Banking system is a network of commercial, savings, and specialized banks that provide financial services, including accepting deposits and providing loans and credit, money transmission and investment facilities (Bnet.com, 2010). However, banks itself is the massiveness of all the money transaction today involves the transfer of bank deposit. Banks which are also known as depository institutions are at the very center of our monetary system (wfhummel.cnchost.com, 2010). Thus banking system is basically the method on how money works.
The banking system functions when Fed created the monetary base when it buys securities for its own portfolio. Bank deposits themselves are not base money; rather they are claims on base money. Additionally, in order to meet its depositors' cash withdrawals and to cover the checks written against their accounts, banks have to hold reserves of the base money. Reserves comprise a bank's vault cash and what it holds on deposit at the Fed, known as Fed funds. The Fed requires banks to maintain reserves of at least 10% of their demand deposits, averaged over successive 14-day periods Next, the movement of bank reserves is also a part of banking system where the depositor's bank must surrender that amount in reserves to the payee's bank for the check to clear when a depositor writes a check against his account. Besides that, as the checks are written and cleared, the reserves are continuously moving from one bank to another. Subsequently, some banks will be short of reserves and others long. Banks trades in the Fed funds market after redistribute reserves among themselves. Therefore, those long on reserves will normally lend to those short ones. The annualized interest rate on interbank loans is known as the Fed funds rate, and varies with supply and demand (wfhummel.cnchost.com, 2010).
The reserve requirement applies only to the bank's demand deposits, not its term or savings deposits. Thus when a bank depositor converts funds in a demand deposit into a term or savings deposit, he frees up the reserves that were held against the demand deposit. The bank can then use those reserves in several ways. For example, it can hold them to back further lending, buy interest-earning Treasury securities, or lend them to other banks in the Fed funds market (wfhummel.cnchost.com, 2010).
On the other hand, banking system's role is also involved in controlling of the Fed fun rates. The Fed controls the Fed funds rate by adjusting the supply of reserves in order to meet the demand at its target interest rate. It does so by adding or draining reserves through its open market operations. The supply of reserves changes whenever base money enters or leaves the banking system. Thus, this occurs when the Fed buys or sells securities or even when the public deposits or withdraws cash from banks. The demand for reserves, however, changes whenever total of demand deposits change, which occurs when banks increase or decrease total lending (wfhummel.cnchost.com, 2010).
However, there are effects occurs due to the banking system. When banks give out excessive loans to the society without checking their ability to pay back, thus financial crisis occurs which banks will have less money thus reverse cycle runs there as it will affect the banks badly.
According to Flyod Norris's article, he has found and stated in statistics that there are more than $1 in every $10 that American banks that have outstanding in loans that is lent to a troubled borrower, on the other hand there is a ratio far higher than previously seen in the quarter-century that such numbers have been compiled. The problems are greatest in construction loans for single-family homes, where nearly 40 percent of the loans either are delinquent or have been written off as uncollectible. But they are also high in mortgage loans for single-family homes, where $1 in every $8 of loans is troubled (ritholtz.com, 2010). This proves the number of bank in trouble will rise dramatically and the rate of bank failures also increases. Hence banking system is getting more affected.
In addition, the government spending also affects the banking system. As you can see, The Fed acts as a depository for the Treasury as well as member banks. All government spending is paid out of the Treasury's account at the Fed. The Fed debits the Treasury's account and credits the Fed account of the payee's bank each time the government spends. The Treasury replenishes its Fed account with transfers from its commercial bank accounts where it deposits the receipts from taxes, and the sale of its securities.
In order to minimize variations in aggregate banking system reserves, the Treasury maintains a nearly constant balance in its Fed account. In effect, Treasury payments are simply transfers from its commercial bank accounts to the bank accounts of the public. Funds move in the reverse direction when the public pays taxes or buys securities from the Treasury. The Treasury must maintain a positive balance in its commercial bank accounts to avoid having to borrow directly from the Fed. However it has no need for, and does not accumulate, balances in excess of its near-term payment obligations.
On average, government spending does affect the banking system in certain ways. If the government borrows money from the bank and spends it lavishly, thus the bank will have insufficient funds to cycle back the money. However, it also depends, on average terms, government spending does not affect the aggregate bank deposits of the private sector because the Treasury sells or redeems securities as required to balance its inflows against outflows. Nevertheless, short-term variations occur because receipts cannot be synchronized with spending. In a result, banking system reserves remain basically unaffected by government spending because the Treasury transfers funds from its commercial bank accounts to replace the funds spent out of its Fed account.
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