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Principles of Macroeconomics 2e

14.3 The Role of Banks

Principles of Macroeconomics 2e14.3 The Role of Banks
  1. Preface
  2. 1 Welcome to Economics!
    1. Introduction
    2. 1.1 What Is Economics, and Why Is It Important?
    3. 1.2 Microeconomics and Macroeconomics
    4. 1.3 How Economists Use Theories and Models to Understand Economic Issues
    5. 1.4 How To Organize Economies: An Overview of Economic Systems
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  3. 2 Choice in a World of Scarcity
    1. Introduction to Choice in a World of Scarcity
    2. 2.1 How Individuals Make Choices Based on Their Budget Constraint
    3. 2.2 The Production Possibilities Frontier and Social Choices
    4. 2.3 Confronting Objections to the Economic Approach
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  4. 3 Demand and Supply
    1. Introduction to Demand and Supply
    2. 3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services
    3. 3.2 Shifts in Demand and Supply for Goods and Services
    4. 3.3 Changes in Equilibrium Price and Quantity: The Four-Step Process
    5. 3.4 Price Ceilings and Price Floors
    6. 3.5 Demand, Supply, and Efficiency
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  5. 4 Labor and Financial Markets
    1. Introduction to Labor and Financial Markets
    2. 4.1 Demand and Supply at Work in Labor Markets
    3. 4.2 Demand and Supply in Financial Markets
    4. 4.3 The Market System as an Efficient Mechanism for Information
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  6. 5 Elasticity
    1. Introduction to Elasticity
    2. 5.1 Price Elasticity of Demand and Price Elasticity of Supply
    3. 5.2 Polar Cases of Elasticity and Constant Elasticity
    4. 5.3 Elasticity and Pricing
    5. 5.4 Elasticity in Areas Other Than Price
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  7. 6 The Macroeconomic Perspective
    1. Introduction to the Macroeconomic Perspective
    2. 6.1 Measuring the Size of the Economy: Gross Domestic Product
    3. 6.2 Adjusting Nominal Values to Real Values
    4. 6.3 Tracking Real GDP over Time
    5. 6.4 Comparing GDP among Countries
    6. 6.5 How Well GDP Measures the Well-Being of Society
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  8. 7 Economic Growth
    1. Introduction to Economic Growth
    2. 7.1 The Relatively Recent Arrival of Economic Growth
    3. 7.2 Labor Productivity and Economic Growth
    4. 7.3 Components of Economic Growth
    5. 7.4 Economic Convergence
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  9. 8 Unemployment
    1. Introduction to Unemployment
    2. 8.1 How Economists Define and Compute Unemployment Rate
    3. 8.2 Patterns of Unemployment
    4. 8.3 What Causes Changes in Unemployment over the Short Run
    5. 8.4 What Causes Changes in Unemployment over the Long Run
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  10. 9 Inflation
    1. Introduction to Inflation
    2. 9.1 Tracking Inflation
    3. 9.2 How to Measure Changes in the Cost of Living
    4. 9.3 How the U.S. and Other Countries Experience Inflation
    5. 9.4 The Confusion Over Inflation
    6. 9.5 Indexing and Its Limitations
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  11. 10 The International Trade and Capital Flows
    1. Introduction to the International Trade and Capital Flows
    2. 10.1 Measuring Trade Balances
    3. 10.2 Trade Balances in Historical and International Context
    4. 10.3 Trade Balances and Flows of Financial Capital
    5. 10.4 The National Saving and Investment Identity
    6. 10.5 The Pros and Cons of Trade Deficits and Surpluses
    7. 10.6 The Difference between Level of Trade and the Trade Balance
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  12. 11 The Aggregate Demand/Aggregate Supply Model
    1. Introduction to the Aggregate Supply–Aggregate Demand Model
    2. 11.1 Macroeconomic Perspectives on Demand and Supply
    3. 11.2 Building a Model of Aggregate Demand and Aggregate Supply
    4. 11.3 Shifts in Aggregate Supply
    5. 11.4 Shifts in Aggregate Demand
    6. 11.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
    7. 11.6 Keynes’ Law and Say’s Law in the AD/AS Model
