The banking system

Banks are dealers in credit

A bank's core business is to make loans and manage the resulting balance sheet. On the asset side are loans, securities, and reserves. On the liability side are deposits, wholesale borrowings, and equity. The bank earns a spread between what it earns on assets and what it pays on liabilities, while bearing credit, liquidity, and interest-rate risk.

This is different from the "intermediary" story in which banks collect deposits from savers and lend those deposits to borrowers. Banks do connect savers and borrowers, but they do not need to wait for a deposit before extending credit. The loan creates the deposit.^[1]

Reserves and settlement

Reserves are balances that banks hold at the central bank. They are the settlement asset for the payment system: when a customer of Bank A pays a customer of Bank B, the banks settle the net claim in reserves.

Reserves are not the same as the cash in an ATM, and they are not the deposits that households and firms hold. They are a liability of the central bank and an asset of the commercial bank. The central bank supplies them according to its operating framework, and their quantity is influenced by asset purchases, lending facilities, and the demand for safe settlement balances.^[2]

Maturity transformation

Banks fund long-term, illiquid assets with short-term, liquid liabilities. A household can withdraw a deposit at short notice; a mortgage or business loan cannot be called in at short notice without disruption. This maturity transformation is economically valuable: it allows households to hold liquid savings while the economy funds long-lived investment.

It also creates a vulnerability. If many depositors try to withdraw at once, the bank may have to sell assets quickly at fire-sale prices. A solvent bank can fail because it is illiquid.

Runs and deposit insurance

The classic bank-run model shows why this can happen even to a healthy bank. Depositors know that the bank has illiquid assets. If they believe others will withdraw, their best response is to withdraw first. The expectation becomes self-fulfilling.^[3]

Deposit insurance changes the incentive. If depositors know their insured balances are safe, they have less reason to run. Central-bank lending can also provide liquidity against good collateral. Together, these institutions reduce the probability of panic — but they do not eliminate the underlying mismatch.

They also create moral hazard. If depositors and creditors expect to be protected, they may demand less compensation for risk, and banks may take more risk than they otherwise would. That is why deposit insurance is usually paired with supervision, capital requirements, and resolution rules.^[4]

Lender of last resort

The central bank can lend to solvent but illiquid banks against collateral. This is the lender-of-last-resort function. It is meant to stop a liquidity panic from becoming a fire sale and a credit contraction.

The line between liquidity support and solvency support is often blurry in a crisis. If the collateral is impaired, or if the bank's losses are larger than its capital, lending may keep a failing institution alive. That is a fiscal and political question as much as a monetary one.

Shadow banking

Many bank-like functions — maturity transformation, credit intermediation, and leverage — take place outside traditional banks. Money market funds, securities dealers, finance companies, and special-purpose vehicles can perform these functions without deposit insurance or direct access to the central bank's safety net.

Shadow banking can be efficient and can diversify risk. It can also concentrate risk in places that are harder to see and backstop. The 2008 crisis showed how runs can happen in wholesale funding markets, not just in retail deposit franchises. Regulators now monitor these channels, but the boundary between banking and shadow banking remains a source of fragility.^[5]

Why fragility persists

Financial systems are procyclical. In good times, asset prices rise, collateral values improve, and lending looks safe. Banks expand. In bad times, losses rise, collateral values fall, and lending contracts. The financial cycle can amplify the business cycle.^[6]

That is not a reason to abolish banks. It is a reason to design capital, liquidity, and resolution rules that make the system more resilient, and to monitor credit growth rather than only current inflation.

Where to go next

• Financial risks — leverage, Minsky moments, and systemic risk.
• The Federal Reserve — the lender of last resort and the payment system.
• Money creation — the balance-sheet mechanics behind deposits.
• Deflation risk — what happens when credit contracts.