Businesses, unlike people, are not created equal. There are some companies that would be missed if they ceased to exist, but life would go on. There are others whose collapse would cause vast sections of economies and societies to implode. Into this second category fall banks.

The companies that make up the banking and financial sector not only store our saved cash and lend us money when we need it, but act as the system of arteries that transports money around the economy, which is why they are often known as financial intermediaries. Their key function is to transfer money, en masse, from those who want to lend to those who want to borrow.

Banks have been a part of the social fabric of societies for centuries -- indeed, the word 'bank' originates from the Latin word banca, which referred to the long desks that moneychangers in Ancient Rome would set up in courtyards to buy and sell foreign currency.

In order for an economy -- whether rich or poor -- to function properly, it must have a well-developed and healthy financial sector. Why? Because both companies and individuals invariably need to borrow to get started and subsequently to build decent, exciting, innovative businesses. Without banks, practically no one would be able to buy a house, since most people need to take out a mortgage in order to afford it.
Similarly, banks play an important role as a medium of exchange. Try to imagine living a day of your life without a bank. We use a bank card, credit card or check to pay for most of our shopping, banks thus being indirectly involved in almost every transaction we make.

At times, banks have grown into goliaths, and were recently found to be doing everything from running people's investments to owning industrial conglomerates and running hotels. Frequently, this level of power has generated resentment, people perceiving banks as parasitic -- feeding off others' wealth in order to propagate their own. Occasionally these critics have had a point. As bank after bank crumbled in the late 2000s it became apparent that much of their expansion had not been based on fundamental growth. However, the plain truth is that without banks, people would not be able to borrow or invest -- actions that are essential if they are to live productive, rewarding lives.

How do Banks Make their Money?

The basic structure and business model of a bank is fundamentally the same wherever you are in the world.
First, banks make a profit by charging more interest on the money they lend out than the money they have as deposits. The gap, or spread, between the two rates allows them to make some profit in return for providing this service, and the riskier a proposition you are (that is, the worse your credit rating), the wider the spread. This is why those taking out a mortgage worth more than 80 per cent or so of their prospective home are often charged a higher interest rate than others. They, after all, are more likely to default, forcing the bank to write off significant amounts of cash.

Second, banks offer customers other financial advice and services -- often for a fee, sometimes merely to encourage them to deposit money with them. For individuals this might include insurance or investment advice. For businesses, it means helping them to issue stock and bonds (in other words to raise money, again connecting borrowers with lenders) and advising them on whether to take over other companies. This is the primary role of investment banks. They also use some of their surplus cash to invest themselves, hoping to make a little extra.

Bank Runs

The modern system of banking in which banks have less cash in their vaults than they officially owe their customers works fine when times are good and depositors are confident that their money is safe. However, in times of crisis, it can fail dramatically. If for some reason -- rumors that a bank is about to collapse, for instance, or following a large robbery or natural disaster that affects the bank -- large numbers of depositors may attempt to withdraw their money. This is called a bank run and was spectacularly illustrated in the 2007 run on UK bank Northern Rock. When savers learnt that the bank had to receive emergency support from the Bank of England -- in its role as lender of last resort -- thousands of people swiftly lined up to withdraw their money.

Because of fractional reserve banking, modern banks do not have enough ready cash to repay all their depositors at one time. As businesses, they are reliant on short-term borrowing (deposits) to fund long-term lending (mortgages and lengthy loans). The latter is highly illiquid, so if customers all demand back their money banks are left facing potential collapse. This would have been the case with Northern Rock had the UK Treasury not intervened and nationalized it.

In the early days of banking, if a bank collapsed the savers faced losing all their money. This is what happened to many during the Great Depression. However, realizing this would cause public consternation and a run on deposits at the first sign of a bank being in trouble, governments have since set up deposit insurance schemes. In the US, the scheme is called the Federal Deposit Insurance Corporation (FDIC) to protect deposits at banks to a certain amount (as of 2008, $250,000).

The experience of the financial crisis that started in 2008 has shown that governments will stop at almost nothing to ensure banks do not collapse. When they do, it can have dire consequences for the wider economy, not only denting consumer confidence and wealth, but also causing sharp falls in the money supply, as banks pour cash into their reserves and stop lending, which in turn can lead to deflation.
With their power to issue money, look after people's life savings, facilitate investment and provide the main arteries for spending, it is no wonder that banks are more regulated than just about any other type of business. Their health and that of the economy are inextricably linked.