DOB: ABCs of Banking - Banks and Our Economy

{Textbooks}    ABC's of Banking

Provided by the State of Connecticut, Department of Banking,
based on information from the Conference of State Bank Supervisors (CSBS)


Banks and Our Economy

"Bank" is a term people use broadly to refer to many different types of financial institutions. What you think of as your "bank" may be a bank and trust company, a savings bank, a savings and loan association or other depository institution.

What is a Bank?

Banks are privately-owned institutions that, generally, accept deposits and make loans. Deposits are money people leave in an institution with the understanding that they can get it back at any time or at an agreed-upon future time. A loan is money let out to a borrower to be generally paid back with interest. This action of taking deposits and making loans is called financial intermediation. A bank's business, however, does not end there.

Most people and businesses pay their bills with bank checking accounts, placing banks at the center of our payments system. Banks are the major source of consumer loans -- loans for cars, houses, education -- as well as main lenders to businesses, especially small businesses.

Banks are often described as our economy's engine, in part because of these functions, but also because of the major role banks play as instruments of the government's monetary policy.

How Banks Create Money

Banks can't lend out all the deposits they collect, or they wouldn't have funds to pay out to depositors. Therefore, they keep primary and secondary reserves. Primary reserves are cash, deposits due from other banks, and the reserves required by the Federal Reserve System. Secondary reserves are securities banks purchase, which may be sold to meet short-term cash needs. These securities are usually government bonds. Federal law sets requirements for the percentage of deposits a bank must keep on reserve, either at the local Federal Reserve Bank or in its own vault. Any money a bank has on hand after it meets its reserve requirement is its excess reserves.

It's the excess reserves that create money. This is how it works (using a theoretical 20% reserve requirement): You deposit $500 in YourBank. YourBank keeps $100 of it to meet its reserve requirement, but lends $400 to Ms. Smith. She uses the money to buy a car. The Sav-U-Mor Car Dealership deposits $400 in its account at TheirBank. TheirBank keeps $80 of it on reserve, but can lend out the other $320 as its own excess reserves. When that money is lent out, it becomes a deposit in a third institution, and the cycle continues. Thus, in this example, your original $500 becomes $1,220 on deposit in three different institutions. This phenomenon is called the multiplier effect. The size of the multiplier depends on the amount of money banks must keep on reserve.

The Federal Reserve can contract or expand the money supply by raising or lowering banks' reserve requirements. Banks themselves can contract the money supply by increasing their own reserves to guard against loan losses or to meet sudden cash demands. A sharp increase in bank reserves, for any reason, can create a "credit crunch" by reducing the amount of money a bank has to lend.

How Banks Make Money

While public policymakers have long recognized the importance of banking to economic development, banks are privately-owned, for-profit institutions. Banks are generally owned by stockholders; the stockholders' stake in the bank forms most of its equity capital, a bank's ultimate buffer against losses. At the end of the year, a bank pays some or all of its profits to its shareholders in the form of dividends. The bank may retain some of its profits to add to its capital. Stockholders may also choose to reinvest their dividends in the bank.

Banks earn money in three ways:

  • They make money from what they call the spread, or the difference between the interest rate they pay for deposits and the interest rate they receive on the loans they make.
  • They earn interest on the securities they hold.
  • They earn fees for customer services, such as checking accounts, financial counseling, loan servicing and the sales of other financial products (e.g., insurance and mutual funds).

Banks earn an average of just over 1% of their assets (loans and securities) every year. This figure is commonly referred to as a bank's "return on assets," or ROA.

A Short History

The first American banks appeared early in the 18th century, to provide currency to colonists who needed a means of exchange. Originally, banks only made loans and issued notes for money deposited. Checking accounts appeared in the mid-19th century, the first of many new bank products and services developed through the state banking system. Today banks offer credit cards, automatic teller machines, NOW accounts, individual retirement accounts, home equity loans, and a host of other financial services.

In today's evolving financial services environment, many other financial institutions provide some traditional banking functions. Banks compete with credit unions, financing companies, investment banks, insurance companies and many other financial services providers. While some claim that banks are becoming obsolete, banks still serve vital economic goals. They continue to evolve to meet the changing needs of their customers, as they have for the past two hundred years. If banks did not exist, we would have to invent them.

Banks and Public Policy

Our government's earliest leaders struggled over the shape of our banking system. They knew that banks have considerable financial power. Should this power be concentrated in a few institutions, they asked, or shared by many? Alexander Hamilton argued strongly for one central bank; that idea troubled Thomas Jefferson, who believed that local control was the only way to restrain banks from becoming financial monsters.

We've tried both ways, and our current system seems to be a compromise. It allows for a multitude of banks, both large and small. Both the federal and state governments issue bank charters for "public need and convenience," and regulate banks to ensure that they meet those needs. The Federal Reserve controls the money supply at a national level; the nation's individual banks facilitate the flow of money in their respective communities.

Since banks hold government-issued charters and generally belong to the federal Bank Insurance Fund, state and federal governments have considered banks as instruments of broad financial policy beyond money supply. Governments encourage or require different types of lending; for instance, they enforce nondiscrimination policies by requiring equal opportunity lending. They promote economic development by requiring lending or investment in banks' local communities, and by deciding where to issue new bank charters. Using banks to accomplish economic policy goals requires a constant balancing of banks' needs against the needs of the community. Banks must be profitable to stay in business, and a failed bank doesn't meet anyone's needs.

Lesson Two: Banks, Thrifts & Credit Unions - What's the Difference?
Lesson Three: Banks and their Regulators
Lesson Four: Deposit Insurance
Lesson Five: Bank Geographic Structure 
Lesson Six: Foreign Banks