BASICS BANKING
What is a Bank?
A bank is a business. Banks sell services - financial services such as car loans, home mortgage loans, business loans, checking accounts, savings accounts, certificates of deposit, and credit card services. Some people go to the bank in search of a safe place to keep their money. Others go to the bank seeking money for loans to buy houses or cars, start businesses, expand farms, or do any of the other things that require borrowing money.
Where do banks get the money to lend? They get it from all the people who open savings and other types of accounts. Banks act as a go between the people who save and people who need to borrow. If savers didn't put their money in banks, the banks would have little or no money to lend.
Your savings are combined with everyone else's savings to form a big pool of money. The bank uses that pool of money to make loans. The money doesn't belong to the bank's president, board of directors, or stockholders. It belongs to the depositors. That's why banks have a special obligation not to take big risks when they make loans.
How did Banking Begin?
No one knows who started the world's first bank, but it's safe to say that banking has it roots in the early trading civilizations of the Mediterranean ocean. Without trade there would have been little need to establish banks. Without banks there would have been less money to finance trading ventures.
Imagine for a moment that you are a merchant in ancient Greece or Phoenicia. You make your living by selling to distant ports with boatloads of olive oil and spices. You don't grow the olive oil and spices yourself; you buy them from growers or other merchants. If all goes well, you will be paid for your cargo when you reach your destination, but before you can sail, you must have money to outfit your ship.
You find it by seeking out people who have money sitting idle. They agree to put up the money for your cargo and supplies in exchange for a share of your profits when you return from your voyage. . if you return. The people with the idle money are among the world's first lenders and you are among the world's first borrowers. You complain that they're demanding too large a share of your profits. They reply that your voyage is perilous and they run a risk of losing their entire investment. Lenders and borrowers have carried on this debate ever since.
Today, most people who want to borrow money go to banks rather than to wealthy individuals. But the basic concepts of borrowing and lending haven't really changed. People don't let you have their money for nothing. It's risky to lend money. There's no guarantee that a lender will get the money back, even if the borrower is an old friend. So why lend money? Why take the risk? Because lending presents an opportunity to make even more money. People will often take a financial risk if they believe there is a good chance of making more money.
If a bank lends $50,000 to a borrower, the bank isn't satisfied to just get its $50,000 back. In order to make a profit, the bank charges interest on the loan. Interest is the price borrowers pay for using someone else's money. If a loan seems risky, the lender will charge more interest to offset the risk. (If you take a bigger risk, you want a bigger return). Of course, the opportunity to earn lots of interest won't mean much if a borrower fails to repay a loan. That's why banks often refuse to make loans that seem too risky.
Banks also use interest to attract savers. After all, people who have extra money don't have to put it in the bank. They have lots of choices. But in addition to all of the different types of accounts banks offer depositors, the added advantage is being able to get to their money quickly.
How is a Bank Started?
The process varies from state to state, but here's a simple version of what it takes to start a bank.
- Individuals get together and decide to start a bank.
- They file an application with the federal and state banking authorities. In Indiana, it's the Indiana Department of Financial Institutions.
- People at the state banking authority review the application. They look closely at the financial condition and the character of the applicants.
4. After reviewing the application, the federal and state banking authorities will either approve
or deny it.
Why are There so Many Different Types of Banks?
Not all banks are exactly the same. There are commercial banks, savings banks, savings and loan associations, S & L cooperative banks, and credit unions. They now offer many of the same services, but in the past, they were very different from one another.
Commercial banks originally concentrated on meeting the needs of business and industry. They served places where business could safely deposit their funds or borrow money when necessary. Many commercial banks also made loans and offered accounts to individual customers but they put most of their effort into serving business (commercial) customers.
Savings banks , S & Ls, and cooperative banks are classified as thrift institutions or "thrifts" rather than banks. Originally, they concentrated on serving people whose banking needs were ignored or unmet by commercial banks. The first savings banks were founded in the early 1800s to give blue-collar workers, clerks, and domestic workers a secure place to save for a "rainy day." Savings banks were usually started by public spirited citizens who wanted to encourage the "thrift habit" among people who didn't earn much money. Savings and loan associations and cooperative banks were first established during the 1800s to help factory workers and other wage earners become homeowners. S & Ls accepted savings deposits and used the money to make loans to homebuyers. Most of the loans went to people who didn't make enough money to be welcome at traditional banks.
Credit unions began as a 19th-century solution to the emergency needs of people who were unable to borrow money from traditional lenders. Before the opening of credit unions, ordinary citizens had no place to turn when they faced unexpected home repairs, medical expenses, or other emergencies. Credit unions were started by people who shared a common bond such as working at the same factory, belonging to the same house of worship, or farming in the same community. Members pooled their savings and used the money to make small loans to one another.
