The Banking System

22- 3-2020’lecture
Money and Banking
Dr. Eid Ashry
• In the previous lecture, we have defined
money and seen how to measure it, we turn our
attention to the principal creators of
money;(the banks).
• A bank is a financial institution that accepts
deposits and makes private loans. This
definition covers the several types of
commercial banks.
• A bank is one kind of financial institution. A
financial institution, also called a financial
intermediary, is any firm that helps channel
funds from savers to investors.
• Financial institution (financial intermediary)
is a firm that helps channel funds from savers
to investors.
• Bank is a financial institution that accepts
deposits and makes private loans.
• A bank is a financial institution defined by two
characteristics:
• First, it raises funds by accepting deposits, including
savings deposits and checking deposits that people and
firms use to make payments. Both types of deposits
earn interest; savings deposits earn more than checking.
• The second characteristic of a bank is that it uses its
funds to make loans to companies and individuals.
• In the past, banks were restricted to accepting deposits
and making loans, but today banks engage in many
financial businesses. They trade securities, sell mutual
funds and insurance, and much more. Still, what make
them banks are their deposits and loans.
• To understand how banking works, we start by looking
at the bank balance sheet, a list of the bank’s assets and
liabilities.
• An asset of a bank is something of value that the bank
owns. This “thing” may be a physical object, such as
the bank building or a computer, or it may be a piece of
paper, such as an IOU signed by a customer to whom
the bank has made a loan (e.g., a mortgage).
• A liability of a bank is something of value that the bank
owes. Most bank liabilities take the form of
bookkeeping entries. For example, if you have an
account in Bank du Caire, your bank balance is a
liability of the bank. (It is, of course, an asset to you.)
• There is an easy test for whether some piece of
paper or bookkeeping entry is a bank’s asset or
liability. Ask yourself a simple question: If this
paper were converted into cash, would the bank
receive the cash (if so, it is an asset) or pay it out
(if so, it is a liability)?
• An asset of an individual or business firm is an
item of value that the individual or firm owns.
• A liability of an individual or business firm is an
item of value that the individual or firm owes.
Many liabilities are known as debts.
• A bank acquires funds by issuing (selling)
liabilities such as deposits, which are the
sources of funds the bank uses. The funds
obtained from issuing liabilities are used to
purchase income-earning assets. Banks have
three main sources of funds: deposits,
borrowings, and equity:
• Demand deposits are payable on demand; that is, if a
depositor shows up at the bank and requests payment
by making a withdrawal, the bank must pay the
depositor immediately.
• Although notice deposits have a notice requirement in
the contractual agreement with the client, the banks
rarely enforce this clause, and so in fact most notice
deposits are really just like demand deposits in this
sense.
• Demand deposits and notice deposits are bank
accounts that allow the owner to write cheques to
third parties.
• Fixed-term deposits are the primary source of
bank funds.
• Owners cannot write cheques on fixed-term
deposits, but the interest rates are usually
higher than those on chequable deposits.
• There are two main types of fixed-term
deposits: savings accounts and time deposits
(also called certificates of deposit or CDs).
• Savings accounts were once the most common
type of fixed-term deposit. In these accounts, to
which funds can be added or from which funds
can be withdrawn at any time, transactions and
interest payments are recorded in a monthly
statement or in a small book (the passbook) held
by the owner of the account.
• Time deposits have a fixed maturity length,
ranging from several months to over five years,
and have substantial penalties for early
withdrawal.
• A bank may want more funds than it raises from
deposits. This can occur, for example, if the bank
wants to increase its lending. A bank can borrow
in several ways:
• a bank can borrow from another bank.
• A bank can also borrow from a corporation or
financial institution that has spare cash.
• Bonds: Bonds are another means of borrowing.
• Banks also can borrow from the Central Bank.
• The final category on the liabilities side of the
balance sheet is bank capital, the bank’s net
worth, which equals the difference between total
assets and liabilities. The funds are raised by
selling new equity (stock) or from retained
earnings.
• Bank capital is a cushion against a drop in the
value of its assets, which could force the bank
into insolvency (having liabilities in excess of
assets, meaning that the bank can be forced into
liquidation).
• A bank uses the funds that it has acquired by
issuing liabilities to purchase income earning
assets. Bank assets are thus naturally referred
to as uses of funds, and the interest payments
earned on them are what enable banks to make
profits.
• All banks hold some of the funds they acquire
as deposits in an account at the central Bank,
in the form of settlement balances. Reserves
are these settlement balances plus currency
that is physically held by banks (called vault
cash because it is stored in bank vaults
overnight).
• Suppose that a cheque written on an account at
another bank is deposited in your bank and the
funds for this cheque have not yet been
received (collected) from the other bank. The
cheque is classified as a cash item in process
of collection, and it is an asset for your bank
because it is a claim on another bank for
funds that will be paid within a few days.
Items in process of collection are also called
items in transit or bank float.
• Many small banks hold deposits in larger
banks in exchange for a variety of services,
including cheque collection, foreign exchange
transactions, and help with securities
purchases. These deposits are known as
interbank deposits. Collectively, reserves, cash
items in process of collection and deposits at
other banks are referred to as cash items.
• A bank’s holdings of securities are an important
income-earning asset: securities (made up entirely
of debt instruments for commercial banks
because banks are not allowed to hold stock).
• Securities pay interest. The interest rates are
lower than rates on bank loans, but banks hold
securities because they pay more than reserves
while also providing liquidity. If depositors make
large withdrawals, a bank may run low on
reserves, but it can easily get more by selling
securities.
• Banks make their profits primarily by issuing
loans. They represent some 50% of bank assets
are in the form of loans, and in recent years they
have generally produced more than half of bank
revenues.
• A loan is a liability for the individual or
corporation receiving it but an asset for a bank
because it provides income to the bank.
• Loans are typically less liquid than other assets
because they cannot be turned into cash until the
loan matures.
• Bankers acceptances and the physical capital
(bank buildings, computers, and other
equipment) owned by the banks are included
in this category.
Dr. Eid Ashry