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, creating them with a deposit. The deposit is a liability of the bank. It is money owed to depositors. In turn the banks lend 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. The crucial feature of banks is that some of their 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. We begin by looking at the present day UK banking system. Although the details vary from country to country, the general principle is much the same everywhere.
In the UK, the commercial banking system comprises about 600 registered banks, 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. The clearing banks are so named because they have a central clearing house for handling payments by cheque.
A clearing system is 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.
Suppose you bank with Barclays but visit a supermarket that banks with Lloyds. To pay for your shopping you write a cheque against your deposit at Barclays. The supermarket pays this cheque into its account at Lloyds. In turn, Lloyds presents the cheque to Barclays which will credit Lloyds’ account at Barclays and debit your account at Barclays by an equivalent amount. Because 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.
However on the same day someone else, call her Joan Groover, is probably writing a cheque on a Lloyd’s deposit account to pay for some stereo equipment from a shop banking with Barclays. The stereo shop pays the cheque into its Barclay’s account, increasing its deposit. Barclays then pay the cheque into its account at Lloyds where Ms Groover’s account is simultaneously debited. Now the transfer flows from Lloyds to Barclays.
Although in both cases the cheque writer’s account is debited and the cheque recipient’s account is credited, it does not make sense for the two banks to make two separate inter – bank transactions between themselves. 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.