Banking and How It Works

Can You Imagine a World Without Banks?

Banking pays interest on deposits and lends money.
••• Photo: JGI/Tom Grill/Getty Images

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 accountscertificates 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. Why? It provides the liquidity needed for families and businesses to invest for the future. Bank loans and credit mean 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 are a safe place to deposit excess cash. 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 $10. They are only required to keep 10 percent of each deposit on hand. That regulation is called the reserve requirement. Banks lend the other 90 percent out. They make money by charging higher interest rates on their loans than they pay for deposits. 

Types of Banks

The most familiar type of banking is retail banking. This kind of bank provides money services to individuals and families. Online banks operate over the internet. There are some online-only banks, such as ING and HSBC. Most other 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 and build relationships with their customers. 

Investment banking was traditionally provided by small, privately-owned companies. They helped corporations find funding through initial public stock offerings or bonds. They also facilitated mergers and acquisitions. 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. Also, Islamic banks don’t lend to alcohol, tobacco, 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. The Fed manages the money supply banks are allowed to lend. The Fed has three primary tools:

  1. The reserve requirement lets a bank lend up to 90 percent 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.
  3. The discount window is a way for banks to borrow funds overnight to make sure they 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. gross domestic product. During that time, the profitability of banking grew even faster. Banking represented 13 percent of all corporate profits during the late 1970s. By 2007, it represented 30 percent of all profits.

The largest banks grew the fastest. From 1990 to 1999, the 10 largest banks' share of all bank assets increased from 26 to 45 percent. Their share of deposits also grew during that period, from 17 to 34 percent. The two largest banks did the best. Citigroup assets rose from $700 billion in 1998 to $2.2 trillion in 2007. It 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. 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. 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 the 2008 financial crisis, 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, U.S. Bank, and Wells Fargo. 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.