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  13. 12 The Keynesian Perspective
    1. Introduction to the Keynesian Perspective
    2. 12.1 Aggregate Demand in Keynesian Analysis
    3. 12.2 The Building Blocks of Keynesian Analysis
    4. 12.3 The Phillips Curve
    5. 12.4 The Keynesian Perspective on Market Forces
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  14. 13 The Neoclassical Perspective
    1. Introduction to the Neoclassical Perspective
    2. 13.1 The Building Blocks of Neoclassical Analysis
    3. 13.2 The Policy Implications of the Neoclassical Perspective
    4. 13.3 Balancing Keynesian and Neoclassical Models
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  15. 14 Money and Banking
    1. Introduction to Money and Banking
    2. 14.1 Defining Money by Its Functions
    3. 14.2 Measuring Money: Currency, M1, and M2
    4. 14.3 The Role of Banks
    5. 14.4 How Banks Create Money
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  16. 15 Monetary Policy and Bank Regulation
    1. Introduction to Monetary Policy and Bank Regulation
    2. 15.1 The Federal Reserve Banking System and Central Banks
    3. 15.2 Bank Regulation
    4. 15.3 How a Central Bank Executes Monetary Policy
    5. 15.4 Monetary Policy and Economic Outcomes
    6. 15.5 Pitfalls for Monetary Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  17. 16 Exchange Rates and International Capital Flows
    1. Introduction to Exchange Rates and International Capital Flows
    2. 16.1 How the Foreign Exchange Market Works
    3. 16.2 Demand and Supply Shifts in Foreign Exchange Markets
    4. 16.3 Macroeconomic Effects of Exchange Rates
    5. 16.4 Exchange Rate Policies
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  18. 17 Government Budgets and Fiscal Policy
    1. Introduction to Government Budgets and Fiscal Policy
    2. 17.1 Government Spending
    3. 17.2 Taxation
    4. 17.3 Federal Deficits and the National Debt
    5. 17.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation
    6. 17.5 Automatic Stabilizers
    7. 17.6 Practical Problems with Discretionary Fiscal Policy
    8. 17.7 The Question of a Balanced Budget
    9. Key Terms
    10. Key Concepts and Summary
    11. Self-Check Questions
    12. Review Questions
    13. Critical Thinking Questions
    14. Problems
  19. 18 The Impacts of Government Borrowing
    1. Introduction to the Impacts of Government Borrowing
    2. 18.1 How Government Borrowing Affects Investment and the Trade Balance
    3. 18.2 Fiscal Policy and the Trade Balance
    4. 18.3 How Government Borrowing Affects Private Saving
    5. 18.4 Fiscal Policy, Investment, and Economic Growth
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  20. 19 Macroeconomic Policy Around the World
    1. Introduction to Macroeconomic Policy around the World
    2. 19.1 The Diversity of Countries and Economies across the World
    3. 19.2 Improving Countries’ Standards of Living
    4. 19.3 Causes of Unemployment around the World
    5. 19.4 Causes of Inflation in Various Countries and Regions
    6. 19.5 Balance of Trade Concerns
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  21. 20 International Trade
    1. Introduction to International Trade
    2. 20.1 Absolute and Comparative Advantage
    3. 20.2 What Happens When a Country Has an Absolute Advantage in All Goods
    4. 20.3 Intra-industry Trade between Similar Economies
    5. 20.4 The Benefits of Reducing Barriers to International Trade
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  22. 21 Globalization and Protectionism
    1. Introduction to Globalization and Protectionism
    2. 21.1 Protectionism: An Indirect Subsidy from Consumers to Producers
    3. 21.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions
    4. 21.3 Arguments in Support of Restricting Imports
    5. 21.4 How Governments Enact Trade Policy: Globally, Regionally, and Nationally
    6. 21.5 The Tradeoffs of Trade Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  23. A | The Use of Mathematics in Principles of Economics
  24. B | The Expenditure-Output Model
  25. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
    17. Chapter 17
    18. Chapter 18
    19. Chapter 19
    20. Chapter 20
    21. Chapter 21
  26. References
  27. Index

