From the course: Finance Foundations

Traditional banks

From the course: Finance Foundations

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Traditional banks

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Let's again think of the worldwide economic environment as a great sea, with three types of players swimming in the sea. There are the entrepreneurs, the doers, the creators. They've got business ideas, but they don't have any money. There are also investors swimming around out there. They have money from their savings in the past, and they can provide it to these entrepreneurs so that the entrepreneurs can turn their dreams into reality. But sometimes it's difficult for the entrepreneurs to find the investors. So they need facilitators, specialized financial institutions that can match up the entrepreneurs with the investors. Now, if we were all infinitely sophisticated and had infinite time, each individual entrepreneur could go out and find a saver, an investor who would provide the capital for business ideas. But we don't have infinite time. So if I'm an entrepreneur, I need a financial intermediary who will put me together with an investor. There are lots of variations of financial institutions: Traditional banks, investment banks, insurance companies, and investment funds. Let's start with a traditional bank. A traditional bank fills the classic role of putting together entrepreneurs with investors/savers. The job of a traditional bank is to collect money from you and me, depositors, hold that money and scan the horizon for potential entrepreneurs who want to borrow that money to use in starting new businesses. So how does a traditional bank make money? Well, look at your bank account. What kind of interest rate are you earning on your savings account? These days I am earning less than one percent on my deposits in my local bank. That's what they're paying me when I deposit money into the bank. So what is my bank charging to business owners who come into the bank and want to borrow money? Well, it depends on the nature of the loan, but I don't see any business loans with interest rates lower than five percent. So how does a traditional bank make money? It borrows money from me and you, the depositors, and lends that money out at higher rates to entrepreneurs. The traditional bank serves the role of a facilitator, a financial facilitator, by taking money from you and me, the savers, and putting that money in the hands of carefully screened entrepreneurs.

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