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Banks and Banking

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What do you do with money that you do not want to spend, carry around, or keep at home? You could deposit it at a bank in a checking or savings account. Or, if you did not have enough money to meet your needs, you could ask a bank to lend you money. By providing these two functions—holding and lending money—banks play a very important role in the U.S. economy. They make the money in bank accounts available to people who need to borrow it.

When you deposit money in a bank as savings, you also earn interest. Interest is a fee paid to you for the use of your money. Suppose, for example, that you deposit $100 in a bank offering an interest rate of 5 percent on savings. At the end of one year the amount of money in your account would be $100 plus the interest.

Money deposited in a bank as savings is loaned to borrowers at a higher interest rate than is paid to savers. For example, a bank that pays 5 percent interest on savings may charge 10 percent interest when the money is loaned. The interest the bank receives is income for the bank. It is used to pay interest to depositors and to cover bank costs. Such costs include the salaries of bank employees, equipment, supplies, and other operating costs.

Banks are owned by stockholders who have invested money in the bank. Part of a bank's total assets are the funds invested by these stockholders. But most of a bank's assets come from money that people have deposited and from interest paid on loans.

History of Banking

Banking activities are almost as old as the earliest civilizations. The earliest bankers were moneychangers or moneylenders. These people had strongboxes in which to keep money. People left money with them for safekeeping. Or they borrowed money from them in exchange for a fee. As early as A.D. 534 the ancient Romans had laws and regulations concerning moneylending and banking.

Modern banking is thought to have begun in Italy during the late 1500's. In fact, the word "bank" comes from the Italian word banco, which means bench. The term became associated with banking because many early Italian bankers conducted their business from benches in the street.

In England during the 1600's it became common practice for people to give their gold and silver to local goldsmiths for safekeeping. These goldsmiths made jewelry and other items. So they had strong vaults in which they kept precious metals. People who did not have safe places for their valuables kept their gold and silver in these vaults. The goldsmiths issued paper receipts, or notes, to the people who left precious metals with them. Eventually, people began to use these paper notes as money. And the goldsmiths became bankers.

As trade flourished in Europe in the 1600's and 1700's banking became so important that commercial banks were set up. These commercial banks were privately owned. Their chief business was to help merchants finance trading activities. They accepted deposits of money, made loans, and collected bills. They also acted as places where money from one country could be converted into the money of another country.

Banking in the United States

The first U.S. banks were state banks. In 1781, the Bank of North America, the first bank to receive a charter, or license to operate, was organized in Philadelphia. Other states soon issued charters to banks of their own. The first national bank was the Bank of the United States. It was established in 1791 and had branches in several cities.

During the late 1700's and early 1800's many state banks followed unsound banking practices. They issued far too many loans in the form of paper bank notes (paper money). The Bank of the United States had the authority to control the amount of paper money issued by the state banks. But in 1811 its charter expired and the Bank of the United States no longer had any control.

Increasing numbers of people became concerned about the value of their paper notes. They asked state banks to exchange the notes for gold and silver coin (called specie). Many banks, however, did not have enough precious metals to back the notes. So they stopped exchanging gold and silver for paper notes. As a result, the notes quickly lost their value. This dangerous financial situation led to many bank failures. When the banks failed, depositors lost their life savings.

The National Bank Act of 1863, which was amended in 1864, created a national banking system in the United States. Under the provisions of this system, the state banks were driven out of the business of issuing paper notes. The national banks were allowed to continue issuing bank notes until 1935. Federal laws then gave the power to issue paper notes solely to a centralized banking system called the Federal Reserve.

The American Banking System

The U.S. banking system today is made up of many banks operating at different levels. All these banks, however, must operate under the jurisdiction and rules of the Federal Reserve System, the centerpiece of American banking.

The Federal Reserve System

The Federal Reserve System was established by Congress in 1913 to correct serious problems in American banking. Prior to the establishment of the Federal Reserve System, the United States experienced several severe financial panics. During these panics many businesses failed. And many banks were forced to close.

The Federal Reserve System is commonly called "the Fed". It is made up of three levels of organization. The top level consists of the Board of Governors, the Federal Open-Market Committee, and the Federal Advisory Council. The Board of Governors is the most important of these groups. It is the central policy-making body of the Federal Reserve System. It consists of seven members appointed by the president and confirmed by the Senate. Each member is appointed for a 14-year term and is ineligible for reappointment. The Board of Governors remains relatively independent of politics. Board decisions do not have to be approved by the president or Congress. Board members do not have to fear losing their jobs when a new president is elected.

The second level of the Federal Reserve System consists of the Federal Reserve Banks. The United States is divided into twelve districts. There is a separate Federal Reserve Bank for each district. The twelve Federal Reserve Banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. The activities of these banks are coordinated by the Board of Governors. The banks do not deal directly with the public. They are "bankers' banks". They deal only with other financial institutions and the government.