By the end of this section, you will be able to:

  • Explain how banks act as intermediaries between savers and borrowers
  • Evaluate the relationship between banks, savings and loans, and credit unions
  • Analyze the causes of bankruptcy and recessions

Somebody once asked the late bank robber named Willie Sutton why he robbed banks. He answered: “That’s where the money is.” While this may have been true at one time, from the perspective of modern economists, Sutton is both right and wrong. He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks, waiting for a robber to appear. Most money is in the form of bank accounts, which exist only as electronic records on computers. From a broader perspective, however, the bank robber was more right than he may have known. Banking is intimately interconnected with money and consequently, with the broader economy.

Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets. Imagine for a moment what the economy would be like if everybody had to make all payments in cash. When shopping for a large purchase or going on vacation you might need to carry hundreds of dollars in a pocket or purse. Even small businesses would need stockpiles of cash to pay workers and to purchase supplies. A bank allows people and businesses to store this money in either a checking account or savings account, for example, and then withdraw this money as needed through the use of a direct withdrawal, writing a check, or using a debit card.

Banks are a critical intermediary in what we call the payment system, which helps an economy exchange goods and services for money or other financial assets. Also, those with extra money that they would like to save can store their money in a bank rather than look for an individual who is willing to borrow it from them and then repay them at a later date. Those who want to borrow money can go directly to a bank rather than trying to find someone to lend them cash. Transaction costs are the costs associated with finding a lender or a borrower for this money. Thus, banks lower transactions costs and act as financial intermediaries—they bring savers and borrowers together. Along with making transactions much safer and easier, banks also play a key role in creating money.

Banks as Financial Intermediaries

An “intermediary” is one who stands between two other parties. Banks are a financial intermediary—that is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. Financial intermediaries include other institutions in the financial market such as insurance companies and pension funds, but we will not include them in this discussion because they are not depository institutions, which are institutions that accept money deposits and then use these to make loans. All the deposited funds mingle in one big pool, which the financial institution then lends. Figure 14.4 illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out. Of course, when banks make loans to firms, the banks will try to funnel financial capital to healthy businesses that have good prospects for repaying the loans, not to firms that are suffering losses and may be unable to repay.

The illustration shows the circular transactions between savers, banks, and borrowers. Savers give deposits to banks, and the bank provides them with withdrawals and interest payments. Borrowers give repayment of loans and interest payments to banks and the banks provide them with loans.
Figure 14.4 Banks as Financial Intermediaries Banks act as financial intermediaries because they stand between savers and borrowers. Savers place deposits with banks, and then receive interest payments and withdraw money. Borrowers receive loans from banks and repay the loans with interest. In turn, banks return money to savers in the form of withdrawals, which also include interest payments from banks to savers.

Clear It Up

How are banks, savings and loans, and credit unions related?

Banks have a couple of close cousins: savings institutions and credit unions. Banks, as we explained, receive deposits from individuals and businesses and make loans with the money. Savings institutions are also sometimes called “savings and loans” or “thrifts.” They also take loans and make deposits. However, from the 1930s until the 1980s, federal law limited how much interest savings institutions were allowed to pay to depositors. They were also required to make most of their loans in the form of housing-related loans, either to homebuyers or to real-estate developers and builders.

A credit union is a nonprofit financial institution that its members own and run. Members of each credit union decide who is eligible to be a member. Usually, potential members would be everyone in a certain community, or groups of employees, or members of a certain organization. The credit union accepts deposits from members and focuses on making loans back to its members. While there are more credit unions than banks and more banks than savings and loans, the total assets of credit unions are growing.

