What Is Banking? How Does It Work?

Can You Imagine a World Without Banks?

Banking pays interest on deposits and lends money. Photo: JGI/Tom Grill/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. Companies can start hiring immediately to build for future demand and expansion.

How It Works

Banks provides a safe place to save excess cash, known as a deposit.

That's because the Federal Deposit Insurance Corporation insures them. Banks also pay a small percent, the interest rate, on the deposit.

Banks can turn every one of those saved dollars into ten. That's because they only have to keep 10% of each deposit on hand. That regulation is called the Reserve Requirement. They lend the other 90% out. Banks make money by charging higher interest rates on their loans than they pay for deposits. 

Types of Banks

The most familiar is 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. But most banks now offer online services. Savings and loans target mortgages. Credit unions provide personalized service but only serve employees of companies or schools.

Commercial banks focus on businesses. Most retail banks also offer commercial banking services.

 Community banks are smaller than commercial banks. They concentrate on the local market. They provide more personalized service based on relationships. 

Investment banking was traditionally small, privately-owned companies. They helped corporations find funding through initial public stock offerings (IPOs) or issuing bonds.

They also facilitated mergers and acquisitions (M&A). Third, they operated hedge funds for high net-worth individuals. After Lehman Brothers failed in 2008, other investment banks became commercial banks. That allowed them to receive government bailout funds. In return, they must now adhere to the regulations in the Dodd-Frank Wall Street Reform Act.

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's why Islamic banks avoided the risky asset classes responsible for the 2008 financial crisis. (Source: "Sharing in Risk and Reward," Global Finance, June 2007. "Islamic Finance Is Seeing Spectacular Growth," International Herald Tribune, November 5, 2007.)

A Special Type of Bank -- Central Banks

Banking wouldn't be able to supply liquidity without central banks.  In the United States, that's the Federal Reserve. The Fed manages the money supply. It's how much money banks can lend. The Fed has three primary tools:

  1. The reserve requirement lets a bank lend up to 90% of its deposits.
  2. The Fed funds rate sets a target for banks' prime interest rate. That's the rate banks charge their best customers.
  1. 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. 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 almost as large as the entire U.S. economy (GDP). 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 increased from 26% to 45%.

Their share of deposits also grew during that period, from 17% to 34%. The two largest banks did the best. Citigroup assets rose from $700 billion in 1998 to $2.2 trillion in 2007. It laos had $1.1 trillion in off-balance sheet assets. Bank of America grew from $570 billion to $1.7 trillion during that same period.

How did this happen? Deregulation. Congress repealed the Glass-Steagall Act in 1999. It had protected commercial banks' deposits from mixing with profit- and risk-seeking banks. After its repeal, the lines between investment banks and commercial banks became blurred. Some commercial banks began investing in derivatives, such as mortgage-backed securities.  When they failed, depositors panicked. It led to the largest bank failure in history, Washington Mutual, in 2008. 

The Riegal-Neal Interstate Banking and Branching Efficiency Act of 1994 repealed constraints on interstate banking. It allowed the large regional banks to become national. The large banks gobbled up smaller ones.

By 2008 financial, there were only 13 banks that mattered in America. They were 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)