The third level of the Fed consists of other financial institutions. These include commercial banks, savings and loan associations, credit unions, and savings banks. These institutions utilize the services of the Federal Reserve System. And they are subject to reserve requirements established by the Fed. They perform the regular day-to-day business of banking in the nation.

The Federal Reserve System performs many important functions. The most important of which is controlling the nation's money supply. It also plays a major role in clearing checks. The Fed supervises member banks. And it serves as a depository for the money that banks are required to keep as reserves. The Fed is also responsible for supplying the nation's paper money in the form of Federal Reserve Notes.

Types of Banks

There are several different types of U.S. financial institutions that are commonly thought of as banks.

Commercial Banks.

Commercial banks make up the largest banking group in the United States. At one time, commercial banks could easily be distinguished from other financial institutions because only they could offer checking accounts. However, changes in the banking laws now allow other financial institutions to offer checking accounts as well.

Commercial banks can be established and operated only after being granted a charter. The charter comes from either the federal government or a state government. Commercial banks chartered by the federal government are called national banks. Those chartered by one of the states are called state banks. The primary functions of commercial banks are to receive deposits, make loans, and provide checking and other services to customers. Commercial banks primarily make short-term commercial loans to businesses and personal loans to individuals.

Savings and Loan Associations.

Savings and loan associations are owned and operated by individuals. They, as shareholders, elect a board of directors to manage the organization. Historically, savings and loan associations primarily made long-term loans—twenty years or longer—. They made them to individuals for building homes or buying existing homes and other real estate. Today, however, savings and loan associations make many other types of loans as well. They also make checking account services available to depositors.

Savings Banks.

Savings banks specialize in individual savings accounts. These banks may be owned by stockholders, although most function as cooperatives, or mutuals, and are owned by their depositors. Mutual savings banks originated in the United States in the early 1800's. At that time commercial banks were not interested in handling the small savings deposits of wage earners. By pooling their savings in a mutual savings bank, wage earners with individual savings could find profitable investment opportunities.

Credit Unions.

Credit unions are cooperative nonprofit associations. They are owned and operated by their members. They are often organized by the employees of large companies. Or they are organized by the members of labor unions for the benefit of their membership. The primary purpose of credit unions is to offer high-interest savings accounts and low-interest loans to members.

Investment Banks.

Investment banks specialize in distributing the securities, or stocks and bonds, of corporations to the public. Investment banks purchase newly issued stocks and bonds from companies. They resell these securities to individual investors in smaller quantities. Investment banks buy securities from a company at a particular price with the intention of reselling them at a higher one. The difference between the two prices is the investment bank's profit. Investment banks provide companies with the money they need so the companies do not have to wait for the public to buy stock.

The World Bank.

The International Bank for Reconstruction and Development (IBRD) is commonly known as the World Bank. It began operating in 1944. Its original purpose was to help finance the reconstruction of areas damaged during World War II. Since that time, the World Bank has also assisted in the economic growth of developing countries by providing them with low-cost loans. In 1956, the World Bank established the International Finance Corporation (IFC). Its purpose is to stimulate private investments in developing countries. The World Bank lends money only for public, or publicly sponsored, projects. The IFC helps to finance private enterprise.

Banking Services

Banks provide many services to the public and the government. But most of their regular business involves accepting deposits from savers and making money available to borrowers in the form of loans.

Time Deposits.

In time deposits, money usually stays in an account for an extended period of time. Savings accounts are a type of time deposit. Most people who put money in a savings account plan to leave it there until it is needed. They may use it to buy a house, to pay for a child's education, or for retirement. Banks pay interest on the money deposited in a savings account. So the amount of money left in an account will gradually increase.

People who have large amounts of money to deposit as savings often put the money in a special account called a certificate of deposit (CD). An advantage of certificates of deposit is that they usually pay higher interest rates than passbook savings accounts. However, certificates of deposit are only payable at a definite date in the future, called the maturity date. This maturity date might range from 30 days to several years. If a person withdraws money from a certificate of deposit before the maturity date, he or she will have to pay a penalty in the form of lost interest.

Demand Deposits.

Demand deposits are checking accounts. Such accounts allow individuals to deposit, withdraw, and transfer their money whenever they want. They provide a convenient way for people to access their money without carrying it around as cash. A person can use a debit card or a check to access funds in a checking account. Or he or she can choose to bank electronically. Checks can be made payable to oneself to withdraw money. Or they can be made payable to someone else to transfer money to that person. Banks sometimes pay interest on checking accounts. But usually a minimum amount of money must be kept in the account at all times.

Each month banks send detailed statements to customers with checking accounts. These statements show how much money was deposited during the month. They also show how much was used and the account's current balance. Some banks enclose the checks that were written, cashed, and returned to the bank during the month. These checks, for which money has been withdrawn from the checking account, are called cancelled checks. They can serve as receipts for any bills paid by check.

Loans.