In 2008, there were 7,085 banks. Due to the bank failures of 2007–2009 and bank mergers, there were 5,571 banks in the United States at the end of the fourth quarter in 2014. According to the Credit Union National Association, as of December 2014 there were 6,535 credit unions with assets totaling $1.1 billion. A day of “Transfer Your Money” took place in 2009 out of general public disgust with big bank bailouts. People were encouraged to transfer their deposits to credit unions. This has grown into the ongoing Move Your Money Project. Consequently, some now hold deposits as large as $50 billion. However, as of 2013, the 12 largest banks (0.2%) controlled 69 percent of all banking assets, according to the Dallas Federal Reserve.

A Bank’s Balance Sheet

A balance sheet is an accounting tool that lists assets and liabilities. An asset is something of value that you own and you can use to produce something. For example, you can use the cash you own to pay your tuition. If you own a home, this is also an asset. A liability is a debt or something you owe. Many people borrow money to buy homes. In this case, a home is the asset, but the mortgage is the liability. The net worth is the asset value minus how much is owed (the liability). A bank’s balance sheet operates in much the same way. A bank’s net worth as bank capital. We also refer to a bank has assets such as cash held in its vaults, monies that the bank holds at the Federal Reserve bank (called “reserves”), loans that it makes to customers, and bonds.

Figure 14.5 illustrates a hypothetical and simplified balance sheet for the Safe and Secure Bank. Because of the two-column format of the balance sheet, with the T-shape formed by the vertical line down the middle and the horizontal line under “Assets” and “Liabilities,” we sometimes call it a T-account.

The assets on the left side of the T-account are as follows: loans ($5 million), U.S. Government Securities (USGS) ($4 million) and Reserves ($2 million). The assets on the left side of the T-account are Loans ($5 million), U.S. Government Securities (USGS) ($4 million) and Reserves ($2 million). The liabilities + net worth on the right side of the T-account are as follows: deposits ($10 million) and net worth ($1 million). There is nothing in the space across from U.S. Government Securities (USGS).
Figure 14.5 A Balance Sheet for the Safe and Secure Bank

The “T” in a T-account separates the assets of a firm, on the left, from its liabilities, on the right. All firms use T-accounts, though most are much more complex. For a bank, the assets are the financial instruments that either the bank is holding (its reserves) or those instruments where other parties owe money to the bank—like loans made by the bank and U.S. Government Securities, such as U.S. treasury bonds purchased by the bank. Liabilities are what the bank owes to others. Specifically, the bank owes any deposits made in the bank to those who have made them. The net worth of the bank is the total assets minus total liabilities. Net worth is included on the liabilities side to have the T account balance to zero. For a healthy business, net worth will be positive. For a bankrupt firm, net worth will be negative. In either case, on a bank’s T-account, assets will always equal liabilities plus net worth.

When bank customers deposit money into a checking account, savings account, or a certificate of deposit, the bank views these deposits as liabilities. After all, the bank owes these deposits to its customers, when the customers wish to withdraw their money. In the example in Figure 14.5, the Safe and Secure Bank holds $10 million in deposits.

Loans are the first category of bank assets in Figure 14.5. Say that a family takes out a 30-year mortgage loan to purchase a house, which means that the borrower will repay the loan over the next 30 years. This loan is clearly an asset from the bank’s perspective, because the borrower has a legal obligation to make payments to the bank over time. However, in practical terms, how can we measure the value of the mortgage loan that the borrower is paying over 30 years in the present? One way of measuring the value of something—whether a loan or anything else—is by estimating what another party in the market is willing to pay for it. Many banks issue home loans, and charge various handling and processing fees for doing so, but then sell the loans to other banks or financial institutions who collect the loan payments. We call the market where financial institutions make loans to borrowers the primary loan market, while the market in which financial institutions buy and sell these loans is the secondary loan market.

