Business 101 — The Basics
CH 9]
Chapter 9
Understanding Money, Banking,
& Financial Institutions
Learning Goals
1. Outline the characteristics of money and list its functions.
2. Explain the differences of money and near-money.
3. List the major categories of financial institutions and the sources
and uses of their funds.
4. Discuss the functions of the Federal Reserve System and the tools
it uses to increase or decrease the money supply.
5. Explain how banks create money.
6. Explain the purpose and primary functions of the Federal Deposit
Insurance Corporation (FDIC) and the Federal Savings and Loan
Insurance Corporation (FSLIC).
7. Discuss the major provisions of the Banking Act of 1980 and its
impact on financial deregulation.
8. Explain the differences between credit cards and debit cards.
9. Discuss the role of the electronic funds transfer system (EFTS),
the trend toward interstate banking, and the financial
supermarkets in the current competition among financial
institutions.
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Chapter Overview
money
Anything generally
accepted as a means of
paying for goods and
services.
For every industry and economy, money is the lubricant that that greases the
cogs that keep them healthy. Whether it be for economic growth and expansion,
progress or recession, employment of unemployment, money affects what
happens. Everyone recognizes the need for adequate funds to finance business
enterprises and carry on management plans.
Money is an important commodity to all of us, it reacts to the marketplace
because it has a supply and demand, and even an equilibrium price that targets the
price of money—the cost of borrowing. In the industrial and economic powers of
the world such as Germany, England, the United States and Japan, we associate
money with banks; therefore, banks and other similar institutions. 1 In analyzing
the monies characteristics, functions, and types, it is useful to begin by defining it.
Money is anything generally accepted as a means of paying for goods and
services and a measure of value. From this definition one recognizes the
psychological influences of money. The word "anything" is important for money
can be a goat, cow, land, equipment and the coins and currency in your pocket. It
has a measure of value that is agreed upon and may be used in transactions of
exchange.
Ask anyone today to define money and they will probably reply with that “it is
the coins and paper bills in my pocket and wallet, and what I currently have in my
checking account.” Of course everyone will agree to this, as they are money.
Money is one of the most fascinating subjects for both individuals and businesses.
“Money answereth all things,” so said King Solomon, and brings on many
responsibilities. 1 Everyone seems to need it:
Money bewitches people. They fret for it, and they sweat for it. They devise
most ingenious ways to get it, and most ingenious ways to get rid of it. Money is
the only commodity that is good for nothing but to be gotten rid of. It will notice
you, clothe you, shelter you, or amuse you unless you spend it or invest it. It
imparts value only in parting. People will do almost anything for money, and
money will do almost anything for people. Money is a captivating, circulating,
masquerading puzzle. 2
Enough with the romance, the wise man recognizes that money is a tool and
in this chapter you will explore money and banking. A discussion of money’s
characteristics, functions, and types will be offered. The operations of commercial
banks and other financial institutions will be discussed, and brief examination of
the methods used by the Federal Reserve System in regulating the U.S. financial
system by controlling the money supply. This chapter discusses the Federal
Reserve System's activities in check processing and in protecting depositors'
funds by providing insurance and evaluating banking practices. The fundamental
changes that have resulted from financial deregulation are assessed, and such
Business 101 — The Basics
CH 9]
Examples of old forms of money include (at left) the oldest known paper currency
issued in China during the Ming Dynasty between 1368 and 1399; (top right) a silver
tetradrachm used in Athens, Greece, in the fifth century B.C.; and iron bells without
clappers used as bride money in Zimbabwe in the nineteenth century.
c1901.gif
Photo source: Smithsonian Institution. National Numismatic Collection photo.
current developments as the growth of electronic funds transfer systems and the
development of the financial supermarket are described. These sweeping changes
in the structure and operations of financial institutions will have a profound effect
on the financial decisions and practices of both business firms and individual
households for the remaining years of the twentieth century. But the starting place
for our analysis is with money.
Money in Exchange Economies
In our economies we recognize that individuals cannot efficiently produce
everything that they need to survive, so exchange takes place. Industrial
economies move away from agrarian societies such that you do not grow your
own food, sew your own clothes, build your own car, home or computer. You
allow very skilled individuals to accomplish those tasks, because they do it
efficiently and cost affectively. You acquire those things through exchange. You
may barter for them (give something of value other than money) or pay for them
with currency.