Although there are still differences between banks and thrifts, they now offer many of the same banking services to their customers. Most commercial banks now compete to make car loans, many thrifts have begun to make commercial loans, and some credit unions make loans to homebuyers.
How do I Choose a Bank?
In the 1950s and 1960s banks used to give away toasters or other appliances to new depositors. Choosing a bank was easy. You went to the one that gave away the best appliance.
Not many banks give appliances away anymore and choosing a bank is a little more complicated than it used to be. For starters you should shop around to find out which banks offer the most competitive services. Some banks charge a monthly fee if your account falls below a certain level and sometimes that fee can be higher than the interest your account may earn.
Some states prohibit banks from charging fees on savings accounts held by people under 18 or 65 and over. Find out if your state has such a law.
Other things you might want to consider:
- Does your bank pay its depositors a competitive interest rate?
- Is the bank in a convenient location and are its business hours convenient to you?
- Is your deposit fully insured by the federal government?
- Is the bank a good corporate citizen? Does it invest in your neighborhood?
Last, but certainly not least, does your bank provide courteous and efficient service? Before you open an account, ask a few people if they are happy with their bank. All banks are not the same. It's up to you to do some comparison shopping before you open an account.
What Types of Accounts do Banks Offer?
People use banks for different purposes. Some have extra money to save and others need to borrow. Banks help their customers meet their needs by offering a variety of accounts.
Savings accounts are for people who want to keep their money in a safe place and earn interest at the same time. You don't need a lot of money to open a savings account and you can withdraw your money any time.
Checking accounts offer safety and convenience. You keep your money in a checking account and write a check when you want to pay a bill or transfer some of your money to someone else. If your checkbook is lost or stolen, all you need to do is to close your account and open a new one so that nobody can use your old checks. (When cash is lost or stolen, you rarely see it again.)
Another attractive feature of a checking account is that every month your bank sends you all the checks you have or a list or copies of the checks; which you can use as receipts if there's ever a disagreement over whether or not you paid a bill. Businesses use checking accounts to hold the money they receive and to transfer money to other people or other businesses. The one drawback to checking accounts is that some do not earn interest.
NOW accounts are checking accounts that pay interest (NOW stands for Negotiable Orders or Withdrawals). Sometimes banks require you to keep a certain minimum amount of money (a minimum balance) in your NOW account in order to keep earning interest. Only non-business customers may open NOW accounts, businesses must use regular checking accounts.
Money market deposit accounts usually pay a higher rate of interest and require a higher minimum balance (usually $2,500).
Certificates of deposit (CDs) are savings deposits that require a customer to keep a certain amount of money in the bank for a fixed period of time (example: $1,000 for two years). As a rule the rate if interest your money earns is higher if you agree to keep your money on deposit for a longer period of time. (That's because banks can plan on using your money for a longer period of time.) Banks do not offer check-writing privileges on certificates of deposit.
Finally, banks don't always call their accounts by the same names. Often they choose distinctive names in hopes of attracting customer. But sometimes there can be a real difference between one bank's accounts and another's, so shop around.
Is it Difficult to Open an Account?
When you have decided on a bank you want to do business with and want to open a savings account, you take your money you want to deposit to the bank. A service representative will help you with the paperwork. The only form you need to fill out is a signature card which requires you to sign your name and then print your name, address, telephone number, date of birth, social security number, and your mother's madden name (as a means of identification).
The service representative will take your money and open an account for you. You will receive a "passbook" or deposit slip which will show your new account number and the amount of money that is in your new account. Whenever you make a deposit or withdrawal, the transaction will be recorded in your "passbook" or deposit or withdrawal slip.
You don't need a lot of money to start a savings account. Some banks let you open one with as little as five dollars. Nor do you need to wait until you are 18. In most cases, you can open a savings account as soon as you are old enough to sign your name or even earlier if you open the account with a parent or guardian.
What are Checks and How do They Work?
Because they are safe and convenient, checks have become a very popular method of paying for things or transferring money. But what exactly is a check? In simple terms, a check is a written set of instructions to your bank. When you write a check, you are instructing your bank to transfer a specific amount of money from your checking account to another person or an organization. You can even write a check just to convert some of the money on deposit in your checking account into cash.
When you fill in the blank spaces on one of your checks, you are telling your bank how much of your money you want to transfer and to whom you want it transferred. You authorize the transfer by signing y our check. One reason why checks are so popular is that people can use a cancelled check to prove they paid a bill. In most cases a cancelled check is as good as a receipt because it bears the endorsements of all the persons, banks, companies, or other organizations that have handled it. For example if the landlord claims you didn't pay your rent, all you need to do is find your cancelled check and point out that it was endorsed by your landlord and your landlord's bank.
Tracing a Check Through the Federal Reserve's Check Collection Network
- Your Aunt sent you a $20 Check for your birthday.
