Banking and How It Works
Can You Imagine a World Without Banks?
Banking is an industry that handles cash, credit, and other financial transactions. Banks provide a safe place to store extra cash and credit. They offer savings accounts, certificates of deposit, and checking accounts. Banks use these deposits to make loans. These loans include home mortgages, business loans, and car loans.
Banking is one of the key drivers of the U.S. economy. It provides the liquidity needed for families and businesses to invest in the future. Bank loans and credit mean families don't have to save up before going to college or buying a house. Companies use loans to start hiring immediately to build for future demand and expansion.
How It Works
Banks are a safe place to deposit excess cash. 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.
Types of Banks
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 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 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.
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.
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 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, 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 provides similar services for small businesses. They provide mezzanine financing, bridge financing, and corporate credit products.
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.
Central Banks Are a Special Type of 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:
- 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.
- The reserve requirement lets a bank lend up to the entire amount of its deposits.
- The Fed funds rate sets a target for banks' prime interest rate. That's the rate banks charge their best customers.
- 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.
How Banking Has Changed
Banking underwent a period of deregulation. Congress repealed the Glass-Steagall Act in 1999. 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 America. 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.
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Special Inspector General for the Troubled Asset Relief Program. "The Legacy of TARP’s Bank Bailout Known as the Capital Purchase Program," Page 5. Accessed June 10, 2020.
Federal Deposit Insurance Corporation. "The Orderly Liquidation of Lehman Brothers Holdings Under the Dodd-Frank Act." Accessed June 10, 2020.
Federation of American Scientists. "The Dodd-Frank Wall Street Reform and Consumer Protection Act: Background and Summary," Page 4-12. Accessed June 10, 2020.
Corporate Finance Institute. "What Is a Merchant Bank?" Accessed June 10, 2020.
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Board of Governors of the Federal Reserve System. "What Is the Prime Rate, and Does the Federal Reserve Set the Prime Rate?" Accessed June 10, 2020.
Board of Governors of the Federal Reserve System. "Discount Window Lending." Accessed June 10, 2020.
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Federal Reserve Bank of Richmond. "Changes in the Size Distribution of U.S. Banks: 1960–2005," Page 291. Accessed June 10, 2020.