Historically, objects have been used in exchange (barter). If we lived in
Ireland 300 years ago, one may acquire 2 acres of land for 1 cow. The cow is
valuable because it could produce milk, from which you could manufacture butter
and cheese. The cow could produce offspring that could eventually be converted
to meat, and the hide to leather. The owner could also trade the cow for other
goods. However, say, you only want 1 acre or were interested in 3 acres of land;
the problem that arises is that 1 acre or 1 additional acre would require only onehalf of a cow. The problem is how to affect the exchange without damaging the
value of the cow? Yes the problem is one of divisibility.
Cows are not the only thins of exchange (barter) value (money). The list of
products that have served as money is long, including such diverse items as wool,
pepper, tea, fishhooks, tobacco, shells, feathers, salt (from which came "salary"
and "being worth one's salt"), boats, sharks' teeth, cocoa beans, wampum beads,
woodpecker scalps, and precious metals. For a number of reasons, precious metals
gained wide acceptance as money. As early as 2000 B.C., gold and silver were
used as money, and up until 1933, gold coins were used as money in the United
States.
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Figure 9.1 Money Functioning as a Unit of Account
c1902.gif
van Gogh’s “Irisis”
Functions of Money
medium of exchange
Means of facilitating
exchange and eliminating the
need for a barter system.
measure of value
A single common factor used
to assign and measure the
value of all goods and
services.
store of value
Temporary accumulation
of wealth until it is needed
for new purchases.
Money is a tool that comes into contact with everyone, it facilitates the exchange
of goods and services, when counted it may be used to determine wealth, and saved
to protect the value of accumulated wealth. Money performs these three basic
functions differently, let’s discuss these functions as it serves in society.
Money serves primarily as a medium of exchange—that is it facilitates the
exchange of goods and services by replacing neatly bartering. Instead of the
cumbersomeness of exchanging milk for bread, where each has a different bulk
value, money allows the creation of a less cumbersome form of exchange over the
bulk of bartered durable goods. For example, rather than follow the barter process of
trading wheat directly for gasoline or clothing, a farmer sells the wheat and use the
money from that sale to make other purchases.
Money functions as a measure of value—a common denominator for measuring
the value of all products and services. Money allows two dissimilar items to be
valued and purchased on a similar basis by removing dissimilarities. How many
loaves of bread does it take to purchase a new suit of clothes. Assume that a new car
will cost $25,900; a New York steak sells for $5.50 per pound; and a 40-yard-line
ticket to the Rose Bowl football game costs $125. Using money as a common
denominator aids in comparing widely different products and services. The
advertisement in Figure 9.1, Dollar Rent A Car uses dollar bills to communicate the
value of its low-price car rental service.
Money also functions as a temporary store of value. Money can be accumulated
and saved until it is used to make a purchase. As a store of value, money retains its
worth (ability to purchase the same quantity of goods and services today or years
from today) over time. However, stored money is affected by inflation—which
steals money’s value. As prices increase during inflationary periods, the purchasing
power of money declines. To assure the store of wealth may require that the holder
CH 9]
Business 101 — The Basics
Functions and Characteristics of Money
Functions
Characteristics
Medium of Exchange
Measure of relative value
Store of value
Acceptance
Divisibility
Portability
Durability
Stability
Scarcity
of money convert its form into such things as stocks and bonds, or real estate,
antiques, works of art, gold, silver, precious gems, or any other valuable goods, that
will offset the affect of inflation and maybe increase in value. Additionally,
converting money to other goods as a store of value can produce dividends and
interest payments from stocks and bonds, rent from real estate, increased value from
the scarcity of art, gold, silver and precious gems. For example, the van Gogh
painting "Irises" rose in value from $47,000 in 1947 to $53.9 million in 1988. Money
as a store of value is also liquid, that is once obtained it can easily and quickly be
disposed of.
