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The business of accepting deposits and lending money. Banking defined in this way, however, is carried out by some other financial intermediaries that perform the functions of safe­guarding deposits and making loans. Building societies and finance houses, for example: are not normally referred to as banks and are not regarded as being part of the banking system in the narrow, traditional sense. The key to this confusing distinction between banking and the banking system is that the latter is the principal mechanism through which the money supply of the country is created and con­trolled. Since 1971 the role of banks (in the widest sense) in the determination of the money supply has been recognized, however.

The banking system is now normally understood to include the commercial banks (joint-stock banks), the secondary banks, the central bank, the merchant banks or accepting houses and the discount houses (which are not banks as such), but to exclude the savings banks and investment banks and other intermediaries. The deposits of some types of bank, e.g. the Post Office Savings Bank, cannot be used in the settlement of debts until they are withdrawn but a deposit in a commercial bank can be used to settle debts by the use of cheques or transfers. When the manager of a branch of one of the joint-stock banks opens an overdraft account for a customer, the loan creates a deposit; that is to say, a book debt has been incurred to the customer in return for a promise to repay it. Whether or not the overdraft is secured by collateral security, such as an insurance policy, or some other asset, the bank has added to the total money supply. In balance sheet terms the deposit is a claim on the bank - that is a liability - while the customer's promise to repay it or the collateral secuiity is an asset to the bank. In the absence of government control on lending the limitation on the bank's ability to create deposits is their obligation, if they are to remain in business, to pay out current account deposits in cash on demand. Since the bank's custorriers meet most of their needs for money by writing cheques on their deposits, the cash holdings the banks need are only a small fraction of their total deposits. This ratio between their deposit liabilities and cash holdings is called the cash ratio (sometimes called the primary ratio). Banks also hold other liquid assets (bills of exchange, loans at call and other loans to the inoney market). In the past the cash ratio in Britain has amounted to at least 8 per cent of total deposits, and the liquidity ratio (secondary ratio), including both cash and the other liquid assets, has been at least 28 per cent.

These minimum ratios were originally based upon banking conventions, but since 1951 have been maintained at the 'request' of the monetary authorities. In many countries the minimum banking reserve ratios are fixed by law, and in 1971 U.K. banks were required to maintain newly defined reserve asset ratios which corresponded to the old secondary ratio. London clearing banks were also required to keep a day-to-day total of 1 ·5 per cent of eligible liabilities in the form of balances at the head office of the Bank of England. Deposits at. the central bank were always regarded by commercial bankers as cash and, in fact, typically accounted for about half of the old 8 per cent cash ratio, so that this primary ratio also survived in modified form. In 1981, however, the reserve asset ratio was abolished. The object of the banker is, of course, to keep his reserves as near as possible to the minimum, since no return at all is earned on holdings of cash and a very Jow return in the money market. The banking system is based on confidence in the system's ability to meet its obligations. In the short run, no bank is able to meet all its obligations in cash, and if demands upon "it-exhausted its cash reserves the bank would be obliged to close its doors.

Reference: Oxford Press Dictonary of Economics, 3rd edt.