What Is Banking?

Banking Explained

Banker talking to couple in his office as they open a checking account
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Banking is an industry that handles cash, credit, and other financial transactions for individual consumers and businesses alike. Banking provides the liquidity needed for families and businesses to invest in the future, and is one of the key drivers of the U.S. economy.

You can use the products and services offered by a bank or credit union to protect your money, to borrow more, and to build savings. Banking means you won't have to save up before going to college or buying a house. Companies can use loans to start hiring immediately to build for future demand and expansion. In short, banking provides the means for further financial growth.

Definition and Examples of Banking

Banking consists of many activities that can be done through a number of financial institutions that accept deposits from individuals and other entities, and then use this money to offer loans and to invest and earn profit.

Banks can be placed into certain categories based on the type of business they conduct. Commercial banks provide services to private individuals and businesses. Retail banking provides credit, deposit, and money management to individuals and families. 

Community Banking

Community banks are smaller than commercial banks. They concentrate on the local market. They provide more personalized service and build relationships with their customers. 

Internet Banking

Internet banking provides these services via the world wide web. The sector is also called e-banking, online banking, and net banking. Most other banks now offer online services. There are many online-only banks. Since they have no branches, they can pass cost savings onto the consumer.

Much like online banking, many banking services can now be done completely through your phone digital device. Banking and investing apps continue to grow in popularity and may mean you never have to visit a brick-and-mortar bank at all.

Savings and Loan Banking

Savings and loans are specialized banking entities, created to promote affordable home ownership. Often these banks will offer a higher interest rate to depositors as they raise money to lend for mortgages.

Credit Unions

Credit unions are financial institutions that operate similarly to standard banks in many ways, but with a different structure. Customers own their credit unions. This ownership structure allows them to provide low-cost and more personalized services. You must be a member of their field of membership to join. That could be employees of companies or schools or residents of a geographic region. 

Investment Banking

Investment banking finds funding for corporations through initial public stock offerings or bonds. They also facilitate mergers and acquisitions. The largest U.S. investment banks include Bank of America, Citigroup, Goldman Sachs, J.P. Morgan Chase, Wells Fargo, Charles Schwab, and Morgan Stanley.

After Lehman Brothers failed in September 2008, signaling the beginning of the global financial crisis of the late-2000s, investment banks became commercial banks. That allowed them to receive government bailout funds. In return, they must now adhere to the Dodd-Frank Wall Street Reform and Consumer Protection Act regulations.

Merchant Banking

Merchant banking provides similar services for small businesses. They provide mezzanine financing, bridge financing, and corporate credit products.

Sharia Banking

Sharia banking conforms to the Islamic prohibition against interest rates. Also, Islamic banks don’t lend to alcohol and gambling businesses. Borrowers profit-share with the lender instead of paying interest. Because of this, Islamic banks avoided the risky asset classes responsible for the 2008 financial crisis.

How Banking Works

Banks are a safe place to deposit excess cash, and to manage money through products like savings accounts, certificates of deposit, and checking accounts. The Federal Deposit Insurance Corporation (FDIC) insures them. Banks also pay savers a small percent of the deposited amount based on an interest rate.

Banks are currently not required to keep any percentage of each deposit on hand, though the Federal Reserve can change this. That regulation is called the reserve requirement. They make money by charging higher interest rates on their loans than they pay for deposits. 

The Central Bank

Banking wouldn't be able to supply liquidity without central banks. In the United States, that's the Federal Reserve, but most countries have a version of a central bank as well. In the U.S., the Fed manages the money supply banks are allowed to lend. The Fed has four primary tools:

  1. Open market operations occur when the Fed buys or sells securities from its member banks. When it buys securities, it adds to the money supply.
  2. The reserve requirement lets a bank lend up to the entire amount of its deposits.
  3. The Fed funds rate sets a target for banks' prime interest rate. That's the rate banks charge their best customers.
  4. The discount window is a way for banks to borrow funds to support liquidity and stability.

In recent years, banking has become very complicated. Banks have ventured into sophisticated investment and insurance products. This level of sophistication led to the banking credit crisis of 2007.

Notable Happenings

Banking underwent a period of deregulation when Congress repealed the Glass-Steagall Act. That law had prevented commercial banks from using ultra-safe deposits for risky investments. After its repeal, the lines between investment banks and commercial banks blurred. Some commercial banks began investing in derivatives, such as mortgage-backed securities. When they failed, depositors panicked. 

Another deregulation change came from the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. The Act repealed constraints on interstate banking. This repeal allowed large regional banks to become national. The large banks gobbled up smaller ones as they competed with one another to gain the market share.

By the 2008 financial crisis, a small number of large banks controlled most of the banking industry's assets in the U.S. That consolidation meant many banks became too big to fail. The federal government was forced to bail them out. If it hadn't, the banks' failures would have threatened the U.S. economy itself. 

Key Takeaways

  • Banking offers savings, loans, and investment products and services to individuals and businesses.
  • There are many types of banks, or financial institutions, with specialized functions and populations they serve.
  • Banking is regulated at the national level by a central bank—the Federal Reserve in the U.S.—that works to maintain liquidity and economic stability.
  • If left unregulated, banks compete in an open market which has historically proven to be risky and led to numerous financial crises.