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A central bank can be said to have two main kinds of functions: (1) macroeconomic when regulating inflation and price stability and (2) micro economic when functioning as a lender of last resort.

Macroeconomic Influences

As it is responsible for price stability, the central bank must regulate the level of inflation by controlling money supplies by means of monetary policy.  The central bank performs open market transactions that either inject the market with liquidity or absorb extra funds, directly affecting the level of inflation.  To increase the amount of money in circulation and decrease the interest rate (cost) for borrowing, the central bank can buy government bonds, bills, or other government-issued notes.  This buying can, however, also lead to higher inflation.  When it needs to absorb money to reduce inflation, the central bank will sell government bonds on the open market, which increases the interest rate and discourages borrowing.  Open market operations are the key means by which a central bank controls inflation, money supply, and price stability.

Microeconomic Influences

The establishment of central banks as lender of last resort has pushed the need for their freedom from commercial banking.  A commercial bank offers funds to clients on a first come, first serve basis.  If the commercial bank does not have enough liquidity to meet its clients’ demands (commercial banks typically do not hold reserves equal to the needs of the entire market), the commercial bank can turn to the central bank to borrow additional funds.  This provides the system with stability in an objective way; central banks cannot favor any particular commercial bank.  As such, many central banks will hold commercial-bank reserves that are based on a ratio of each commercial bank’s deposits.  Thus, a central bank may require all commercial banks to keep, for example, a 1:10 reserve/deposit ratio.  Enforcing a policy of commercial bank reserves functions as another means to control money supply in the market.  Not all central banks, however, require commercial banks to deposit reserves.  The United Kingdom, for example, does not have this policy while the United States does.

The rate at which commercial banks and other lending facilities can borrow short-term funds from the central bank is called the discount rate (which is set by the central bank and provides a base rate for interest rates).  It has been argued that, for open market transactions to become more efficient, the discount rate should keep the banks from perpetual borrowing, which would disrupt the market’s money supply and the central bank’s monetary policy.  By borrowing too much, the commercial bank will be circulating more money in the system.  Use of the discount rate can be restricted by making it unattractive when used repeatedly.

So does all that make sense?  Basically we can see how Central Banks play a role in the normal economic cycle of the developed word.  And with the financial crisis that we are having you can see how banks can exhort real pressures on the economy as a whole.

This is an interesting video that takes a look at the Wall Street bailout and it is about economic influences and how they lead to the mess that we are in now.  Enjoy.

Next week we’re going to have a look at some other interesting facts about banking that are having an impact on the world today.  Until then wishing you wisdom, peace and an abundance of love.

M4Quan
Warrior for Truth
Professor (things that make you go Hmm..)

Most people believe that central banks are government owned but separate from the country’s ministry of finance.  That is only true in a small number of countries.  The central bank for the United Kingdom (UK), the Bank of England, and the United States of America (USA, the Federal Reserve, are in fact private organisations.

You may wonder then why these central banks along with the central bank of the European Union (EU), the European Central Bank and the Australian central bank, the Reserve Bank of Australia want people to think they are part of government.  Think about it.  If you were a private organisation and you controlled the money supply of a country, would you want the people to fully understand that your business is about making money (profit) from government debt?  And more importantly as a private company whose interest will you look after first, the people or your shareholders?

If you fully grasp that then you can understand why these central banks like to fly under the radar when it comes to there separation from government and hence the people that the government is supposed to serve.

The central bank is frequently termed the “government’s bank” because it handles the buying and selling of government bonds and other instruments, political decisions should not influence central bank operations.  Of course, the nature of the relationship between the central bank and the ruling regime varies from country to country and continues to evolve with time.  To ensure the stability of a country’s currency, most central banks are the regulator and authority in the banking and monetary systems.

Historically, the role of the central bank has been growing, some may argue, since the establishment of the Bank of England in 1694.  It is, however, generally agreed upon that the concept of the modern central bank did not appear until the 20th century as problems developed in the commercial banking system.  Thus, the central bank’s modern function emerged in response to an already present commercial banking structure.

Between 1870 and 1914, when world currencies were pegged to the gold standard (GS), maintaining price stability was a lot easier because the amount of gold available was limited.  Consequently, monetary expansion could not occur simply from a political decision to print more money, so inflation was easier to control.  The central bank at that time was primarily responsible for maintaining the convertibility of gold into currency, it issued notes based on a country’s reserves of gold.

At the outbreak of World War I (WWI), the GS was abandoned, and it came apparent that, in times of crisis, governments, facing budget deficits (because it costs money to wage war) and needing greater resources, will order the printing of more money.  As governments did so, they encountered inflation.  After WWI, many governments opted to go back to the GS to try to stabilize their economies.  With this rose the awareness of the importance of the central bank’s independence from the political machine.

Next week we’ll look at how the central bank influences the economy through macro and micro economics.

4Quan
Warrior for Truth
Professor (things that make you go Hmm..)

