Saturday, March 8, 2008

Commercial and retail banking revealed

I find it very strange, when people do not know how do commercial and retail banks work. They seem to think, that banks just "make" money, literally. That's why i decided to explain the main concepts of banking and present them really simply.
When people have more money than they need to spend, they may choose to save it. They deposit it in a bank account, at a commercial or retail bank, and the bank generally pays interest to the depositors. The bank then uses the money that has been deposited to grant loans - lend money to borrowers who need more money than they have available. Banks make a profit by charging a higher rate of interest to borrowers than they pay to depositors. (Now that's business!)
Commercial banks can also move or transfer money from one customer's bank account to another one, at the same or another bank, when the customer asks them to. Well, this is basically how a bank works. It gets money from some people and then lends it to other people. Could not be any more simple, but the best thing about it - IT WORKS!

Banks also create credit - make money available for someone to borrow - because the money they lend, from their deposits, is usually spent and so transferred to another bank account. (They sure think ahead of it.)
The capital a bank has and the loans it has made are its assets. The customers' deposits are liabilities because the money is owed to someone else. Banks have to keep a certain percentage of their assets as reserves for borrowers who want to withdraw their money. This is known as the reserve requirement. For example, if the reserve requirement is 10%, a bank that receives a $100 deposit can lend $90 of it. If the borrower spends this money and writes a cheque to someone who deposits the $90, the bank receiving that deposit can lend another $81! As the process continues, the banking system can expand the first deposit of $100 into nearly $1000!!! In this way, it creates credit of almost $900! Wow!

Before lending money, a bank has to assess or calculate the risk involved. Generally, the greater the risk for the bank of not being repaid, the higher the interest rate they charge. Most retail banks have standardized products for personal customers, such as personal loans. This means that all customers who have been granted a loan have the same terms and conditions - they have the same rules for paying back the money. (We're all equal before God, aren't we?)
Banks have more complicated risk assessment methods for corporate customers - business clients - but large companies these days prefer to raise their own finance rather than borrow from banks.
Banks have to find a balance between liquidity - having cash available when depositors want it - and different maturities - dates when loans will be repaid. They also have to balance yield - how much money a loan pays - and risk.

Well, there you have it. I hope i pointed out the main points and have most of the questions answered.. If there is anything else you wanted to know, feel free to ask anything.

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