Monday, January 4, 2010

What is a Bank?

"Bank" is a term people use broadly to refer to many different businesses.
When people discuss the financial services industry, however, bank means "commercial bank", and a commercial bank is a specific, unique institution.

The Commercial Bank

The official definition of a commercial bank is a privately-owned institution that accepts demand deposits and makes commercial loans. Demand deposits are money people leave in an institution with the understanding that they can get it back at any time. Commercial loans are simply loans to businesses. This action of taking deposits and making loans is called financial intermediation. A bank's business, however, does not end there.

How Banks Create Money
Banks can't lend out all the deposits they collect, or they wouldn't have funds to pay out to depositors. Therefore, they keep primary and secondary reserves. Primary reserves are cash, deposits due from other banks, and the reserves required by the Federal Reserve System. Secondary reserves are securities banks purchase on the open market, which may be sold to meet short-term cash needs. These securities are usually government bonds of some kind. Federal law sets requirements for the percentage of deposits a bank must keep on reserve, either at the local Federal Reserve Bank or in its own vault. Any money a bank has on hand after it meets its reserve requirement is its excess reserves.
How Banks Make Money
Although banks are important tools of public policy, they are privately-owned, for-profit institutions. Banks are owned by stockholders. The stockholders' stake in the bank forms most of its equity capital, a bank's ultimate buffer against losses. At the end of the year, a bank pays some or all of its profits to its shareholders in the form of dividends. The bank may retain some of its profits to add to its capital. Stockholders may also choose to reinvest their dividends in the bank.