Banks are the most visible financial intermediaries in the economy. Most of us use the word bank to describe what people in the financial world call depository institutions. These are the financial institutions that accept deposits from savers and make loans to borrowers. What distinguishes depository institutions from nondepository institutions is their primary source of funds—that is, the liability side of their balance sheets. Depository institutions include commercial banks, savings and loans, and credit unions—the financial intermediaries most of us encounter in the course of our dayto- day lives.

Banking is a business. Actually, it's a combination of businesses designed to deliver the services discussed in Chapter 11. One business provides the accounting and record-keeping services that track the balances in your accounts. Another grants you access to the payments system, allowing you to convert your account balances into cash or transfer them to someone else. Yet a third business pools the savings of many small depositors and uses them to make large loans to trustworthy borrowers. A fourth business offers customers diversification services, buying and selling financial instruments in the financial markets in an effort to make a profit. Banks trade in the financial markets not just as a service to their customers but in an effort to earn a profit for their owners as well.

The intent of banks, of course, is to profit from each of these lines of business. Our objective in this chapter is to see how they do it. Surprisingly, not all banks make a profit. While some banks are extremely large, with hundreds of billions of dollars in loans and securities on their balance sheets, their access to funds is no guarantee of profitability. The risk that banks may fail is a problem not just for their owners and managers but for the rest of us, too.

We have emphasized repeatedly that a thriving financial system is a precondition for economic growth. An economy that lacks the institutions to channel resources effectively from savers to investors will perform poorly. This statement applies regardless of whether a country is rich or poor. The United States and Japan provide a striking example. By virtually any standard, both countries are well off. Yet during the 1990s, U.S. banks made substantial profits, while Japanese banks suffered prodigious losses. At the same time, Japan's economy grew at a rate of just over 1 percent, while the U.S. economy grew at a rate well over 3 percent. The financial problems of Japanese banks played an important role in Japan's poor economic performance. Banks are important; when they are poorly managed, we all suffer.

In this chapter, we will examine the business of banking. We will see where depository institutions get their funds and what they do with them. That is, we will study the sources of banks' liabilities and learn how they manage their assets. And because banking is a risky business, we will examine the sources of risk that bankers face, as well as how those risks can be managed.