Banks make many types of loans to individuals or businesses. One major type of loan is a home mortgage loan. It is provided to people who want to buy or build a home. Home mortgage loans usually require repayment over a term. This can be as long as twenty to thirty years. After the buyer pays a down payment on the home, the bank finances the balance of the cost. The buyer then pays off this amount, plus interest, in periodic (usually monthly) installments. On a large loan repaid over many years, the buyer will pay a large amount of interest as a part of each payment.

Banks make many short-term loans to both individuals and businesses. For example, a person might borrow $1,000 from a bank for a period of six months. The person signs a note promising to repay the money in addition to interest charged by the bank for the use of its money. Usually, the person must also offer something of value, such as an automobile, as security, or collateral. If the person fails to repay the loan, the bank can take possession of this collateral.

The rate of interest that banks charge depends on the type and length of the loan. The prime rate is the rate of interest that large city banks charge their best customers. (Their best customers are generally large businesses with excellent credit ratings). The rate of interest paid by the average borrower is usually higher than the prime rate.

Other Services.

Banks also provide many other services. Most banks have safe-deposit boxes in their vaults. They rent the boxes to customers for safekeeping valuable possessions. Banks also provide financial advice to their customers, sell traveler's checks, and issue credit cards.

Financial experts in a bank's trust department provide a variety of services. They manage real estate and collect rents, invest money in stocks and bonds, and sell securities. They also give advice on drawing up wills and manage company pension and health-insurance plans. Money left to charities is often handled by the trust departments of banks as well. Of course, the bank charges a fee for all these services.

Many banks also offer bank credit cards. These credit cards enable people to buy items on credit by charging the items on their cards. The banks pay the merchants for the purchases and then bill the credit card holders, who make payments to their banks. The banks charge interest only on the amounts of the monthly bills that are not paid on time. Bank cards can also be used by customers to get cash advances.

Many banks have automatic teller machines (ATM's) that allow customers to access their accounts 24 hours a day. The customer inserts a special card into the machine and then enters a secret identification number. Once this is done, the customer has access to his or her bank account and can deposit, withdraw, and transfer money without the help of a bank employee.

Another service offered by many banks is electronic funds transfer (EFT). An electronic funds transfer system moves money into or out of a customer's account electronically. For example, some employees have their salaries electronically credited to their accounts. This eliminates the need to cash or deposit paychecks. Electronic funds transfer speeds service to customers. It also eliminates much of the paperwork involved in banking services.

Safety of Bank Deposits

During the Great Depression of the 1930's many people lost their life savings when banks failed. Government insurance funds were created to prevent that from happening again. These funds guaranteed that depositors would be paid the full amount of their deposits if a bank failed.

Prior to 1989, accounts in savings and loan associations were insured by the Federal Savings and Loan Insurance Corporation (FSLIC). Accounts in commercial banks were insured by the Federal Deposit Insurance Corporation (FDIC). In the late 1980's, however, the failure of many savings and loan associations caused the bankruptcy of the FSLIC insurance fund. As a result, beginning in 1989, the FDIC became responsible for insuring accounts in both commercial banks and savings and loan associations.

To handle all these accounts, two insurance funds were established within the FDIC—the Banking Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF). The BIF insures deposits in commercial banks up to $100,000 per deposit. The SAIF insures deposits in savings and loan associations up to a total of $100,000. If a bank or savings and loan association has financial troubles and is unable to repay depositors, repayment will be made out of the insurance funds. Credit union deposits are also insured up to $100,000 by insurance funds.

Banking in Canada

Attempts to establish a Canadian bank go back to the late 1700's. But it was not until 1817 that the first bank in Canada was successfully launched. Early banks in Canada were established as private partnerships, by provincial law, or by royal charters obtained in England. However, by 1867 the federal government had assumed sole responsibility for the country's banking system.

Canada's central bank, the Bank of Canada, is the centerpiece of Canadian banking. It was founded in 1934 and nationalized in 1938. In addition, there are five large banks chartered under Canadian law, each of which has a nationwide network of branch banks.

The Bank of Canada is directed by law to regulate credit and currency in such a way as to promote the best interests of the Canadian economy. It carries out banking policies by changing rates of interest on loans, altering the amount of reserves that must be held by chartered banks to back up deposits, buying and selling securities, and responding to changes in foreign exchange rates. Canadian banks provide basically the same services as American banks. There are differences, however, in policy and in the services provided.

Careers in Banking

Most of the people working in banks are either bank officers or clerical workers. Bank officers, depending on their rank, usually have some authority to make business decisions involving the bank. Bank officers might include positions such as president, vice president, and comptroller. Some, such as loan and trust officers, head specific departments.

Clerical workers in banks include secretaries, bank tellers, bookkeepers, and various other employees who do clerical work. These positions generally outnumber bank officers by a ratio of about six to one.

Allen Smith
Professor of Economics
Eastern Illinois University

See also: Credit Cards ; Economics ; Inflation and Deflation ; Money .

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