Importance of the Banking Sector in the Country

Banks should be able to lend money to consumers and businesses in both upturns and downturns. In addition, payments for goods and services should be processed swiftly, safely, and at a low cost. If banks fail to perform these tasks, the consequences for the entire economy could quickly become so wide-reaching that even the banking system would be exposed to large shocks. It is therefore important that banks are able to absorb losses and meet their current payment obligations. To ensure this, banks must comply with strict regulatory requirements. Among these are the capital and liquidity (money that can be paid on short notice) requirements applying to banks in order to ensure that they can meet their current payment obligations. The banks’ own payment systems are also required to be secure and efficient.

Making loans: While at any given moment some depositors need their money, most do not. That enables banks to use shorter-term deposits to make longer-term loans. The process involves maturity transformation—converting short-term liabilities (deposits) to long-term assets (loans). Banks pay depositors less than they receive from borrowers, and that difference accounts for the bulk of banks’ income in most countries. Banks can complement traditional deposits as a source of funding by directly borrowing in the money and capital markets. They can issue securities such as commercial paper or bonds; or they can temporarily lend securities they already own to other institutions for cash—a transaction often called a repurchase agreement (repo). Banks can also package the loans they have on their books into a security and sell this to the market (a process called liquidity transformation and securitization) to obtain funds they can lend. Please go here to this Business Online Banking service and know more about importance of the banking sector.

Creating money: Banks also create money. They do this because they must hold on reserve, and not lend out, some portion of their deposits—either in cash or in securities that can be quickly converted to cash. The amount of those reserves depends both on the bank’s assessment of its depositors’ need for cash and on the requirements of bank regulators, typically the central bank—a government institution that is at the center of a country’s monetary and banking system. Banks keep those required reserves on deposit with central banks, such as the U.S. Federal Reserve, the Bank of Japan, and the European Central Bank. Banks create money when they lend the rest of the money depositors give them. This money can be used to purchase goods and services and can find its way back into the banking system as a deposit in another bank, which then can lend a fraction of it. The process of re-lending can repeat itself a number of times in a phenomenon called the multiplier effect. The size of the multiplier—the amount of money created from an initial deposit—depends on the amount of money banks must keep on reserve.

Transmitting monetary policy: Banks also play a central role in the transmission of monetary policy, one of the government’s most important tools for achieving economic growth without inflation. The central bank controls the money supply at the national level, while banks facilitate the flow of money in the markets within which they operate. At the national level, central banks can shrink or expand the money supply by raising or lowering banks’ reserve requirements and by buying and selling securities on the open market with banks as key counterparties in the transactions. Banks can shrink the money supply by putting away more deposits as reserves at the central bank or by increasing their holdings of other forms of liquid assets—those that can be easily converted to cash with little impact on their price. A sharp increase in bank reserves or liquid assets—for any reason—can lead to a “credit crunch” by reducing the amount of money banks have to lend, which can lead to higher borrowing costs as customers pay more for scarcer bank funds. A credit crunch can hurt economic growth.

The need for regulation: Bank safety and soundness are major public policy concerns, and government policies have been designed to limit bank failures and the panic they can ignite. In most countries, banks need the charter to carry out banking activities and to be eligible for government backstop facilities—such as emergency loans from the central bank and explicit guarantees to insure bank deposits up to a certain amount. Banks are regulated by the laws of their home country and are typically subject to regular supervision. If banks are active abroad, they may also be regulated by the host country. Regulators have broad powers to intervene in troubled banks to minimize disruptions.