ABCs of Banking - Banks and Our Economy (2024)

ABC's of Banking

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

Lesson One: Banks and our Economy
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

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?

ABCs of Banking - Banks and Our Economy (2024)


What is the ABCs of banking law? ›

The ABCs of Banking Law is an annual continuing legal education program presented by the Center for Banking and Finance that focuses on the basics of banking law for lawyers. This program introduces the banking law regulatory structure.

What is bank answers? ›

A bank is a financial institution licensed to receive deposits and make loans. There are several types of banks including retail, commercial, and investment banks. In most countries, banks are regulated by the national government or central bank.

What are two reasons why banks are so important to our economy? ›

As the primary supplier of credit, it provides money for people to buy cars and homes and for businesses to buy equipment, expand their operations, and meet their payrolls. Banks also provide depositors with a safe place to keep their money (particularly since the advent of the Federal Deposit Insurance Corp.

What are the 4 functions of banks? ›

  • What are the four main functions of banks today? storing money, transferring money, lending money, and financial services.
  • Which of the following is a function of our current banking system? lending money.
  • Why did the first national bank fail?

What does ABC stand for in legal terms? ›

Assignments for the benefit of creditors are an alternative to the formal burial process of a Chapter 7 bankruptcy. The ABC process may allow the parties to avoid the delay and uncertainty of formal federal bankruptcy court proceedings.

What is B and C in banking? ›

What Is a B/C Loan? A B/C loan is a loan to low credit quality borrowers and borrowers with minimal credit history. This type of financing, which includes personal consumer loans and mortgages, is typically issued by alternative lenders charging high-interest rates and fees.

Why banking best answers? ›

Sample Answer:

The banking industry is lucrative and plays an important role in our economy. It offers challenging roles and opportunities to develop skills and knowledge. The dynamic nature of the industry and its relevance in the economic scenario is why I want to pursue a career in the banking sector.

What is secret question in banking? ›

Secret questions usually ask for an obscure fact that hopefully only the account owner would know and supposedly would never forget. Many Web sites assume that the user providing the answer to the question is sufficient to identify the user.

How do you answer the question why banking? ›

Here are some helpful steps you can follow to respond to this question when you're applying for an investment banker position:
  1. Showcase your interest in the industry. ...
  2. Focus on how can you can be beneficial. ...
  3. Include your educational background. ...
  4. Offer some on-the-job examples. ...
  5. Highlight your strengths and skills.
Mar 10, 2023

How do banks help the economy the most? ›

A bank's most important role may be matching up creditors and borrowers, but banks are also essential to the domestic and international payments system—and they create money.

What are the two 2 major functions of banks? ›

All banks have to perform two major primary functions namely:
  • Accepting of deposits.
  • Granting of loans and advances.

What are the 2 main ways banks make money? ›

How Banks Make Money
  • 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.

What are the 7 functions of banks? ›

Functions of Banks
  • Acceptance of deposits from the public.
  • Provide demand withdrawal facility.
  • Lending facility.
  • Transfer of funds.
  • Issue of drafts.
  • Provide customers with locker facilities.
  • Dealing with foreign exchange.

What are the 3 main functions of a bank? ›

There are three main functions for a bank:
  • Receiving money: Deposits are the sums of money that a consumer gives to the bank. ...
  • Keeping money: Reserves can be kept in two ways by banks. ...
  • Lending money: People are given money by the bank on the basis of time and interest.

What are the 5 most important banking services? ›

The 5 most important banking services are checking and savings accounts, loan and mortgage services, wealth management, providing Credit and Debit Cards, Overdraft services. You can read about the Types of Banks in India – Category and Functions of Banks in India in the given link.

What does bank mean in slang? ›

New Word Suggestion. One that has a lot of money saved.

What is the definition of a bank? ›

bank, an institution that deals in money and its substitutes and provides other money-related services. In its role as a financial intermediary, a bank accepts deposits and makes loans.

What is commercial bank answers? ›

A commercial bank is a financial institution that provides services like loans, certificates of deposits, savings bank accounts bank overdrafts, etc. to its customers. These institutions make money by lending loans to individuals and earning interest on loans.

What do you mean by bank? ›

Banks are intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money). The amount banks pay for deposits and the income they receive on their loans are both called interest.

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