The van Gogh investment will increase in value, however, the owner can only
obtain money for it after finding a purchaser of substantial means. To convert real
estate to cash, the owner contacts a broker who will then offer the property to
purchasers of real estate, still time will be an issue. To convert stocks and bonds to
money, the owner will contact a stock broker who will offer them for sale in the
stock market, which has many more purchasers and are thus more easily converted to
money. Of course it is possible that the value of real estate or stocks and bonds may
be worth less than when originally purchased because they are subject to market
influences. This is an issue of timing for the market.
Holding money during inflationary periods is particularly disadvantageous. To
illustrate, if the costs of goods and services double, then money that is completely
liquid would loose its purchasing power by 50 percent. Having ready
access to money has its chief advantage in its availability to
immediately purchase goods and pay debts. The dilemma is to have
money adequately placed in liquid and not so liquid assets.
Characteristics of Money
Remembering that money can be anything, most early forms of
money possessed some unique disadvantages. The Irish farmer who
wanted to purchase an additional acre of land was faced with the fact
that it would cost him one-half of a cow; the dilemma how do you
divide a cow and not loose it’s unique worth? The South Pacific
Island inhabitants of Yap willingly traded their agriculture
production, fish, pigs, goats and cattle and even land to obtain the
stones shaped life “full moons” with a hole in the middle. The stone
money came in various sizes from tiny to 9-10 feet high and
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Spanish Gold: pieces of eight
Twenty Shillings and One pound note printed in Rhode Island, May 1786
Silver Dollar: 1 ounce
Silver Quarter: 1/4 ounce
Silver Dime: 1/10 ounce
weighing several tons. These stones possessed the characteristics of money with
some weighty problems with exchange.
Exchanging money permits a unique base for purchasing power and permits
elaborate specialization. For money to be useful as a medium of exchange it must
be acceptable, divisible, portable, durable, and to have a stable store of value it
should be scarce and difficult to counterfeit.
Acceptability requires that the general population agree that the money
contains worth for their society. The acceptance is that it will be allowed for the
exchange for goods and services. During the American Revolution the Continental
Congress authorized a number of printers (including Benjamin Franklin) to print
currency, called “continental dollars,” that was to be supported by Spanish Silver
doubloons and British Silver pounds, to pay for war supplies, food, and clothing
for the troops. The currency was printed in such large quantities and the holder
could not necessarily receive the silver that backed it that the currency was
virtually useless for purchases. This gave rise to the expression “That it isn’t
worth a continental.”
Divisibility. Buying that additional acre for the Irish farmer using cows as the
medium of exchange posed a major dilemma. So do those owners of items using
them as money. Gold and silver coins could be minted in different sizes with
differing values in order to facilitate exchange. Spanish doubloons could literally
divided into eight pieces, break off a piece (1/8) and pay food and rum, thus
pieces of eight, is how they became known.
Today, you go to the store and purchase a Snickers bar for seventy-five cents,
you may give the merchant a dollar bill. You will receive in change twenty-five
cents. If you the dollar was not divisible, you may be faced with having to accept
an additional twenty-five cents in merchandise or allow the merchant to keep an
extra twenty-five cents as additional profit. But the U.S. dollar is easily divisible.
Today the U.S. dollar can be converted into 100 pennies, 20 nickels, 10 dimes,
2 fifty cent pieces and 4 quarters. Similarly the British pound is worth 100 pence,
the new Euro dollar is divisible as 50 cents, 20 cents, 10 cents, 5 cents, 2 cents,
and 1 cent.
When the United States finalized that the silver dollar was to contain one
ounce of silver, then it was easily divisible for the quarter to contain one-quarter
ounce of silver, and the dime to contain one-tenth of an ounce.
CH 9]
Business 101 — The Basics
Of course one recognizes that these divisions allow for goods to be
more easily exchanged.
Portability. In days gone by, the farmer could herd his cattle, swine
or geese to market, or haul his pumpkins and grain in carts. Indeed these
are uniquely portable. The round money stones for the Yapese was often
placed at the door of its owner, so that their individual wealth was
known to all who passed by. The Yap stones were made round with a
hole in the middle which was characteristic of their difficult
portability—in turn the process of trading the stones for needed goods
and services was at least cumbersome.
