What is the nature of a banking business?

Answer 1

The nature of the banking business is to connect those in need of funds (borrowers) with those with an excess of funds (savers) while paying a return to the saver less than the interest charged to the borrower (in betting terms, this would be known as the 'vig' or 'vigorish'). Banks can lend money to borrowers in a variety of ways depending on how the money supply is defined and the nature of the deposits it holds. For example, banks operate on a fractional reserve system: a bank can lend x% of the funds it holds on deposits but must hold a reserve requirement to be met at the end of each business day. For example: If a bank has a reserve requirement of 10% and deposits of $1000, it can lend $900; but this is only the beginning of the story. Suppose you borrow $10,000 to buy a car. The dealership will take its profits and deposit the remainder into a bank which is viewed as new reserves and can lend against these new reserves. This is the phenomenon know as the deposit expansion multiplier process. Generally speaking, for every $1 a bank holds as a deposit, it can lend up to (1/rr). Mathematically if the reserve requirement (rr) is 10%, for a dollar the bank holds as a deposit, it can lend up to $10 total against it (once all rounds of spending and depositing have been accounted for and there are assumed no 'leakages'). This is also the phenomenon which accounts for 'bank runs.' Banks only hold a small percentage of total deposits on hand (aka 'vault cash'). If all depositors wanted to withdraw their total deposits simultaneously, the bank could not accommodate the outflow of cash as it is held in the form of assets (loans). This is why the Federal Reserve System was created: first and foremost to be a lender of last resort for the Commercial Banking System. Should a bank find itself short of reserve requirements at the end of a business day, it could borrow from another bank at the Fed Funds Rate (the rate at which banks lend to other banks) or directly from the Federal Reserve at the Discount Rate (the rate at which the Fed lends to commercial banks.

Simply stated, banks borrow short and lend long. That means that the majority of their assets are not very liquid (easily converted to cash).