Apr 8, 2009

Basics Of How Banks and Loans Work

In the old days, when the frontier of America was being settled, people would make, grow or barter for everything they needed. For example; a farmer would grow his crop, make his own well/fences and offer what he had to someone else in exchange for something he wanted from the other person. That is how trade began with the Native Americans. Traders would take fur pelts and in exchange would give them horses or guns etc. This process of exchange is called barter.

Before we had money we bartered for what we wanted. The problem with barter is that we have to have what the other wants in order to get what we want.

Later gold became a standard of exchange. So now if we wanted a horse and had a cow we didn't have to find someone who had a horse and wanted a cow to make an exchange - we could just sell the horse, get some gold and go buy a cow. That is how money makes it easier to trade.

As the amount of gold in an economy grew a new fad developed. People would put their gold in a safe place with an institution (like a jeweler) and the jeweler would give the person a note saying how much gold the person had kept with them. Since it was risky to carry alot of gold around (as it was heavy) people just started using their notes from the big jewelers as proof of how much gold they had and simply transferring over the note to someone in exchange for what they wanted. This is how paper money was born.

After a while a jewelers noticed that people didn't withdraw most of the gold that they kept with them for safety. The people would just pass around their notes. On average a person would take only 30 percent of the gold that was kept with them (just an example).

So what the jewelers did was assume that people would only take out 30% of what they put in which means that for every 100 dollars worth of gold deposited only 30 dollars of it would ever be taken out. So these jewelers started keeping 30 dollars of every gold deposit aside (called a "reserve" or "capital reserve") and would loan out the remaining 70 dollars to people at an interest rate.

The person who took out the loan would - over time - pay back the gold he borrowed plus the interest rate for the gold he borrowed. The person borrowing doesn't mind as he gets his money to do what he wants and pays a little extra for the ability to get the money he needs. The jeweler is taking on risk by giving out the loan and the interest is the profit made for taking on the risk. This is how loans came to be.

The process of loaning only works as long as people trust the jeweler to keep their gold safe. If people begin to think that the jeweler may have squandered their money away then of course they will want their money back. If one person wants all their money back that is not a problem. The jeweler has enough gold from many people to easily pay back one or two or even three people in full. However, if everyone wants thier gold back then that is a problem as the jeweler kept only 30 percent of it and loaned out 70 percent. In other words, the jeweler doesn't have the gold it has been loaned out - thus they can't pay back everybody. If everyone can't get their money back they panic and start demanding their money. This is how a bank run starts.

If people don't get their money back then they lose trust in the jeweler and will not keep their gold with the jeweler and the jeweler will go out of business.

All of the above assumes ONE jeweler. But suppose there are two jewelers?

Then if one jeweler lends out 70 dollars of gold and the person borrowing the gold puts it for safe keeping in another jewelers safe house THEN the other jeweler will do the same thing as the first one. 30% of the seventy dollars is kept and the rest is loaned out. Thus the money circulates in the economy and 'creates' more money as people work to pay back loans. This is a factor of economic growth.

Here is how a modern bank works (image from here):

By paying interest people want to put money in. This gives the bankers money to lend out and they get interest from taking on the risk. They charge more interest on loans than they give to depositors and thus they make a profit. For the person putting in the money in the bank they have safety for their money and for the person taking out the loan they have money for business. So everyone wins.

Since banks runs in the 30's destroyed the economy as many banks collapsed (with people losing their trust in the banks) the government stepped in and insured the bank up to a certain amount thus assuring the average person that they would get their money back if the bank went bankrupt. This was done to prevent bank runs in the future as more often then not a good solid bank can be destroyed just by the rumor that it is in trouble IF that rumor started a bank run.

Thus, in America, the FDIC guarantees all deposits up to 100,000 dollars. This is to keep the banks safe and running. The banks give out loans and the economy grows. The basic process of loans and 'money creation' which expands an economy is illustrated by the following image (taken from here)

Extracts about banks from "How Banks Work":

The funny thing about how a bank works is that it functions because of our trust. We give a bank our money to keep it safe for us, and then the bank turns around and gives it to someone else in order to make money for itself. Banks can legally extend considerably more credit than they have cash. Still, most of us have total trust in the bank's ability to protect our money and give it to us when we ask for it.

What is a bank?

According to Britannica.com, a bank is:

an institution that deals in money and its substitutes and provides other financial services. Banks accept deposits and make loans and derive a profit from the difference in the interest rates paid and charged, respectively.

Banks are critical to our economy. The primary function of banks is to put their account holders' money to use by lending it out to others who can then use it to buy homes, businesses, send kids to college...

When you deposit your money in the bank, your money goes into a big pool of money along with everyone else's, and your account is credited with the amount of your deposit. When you write checks or make withdrawals, that amount is deducted from your account balance. Interest you earn on your balance is also added to your account.

Banks create money in the economy by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by the Federal Reserve. The reserve requirement is currently 3 percent to 10 percent of a bank's total deposits. This amount can be held either in cash on hand or in the bank's reserve account with the Fed. To see how this affects the economy, think about it like this. When a bank gets a deposit of $100, assuming a reserve requirement of 10 percent, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it.

Why does banking work?

Banking is all about trust. We trust that the bank will have our money for us when we go to get it. We trust that it will honor the checks we write to pay our bills. The thing that's hard to grasp is the fact that while people are putting money into the bank every day, the bank is lending that same money and more to other people every day. Banks consistently extend more credit than they have cash. That's a little scary; but if you go to the bank and demand your money, you'll get it. However, if everyone goes to the bank at the same time and demands their money (a run on the bank), there might be problem.

Even though the Federal Reserve Act requires that banks keep a certain percentage of their money in reserve, if everyone came to withdraw their money at the same time, there wouldn't be enough. In the event of a bank failure, your money is protected as long as the bank is insured by the Federal Deposit Insurance Corporation (FDIC). The key to the success of banking, however, still lies in the confidence that consumers have in the bank's ability to grow and protect their money. Because banks rely so heavily on consumer trust, and trust depends on the perception of integrity, the banking industry is highly regulated by the government.

Types of Banks

­There are several types of banking institutions, and initially they were quite distinct. Commercial banks were originally set up to provide services for businesses. Now, most commercial banks offer accounts to everyone.

Savings banks, savings and loans, cooperative banks and credit unions are actually classified as thrift institutions. Each originally concentrated on meeting specific needs of people who were not covered by commercial banks. Savings banks were originally founded in order to provide a place for lower-income workers to save their money. Savings and loan associations and cooperative banks were established during the 1800s to make it possible for factory workers and other lower-income workers to buy homes. Credit unions were usually started by people who shared a common bond, like working at the same company (usually a factory) or living in the same community. The credit union's main function was to provide emergency loans for people who couldn't get loans from traditional lenders. These loans might be for things like medical costs or home repairs.

Now, even though there is still a differentiation between banks and thrifts, they offer many of the same services. Commercial banks can offer car loans, thrift institutions can make commercial loans, and credit unions offer mortgages!

More later.

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