Comprehensive Guide to the Banking System and the Federal Reserve
Definition and Structure of the Banking System
Financial Institutions: Banks are categorized as financial institutions, which are defined as firms that deal mainly with money, rather than goods and services. Other examples of financial institutions include stock brokerages.
Charters and Regulation: Every bank must possess a charter issued by either the state or federal government. This legal document explicitly spells out how the bank will operate and the specific regulations it must follow.
Types of Banks:
Commercial Banks: Historically, these banks primarily served business and industry.
Savings and Loans: Traditionally focused on consumers, encouraging the practice of saving.
Mutual Savings Banks: Focused on helping consumers save.
Credit Unions: Member-focused institutions that traditionally supported consumer saving.
Modern Banking Evolution: While these categories had distinct historical purposes, there are few differences today. All types of banks now serve both consumers and businesses and provide essentially the same range of services.
Saving Definition: Saving is defined as the act of setting aside a portion of income for use in the future.
Core Functions and Range of Services Offered by Banks
Financial Intermediary: The primary function of a bank is to act as a financial intermediary. This is a business that brings together savers (referred to as sellers) and borrowers (referred to as buyers) in financial markets.
Transfer of Assets: Banks facilitate the transfer of assets by receiving deposits from savers and distributing those funds as loans to borrowers.
Basic and Specialized Services:
Commercial Assistance: Banks provide loans to farmers for expensive equipment, such as a harvester, which may be too costly to pay for upfront.
Cash and Credit: Banks cash checks, issue credit cards, and exchange foreign currency into U.S. dollars and vice versa.
Security: They provide safe-deposit boxes for customers to store valuables.
Electronic Banking Convenience:
ATMs and Debit Cards: Facilitate cash withdrawals and transactions.
Direct Deposits: Allows for the automatic deposit of paychecks.
Automatic Bill Payment: Automates the payment of recurring bills.
Internet Banking: Customers can monitor account activity, pay bills, and transfer money between accounts remotely.
Analysis of Customer Deposits: Types, Liquidity, and Returns
Liquidity: This is defined as the ease with which assets can be converted into cash. Accounts with high liquidity allow for immediate access to funds, whereas low liquidity accounts usually involve restrictions.
Return: This refers to the amount of earnings or interest an account generates.
Checkable Deposits:
Description: Money placed in a checking account.
Liquidity: Highly liquid; funds are available "on demand" at any time.
Access: Historically accessed by writing a paper check, but now primarily managed via the internet, debit cards, or ATMs.
Earnings: Provide safety and high liquidity but offer little to no interest.
Savings Deposits:
Description: Money held in a savings account.
Liquidity: Only slightly less liquid than checkable deposits; funds can be withdrawn on demand via bank tellers or ATMs.
Earnings: Earns more interest than checkable deposits, though the return remains relatively low.
Time Deposits (Certificates of Deposit/CDs):
Description: These accounts tie up cash for a fixed period, typically ranging from several months to several years.
Liquidity: Low liquidity compared to other deposits.
Early Withdrawal Penalty: If a saver withdraws money before the CD's end date, they must pay a penalty, which is often a percentage of the interest that would have been earned.
Earnings: Offers higher returns as a trade-off for the lack of immediate access to the cash.
Security and the Federal Deposit Insurance Corporation (FDIC)
Risk: Defined as the chance of losing money or failing in some way.
The Great Depression and Stabilization: Congress established the FDIC in to stabilize the banking system during the Great Depression.
Insurance Coverage: Nearly all modern bank deposits are insured by the FDIC for up to per depositor.
Guarantee: If a bank fails, the FDIC guarantees that depositors will receive their money back up to the specified limit ().
Lending Operations: Commercial, Consumer, and Mortgage Loans
Commercial Loans:
Usage: Used by businesses to pay for equipment, machinery, materials, and labor costs.
Approval Factors: Banks review a firm's financial condition, its borrowing history, and the overall state of the economy before approval.
Consumer Loans:
Usage: Used by individuals for major purchases like cars or boats.
Installment Loans: These are loans typically paid back in equal monthly payments (installments).
Credit History: A person's record of past borrowing and repayment. Banks use this to see if the individual has a history of paying loans back on time and in full.
Credit Cards: A form of high-interest consumer loan for smaller items. If the balance is not paid in full each month, interest is charged on the unpaid balance. Interest rates for credit card debt are generally much higher than other loans.
Mortgage Loans:
Definition: A loan specifically for real estate, such as a house, land, or office building.
Duration: Typically ranges from to years.
Principal: The actual amount of money borrowed or still owed, distinct from interest.
Total Cost Example: A house purchased for with a traditional -year mortgage at a fixed annual interest rate of can end up costing the buyer more than over the life of the loan.
The Economics of Banking: Fractional Reserve Banking and Profitability
Profit Mechanism: Banks profit by charging more interest on loans than they pay out on deposits.
Interest Perspectives: For borrowers, interest is the cost of using others' money; for savers, interest is the payment received for letting others use their money.
Fractional Reserve Banking: A system where banks are required by law to keep only a fraction of their deposits in reserve to cover potential withdrawals, lending out the remainder to generate profit.
Example of Reserves: If a customer deposits and the reserve requirement is one-tenth (), the bank must keep and can lend out the remaining .
Reserve Ratios: The Federal Reserve System sets the specific fraction that banks must keep on hand.
The Federal Reserve System: Functions, Services, and Management
Background: Established in and headquartered in Washington, D.C., the Federal Reserve (often called "the Fed") acts as the central bank of the United States.
Primary Goals: The Fed does not aim for profit; instead, it works to keep the banking system healthy and stable. Its customers are other banks, not individuals.
Core Services:
Holding Reserves: The Fed requires banks to keep a fraction of deposits in reserve, either as vault currency or in an account at the Fed.
Providing Cash and Loans: Supplies cash to banks to meet withdrawal demands and lends money to banks when they are short on funds.
Check Clearing: The Fed clears billions of checks annually by transferring funds from the bank of the person who wrote the check to the bank of the person who received it.
Electronic Linking: Nearly all U.S. banks are linked to the Fed electronically, allowing for rapid fund transfers between institutions.
Managing the Money Supply:
Reserve Requirements: Setting the minimum fraction of deposits banks must keep.
Issuing Currency: The Fed issues Federal Reserve notes, which are the paper dollars used in the U.S.
Liquidity Provision: Ensures businesses and consumers have access to money.
Structural Organization of the Federal Reserve
Board of Governors: A seven-member board based in Washington, D.C. that oversees the entire system and creates policies regarding the money supply and reserve requirements.
Regional Federal Reserve Banks: There are regional banks that handle day-to-day activities, provide financial services to their region's banks, and supervise regional operations. They also report economic data back to the Board of Governors.
Membership: Approximately of U.S. banks are formal members, including all national banks (chartered by the federal government) and many state-chartered banks.
Universal Regulation: Even non-member commercial banks must follow Fed regulations and have the same privileges to borrow from the Fed; they are all affected by Fed adjustments to the money supply.
Questions & Discussion
Reading Check Question: The Federal Reserve sets the required reserve ratio, or the percentage of a bank's deposits that it must hold in reserve. Which of the following graphs best describes what would happen to the supply of money if the Fed increases the required reserve ratio?
Answer Context: The transcript references three graphs (A, B, C) to illustrate the relationship between the reserve ratio and money supply. Increasing the required reserve ratio means banks have less money to lend, which typically decreases the overall supply of money.