What Is Banking? How Does It Work?

A World Without Banks?

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Banking keeps the world's economic engine humming.. Photo: Ariel Skelley/Getty Images

Definition: Banking is one of the key drivers of the U.S. economy. Why? It provides the liquidity needed for families and businesses to invest for the future. Bank loans and credit means families don't have to save up before going to college or buying a house, and companies can start hiring immediately to build for future demand and expansion. Credit has gotten a bad name, thanks to the 2008 financial crisis, but that's only because it was unregulated, used for consumption instead of investment, and allowed to create a bubble.

How It Works

Banks provides a safe place to save excess cash, known as deposits. That's because deposits are insured by the Federal Deposit Insurance Corporation. Instead of sitting uselessly under the mattress, banks can turn every one of those dollars into ten. That's because they only have to keep 10% of your deposit on hand. They lend the other 90% out. Banks primarily make money by charging higher interest rates on their loans than they pay for deposits.

Types of Banks

You are probably most familiar with retail banking. They provide money services to individuals and families. Online banks operate over the Internet. There are some that are online-only banks, such as ING and HSBC. However, most banks now offer online services. Savings and loans target mortgages. Credit unions provide personalized service, but are usually restricted to employees of companies or schools.

Commercial banks focus on businesses.

Community banks are smaller commercial banks. They focus on the local market, and provide more personalized service that's based on relationships. Most retail banks also offer commercial banking services.

Investment banking has become much more important since many banking laws were deregulated in the 1990s.

These banks traditionally were small, privately-owned companies that helped corporations find funding through initial public stock offerings (IPOs) or issuing bonds, facilitating mergers and acquisitions (M&A), and operating hedge funds for high net-worth individuals.

Shariah banking conforms to the Islamic prohibition against interest rates. Islamic banks must also avoid alcohol, tobacco and gambling businesses. Borrowers profit-share with the lender instead of paying interest That helped Islamic banks avoid the risky asset classes responsible for the 2008 financial crisis.. (Source: Global Finance, "Sharing in Risk and Reward", June 2008; IHT, Islamic finance is seeing spectacular growth, November 5, 2007)

The Glass-Steagall Act protected commercial banks' deposits from mixing with these profit- and risk-seeking banks. When Glass-Steagall was repealed in 1999, the lines became blurred. Some commercial banks began investing in derivatives, such as mortgage-backed securities, and depositors panicked.

This led to the largest bank failure in history, Washington Mutual, in 2008.

A Special Type of Bank -- Central Banks

Banking wouldn't be as effective in supplying liquidity without central banks.  In the United States, that's the Federal Reserve. The Fed manages the money supply. It's the amount of money banks can lend. The Fed has three primary tools:

  1. The reserve requirement typically lets a bank lend up to 90% of its deposits.
  2. The Fed funds rate sets a target for banks' prime interest rate, which is the rate banks charge their best customers.
  3. The discount window is where banks can borrow funds overnight to make sure they have enough to meet the reserve requirement.

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

How Banking Has Changed

Between 1980 and 2000, the banking business doubled. If you count all the assets and the securities they created, it would be nearly as large as the entire economic output (GDP) of the U.S. During that time, the profitability of banking grew even faster. Banking represented 13% of all corporate profits during the late 1970s. By 2007, they represented 30% of all profits.

The largest banks grew the fastest. From 1990-1999, the ten largest banks share of all bank assets grew from 26% to 45%. Their share of deposits also grew during that time period, from 17% to 34%.The two largest banks did the best. Citigroup assets grew from $700 billion in 1998 to $2.2 trillion in 2007 (plus $1.1 trillion in off-balance sheet assets). Bank of America grew from $570 billion to $1.7 trillion during that same time period.

How did this happen? Deregulation. The repeal of Glass-Steagall allowed commercial banks to get into investment banking and securitization. The Riegal-Neal Interstate Banking and Branching Efficiency Act of 1994 repealed constraints on interstate banking. This allowed the large regional banks to become national. The large banks gobbled up smaller ones, so that by the 2008 financial crisis there were, in effect, only 13 banks that mattered in America: Bank of America, JPMorgan Chase, Citigroup, American Express, Bank of New York Mellon, Goldman Sachs, Freddie Mac, Morgan Stanley, Northern Trust, PNC, State Street, US Bank and Wells Fargo. (Source: Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books:New York. 2010)

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