The deposit and loan services provided by banks benefit an economy in many ways. First, checking accounts, because they act like cash, make it much easier to buy goods and services and therefore help both consumers and businesses, who would find it inconvenient to carry or send through the mail huge amounts of cash. Second, loans enable consumers to improve their standard of living by borrowing money to purchase cars, houses, and other expensive consumer goods that they otherwise could not afford. Third, loans help businesses finance plant expansion and production of new goods, and therefore increase employment and economic growth. Finally, since banks want loans repaid, banks choose borrowers carefully and monitor performance of a company’s managers very closely. This helps ensure that only the best projects get financed and that companies are run efficiently. This creates a healthy, efficient economy. In addition, since the owners (stockholders) of a company receiving a loan want their company to be profitable and managed efficiently, bankers act as surrogate monitors for stockholders who cannot be present on a regular basis to watch the company’s managers.
The checking account services offered by banks provide an additional benefit to the economy. Because checks are widely accepted as payment for goods and services, the checking accounts offered by banks are functionally equivalent to real money—that is, currency and coin. When banks issue checking accounts they, in effect, create money without the federal government having to print more currency. Under government regulations in many countries, banks must hold a reserve of paper currency and coin equal to at least 10 percent of their checking account deposits. In the United States banks keep these reserves in their own vaults or on deposit with the U.S. government’s central bank known as the Federal Reserve, or the Fed. If someone wants a $10 loan, the bank can give that person a $10 checking account with only $1 of currency in its vault. As a result U.S. banks can create at least $10 of checking account money for every $1 of real money (currency or coin) actually printed by the federal government. This arrangement, which allows extra deposit money to be created by banks, is referred to as a fractional reserve banking system.
Because banks attract large amounts of savings from depositors, banks can make many loans to many different customers in various amounts and for various maturities (dates when loans are due). Banks can thereby diversify their loans, and this in turn means that a bank is at less risk if one of its customers fails to repay a loan. The lowering of risk makes bank deposits safer for depositors. Safety encourages even more bank deposits and therefore even more loans. This flow of money from savers through banks to the ultimate borrower is called financial intermediation because money flows through an intermediary—that is, the bank.