How Banks Make Money

Most of you like me would say that banks made their money by charging us consumers like wounded bulls for every thing we do from going into a bank to withdrawing our own money.

Banks create money in the economy by making loans.  The amount of money that banks can lend is directly affected by the reserve requirement set by the Central Bank.  This amount can be held either in cash on hand or in the bank’s reserve account with the Central Bank.  To see how this affects the economy, think about it like this.  When a bank gets a deposit of $100, assuming a reserve requirement of 10 percent, the bank can then lend out $90.  That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank.  That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it.

In this way, money grows and flows throughout the community in a much greater amount than physically exists.  That $100 makes a much larger ripple in the economy than you may realise!

Bank Loans

Banks are just like other businesses.  Their product just happens to be money.  Other businesses sell widgets or services; banks sell money in the form of loans, certificates of deposit (CDs) and other financial products.  They make money on the interest they charge on loans because that interest is higher than the interest they pay on depositors’ accounts.

The interest rate a bank charges its borrowers depends on both the number of people who want to borrow and the amount of money the bank has available to lend.  The amount available to lend also depends upon the reserve requirement the Central Bank has set.  At the same time, it may also be affected by the funds rate, which is the interest rate that banks charge each other for short-term loans to meet their reserve requirements.

Loaning money is also inherently risky.  A bank never really knows if it’ll get that money back.  Therefore, the riskier the loan the higher the interest rate the bank charges.  While paying interest may not seem to be a great financial move in some respects, it really is a small price to pay for using someone else’s money.  Imagine having to save all of the money you needed in order to buy a house.  We wouldn’t be able to buy houses until we retired!

Bank Income

Banks also charge fees for services like checking, ATM access and overdraft protection.  Loans have their own set of fees that go along with them.  Another source of income for banks is investments and securities.

Next we’ll be taking a look at banks and how they control the money supply.

4Quan
Warrior for Truth
Professor (things that make you go Hmm..)

Banks – Their purpose? (part 2)

Continuing on with our discussion on the purpose of banks.

What happens when you deposit money into a bank?  First, the money is recorded (usually by computer) and added to your account.  It is then placed into the vault.  At various times during the day, money is removed from the vault and taken to a second bank.  This bank, unlike the first, does not serve individuals.  It is a “banks’ bank,” usually a branch of the Central Bank of the country.  The first bank is able to make deposits, withdrawals, and take out loans from the second bank (Central Bank).

When you walk into a bank to withdraw money or to take out a loan, the reverse of the process outlined above occurs.  If the first bank does not have enough money in the vault to cover the withdrawal or the loan, the first bank goes to the second bank and withdraws money.  If the first bank does not have enough money in its account at the second bank, then it must take out a loan at a lower rate of interest than the loan that it will eventually give to the individual borrower.  In this way, a bank is able to accept deposits, honor withdrawals, and make loans without having to maintain all of the deposited cash on hand in the vault.

So think about what’s been happening lately with the credit crunch.  Banks have not been willing to loan each other money.  So you can see where they have created a true bottleneck at that point in the banking process.  I wonder, to myself, why respective governments don’t just force them to do so.  Wouldn’t that make more sense than pumping untold public monies into the market?

In the next edition we will be looking at how banks make money and where money actually comes from, should be good.

4Quan
Warrior for Truth
Professor (things that make you go Hmm..)

Banks – (part 1)

Given the current financial crisis that has been sweeping over the planet I am finding it an opportune time to actually look at the role of banks and how they have evolved to be in our world.  We’ll also be looking at money (later posting), what it is and how it operates.

The definition of banks vary from country to country.  Their history has influenced economies and politics for centuries and did you know that the first modern bank was founded in Italy in 1406?

This blog is dedicated to sharing information that relates to and deals with banks and money.  Now with that said….

1st Central Bank in USA

What do banks do?

Traditional banks serve to accept deposits and make loans.  They act as safe stores of wealth for savers and as predictable sources of loans for borrowers.  In this way, the major business of banks is that of a financial intermediary between savers and borrowers.  The bank simplifies this process by eliminating the need for savers to find the right borrowers and the right time to directly make a loan.

Banks are generally trusted by the public.  When people put their savings into banks, they receive little more than a paper receipt in return.  There are organisations in place, in each respective country, to ensure that banks are trustworthy with individuals’ money and reasonable in the loans that they make.  Deposits are insured by government and non government organisations on accounts to a predetermined level and will be returned to the depositor even if the bank fails.  Individual banks also have a board of directors to regulate the sizes and interest rates of loans the bank makes.  This board is charged with ensuring that the bank is taking reasonable risks with its depositors’ money.

Individual banks serve as the issuing and regulating bodies for many financial services often employed by consumers.  In this way, banks are able to give depositors access to their money while also maintaining a large number of loans.

In the next post we will continue what is known as the definition of banks and banking moving towards answering the question - are they serving the people, or are the people serving them?

Until next time…

4Quan
Warrior for Truth
(things that make you go hmm..)