Of course modern paper currency and coins are the most common
forms of money throughout the world, they are lightweight, which
facilitates their portability. Paper currency is easily folded and carried
and coins can be carried in your pocket or coin purse. United States
paper currency is printed in denominations ranging from $1 to
$100,000; the highest common printing is for the $100 bill.
Durability. The monetary system using butter or cheese faces the
durability problem as an issue of shelf life in a matter of weeks. Money
that does not last as it is exchanged cannot act as effective store of
value. The typical dollar bill changes hands 400 times during its
lifetime, staying in the average person's pocket or purse less than two
days. Although coins and paper currency do wear out over time, they are
Yap Money Stones
replaced easily with new crisp paper bills and shiny coins. The average
life of the U.S. dollar bills is 18 months and can be folded several
thousand times without tearing.
.Stable store of value. If the value of money is not stable, people will loose
faith in it, will be less willing to accept it in trade for goods and services. A nations
money looses value when it is inflated (government prints excess amounts and
puts it in the market place). Inflation is a serious concern for governments. As
people fear that the money will lose its value, they will look for safer means of
storing their wealth. When inflation ran rampant in Argentina, the people
abandoned the Argentine peso and engaged a barter system or resorted to using
another country’s currency such as the U.S. dollar. Using a barter system stunts
economic growth because of the inefficiencies of barter, and using other nations
currency’s are in insufficient supply for normal economic growth.
Scarcity. Scarcity does not mean that money needs to be rare
as with numismatics or stamps, rather that the supply of money
should be controlled and limited to avoid inflation. Money cannot
be unlimited, “grow on trees,” or it will have little store of value.
Governments will also go to great lengths to prevent its currency
from being counterfeited.
Difficulty in Counterfeiting. Hold a Federal Reserve dollar bill
$50 — 2005 version
to the light and you will notice small red, blue and green silk
threads imbedded in the paper. On five, ten, twenty, fifty, and
hundred dollar bills is imbedded a metal strip with the currency
value imprinted. The purpose of these threads and metal strip is to
make counterfeiting difficult. This strip can be electronically
detected during transport. Theft of currency plates from a
government mint is a common plot element for espionage and
mystery novels and movies because the production and distribution
$50 — 1996 version
of counterfeit money could undermine a nation's monetary system
by devaluing the value of legitimate money (inflation). For this reason, all
governments make counterfeiting a serious crime and take elaborate steps to
prevent it. A new one-hundred dollar bill was introduced in 1996 to thwart
counterfeiting. Counterfeit one-hundred dollar bills are being distributed in the
Middle-East, Asia, Africa and Europe. All major U.S. bills have been again
changed beginning in 2002.
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Money, Banking & Financial Institutions
TABLE 9.4 Alternative Measures of the
Money Supply
Measures of the money supply are intended to
gauge the extent of purchasing power held by
consumers. But the extent of purchasing
power depends on how accessible assets are
and how often people use them. The various
money-supply measures reflect variations in
the liquidity and accessibility of assets.
Measure
[CH 9
Components
M1
Currency in circulation outside of bank vaults
Demand deposits at commercial banks
NOW and ATS accounts
Credit union share drafts
Demand deposits at mutual savings banks
Traveler's checks (non-bank)
M2
M1 plus:
Savings accounts
Time deposits of less than $100,000
Money-market mutual funds
M3
M2 plus:
Time deposits larger than $100,000
Repurchase agreements
Overnight Eurodollars
L
M3 plus other liquid assets, for example:
Treasury bills
U.S. savings bonds
Bankers' acceptances
Term Eurodollars
Commercial paper
The Money Supply
liquidity
A measure of how quickly an
item can be converted to
cash.
M1
The first level of the money
supply and includes the most
liquid forms of money:
currency and demand
deposits.
currency
Two of the components of the
money supply—coins and
paper money.
demand deposits
Promises to pay immediately
to the depositor any amount
of money requested as long as
it does not exceed the account
balance.
Have you ever thought of the question “How much money is there in the United
States?” As a function of controlling currency inflation, this question is asked and
answered; it is the money supply measurement. To understand this concept one
must know the term liquidity. Liquidity is a measure of how quickly an item can be
converted to cash. Obviously the most liquid money item is cash or currency (coins
and paper money). Currency does not need to be converted in that it is money.
