ByStephen D. Simpson, CFA

Banks both create and issue money. While commercial banks no longer issue their own banknotes, they are effectively the distribution system for the notes printed, and the coins minted, by the U.S. Treasury. The Federal Reserve buys coins and paper money from the Treasury and distributes them through the banking system, as needed. Banks effectively buy currency from the Fed, or sell it back when they have excess amounts on hand. (To lean more, see How The Federal Reserve Was Formed.)

Settle Payments
Every day there are millions of financial transactions in the United States, some conducted with paper currency, but many more done with checks, wire transfers and various types of electronic payments. Banks play an invaluable role in the settling of these payments, making sure that the proper accounts are credited or debited, in the proper amounts and with relatively little delay.

Credit Intermediation
Banks play a major role as financial intermediaries. Banks collect money from depositors, essentially borrowing the money, and then simultaneously lend it out to other borrowers, forging a chain of debts. This is especially significant when asset values decline. As asset values decline, those assets are less able to service debt, which in turn makes it more difficult for borrowers to borrow, and reduces lending capacity. What follows, is a decrease in the flow of credit from savers to spenders and a decline in economic activity. At the same time, banks often find that they must raise capital, and their capital needs compete with those available savings.

Maturity Transformation
Maturity transformation is part and parcel of what banks do on a daily basis. Many investors are willing to invest on a very short term basis, but many projects require long-term financial commitments. What banks do, then, is borrow short-term, in the form of
demand deposits and short-term certificates of deposit, but lend long-term; mortgages, for instance, are frequently repaid over 30 years. By doing this, banks transform debts with very short maturities (deposits) into credits with very long maturities (loans), and collect the difference in the rates as profit. However, they are also exposed to the risk that short-term funding costs may rise much faster than they can recoup through lending.

Money Creation
One of the most vital roles of banks is in money creation. Importantly, money creation at the individual bank level is not the same thing as "printing money;" currency is just one type of money. Instead, banks create money through
fractional reserve banking. Fractional reserve banking is a key concept to understanding modern banking and money creation.

Fractional reserve banking refers to the fact that banks keep only a small portion of their deposits on hand. When a customer comes into the bank and deposits $100, perhaps $10 of that will be kept on hand in the form of cash or easily-liquidated securities. The remaining $90 will be lent out to customers as loans, or used to acquire the stock or bonds of other companies. This phenomenon is known as the money multiplier and can be expressed as the formula: m = 1 / reserve requirement. If the reserve requirement is 10% (or 0.1), every dollar deposited with a bank, can become $10 of new money.

This is a key concept, because this is how banks increase the money supply and effectively create money. If banks simply acted as storehouses or vaults for money, there would be far less money available to lend.

Next: The Banking System: Commercial Banking - How Banks Make Money »

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