Banking System

A banking system is the whole set of banks operating in an economy, together with the central bank that sits above them, the laws and supervisors that govern them and the payment networks that connect them. It includes commercial banks, savings and cooperative banks, specialised development banks and, in many countries, Islamic banks. It is the main channel through which household savings are pooled and lent to firms, governments and other households, and the place where most of a country's money is held and moved.

Statisticians and supervisors treat the banking system as one unit. In the International Monetary Fund's monetary statistics, the central bank and the deposit-taking banks together form the "depository corporations" sector, whose balance sheet is the starting point for measuring the money supply. The banking system is narrower than the financial system as a whole, which also covers insurers, pension funds, securities markets and shadow banking. Each country's financial regulator, usually the central bank, licenses and supervises its banks.

Think of a town's water network. Rain is collected in many small tanks (people's accounts), pumped through shared pipes, and delivered to the houses and fields that need it. A main reservoir run by the town keeps the pressure steady and can top up any tank that runs dry.

The banking system works the same way with money. Banks collect spare cash from savers, lend it to people and businesses that need it, and pass payments to each other through shared pipes. The central bank is the reservoir: it supplies the money banks use to settle with each other, and it steps in when a bank is short. Because everyone is connected, a leak in one big tank can lower the pressure for everybody, which is why the system is watched so closely.

Economists usually describe four jobs that the banking system performs for the wider economy:

• Intermediation. Banks act as a financial intermediary between savers and borrowers, collecting bank deposits and turning them into loans and holdings of government securities.
• Maturity transformation. Banks fund long-term lending with deposits that can be withdrawn quickly, a practice known as maturity transformation. It makes credit available but leaves banks exposed to sudden withdrawals.
• Payments. Most transfers, card payments and cheques are settled by moving balances between banks, ultimately across accounts at the central bank.
• Money creation. When a bank makes a loan it credits the borrower's account, creating new commercial bank money. The Bank of England described this process in its 2014 article "Money creation in the modern economy".

Modern banking systems have two tiers. At the top, the central bank issues banknotes and holds reserve accounts for banks. Balances in those accounts are central bank money, the asset banks use to settle with each other, usually through a real-time gross settlement (RTGS) system. Below sit the commercial banks, which serve the public.

The central bank influences the system through monetary policy. It sets a policy rate, adds or drains reserves through open market operations, may impose a reserve requirement and acts as lender of last resort to sound banks facing a temporary shortage of cash. Banks with surplus reserves lend to banks with a shortfall in the interbank market, where overnight lending sets the call money rate.

The mix differs by country, but most banking systems include several kinds of institution:

• Commercial banks, which take deposits from and lend to households and businesses. Many are large groups with networks of branches; others are digital banks without branches.
• Mutual and cooperative lenders, such as the building society in the UK and the credit union in the US, owned by their members.
• Specialised or development banks, often state-owned, that lend to agriculture, housing, industry or small firms.
• Islamic banks and conventional banks' Islamic windows, which follow Islamic banking rules and replace interest with profit-sharing and trade-based contracts.
• Foreign banks operating through branches or subsidiaries, and a correspondent bank network that links the domestic system to the rest of the world.

Because banks hold the public's money and are linked to each other, the banking system is one of the most heavily regulated parts of any economy. Entry is controlled through a bank charter or licence. Supervisors set minimum bank capital and liquidity standards, mostly based on the Basel III framework agreed by the Basel Committee on Banking Supervision. Deposit insurance reassures small depositors that their money is safe up to a limit, which reduces the risk of a bank run.

The 2008 financial crisis showed how problems in a few large institutions can spread through the whole system. Since then, supervisors have focused on financial stability as a whole, adding extra capital charges for systemically important banks, stress tests and resolution plans that let a failing bank be wound down without taxpayer bail-outs.

In Pakistan the State Bank of Pakistan (SBP) is both the central bank and the banking regulator, acting under the State Bank of Pakistan Act 1956 and the Banking Companies Ordinance 1962. Banks that the SBP has placed on its statutory list are called scheduled banks. In its statistics the SBP groups them into public-sector commercial banks, local private banks, foreign banks and specialised banks, and reports full-fledged Islamic banks and the Islamic branches of conventional banks separately. Microfinance banks are licensed under separate microfinance legislation.

The SBP publishes regular data on the system's deposits, advances and investments. These series feed into its measures of broad money (M2) and into the flow of funds accounts that show how savings move between sectors of the economy.

• Bank for International Settlements: Basel III
• State Bank of Pakistan Act 1956