What Is Retail Banking? Types and Economic Impact

How It Works and How It Affects the U.S. Economy

man writing check in bank
Retail banks provide the capital needed for the economy to grow. Photo: Image Source/Digital Vision/Getty Images

Definition: Retail banking provides financial services for families and small businesses. The three most important functions are credit, deposit and money management.

First, these banks offer consumers credit to purchase homes, cars and furniture. These include mortgages, auto loans and credit cards. The resulting consumer spending drives almost 70 percent of the U.S. economy. They provide extra liquidity to the economy this way.

Credit allows people to spend future earnings now. Retail banks also offer small business loans to entrepreneurs. These small companies create up to 65 percent of all new jobs as they grow.

Second, retail banks provide a safe place for people to deposit their money. Savings accounts, certificates of deposit and other financial products offer a better rate of return compared to stuffing their money under a mattress. Banks base their interest rates on the Fed funds rate and Treasury bond interest rates. That's why they rise and fall over time. The Federal Deposit Insurance Corporation insures most of these deposits.

Third, retail banks allow you to manage your money with checking accounts and debit cards. That means you don't have to do all your transactions with dollar bills and coins. All of this can be done online, making it an added convenience.

Types of Retail Banks

Most of America's largest banks have retail banking divisions.

These include Bank of America, JP Morgan Chase, Wells Fargo and Citigroup. It often makes up to 50-60 percent of these banks' total revenue.

There are many smaller community banks as well. They focus on building relationships with the people in their local towns, cities and regions. They usually have less than $1 billion in total assets.

Credit unions are another type of retail banks. They restrict services to employees of companies or schools. They operate as non-profits. That means they can offer better terms to savers and borrowers because they aren't as focused on profitability as the bigger banks.

Savings and loans are retail banks that only target mortgages. They've almost disappeared since the 1989 Savings and Loans Crisis

Lastly, Sharia banking conforms to the Islamic prohibition against interest rates. So borrowers share their profits with the bank instead of paying interest. This policy helped Islamic banks avoid the 2008 financial crisis. They didn't invest in risky derivatives. These banks cannot invest in alcohol, tobacco and gambling businesses. (Source: “Sharing in Risk and Reward,” Global Finance, June 01, 2008 & “Islamic finance is seeing spectacular growth,” International Herald Tribune, November 05, 2007)

How Retail Banks Work

Retail banks use the depositors' funds to give out loans. They make money by charging higher interest rates on loans than they pay on deposits. 

The Federal Reserve, the nation's central bank, regulates most retail banks. Except for the smallest banks, it requires all other banks to keep around 10 percent of their deposits in reserve each night.

They are free to lend out the rest. At the end of each day, banks that are short of the Fed's reserve requirement borrow from other banks to make up for the shortfall. This amount borrowed is called the fed funds.

How They Affect the U.S. Economy and You

Retail banks create the supply of money in the economy. Since the Fed only requires them to keep 10 percent of deposits on hand, they loan out the remaining 90 percent. Each dollar lent out goes to the borrower's bank account. That bank then lends 90percent of this money, which goes into another bank account. That's how a bank creates $9 for every dollar you deposit.

As you can imagine, this is a powerful tool for economic expansion. To ensure proper conduct, the Fed controls this as well. It sets the interest rate banks use to lend fed funds to each other.

That's called the fed funds rate. That's the most important interest rate in the world. Why? Banks set all other interest rates against it. If the Fed funds rate moves higher, so do all other rates.

Most retail banks sold off their mortgages to large banks in the secondary market. For this reason, and because they had large deposits, they were primarily spared from the banking credit crisis of 2007