Banking Sector and Financial System

Bank Money: Electronic money created when banks lend.
Base Money:
- Notes and coins.
- Reserves commercial banks hold at the central bank for settling discrepancies.

Commercial banks lend to borrowers (individuals, firms).
Savers have options:
- Deposit money in commercial banks for interest.
- Buy government bonds and trade in the money market.
Commercial banks with excess money:
- Deposit at the central bank and earn interest.
Money Market: A place where banks and governments lend and borrow money.

Reserve Bank sets the Official Cash Rate (OCR).
Example: OCR at 3.5%.
- Banks earn 3.5% on deposits at the central bank.
- Banks can borrow from the money market at approximately 3.5% due to the central bank's trading activities.
Commercial banks charge households and firms higher interest rates than the OCR due to risk.

Banks borrow from the money market at a rate close to the OCR (e.g., 3.5%).
They pay savers a lower rate (e.g., 2%).
They lend to borrowers at a higher rate (e.g., mortgage rate of 6%).
The difference between lending and borrowing rates generates profit.
If the Reserve Bank increases the OCR to 4%, banks will increase rates for both borrowers and savers, maintaining a premium to compensate for risk.

Reserve Bank increases interest rates to slow the economy.
- Shifts the supply curve, reducing money in the economy.
- Leads to fewer transactions and less economic activity.
- Results in less inflation.

Bank Run: People lose confidence in a bank, fearing it will collapse due to excessive debt.
- Depositors withdraw funds (notes, coins, electronic transfers).
- Banks may be unable to meet obligations, potentially leading to collapse.
- Governments often step in to guarantee deposits.
- Example: Global Financial Crisis in the UK.
- Potential cascading effect through the banking system.
Bad Investments: Banks make loans that are not repaid.
Principal Agent Problem: Information asymmetry between borrower and lender.
- Borrower has more information about the risk of the project.
- Banks mitigate this by:
  - Requiring borrowers to invest their own money.
    - Example: 20% deposit for house purchases.
    - Gives the borrower a stake in the investment.
  - Requiring collateral.
    - Borrower puts up property that the lender can claim if the loan is not repaid.

Deposit Insurance: Government guarantees deposits to prevent bank runs.
Minimum Deposit Issues:
- Perpetuates intergenerational inequalities.
- Many people rely on family wealth to meet deposit requirements.
Credit Exclusion: People without sufficient deposits or collateral cannot access credit.
Credit Constraint: People who can borrow but are charged higher interest rates due to higher risk.