To quote the American poet Robert Frost, “A bank is a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain”. This quote is very relevant in today’s world. Money, banks and the banking system form a major part of an economist’s study paradigm. But what exactly is the concept of money? It is just a clever invention to save time and make transactions easier. And banks are institutions that just act as a connection between people who have enough money to save and those who do not have enough money to invest, commonly known as the lenders and the borrowers.
Money was invented as an escape from the barter system in the economy where people exchanged commodities for commodities. For instance, if person A produces potatoes and person B produces bread, then person A can trade some of his potatoes for some bread with person B and both can have a wholesome dinner. This is the general idea of the barter system. However, a twist was brought in here. What if B does not want A’s potatoes? That is, what if there is no double coincidence of wants? Further, this example is only for a simple two-person economy. It will be impossible for people to figure out who has the commodity that they want and who wants the commodity that they are willing to offer. This calls for an integrated arrangement where people can have clear information on their options. Thus, the concepts of markets, buyers and sellers come up.
However, this barter system also suffered a certain problem, which is why the concept of money had to be thought of. In the barter system, it is not always possible to find out mutually beneficial trade terms. Even if certain such terms are made possible, the transaction costs to bring such a deal into the picture will be quite large. Therefore, money as a common medium which every seller would accept in return of their commodities seemed to be a very feasible and convenient solution.
But it is this very convenience that also creates turbulence. Notice that in the barter system, an act of supply is always complemented by a simultaneous act of demand. In the example above, person A cannot give away his potatoes without taking some of person B’s bread. In this way, it ensures that there is always a balance between demand and supply in the economy.
We know that recessions and economic crises situations usually occur when the aggregate demand falls short of the supply, but in a barter economy, demand will always be equal to supply and thus there will be no chance of a mismatch. However, in a money economy, it is possible for the buyers and sellers to supply without subsequently demanding the product. Once the value of the commodity is paid in monetary terms, it is up to the sellers whether to use that money for buying or save it for future use. In case they decide to save it for future use, they are not contributing to current demand and this will make supply greater than demand, laying the foundations for recessionary trends in the economy.
With the concept of money also came the concept of banks and the banking system. When people want to save some of their earned income, as we discussed in the above paragraph, they need someplace safe to keep that extra cash. This is where banks come into the picture. Banks are institutions that house the extra cash from people who want to spend less than what they earn, and then loan out this money to people who want to spend more than what they earn. If banks did not exist, then it would be very difficult for the borrowers and the lenders to locate each other and reach mutually beneficial terms of the transaction.
However, the borrower and the lender are not introduced to each other for a proper two-way process to take place. Instead, the bank acts as an intermediary for both these parties. But if both these parties insist on exercising their rights at the same time, the bank will not be able to keep up the obligation to either. That means, if the bank lends out money to a borrower and is at the same time, confronted by a depositor who claims his savings, then it will go bankrupt!
To minimize this risk, banks tend to do two things. They either try to maximize the difference between the interest rate they charge on the loans that they give out and the interest they give out on deposits, or they try to increase the number of loans that they give out. Now, the first method is not possible because interest rates are more often than not, determined by the central bank of the country. Even if it isn’t, the banking industry is highly competitive, and any bank charging a higher interest rate on loans will lose its customers to banks that offer loans at lower interest rates, and any bank giving a lower interest on deposits will again lose customers to banks that offer higher interest.
The only way left for the banks to maximize their profits is by giving out more loans. If the agenda is to maximize the number of loans given out, then the banks will tend to overlook the credit rating of the borrowers and give out quick loans and when loans are given out to people with lower credit ratings, the chance of default on repayment of the loan increases more. This is one of the main reasons why in the present context we see NPAs on the rise. This is why the central banks of all economies keep a minimum reserve requirement wherein banks are mandated to keep a certain percentage of their deposits as reserves and are not allowed to lend it to the borrowers and this ensures that the banks have something to fall back on in case some borrowers default.
Thus, we can see that the entire banking system relies on a very huge gamble, which if backfired, can bring an entire economy down, as we saw during the subprime crisis of 2008 in the US. It is imperative that banks focus less on their profit maximization and more on securing the economy from such situations.
Picture Courtesy- GUC