Modern banking

An entity whose income exceeds its expenditure can lend or invest the excess income. On the other hand, an entity whose income is less than its expenditure can raise capital by borrowing, decreasing its expenses, or increasing its income. The lender can find a borrower, a financial intermediary such as a bank, or buy bonds in the bond market. The interest rate for the borrowers is higher than that for the lender, and the financial intermediary earns the difference for arranging the loan, which is called its rate of return.

A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it pays interest. The bank then lends these deposits to borrowers. The deposit is a liability of the bank, i.e. it is money owed to depositors. Banks allow borrowers and lenders of different sizes (such as households, firms or governments) to coordinate their activity.

Commercial banks are financial intermediaries with a government licence to make loans and issue deposits, including deposits against which cheques can be written.

Banks are not the only financial intermediaries. Insurance companies, pension funds, and building societies also take in money in order to relend it. The crucial feature of banks is that some of their liabilities are used as a means of payment, and are therefore part of the money stock