What It Means
A bank, at its most basic level, is an institution that holds people’s money for safekeeping and lends money to individuals and businesses for a variety of reasons. The money people put, or deposit, in a bank is not separate from the money the bank loans out: banks take in money from people (referred to as depositors) precisely so they can lend it out and charge interest (a fee people must pay to borrow money). Banks also pay interest to depositors, depending on what type of account they open. A bank makes profits by taking in more money in interest payments on loans than it spends paying interest to its depositors and servicing their accounts.
The deposit-taking and lending activities of banks affect far more than the individual goals of consumers and businesses, however; these activities are central to the functioning of a modern capitalist economy (one in which businesses are largely owned by private individuals, not the government). When banks receive deposits, they typically lend as much of that money out as possible, so they can charge interest and maximize their profits. The law usually requires them to set aside (reserve) only a small portion of the deposits, allowing the bank to loan much more money than it keeps in its reserves. This is called fractional reserve banking. The money is simultaneously recorded as being in the depositors’ accounts and as on loan to someone else; in this way the bank has created more money than physically exists in the form of bills and coins. Banks actually create much of the money that is circulating in the economy at any given time.
Some institutions that engage in a similar process of taking deposits and making loans are not, strictly speaking, banks. Savings and loan associations and credit unions are among the most prominent examples of what are called thrift institutions. Thrifts were originally associated with community-building and the encouraging of personal savings, and because of this history they are subject to different legal standards than banks, even though they have come to function much as banks do.
These days many banks count on noninterest fees, those charged to account-holders and customers for various kinds of financial services and products, for a growing amount of their profits. Also, banks use the money depositors bring in to invest in financial markets (places, some real and some computerized, where people can buy and sell stocks, or shares of ownership in a company, and bonds, or shares of governmental and other types of debt), as well as to make loans. Those banks that focus on the deposits and loans of individual consumers and businesses are called retail banks, and those that focus on the buying and selling of stocks, bonds, and other securities in the financial markets are called investment banks. Today many companies combine retail and investment banking.
All banks and banklike institutions in a modern economy are subject to the regulation and policies of a central bank, which ensures the banking system’s reliability and oversees the money supply (the amount of money circulating in the economy) with the goal of encouraging overall economic health. The central bank in the United States is called the Federal Reserve System.
When Did It Begin
Banking is thought to have grown naturally out of the invention of money. Once any culture had agreed to use a given symbol (gold, discs of stone, cows, shells) to indicate value, the people in that culture had to think about how to store those items safely. Historical evidence of people storing and loaning money has been found as far back as the eighteenth century bc in ancient Babylon (located in present-day Iraq) and also in ancient Greece, among other early civilizations. Banking became more regulated and efficient in ancient Rome.
The modern banking system has its roots in Europe of the Middle Ages (a period that lasted from about 500–1500 ad ), where gold was the most common form of money. Because gold is heavy and cumbersome, it was difficult to carry in large quantities and to store safely, so people began depositing their money with goldsmiths, men who worked with gold and therefore had sufficient storage facilities and knowledge of the metal’s purity. When an individual deposited gold for safekeeping with a goldsmith, the goldsmith examined the gold to judge its purity and then issued a receipt. Goldsmiths charged a fee for storing gold, just as banks today charge a fee for maintaining checking and savings accounts.
Before long, whole societies began recognizing the value of a goldsmith’s receipt, and the receipts were used as money, which made retrieving and exchanging actual gold unnecessary. After some time the goldsmiths perceived that, as people were using the receipts to buy most of what they needed, it was very unlikely that a majority of depositors would demand their gold all at once. Because it was only necessary to keep a fraction of that gold on hand at any given time, goldsmiths saw that they could make loans in the form of paper money and that they could loan out far more than they had in reserve. Thus was born the concept of fractional-reserve banking, which has led to the huge significance of banks in modern economies.
More Detailed Information
Banks literally create money in today’s world. Only about one-third of the money supply in the United States, for instance, consists of government-issued bills and coins. Most of the rest of the money supply is made up of checkable deposits (the money that people have in various kinds of bank accounts).
To understand how banks create money, imagine that you are the first person to deposit money in Bank A, which has just opened for business. You take a stack of $1-, $5-, $10-, $20-, $50-, and $100-bills out from under your mattress, and you open an account at Bank A. Bank A gives you a receipt stating that your stack of money added up to $1,000, which you still possess even though you are no longer keeping the money at your house. You go home, confident that the bank will take care of your money.
After you leave, Bank A will lend out as much of that $1,000 as the law allows. Say that the government currently requires Bank A to set aside 10 percent, or $100, of your deposit, and that Jane Smith walks into the bank asking for a $900 loan. If the bank approves Jane’s loan application, it will give her a checkbook with a balance of $900. Jane now has $900, and you have $1,000, where before only $1,000 existed. The bank has created money out of thin air, by adding numbers to its balance sheet.
But the potential for money creation does not stop there. When Jane writes checks on her account, the checks will be deposited into other banks, and those banks will use the increased size of their deposit balances to finance more loans.
What happens if you go back and demand your $1,000 (or go to the ATM—automated teller machine—and take it out the day after Bank A has made loans based on your deposit)? As long as Bank A is a soundly run bank, you will be able to get the full balance of your account in cash, and there will be no problem. But what happens if, a year down the road, all of Bank A’s customers show up demanding cash? What if every customer at every bank in the country wanted their entire account balances in cash? This would be an enormous problem. There would not be enough hard currency to repay everyone. This situation is called a banking run, and it is catastrophic for the economy.