However there are other items that approach currency in liquidity because they
function as cash. These items include travelers checks; demand deposits, against
which checks can be written or from which funds can be withdrawn; time deposits,
from which funds can be withdrawn; money market funds, which can be sold
immediately for cash.
When the U.S. money supply is measured, they look at various levels, beginning
with the most liquid and ending with the least liquid, each ranked in terms of their
liquidity. For this discussion, the first two levels of the money supply are the most
important—these are referred to as M1 and M2.
M1
M1 is the first level of the money supply and includes the most liquid forms of
money: currency and demand deposits.
Currency. We generally think of currency as including the coins and paper
money spent on the purchase of goods and services. When you go to your favorite
restaurant and pay the bill with cash, this is a part of the money supply. Yet, this
cash actually represents about 30 percent of M1. Cashiers’ checks, money orders,
and travelers’ checks are also considered currency since they represent money ondemand and the individual negotiating them need not be personally known.
Demand Deposits. The demand deposit is the technical name for checking
accounts at commercial banks and savings banks. The holder of the account only
needs to execute a demand (write a check) and the money may be withdrawn
immediately, on demand, without prior notice to the bank. Of course the bank will
CH 9]
United Missouri was one of the
first banks in the nation to
introduce the MasterCard
BusinessCard. The credit card
was developed in response to
customer demand to control
the $10 billion business travel
expense industry. The
BusinessCard offers company
travelers acceptance of the
MasterCard at millions of merchants worldwide and a reporting system that identifies
business-related travel and
entertainment expenses. Card
holders receive monthly reports detailing their business
expenses.
Business 101 — The Basics
9-9
UMB Commercial Cards
Credit Card Benefits
 Billing Options
 Spending Controls
 Worldwide Acceptance
 Business Reporting Packages
 Online Account Access
 Fraud Protection
Photo source: Courtesy of United Missouri Bancshare, Inc.
not honor the demand if there are insufficient funds in the account to meet the
demand.
Checks are a very popular form of payment and Americans write and cash more
than 1,000 checks a second. There are several reasons for this frequent use of
checks:
1. Checks are more secure than currency; they reduce the possibility of theft
or loss of currency because checks cannot be spent by anyone other than
the account holder.
2. A check is a convenient form of payment for large purchases or oddnumbered purchases. For example, writing a check for a $132.45 jacket is
more convenient than handing the salesperson the exact purchase price of
six $20s, a $10, two dollars, one quarter, a dime, and a nickel.
3. It is safer, as carrying large amounts of cash invites crime.
4. Checks make bill payment by mail easier and safer.
5. For taxation audits, they provide a proof of the transactions.
Interest-Bearing Checking Accounts. The federal government, as a part of
banking deregulation in the 1980s, decided to permit commercial banks, savings
and loan associations, and savings banks to officer interest-bearing checking
account called a negotiable order of withdrawal (NOW) account. The interest
paid on these accounts offer the holder the opportunity to maintain value of the
money in the account by offering the benefit of earning interest on those funds in
deposit. Credit unions offer their members what is called share draft accounts.
These are interest-bearing accounts that permit the account holder to write drafts
that are essentially checks.
M2
M2 is the second level of the money supply measurement. M2 adds time
deposits, and money market accounts to the M1 calculation.
Time Deposits. Commercial banks and savings banks offer savings accounts to
their customers. Savings accounts that allow the bank to require notice prior to the
account holder withdrawing their funds and may allow the institution to assess a
penalty for early withdrawal is termed a time deposit. Time deposits are liquid,
even though they are not used for transactions or as a medium of exchange. Time
deposits will offer the holder a higher interest rate than a regular savings account.
Money Market Accounts. Money market accounts are accounts that offer
interest rate returns that are competitive with short-term investments such as shortterm U.S. Treasury bills. The investor in money market accounts can write checks
negotiable order of
withdrawal (NOW)
account
Interest-bearing checking
account offered by
commercial banks, savings
and loan associations, and
savings banks.
share draft accounts
Interest-bearing credit union
accounts that permit
depositors to write drafts
against them.