One key factor that affects what financial institutions are willing to pay for a loan, when they buy it in the secondary loan market, is the perceived riskiness of the loan: that is, given the borrower's characteristics, such as income level and whether the local economy is performing strongly, what proportion of loans of this type will the borrower repay? The greater the risk that a borrower will not repay loan, the less that any financial institution will pay to acquire the loan. Another key factor is to compare the interest rate the financial institution charged on the original loan with the current interest rate in the economy. If the original loan requires the borrower to pay a low interest rate, but current interest rates are relatively high, then a financial institution will pay less to acquire the loan. In contrast, if the original loan requires the borrower to pay a high interest rate, while current interest rates are relatively low, then a financial institution will pay more to acquire the loan. For the Safe and Secure Bank in this example, the total value of its loans if they sold them to other financial institutions in the secondary market is $5 million.

The second category of bank asset is bonds, which are a common mechanism for borrowing, used by the federal and local government, and also private companies, and nonprofit organizations. A bank takes some of the money it has received in deposits and uses the money to buy bonds—typically bonds issued that the U.S. government issues. Government bonds are low-risk because the government is virtually certain to pay off the bond, albeit at a low rate of interest. These bonds are an asset for banks in the same way that loans are an asset: The bank will receive a stream of payments in the future. In our example, the Safe and Secure Bank holds bonds worth a total value of $4 million.

The final entry under assets is reserves, which is money that the bank keeps on hand, and that it does not lend or invest in bonds—and thus does not lead to interest payments. The Federal Reserve requires that banks keep a certain percentage of depositors’ money on “reserve,” which means either in their vaults or at the Federal Reserve Bank. We call this a reserve requirement. (Monetary Policy and Bank Regulation will explain how the level of these required reserves are one policy tool that governments have to influence bank behavior.) Additionally, banks may also want to keep a certain amount of reserves on hand in excess of what is required. The Safe and Secure Bank is holding $2 million in reserves.

We define net worth of a bank as its total assets minus its total liabilities. For the Safe and Secure Bank in Figure 14.5, net worth is equal to $1 million; that is, $11 million in assets minus $10 million in liabilities. For a financially healthy bank, the net worth will be positive. If a bank has negative net worth and depositors tried to withdraw their money, the bank would not be able to give all depositors their money.

Link It Up

For some concrete examples of what banks do, watch this video from Paul Solman’s “Making Sense of Financial News.”

How Banks Go Bankrupt

A bank that is bankrupt will have a negative net worth, meaning its assets will be worth less than its liabilities. How can this happen? Again, looking at the balance sheet helps to explain.

A well-run bank will assume that a small percentage of borrowers will not repay their loans on time, or at all, and factor these missing payments into its planning. Remember, the calculations of the banks' expenses every year include a factor for loans that borrowers do not repay, and the value of a bank’s loans on its balance sheet assumes a certain level of riskiness because some customers will not repay loans. Even if a bank expects a certain number of loan defaults, it will suffer if the number of loan defaults is much greater than expected, as can happen during a recession. For example, if the Safe and Secure Bank in Figure 14.5 experienced a wave of unexpected defaults, so that its loans declined in value from $5 million to $3 million, then the assets of the Safe and Secure Bank would decline so that the bank had negative net worth.

Clear It Up

What led to the 2008–2009 financial crisis?

Many banks make mortgage loans so that people can buy a home, but then do not keep the loans on their books as an asset. Instead, the bank sells the loan. These loans are “securitized,” which means that they are bundled together into a financial security that a financial institution sells to investors. Investors in these mortgage-backed securities receive a rate of return based on the level of payments that people make on all the mortgages that stand behind the security.

Securitization offers certain advantages. If a bank makes most of its loans in a local area, then the bank may be financially vulnerable if the local economy declines, so that many people are unable to make their payments. However, if a bank sells its local loans, and then buys a mortgage-backed security based on home loans in many parts of the country, it can avoid exposure to local financial risks. (In the simple example in the text, banks just own “bonds.” In reality, banks can own a number of financial instruments, as long as these financial investments are safe enough to satisfy the government bank regulators.) From the standpoint of a local homebuyer, securitization offers the benefit that a local bank does not need to have significant extra funds to make a loan, because the bank is only planning to hold that loan for a short time, before selling the loan so that it can pool it into a financial security.

