13. Describe the modern banking system. How does the clearance system work?

Money is important to the well-being of any economy, politicians care about the conduct of monetary policy, the management of money and interest rates. The organization responsible for the conduct of a nation’s monetary policy is the central bank.

The goldsmith bankers were an early example of a financial intermediary. A financial intermediary is an institution that specializes in bringing lenders and borrowers together. A commercial bank borrows money from the public, crediting them with a deposit. The deposit is a liability of the bank. the bank lends money to firms, households, or governments wishing to borrow.

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

Commercial banks are financial intermediaries with a government license to make loans and issue deposits, including deposits against which cheques can be written. In the UK the National Girobank operating through post offices, and about a dozen trustee savings banks. Much the most important single group is the London clearing banks. A clearing system is a set of arrangements in which debts between banks are settled by adding up all the transactions in a given period and paying only the net amounts needed to balance inter-bank accounts. When you purchased goods from a supermarket using a different bank, a transfer of funds between the two banks is required. Crediting or debiting one bank's account at another bank is the simplest way to achieve this.

The clearing system calculates the net flows between the member clearing banks and these are the settlements that they make between themselves. Thus the system of clearing cheques represents another way society reduces the costs of making transactions.

A bank is a business and its owners or managers aim to maximize profits. A bank makes profits by lending and borrowing. To get money in, the bank offers favourable terms to potential depositors. British clearing banks offer interest on sight deposits only to important customers, but they usually offer free chequing facilities to people whose sight deposits or current accounts do not fall below a certain level. And they offer interest on time deposits.

Next, the banks have to find profitable ways to lend what has been borrowed. Most is lent out as advances of overdrafts to households and firms, usually at interest rates well in excess of the rate simultaneously being paid to the bank customers with time deposits. Some is used to purchase securities such as long-term government bonds. Some is more prudently invested in liquid assets. Although these do not pay such a high rate of interest, the bank knows that it can get its money back quickly if people start withdrawing a lot of money from their sight deposits. And some money is held as cash, the most liquid asset of all.

What economic services does the bank provide? It is transforming household loans to the bank into bank loans to a wide range of people – governments wishing to finance a budget deficit, firms borrowing to build a new factory, and individuals borrowing to start a new business or to buy a new home. Without the existence of the intermediary, depositors would have neither the time nor the expertise to decide which of these loans or investments to make. That is the economic service that the bank as an intermediary provides.