M2
Adds time deposits, and
money market accounts to
the M1 calculation.
time deposit
Account that requires
prior withdrawal notice to
avoid penalty.
Money Market Accounts
Deposits that pay interest
rates very competitive
with those paid on other
short-term investments;
some allow a limited
number of checks to be
written in amounts
exceeding $500.
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Figure 9.2 The Operations of a Commercial Bank
Bank lends
money to
Commercial
Borrowers
Bank receives
money from
Depositors
Users
Banks
Depositors
Bank pays interest
to or establish
checking accounts
for
Depositors
Bank receives
interest and
repayments from
Borrowers
against these funds, however the number of checks that may be written are generally
limited to three per month.
Money market mutual funds emerged in the high inflation years of the early
1980s. These funds sold ownership shares to investors and used this revenue to
purchase short-term notes of government agencies and major corporations.
credit card
Plastic card used in
making credit purchases;
special credit arrangement
between issuer, card
holder, and merchant.
Credit Cards
People frequently use their credit card as a substitute for currency and checks.
Credit cards are not a part of the money supply, but this plastic money represents an
individual’s credit standing. Names such as American Express, MasterCard and
Visa are widely known, used, and accepted around the world by nearly every
business. They are a medium of exchange, but what they create is a use of credit; a
unique credit arrangement between the cardholder and the financial institution that
issues the card. Each time that the card holder uses their credit card, they are
entering a short-term loan arrangement for the amount of the transaction. This shortterm loan can be repaid when billed, or make the stated minimum amount each
month; interest is charged on the outstanding balance until it is paid in-full. Of the
1.1 billion credit cards in circulation, this represents that each U.S. household has on
average 12 cards. Credit cards have become very popular as a medium of exchange
because of the willingness of merchants to accept credit cards and financial
institution recognizing them for their profitability.3
Merchants typically pay fees of 1 percent to 5 percent for credit-card sales by
discounting their credit card sales to the bank; cardholders frequently pay an annual
fee and interest charges between 9 percent and 24 percent on unpaid balances. As
such, credit cards can generate profits three times as high as other bank services,
and this profitability potential prompted American Express to develop its own
Optima bank card and Sears to create its Discover card.4
The American Banking Industry: Their role in Business
American business is served by several variations of the banking industry,
commercial banks, thrifts, credit unions and even non-banking institutions such as
insurance companies, and commercial and consumer finance companies.
There are about 13,000 commercial banks that make up the U.S. banking
Business 101 — The Basics
CH 9]
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Table 9.2 Major Financial Institutions: Sources and Uses of Funds
Typical
Investments
Types of Accounts
Offered to Depositors
Commercial bank
Personal loans
Business loans
Increasingly involved in real
estate construction and
home mortgage loans
Deposit Institutions
Checking accounts
NOW accounts
Passbook savings accounts
Time deposits
Money market
deposit accounts
Savings and loan
association
Bond purchases
Home mortgages
Construction loans
Savings accounts
NOW accounts
Time deposits
Money market
deposit accounts
Customer deposits
Interest earned on loans
Savings bank
Bond purchases
Home mortgages
Construction loans
Savings accounts
NOW accounts
Time deposits
Money market
deposit accounts
Customer deposits
Interest earned on loans
Credit union
Short-term consumer loans
Increasingly involved
in making longerterm mortgage loans
Share draft accounts
Savings accounts
Money market
deposit accounts
Deposits by credit
union members
Interest earned on loans
Insurance
company
Corporate long-term loans
Mortgage of commercial real
estate—major buildings/
shopping centers
Government bonds
Premiums paid by
policyholders
Earnings on investments
Pension fund
Some long-term mortgages on
commercial property and
business loans
Government bonds
Corporate securities
Contributions by
member employees
and employers
Earnings on investments
Commercial and/or
consumer
finance
company
Short-term loans to
businesses (commercial
finance companies)
Individual consumer loans
(consumer finance companies)
Interest earned on loans
Sale of bonds
Short-term borrowing
from other firms
Institution
Primary Sources
of Funds
Customer deposits
Interest earned on loans
Non-deposit Institutions
Source: Federal Reserve System.
system. The number of banks changes because of mergers and acquisitions with
other financial institutions. Commercial banks are profit-making businesses that
performs two basic functions: they hold the deposits of individuals and business
firms in the form of checking and savings accounts pay them interest for the
funds deposited with them; and they loan those funds to individuals and business
for interest payments. Figure 9.2 illustrates how a commercial bank performs
these two functions.
