interest on deposits. And the banks make loans for which they charge interest. Banks earn a profit by charging a higher interest rate on the money that they lend, than they pay on the deposits that they receive. They earn this money by being a valuable middleman. Not only do the banks link savers with borrowers, they evaluate the quality of the borrowers, so that the loans are productive. Imagine that Howard Schultz came looking for a loan of a million dollars to buy a coffee company called Starbucks and transform it into something new.


Now maybe you're rich and you can afford to lend him all the money. But if his venture failed and he couldn't repay the loan, it's going to be a pretty big hit on your wallet. So instead, perhaps you and 99 of your friends decide to share the risk, and you each lend him $10,000. Well, it would be extremely time-consuming and costly for all 100 of you to investigate the Starbucks business plan and decide whether to lend your $10,000. It would make more sense to appoint a single person to do the due diligence to evaluate the business on behalf of everyone. And maybe you would appoint someone who already was an expert in, say, the market for coffee. That's exactly what a bank does.


It coordinates the lending of everyone's deposits, and a bank has specialized people and systems to evaluate loan applications. The bank scans the landscape, looking for the most qualified businesses and individuals to receive loans. By pooling the savings of many different individuals, the bank can make large loans, and also spread the risk across a whole portfolio of loans. That means that even if a few loans go bad, it won't bankrupt the bank. So instead of one person lending Schultz a million dollars, it's more like a 100,000 people lending Schultz $10 each, and also lending a similar amount to thousands of other entrepreneurs.


Notice that since deposits are being lent out, that means that your savings doesn't just sit in the vault waiting for the day that you want to make a withdrawal. Bank managers pay careful attention to reserve enough cash on hand to fund those depositors that do come calling, while lending out the rest of the deposits to make productive loans. The cash that banks keep on hand -- that's called reserves, and as we'll see in a later video, things can fall apart pretty quickly if banks don't have enough reserves to pay back depositors when they do come calling.


So, let's sum up. Banks provide valuable middleman services to make our lives simpler. We deposit money in the bank and we earn interest without having to worry very much about risk, and without having to give much thought to how our savings are flowing into productive loans and helping to boost economic growth throughout the economy.


Next up, we'll turn to another financial intermediary: stock markets. And we'll explain how stock markets turn savings into investment.


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