WHAT IS A BANK?

What is a Bank?

"Bank" is a term people use broadly to refer to many different businesses. What you think of as your "bank" may be a commercial bank, a savings and loan association, a savings bank, or a credit union.

When people discuss the financial services industry, however, bank means "commercial bank", and a commercial bank is a specific, unique institution.

The Commercial Bank

The official definition of a commercial bank is a privately-owned institution that accepts demand deposits and makes commercial loans. Demand deposits are money people leave in an institution with the understanding that they can get it back at any time. Commercial loans are simply loans to businesses. This action of taking deposits and making loans is called financial intermediation. A bank's business, however, does not end there.

Banks, as the robber Willie Sutton pointed out, are where the money is. Banks hold approximately two-fifths of all assets in American financial institutions. Most people and businesses pay their bills with bank checking accounts, placing banks at the center of our payments systems. 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 the engines of an economy, in part because of these functions, but also because of the major role banks play as instruments of the government's monetary policy. Unlike nondepository institutions, banks actually create money.

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 on the open market, which may be sold to meet short-term cash needs. These securities are usually government bonds of some kind. 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 is 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 by 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 deposits 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 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

Although banks are important tools of public policy, they are privately-owned, for-profit institutions. Banks are 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, 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, and loan servicing.

Banks earn an average of just over 1% of their assets (loans and securities) every year.

A Short History of Banking

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 noted for money deposited. Checking accounts appeared in the mid-19th century, the first of many new bank products and services. These now include credit cards, automatic teller machines, NOW accounts, individual retirement accounts, home equity loans, and a host of other financial services.

Many financial institutions can now perform some banking functions. Banks compete with savings and loans, savings banks, credit unions, financing companies, investment banks, insurance companies and many other financial services providers. Some experts claim that banks are becoming obsolete, but 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 horrified 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 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 10,715 banks control the flow of money in their respective communities.

Because banks hold government-issue charters and generally belong to the federal Bank Insurance Fund, state and federal governments use 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 as tools of economic policy 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.