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Keeping in Touch with Some Basics as to How Banks Operate

Jan 10, 2008
There are some people who may wish to know a little about what banks are all about, especially when these financial institutions have had to swim in rather troubled waters just lately.

Banks are here to make money. It is hard to manage without them, and it is hard for them to manage without us. On the face of it, this looks like a marriage made in heaven. However, since all marriages are based on absolute trust and hate turbulent situations, and because these two features seem to be coming into play, it is not surprising that this is causing a certain amount of concern to depositors.

Basically, a client places money into his account. The bank will lend that money to other clients and make a profit on the deal. If the client banked say $10000, the bank can lend $90000 out because they must maintain a 10 per cent cash reserve ratio. In other countries, the cash reserve ratio requirement can be higher or lower. Any country can decide to alter the cash reserve ratio if needs be.

There is nothing to stop a bank to set aside more than the required minimum, meaning having excess reserves. It is not particularly rewarding for banks to do this, since they get no interest on that money, albeit they can channel it out on short and overnight terms to banks which need to maintain their minimum reserve ratio.

Getting back to that $90000 the bank can lend out, and let us say grant overdrafts but creating of course a liability factor, as the bank has to pay out whenever the various borrowers issue their cheques.

The position of the bank is that it has a total cash sum of $10000 received.
However, it has lent out deposits of totalling $90000. Add this together and you get a figure of $100000 representing total assets which are the $90000 in overdrafts plus the original $10000 cash received, which of course includes the required 10% reserve.

What took place is that the bank granted loans worth $90000 giving birth to money which did not exist before, based on the $10000 received in cash and locked in the safe.

People do not put in all the money on the same day, and they do not take out all the money on the same day. Cash in form of bank reserves is there to meet some withdrawals that may possibly be required. Banks have been managing quite well with small cash reserves in their safe, because they hold a number of liquid assets which they can sell for instant money. It is better for them to earn more money out of these liquid assets than having cash. Bankers are clever enough to know what kind of mixture of investments they should hold not to be caught with their pants down.

As well as lending money both short and long term, banks place investments in other areas. For instance, apart from the liquid assets, they can purchase long term government bonds and other securities. However, without cash reserves it is not possible to give birth to additional money unless breaking the rules.

Of course banking is far more intricate than that, but at least one can grasp some basics, and understand why, when a spanner is thrown into the works due to whatever reason, hiccups can follow.
About the Author
Paul Dubsky is director of Foreign Currency Exchange Services Ltd. The company is focused on being able to offer really friendly currency exchange rates and international money transfers. We believe we are the only Foreign Currency Exchange company which offers special rates to Senior Citizens.
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