A bank is a financial intermediary that accepts deposits, makes loans, and helps process payments. In economic terms, banks matter because they perform maturity transformation (funding longer-term, riskier assets with shorter-term liabilities) and because they are central to how credit conditions affect the real economy.
Bank Balance Sheet (Core Mechanics)
At a high level:
- Assets: loans, securities, reserves (and other claims)
- Liabilities: deposits and wholesale funding
- Equity (capital): the buffer that absorbs losses
Losses hit equity first. If equity is too small, the bank becomes insolvent even if it can still make payments today.
What Banks Do For The Economy
Banks provide several services that are costly to replicate with direct finance:
- Payments and settlement: accounts, transfers, and access to the payment system.
- Credit screening and monitoring: banks specialize in evaluating borrowers and enforcing contracts.
- Liquidity provision: depositors can withdraw on demand even though the bank’s assets are long-term.
- Risk transformation: diversification and portfolio management can lower the cost of credit for borrowers.
Why Banks Can Be Fragile
The same features that make banks useful also create fragility:
- Run risk: if many depositors demand cash at once, the bank may be forced to sell illiquid assets at fire-sale prices.
- Leverage: banks operate with high leverage, so modest asset losses can wipe out equity.
- Contagion: bank distress can spread through interbank exposures and payment-system links.
Policy Context
Because of systemic risk, banks are heavily regulated. Common policy tools include deposit insurance, capital requirements, reserve and liquidity rules, and central-bank facilities intended to stabilize the payment system in stress.