Role of Banks in the Economy

Channelling Savings Towards Investment

Some households and firms have more money than they want to spend right now. Others want to spend more than they have. A bank brings the two groups together.

Financial intermediary: an organisation, such as a bank, that takes in money from savers and lends it to borrowers.

Savers deposit money with a bank and are paid interest on it. The bank lends that money on to firms that want to invest, and charges them interest. A café owner who wants £30,000 for a second shop does not have to find hundreds of savers: the bank has already collected their deposits.

Without banks, this would be much harder, because:

• savers want to be able to take their money out at short notice, while firms want to borrow for years
• a single saver lending to a single firm could lose everything if that firm failed, whereas a bank spreads its lending across thousands of borrowers
• most savers have no way of judging whether a business is likely to repay.

Across the economy, this means savings end up paying for investment. Investment raises firms' capacity and productivity, so the economy can produce more. Money left sitting idle does neither.

Role of Banks in Providing Credit

Credit: money lent to a household or firm that has to be paid back later, usually with interest.

Firms borrow to start up before they have any sales, to cover a gap between paying bills and being paid, or to invest in more capacity than their profits can pay for.

Before lending, a bank checks how likely the borrower is to repay, usually from a business plan, a cash-flow forecast and the firm's credit history. The main types of credit are covered in 1.4.3.

Banks make most of their profit from the gap between the interest they charge borrowers and the interest they pay savers. So a bank wants to lend, but only to borrowers it expects to pay it back.

Interest Rates

Interest rate: the cost of borrowing money, or the reward for saving it, shown as a percentage of the amount borrowed or saved per year.

A firm that borrows £30,000 at 8% a year pays £2,400 in interest in the first year, on top of repaying the loan itself. The higher the rate, the more each project has to earn to be worth borrowing for.

The general level of interest rates also links back to saving and investment. Low rates → saving earns little and borrowing is cheap → households save less and firms invest more. High rates do the opposite.

Different borrowers pay different rates. The rate a bank charges depends on:

Collateral

Collateral: an asset a borrower promises to a lender, which the lender can take and sell if the loan is not repaid.

Property is the most common collateral, but machinery, vehicles and stock can also be used. A loan backed by collateral is a secured loan. One without is an unsecured loan.

Collateral lowers the bank's risk, so it makes lending more likely and cheaper. New and small firms lose out: few assets → little to offer as security → the bank asks the owner for a personal guarantee, a promise to repay from their own money, sometimes backed by their home → if the business fails, the owner can lose personal assets as well as the business (see 1.4.2).