2. You deposit the check in your savings account at your bank.
3. Your bank endorses the check and sends it to its Federal Reserve Bank.
4. The Federal Reserve Bank gives your bank credit for the check by adding the amount of
the check to your bank’s reserve account or clearing balance.
5. The Federal Reserve Transportation system flies the check to your Aunt's Bank Federal
Reserve Bank.
6. That Federal Reserve Bank forwards the check to your Aunt's bank and deducts the
appropriate amount from that bank's reserve account.
7. Your Aunt's bank deducts the $20 from your Aunt's checking account.
What is Electronic Banking?
Electronics and computers have made banking an around-the-clock business. You can now do much of your banking even when your bank is closed. You no longer need to plan your schedule around your banks business hours.
Automated Teller Machines (ATMs) are computers that are much like limited-service bank branches. You can use them to make a withdrawal, make a deposit, make a payment, transfer money from one account to another, or check your account balance. In some cases, ATMs of different banks are linked together so you can use them when you travel to a different part of town or even to another state. All you need to use an ATM is a plastic card from your bank and your own personal password called a PIN number.
You can also have your employer electronically deposit your pay directly to your bank account each payday. Direct deposit is also popular among people who receive Social Security checks or pension checks because it saves them the bother of standing in line at the bank, battling bad weather, or worrying about being robbed on the way home from the bank
Another electronic banking service is called electronic funds transfer or EFT. By using EFT, a bank can transfer large amounts of money to another bank by wiring an electronic message. There is no need to write a check or load up an armored car with cash and there's no long wait for the money to be moved. Electronic transfers take only an instant. An electronic message instructs a computer to deduct a certain amount of money from one bank account and then add the same amount to another bank account. No cash changes hands, but money is transferred just the same.
People have been predicting for years that electronic banking will someday replace checks and cash, but so far the predictions haven't been accurate. Electronic banking has grown steadily but so has the use of checks and the amount of cash in circulation. People like to use cash and checks because they are familiar and convenient methods of payment.
Do Banks Keep Large Amounts of Gold and Silver in Their Vaults?
Banks rarely keep gold or silver in their vaults anymore. That's because our paper money is no longer backed by gold or silver and our coins do not contain precious metal. The U. S, government still holds millions of ounces of gold and silver but citizens and foreign governments can no longer exchange their U. S. paper money for the precious metals. The government's gold and silver are considered valuable assets rather than forms of money.
Today's coins and paper money (currency) are backed by the promise of the U. S. government. To most people, that promise is as good as gold. Of course, coins and currency are not the only forms of money. You won't have to keep your money in the form of cash. Money held in a savings account or a checking account is still money. It just isn't cash.
Other Forms of Money
Contrary to popular belief, credit cards are a form of money even though people often refer to
them as "plastic money. " Credit card users are actually taking out a loan and sooner or later, they will have to pay the bill for all those things they have charged. They are buying something now and agreeing to pay for it at a later date with money, usually a check.
Many banks issue credit cards, even to people who aren't regular customers. Before issuing you a credit card, a bank will require you to complete an application form and will examine your credit record to see if you have a history of paying back your debts on time. Many people run up credit card bills that are too big to pay off every month. When that happens customers must pay a monthly finance charge that can run anywhere from 10 percent to 24 percent a year. In addition, many banks and other companies that issue credit cards charge their cardholders an annual fee¾ usually $20 to $50 a year. Even customers who pay off their entire credit card bill every month still have to pay the annual fee. Banks and credit card companies also charge merchants a fee for making the credit card service available. Finance charges, annual fees, and merchant fees have become an important source of profit for banks.
Finally there's another plastic card that resembles a credit card in appearance but is actually very different in function¾the debit card. A debit card is much more like an ATM card than a credit card. When someone uses a debit card at the gas pump or at a store, the amount of the purchase is electronically deducted from the user's bank balance. There's no monthly bill because the amount of cash purchase is deducted almost immediately from the user’s account.
What Happens to Your Money After You Deposit it in Your Bank Account?
The bank begins by adding the amount you're depositing to the amount that's already in your
account (your existing balance). Your deposit and new balance are entered into your "passbook" and into the bank's computer system. The money you deposited is mixed in with all the other cash the bank received that day.
When you and other customers deposit money in a bank, the bank puts most of it to work. Part of the money is set aside and held in reserve, but much of the rest is loaned to people who need to borrow money in order to buy houses and cars, start or expand businesses, buy farm equipment or to plant crops, or do any of the other things that require people to borrow money.
Interest - Compounding
When you keep your savings in a bank, the bank pays you extra money, which is called interest. The interest is added to your account on a regular basis¾usually once a month or once every three months (quarterly). Compounded interest means that interest is added to your balance (usually quarterly), then the next quarter the interest is computed on your money deposited plus the last quarter interest.
