In the broadest sense of the term, "banking" is the business of accepting temporary responsibility for safeguarding other people's money ("deposits") and then lending out these funds (along with the bankers' own funds) in order to earn interest for the bank's own account. Banking firms thus earn their profits primarily by serving as "financial intermediaries" who mobilize the scattered savings of many households and firms (by offering safekeeping services and paying interest on at least some kinds of accounts) and then make these pooled funds available to suitable borrowers (to business firms that want to finance proposed investment projects or perhaps to consumers who want to finance big ticket durable consumers' goods like automobiles or perhaps to governmental entities whose policy-makers have decided to spend more money than they have received in revenue collections). The bank pledges its own capital (and also buys outside deposit insurance) to guarantee that any depositor can get all his/her money back in cash no later than some contractually specified length of time after giving notice of withdrawal. The bank makes this somewhat risky guarantee even though it is quite predictable that some (hopefully small) percentage of the loans the bankers make using depositers' funds will "turn sour" and not be repaid by the borrower. The bank's profits arise mainly from the (positive) spread between its costs of securing and servicing deposits and its revenues from fees and interest on the loans extended. (Of course banks frequently seek to make additional profits selling other financial services to their clients and customers as well, but the business of accepting deposits and making loans is the defining core of the banking business.)

Not all firms engaging in "banking" in this broad sense are officially called "banks." Savings and loan associations, credit unions and other miscellaneous thrift institutions provide similar services under other names. The laws of the United States and most other developed industrial countries provide for multiple types of financial intermediary institutions whose official "labels" normally depend upon the selected purposes for which they will loan money (business loans, consumer loans, real estate mortgages, etc.), the maximum time period for which they will contract a loan (2 years? 5 years? 30 years?), and the kinds of supplementary services (checking privileges, foreign exchange, management of trusts and estates, etc.) that they may provide for their customers beyond basic taking of deposits and extension of loans.

From the perspective of this course, banks are mainly of interest because of their key role in determining the size of the money stock. Considerably less than half of the US money stock (M1) consists of physical cash or currency (coins and bills). Most of the money stock in the US (or any other present-day advanced industrial economy) is in the form of "mere" ledger entries representing bank depositers' credit balances in their individual or corporate checking accounts. And, amazingly enough to the uninitiated, this means that banks are constantly creating money "out of thin air" simply by making bookkeeping entries that assign new checking account credits to customers as they take out loans from the bank.

Of course, private banks cannot simply create money out of thin air without limit and still expect to stay in business. When the bank credits a borrower's account with the amount of his new loan, it is to be expected that the borrower will very soon want to spend part or all of the money he has borrowed. After the check the borrower writes is deposited in somebody else's account in another bank, the check will soon be presented for collection at the lending bank, and they will have to have the cash on hand to pay the other bank off at that time. The more dollars' worth of loans a bank has extended, the more cash it will have to have on hand in reserves to meet the daily flow of redemptions. Most or all of the check redemption demands coming in every day can normally be offset by the cash and checks drawn on other banks that the depositers and borrowers have brought in and deposited or paid that day, but an "unsound" bank that extends loans with reckless abandon sooner or later will find that the flow of checks presented to it for collection greatly exceeds the flow of outside checks and cash being brought in. Once the bank's vaults are empty and the cash reserves are gone, the management must quickly (overnight!) either borrow the necessary additional cash elsewhere (probably at high interest rates ) or else sell off some of the bank's assets (because of the haste, probably at fire-sale prices). When the troubled bank can no longer borrow and has no assets left that can be sold on short notice, it can no longer fulfill its ontractual guarantees to pay its obligations on demand and is therefore out of business with the banks owners and managers now subject to civil (and perhaps criminal) legal penalties (bankrupcy, suits for breach of contract, negligence, and fraud, indictments for fraud, embezzlement, etc.).

"Sound" banks limit the volume of the loans they extend so that they remain in a prudent proportional relationship to the amount of instantly liquid funds they have available in "reserves" (either as currency in the vault or as demand deposits in some other bank, such as the Federal Reserve ). But bankers face a difficult trade-off. The flow of checks that will be presented for payment and the volume of new deposits and loan repayments coming in every day cannot be predicted with 100% accuracy, so the higher the fraction of its total deposit obligations the bank holds ready in reserves, the safer or "sounder" the bank can be considered (and the more attractive the bank will seem to depositers and other potential business associates). However, reserves do not yield any interest income to the bank; only the funds that are tied up in loans to (solvent) borrowers can contribute directly and immediately to the bank's profitability. To maximize their profits, bank management must find the best way to strike a balance between the need to maintain their "reserve ratio" at a level high enough to limit their risks of becoming insolvent and the conflicting need to keep the highest feasible proportion of the bank's available funds loaned out at interest.

[See also: money stock, monetary policy, reserve requirement, Federal Reserve System]