However, securitization also offers one potentially large disadvantage. If a bank plans to hold a mortgage loan as an asset, the bank has an incentive to scrutinize the borrower carefully to ensure that the customer is likely to repay the loan. However, a bank that plans to sell the loan may be less careful in making the loan in the first place. The bank will be more willing to make what we call “subprime loans,” which are loans that have characteristics like low or zero down-payment, little scrutiny of whether the borrower has a reliable income, and sometimes low payments for the first year or two that will be followed by much higher payments. Economists dubbed some of the subprime loans made by financial institutions in the mid-2000s NINJA loans: loans that financial institutions made even though the borrower had demonstrated No Income, No Job, or Assets.

Financial institutions typically sold these subprime loans and turned them into financial securities—but with a twist. The idea was that if losses occurred on these mortgage-backed securities, certain investors would agree to take the first, say, 5% of such losses. Other investors would agree to take, say, the next 5% of losses. By this approach, still other investors would not need to take any losses unless these mortgage-backed financial securities lost 25% or 30% or more of their total value. These complex securities, along with other economic factors, encouraged a large expansion of subprime loans in the mid-2000s.

The economic stage was now set for a banking crisis. Banks thought they were buying only ultra-safe securities, because even though the securities were ultimately backed by risky subprime mortgages, the banks only invested in the part of those securities where they were protected from small or moderate levels of losses. However, as housing prices fell after 2007, and the deepening recession made it harder for many people to make their mortgage payments, many banks found that their mortgage-backed financial assets could be worth much less than they had expected—and so the banks were faced with staring bankruptcy. In the 2008–2011 period, 318 banks failed in the United States.

The risk of an unexpectedly high level of loan defaults can be especially difficult for banks because a bank’s liabilities, namely it customers' deposits. Customers can withdraw funds quickly but many of the bank’s assets like loans and bonds will only be repaid over years or even decades. This asset-liability time mismatch—the ability for customers to withdraw bank’s liabilities in the short term while customers repay its assets in the long term—can cause severe problems for a bank. For example, imagine a bank that has loaned a substantial amount of money at a certain interest rate, but then sees interest rates rise substantially. The bank can find itself in a precarious situation. If it does not raise the interest rate it pays to depositors, then deposits will flow to other institutions that offer the higher interest rates that are now prevailing. However, if the bank raises the interest rates that it pays to depositors, it may end up in a situation where it is paying a higher interest rate to depositors than it is collecting from those past loans that it at lower interest rates. Clearly, the bank cannot survive in the long term if it is paying out more in interest to depositors than it is receiving from borrowers.

How can banks protect themselves against an unexpectedly high rate of loan defaults and against the risk of an asset-liability time mismatch? One strategy is for a bank to diversify its loans, which means lending to a variety of customers. For example, suppose a bank specialized in lending to a niche market—say, making a high proportion of its loans to construction companies that build offices in one downtown area. If that one area suffers an unexpected economic downturn, the bank will suffer large losses. However, if a bank loans both to consumers who are buying homes and cars and also to a wide range of firms in many industries and geographic areas, the bank is less exposed to risk. When a bank diversifies its loans, those categories of borrowers who have an unexpectedly large number of defaults will tend to be balanced out, according to random chance, by other borrowers who have an unexpectedly low number of defaults. Thus, diversification of loans can help banks to keep a positive net worth. However, if a widespread recession occurs that touches many industries and geographic areas, diversification will not help.

Along with diversifying their loans, banks have several other strategies to reduce the risk of an unexpectedly large number of loan defaults. For example, banks can sell some of the loans they make in the secondary loan market, as we described earlier, and instead hold a greater share of assets in the form of government bonds or reserves. Nevertheless, in a lengthy recession, most banks will see their net worth decline because customers will not repay a higher share of loans in tough economic times.

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