Banks play a vital role in the economy. As financial intermediaries, banks efficiently allocate funds from savers to borrowers. Banks also provide pricing information regarding the cost of borrowing money. For example, information, such as prevailing mortgage rates on loans of various terms, help home buyers shop for the best rates. Likewise, businesses can shop for best rates on commercial loans.
How a Bank Works
A bank's ability to lend money is largely dependent on its ability to attract deposits, which are the liabilities of the bank. Banks use incoming funds to lend money to borrowers above the cost it to pays on deposits. Banks also borrow money in the money markets to lend out to borrowers. However, above all else, the bank must be able to earn a sufficient return above its own borrowing costs. The difference between the bank's borrowing cost and the interest rate it charges on loans is called a spread.
As a go between savers and borrowers, banks also provide market participants information necessary to make decisions about how much to save or borrow and when. For example, banks often compete for deposits by increasing rates on certificates of deposits, giving incentive to savers to shop for the banks paying the highest rates. Conversely, borrowers can also shop for best rate on loans. The cheaper a bank's cost to acquire deposits or borrow money, the more aggressive it can be in making loans.
Instrument of the Fed
The Federal Reserve, called the Fed, is the central bank of the United States and is responsible for setting monetary policy. The Fed uses the banking system to implement its monetary policy. One of the ways it accomplishes this task is by adjusting the federal fund rate or the rate at which banks can lend to one another overnight. If the Fed wants to fuel the economy, it can lower the Fed Funds Rate, spurring an increase in bank lending. This is referred to monetary easing. Conversely, a tightening of monetary policy is the exact opposite; the Fed increases the funds rate.
The level of sophistication of the capital markets is what allows a country's economy to prosper and weather economic downturns. Banks play an important role within the capital markets by providing a vehicle for individuals, businesses and the government to allocate funds between savings and borrowing. The capital markets of the United States is one of the most sophisticated in the world, which is why the banking system is highly regulated. A bank must keep a minimum of capital to prevent it from taking undue risk. A bank faces the risk of losing it charter if it suffers too many losses.