Understanding Banking and Financial Intermediaries
The Banking System and Money Creation
Banks
Banks are a set of entities forming the core of the banking system, often operating in addition to savings and credit cooperatives.
Core Banking Functions
The primary function of banking is to capture lawful money from savers to lend to economic agents that need funding. Banks perform several key activities:
- Managing immediately available funds.
- Lending money in exchange for interest.
- Maintaining emergency stocks of funds (reserves) to tackle any withdrawal of deposits.
Reserve Ratios and Liquidity Management
These ratios dictate the amount of cash banks must hold inactive:
- Cash Ratio (Reserve Ratio): This is the percentage of total deposits received that the bank maintains in an inactive state (cash reserves) to address withdrawals from their clients. The European Central Bank (ECB) sets a minimum for banks in the euro area.
- Statutory/Legal Cash Ratio: This is the percentage of money that, by imposition of the ECB, banks must keep inactive to cope with the withdrawals of money from their customers. The ECB can vary this ratio.
Creation of Bank Money
The creation of bank money operates under the fractional reserve system:
- The money a bank lends often results in a new deposit that must eventually be paid back.
- A cash coefficient (reserve requirement) exists, representing the portion of deposits that does not get paid out.
- Banks can only lend the money deposited in their coffers (savings) minus the percentage of money the bank has to maintain inactive in the form of reserves.
Financially Non-Bank Intermediaries
These entities act as financial mediators whose liabilities are typically not considered money. They play a crucial role in the financial system.
Key Non-Bank Financial Intermediaries
ICO (Official Credit Institute)
Operates under the instructions of the government, providing grants to economic sectors facing difficulties and financing structural projects.
Insurance Companies
They issue a specific financial asset, the policy. The insured pays a premium in exchange for services (indemnification). They invest premiums in other financial assets and fixed-income securities so that they can cover claims if necessary.
Pension Funds
During their working life, associated contributors pay money that accumulates with agreed interest, which they receive when they retire.
Investment and Mutual Funds
Investors are associated to gain better access to the stock market. Everyone holds a participation certificate that will fluctuate according to the contributions and the fund's performance.
Leasing Companies
They rent a capital good in exchange for a lease fee over a term. At the end of the rental period, the lessee can return the property or pay an agreed residual price specified in the contract.
Factoring Companies
A factoring company purchases the collection rights (accounts receivable) of another company (the assignor). In exchange for a commission, the factor provides immediate liquidity to the company that assigns these rights, avoiding the problem of collections management and defaults.
Money Market Mediators
These societies manage assets of high liquidity, such as those traded on the stock market. They can be:
- Brokers: They put together buyers and sellers.
- Dealers: They put together buyers and sellers, and also buy and sell on their own account.
Mutual Guarantee Systems
They enable partners to access finance by acting as guarantors of their credits.
Entities for Hire Purchase Financing
They provide funding in exchange for interest. If the borrower defaults on payment, the property is repossessed.