Example: New Balance = $500. 00 Interest rate = 5% Annual = $25. 00
New Balance = $500. 00 Interest rate = 5% Compounded quarterly = $25. 72
You would earn $. 72 more with the interest compounded quarterly and the annual yield rate would be 5. 14%. Banks must disclose to you if the savings account is compounded and how often it is compounded and give you the annual yield rate as a result of the compounding. Some banks may compound interest as often as daily. The shorter the compound period, the higher the yield rate would be.
There is another side to interest. When someone borrows money from a bank, the bank charges them interest and it charges borrowers a higher rate than it pays savers. For example, it might pay savers 5% and charge borrowers 8% on up to as high as 25% imposed on some bank credit cards.
Why do Banks Fail and What Happens When They do?
A bank is a business and like other businesses, banks sometimes fail. But why should banks go out of business? Sometimes banks fail because the people who run them make poor business decisions such as expanding too quickly, pushing too much money into one type of loan, or using bad judgment making loans. Sometimes banks fail because of fraud. Maybe the president makes questionable loans to friends or hires unqualified people and pay them huge salaries.
Things like that happen and they sometimes lead to bank failures. But in most cases, banks go out of business because changing economic conditions make it difficult or impossible for borrowers to repay their loans. The economy might slow down and many people are laid-off. As a result, real estate values may fall drastically and banks that have made a large number of real estate loans could be faced with unpaid loans or property that is worth much less now than when the loan was made.
Finally, the bank lost so much money to bad loans that government regulators stepped in and closed the bank. The bank had fallen victim to changing economic conditions, falling real estate values, and a high concentration of real estate loans.
Also, for example, take a bank that gets too big too fast. The bank's president was determined to turn the conservative old institution into the region's biggest bank. The bank's loan officers got the message and started making as many loans as they could. Loan applications weren't always checked as closely as they had been in the past and some of the loans were approved more quickly than they were in the old days. But nobody seemed too concerned because the local economy was strong and real estate values were rising rapidly. Then the economy slowed down and things took a turn for the worse. Businesses the bank had loaned money to began to close and failed to make their payment to the bank on their loans. In the end, the bank was losing so much money on bad loans that government regulators were forced to step in and close it. The regulators tried to find a buyer for the bank, but no other bank wanted to get stuck with all the loans that had turned sour. Eventually another bank agreed to buy the bank if the federal government would agree to keep many of the problem loans.
Do Depositors Lose Their Money When a Bank Fails?
The Federal Deposit Insurance Corporation (FDIC) has protected bank deposits up to a certain amount since 1934. In all that time, no one has lost money in an FDIC insured account. The FDIC covers most types of deposits, including savings deposits, checking deposits, and certificates of deposit. The basic insured amount is $100,000 per depositor.
In the days before federal deposit insurance, the U. S. banking system was plagued by bank "runs" or "panics." At the slightest hint of trouble, depositors would run to the bank and line up to withdraw their money. All too often, only the first few people in line had any hope of ever seeing their money again, others lost everything. Even healthy banks sometimes failed after rumors caused depositors to panic and withdraw their money.
For many years the public seemed willing to accept the tragic losses that resulted from bank failures. But then came the Great Depression of the 1930s. Hard times forced thousands of banks to close their doors forever. Financial losses ran into the hundreds of millions of dollars. The human suffering was impossible to calculate. The wave of bank failures and shattered public confidence in the banking system caused Americans to look to the federal government for help. Congress responded by establishing the FDIC which provides deposit insurance coverage of up to $2,500 per depositor. Public confidence rebounded and bank failures declined from approximately 4,000 in 1933 to 61 in 1934.
Over the years the amount of the federal insurance has increased and has helped to maintain public confidence in the U. S. banking system. Bank failures have not been eliminated, but long lines of panic stricken depositors have become an uncommon sight. When people are confident that their money is safe, they don't panic and rush to withdraw it.
Do Depositors Lose Money if Their Bank is Robbed?
No. Nearly all banks have private insurance that covers them if they are robbed. (It is not the same as federal deposit insurance.) In addition, most banks take elaborate measures to safeguard the
cash and other valuable items left in their care. Bank vaults have long been protected by steel reinforced concrete walls, time locks, and metal alloy doors that resist drilling and explosions.
At one time, armed security guards stood watch over banks, but nowadays most banks seem to have decided (wisely) that they would rather not expose their customers and employees to gun play. Shotguns and revolvers have been replaced largely by closed-circuit television cameras that maintain a constant watch over everyone who enters or exits the bank.
Another fairly recent innovation is the exploding dye pack. In certain cases, bank employees are able to place a package of red dye in with the robber's stash of stolen cash. Later, when the crook opens the stash, the concealed dye pack explodes covering the robber and the stolen money with dye that won't wash off.