Banking runs are increasingly uncommon in developed economies. They have always occurred as a result of financial panic, when people lose faith in the banking system’s ability to keep their money secure. For instance, the Great Depression (1929‐39) resulted in a run on U.S. banks. There were numerous bank runs before that, especially in the early decades of the twentieth century. In response to these events, the U.S. banking system was centralized to increase its reliability. The resulting central bank, created in 1913, the Federal Reserve System (or the Fed), is an independent agency of the U.S. government.
The Fed is essentially a bank for banks. Bank A can borrow money from the Fed to pay depositors or to build up its reserves so that it can make more loans, and it can store its reserves with the Fed. The Fed also serves as a bank for the U.S. government. When you get a tax refund, an unemployment check, or any other payment from the federal government, it comes in the form of a check drawn on the Federal Reserve System. Most importantly, the Fed is responsible for overseeing the money supply. Because banks have the ability to create money, and because the size of the money supply is one of the most important factors in the economy’s health, the Fed attempts to control the amount of money deposited in and loaned out by banks. The Fed can increase or decrease the money supply to sustain favorable economic conditions. It does this in various ways, all of which have one aim: to affect the amount of money that banks have in reserve. The larger banks’ reserves are, the more money they create, and vice versa. The Fed’s goal in regulating the money supply is the long-term health of the economy.
In the early years of the twenty-first century, interest rates were at historic lows. This meant that people who wanted to borrow money from banks could do so much more cheaply than in past decades. For example, in much of 1981 the prime interest rate (the interest rate that banks usually use as a basic guideline for establishing other rates, such as those for home loans) was near 20 percent, and in some months it was more than 20 percent. By 2003 the prime interest rate hovered at around 4 percent. On a purchase as large as a home, which costs hundreds of thousands of dollars, a 16 percent variation in the interest rate makes an enormous difference to the consumer. A $200,000 home purchased at an interest rate of 20 percent would result in a monthly mortgage payment (for a 30-year loan, the most common type of home loan) of around $3,350. Over the 30 years of the loan’s life, the purchaser would end up paying more than $1 million in interest. The same $200,000 loan at a 4 percent interest rate would result in a monthly payment of under $1000 and total interest payments of around $144,000 over the loan’s 30-year life.
It would seem, then, that banks would prefer the interest-rate climate of 1981 to that of 2003, because the former would allow them to make $1 million instead of $144,000 in profit on a $200,000 home loan. The catch, however, is that low interest rates encourage a much larger number of borrowers to apply for loans. Indeed, the years 2001–2005 saw Americans become homeowners at record rates. This meant that banks were making more loans than ever before. Though their profits on an individual loan were smaller, they were making so many loans, both to homeowners and to businesses, that banks boomed during those years even while many other sectors of the U.S. economy struggled. Consumers, meanwhile, were not necessarily running away with homes at bargain prices. Though the price consumers paid to borrow money was low by historic standards, real estate prices grew enormously as sellers took advantage of the competition among buyers.
bank1 / bangk/ • n. 1. the land alongside or sloping down to a river or lake: willows lined the bank. 2. a slope, mass, or mound of a particular substance: a bank of clouds a bank of snow. ∎ an elevation in the seabed or a riverbed; a mudbank or sandbank. ∎ a transverse slope given to a road, railroad, or sports track to enable vehicles or runners to maintain speed around a curve. ∎ the sideways tilt of an aircraft when turning in flight. 3. a set or series of similar things, esp. electrical or electronic devices, grouped together in rows: the DJ had big banks of lights and speakers on either side of his console. 4. the cushion of a pool table: [as adj.] a bank shot. • v. [tr.] 1. heap (a substance) into a mass or mound: the rain banked the soil up behind the gate. ∎ [intr.] rise or form into a mass or mound. ∎ heap a mass or mound of a substance against (something): people were banking their houses with earth. ∎ heap (a fire) with tightly packed fuel so that it burns slowly: she could have made a fire and banked it with dirt. 2. (of an aircraft or vehicle) tilt or cause to tilt sideways in making a turn: [intr.] the plane banked as if to return to the airport [tr.] I banked the aircraft steeply and turned. ∎ [intr.] build (a road, railroad, or sports track) higher at the outer edge of a bend to facilitate fast cornering. 3. (in pool and other games) play (a ball) so that it rebounds off a surface such as a backboard or cushion. bank2 • n. a financial establishment that invests money deposited by customers, pays it out when required, makes loans at interest, and exchanges currency: I paid the money straight into my bank. ∎ a stock of something available for use when required: a blood bank building a bank of test items is the responsibility of teachers. ∎ a place where something may be safely kept: the computer's memory bank. ∎ (the bank) the store of money or tokens held by the banker in some gambling or board games. ∎ the person holding this store; the banker. • v. [tr.] deposit (money or valuables) in a bank: I banked the check. ∎ [intr.] have an account at a particular bank: he did not bank with the old family banks. ∎ inf. (esp. of a competitor in a game or race) win or earn (a sum of money): he banked $100,000 for a hole-in-one. ∎ store (something, esp. blood, tissue, or sperm) for future use: the sperm is banked or held in storage for the following spring. PHRASES: break the bank (in gambling) win more money than is held by the bank. ∎ inf. cost more than one can afford: Christmas need not break the bank. PHRASAL VERBS: bank on base one's hopes or confidence on: they can bank on my winning 25 games next year.
a mound, pile, or ridge; a group or series of objects; an amount or stock of money; a batch of paper money. See also balk, bar, heap, mass.
Examples: bank of ants; of books, 1577; of clouds, 1626; of electric lights; of fog, 1848; of hill ants, 1747; of judges [a full court in which the judges are “in bank”]; of mist, 1840; of money, 1878; of mussels, 1861; of oars, 1884; of organ keys, 1884; of oysters, 1861; of rememberances, 1576; of sand; of snow; of swans [on the ground].
So banker †money-changer, usurer XVI; proprietor of a bank XVII. — F. banquier (see -ER2).