In their role as financial intermediaries, banks receive savings from many individuals, pay them interest, and then loan these funds to borrowers, charging them interest. Banks earn profit by charging more for their loans than they pay for the savings. To earn this money, they must provide useful “middleman” services by evaluating investments and spreading risk.

Imagine that you, as a bank depositor, had to decide which companies were worth lending money to. Is this guy Fred Smith with his FedEx idea a genius or a kook? Banks don’t always get it right, but by specializing in loan evaluation, they have a better idea than most of us of which business ideas make sense. When banks specialize, individual savers don’t have to evaluate which factories ought to be built or which businesses deserve to be supported.

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Even if individuals could evaluate business ideas, it would be wasteful if every saver spent time evaluating the same business. Imagine that a business needs a million dollar loan. One thousand savers are each willing to lend the business $1,000. If each saver spent a day evaluating the quality of the business, that would be 999 wasted days of effort. It makes more sense for the lenders to appoint a single person to evaluate the business on behalf of all of them. That’s exactly what a bank does. Banks coordinate lenders and minimize information costs. Banks are thus an important example of the benefits of specialization and the division of labor.

Banks also spread risk. If Fred Smith, or some other borrower, defaults on his loan, banks spread that loss across the many lenders who deposit money in the bank. This avoids the risk that you have lent Fred Smith $1,000 and suddenly are out the entire sum. It’s less risky and no less profitable to lend one thousand firms $1 each than to lend one firm $1,000, so the spreading of risk encourages greater lending and investment.

Banks also play a role in the payments system. Money deposited in a bank can be drawn on with a check or debit card or via the ATM. We discuss banks and the payment system at greater length in Chapter 15.

Overall, banks make our lives simpler. We open our accounts, deposit our money, receive our interest payments, and write our checks; at the same time we are participating in the process of economic growth because the bank oversees a process by which our savings are turned into productive investments.