The Banking Cycle

The Banking Cycle

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Present Banking Systems

Consumers of all socioeconomic classes rely on banking systems as a place of security, preservation, and gradual growth in wealth. Despite the recent insecurities in American banking in early 2023, banking has maintained its position as a pivotal transfer-point between businesses and consumers alike from as early as the 18th century.

But what draws the consumer to the bank? What factors make banking systems preferable to holding cash individually? In the same way banks charge interest on loans, they provide a similar return interest on your money by simply safeguarding with their bank. In simpler terms, by offering your money to a bank, you will receive a small percentage of that money back yearly, just by leaving it with the bank. Along with return interest, banks will often reward you for using affiliated debit or credit cards, or using affiliated trading platforms they endorse. This bank model is known as the retail bank, which focuses on interactions with single consumers. The commercial bank offers similar services such as loans, cash management, and credit specifically for large corporation dynamics. 

Additions beyond the commercial bank and retail bank models begin to give individual banks character and desirability. For example, investment banks offer various services to clients, most commonly serving as an intermediary to the investor. Through investment banks, consumers can exchange for bonds as well as trade stocks on the market. In this sense, an investment bank functions as more of a business than a traditional bank. Another major division of banking is the central banking sector, which manages the funding, finance, cash, trades, and other financial services of a single nation or country; hence the title central. Central banks often oversee the smaller banks within a particular country and provide services to them, serving as the bank of the banks. Central banks are key to macroeconomics as a whole because they stabilize individual economies within the world, and maintain unique currency reserves, which plays into forex and currency trade.

Fractional Reserve Banking

On the surface, banks appear as a secure location to deposit, loan, and withdraw money, but banks do not operate so simply. When one deposits their money in a bank, their money isn’t really held exclusively for them. Banks use the accumulated wealth of their customers as material to loan to their other clients. A loan in its simplest form is borrowing something to eventually be returned in a contracted timeframe. Consumers often take money loans from banks to pay for large expenses, for which they do not have cash to pay upfront. The most common of such are for auto, home, and university. Although the banks are able to lend cash upfront to their customer, they will charge the customer based on how much time it takes for them to return the loaned money, in the form of interest. The interest of a loan is a percentage-based payment required to the bank by the customer as a confirmation that the loan will eventually be paid, and that they will be charged more in interest if the loan is not paid by the agreed date. 

By charging interest on loans they administer using the money of their clients, banks are able to profit from loaning their money without making any expenses. This process is called fractional reserve banking, and many banks across the world operate on this system. Fractional reserve banks, using this system, do not need to hold on to as much capital as they would if they were a 100% reserve bank (not administering loans with consumer funds), and fuel the economy as a whole by exercising the present cash rather than letting it stagnate within the bank. Even though this process seems beneficial to both the consumer and providing bank, fractional reserve banking fails when consumer distrust occurs, and capital within the bank significantly declines.

Because banks have proven to be historically reliant in terms of security, service diversity, and reputation, consumer trust is the real reason behind the success and prevalence of banking today. There will always be a dominant consumer population within almost any economy, and each will need services that banking provides to flourish financially. Because many consumers have confidence and trust within their individual banks, they drive the banking industry towards positive progression. Varieties of interest rates, loans, deposit policies, withdrawal policies, and overall customer to bank experience fuels the business of banking. This is why we have millions of different banks across the world, each offering unique circumstances to apples to different types of people and financial groups. Banking functionally serves as an industry rather than a single service that people use.

The Money Multiplier

For every bank, there is a required portion of capital that must be held with the central bank in relation to this bank in order to maintain security of sudden withdrawal from the bank. This portion is determined by a constant known as the reserve requirement ratio, which differs per central bank. In fractional reserve banking systems, this is especially relevant because it limits how much a bank can lend in relation to total capital. The reserve requirement ratio is not necessarily a general reflection of the economic health of a particular central bank, but rather a means of managing inflation and financial stability. This ratio is different between regions and countries because economic health and condition changes significantly between different areas of the world. As a whole, this ratio is determined by how easily an economy can crash.

But what does this ratio imply for the possible expansion of a bank? In macroeconomics, a term known as the money multiplier describes the relationship between the reserves of a bank and the money supply in the economy. The money multiplier can be written as:Money Multiplier = Principal LendReserve Requirement Ratio. Let’s look at this through an example to illustrate what it means. Say a central bank provides $2,000 to a lower banking system, and this particular central bank has a reserve requirement ratio of 20%. 20% of the $2,000 from the central bank is $400, meaning the lower bank can lend at most $1,600 of the original $2,000 provided by the central bank. If this bank deposits this $1,600 in another bank, this other bank will only be able to use $1,600 – (20% of $1,600) =  $1,280 as lending material. This process infinitely occurs within the banking system, as the original $2,000 decreases as the number of interactions increases. The total amount of lendable money between all interactions can be written as this money multiplier, which in this case will be $2,000(5) = $10,000.

Although this money multiplier is only valid if the bank utilizes as much of their reserve as permitted and external factors do not influence this cycle, the money multiplier provides insight on monetary, or general banking policies, as a result of the reserve requirement ratio influencing the growth of the money supply. It allows central banks to have a better understanding of their respective economy as well as stabilizing and managing risk within banks. It is a very important metric for assessing the effects of a policy change as well as predicting the future of an economy.

Banking as a Cycle

After defining the individual systems and metrics that determine banking success, we need to look at how this functions as a cycle from the consumer to beyond the central bank. The cycle begins with consumers placing their funds into a fractional reserve bank. This initial deposit serves as a foundation for the interactions that take place at the highest level of economics. This bank then lends the funds to another party, and enables money expansion from the money multiplier. This bolsters economic activity and growth through creating more opportunity to exercise the same initial deposit. The central bank and national monetary policies will influence this expansion through modifying the reserve requirement ratio and other similar metrics, such as interest and credit, to regulate stability and economic health. The consumers and banks will react to these changes in policy by making new and informed decisions to manage their wealth. As this cycle repeats with more and more feedback, the economy reacts to consumer behavior and various economic industries grow. Without banking, macroeconomics would lack an integral system to economic activity and growth across the world.

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