Types of Commercial Banks
Prior to 1863 all commercial banks were chartered only by the banking
commissions of the states they were doing business in. The National Banking Act
of 1863 created a new banking system of federally chartered banks, supervised by
the Office of the Comptroller of Currency, a department of the U.S. Treasury.8
commercial bank
Profit-making business
that holds deposits of
individuals and
businesses in the form of
checking or savings
accounts and uses these
funds to make loans to
individuals and businesses.
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state banks
Commercial banks
chartered by individual
states.
national banks
Commercial banks
chartered by the federal
government.
Money, Banking & Financial Institutions
[CH 9
This lead then to two types of banks: state banks and national banks. State
banks are commercial banks chartered by individual states whereas national
banks are commercial banks chartered by the federal government. National banks
tend to be larger and engage in banking across state lines. Though the regulations
affecting state and national banks vary slightly, in practice there is little difference
between the two from the viewpoint of the individual depositor or borrower.
A bit of history. The day after Franklin D. Roosevelt was sworn into office he
issued Presidential Proclamation 2038, to convene a special session of congress to
address the problems of the depression. FDR’s, using President Woodrow
Wilson’s Trading with the Enemy Act then issued Presidential Proclamation 2039,
ordering all banks—already closed—to remain closed until March 9. FDR then
issued proclamation 2040 which extend the amount of time banks were kept
closed. Because the Trading with the Enemy Act only applied during wartime,
and since the United States were not at war, what FDR had accomplished was
illegal. As Congress was convened in special session FDR urged Congress to pass
the Emergency Banking Act, amending the Trading with the Enemy Act to apply
“during time of war or during any other period of national emergency declared
by the president” (text revision in italics). Title I of the Emergency Banking Act
sanctioned FDR’s order extending the “bank holiday” after the fact.9
Historians have recorded these bank holidays and banking reform measures as
“sav[ing] the whole system of credit and monetary exchange.10 However, FDR’s
extended bank holiday made life tougher for everybody. Banks needed
permission from the secretary of the Treasury to do anything.11 Business became
reluctant to accept checks because they would not clear and the merchant would
not be paid. “Subway tokens, stamps, and IOUs took the place of money,”
observed historian Page Smith.12 In contrast, during the banking panic of 1907,
when J. Pierpont Morgan himself had taken charge of a successful bank rescue
operation, some banks did close their doors temporarily, but they continued
clearing checks so that people could pay bills; Morgan maintained the mobility of
deposits.
The Emergency Banking Act also authorized the printing of Federal Reserve
notes backed not by gold but by government bonds, which meant that the
government could print as much money (inflate the currency) as it wanted and not
be limited by the amount of gold on hand. 13
Services Provided by Commercial Banks
automated teller machine
(ATM)
Electronic banking
machine that permits
customers to make cash
withdrawals, deposits, and
transfers on a 24-hour
basis by using an access
card.
The typical commercial bank could be described as a Full-service bank
because of the numerous services it offers its depositors—banks refer to services
as product. Commercial banks offer a variety of checking accounts and savings
accounts with varying limits and rewards, they offer personal and business loans,
credit cards, safe deposit boxes, tax-deferred individual retirement accounts
(IRAs), discount brokerage services, wire transfers (which permit immediate
movement of funds by electronic transfers to distant banks), and financial
counseling. They can provide customers with traveler's checks at a small fee and
many of them offer overdraft protection on their checking accounts for some of
their depositors.
Customers who need to make deposits or withdrawals when the bank is closed
can usually do this by using their bank issued automated teller machine (ATM)
card. ATM machines may be found outside bank buildings, in freestanding kiosks,
and in supermarkets, shopping malls, and airline terminals. Networks of
interlinked systems such as MAC, CIRRUS, or TYME give users access to their
hometown bank accounts from ATMs across the country.9
Competition among all financial institutions has forced banks to become more
customer and service-oriented in attracting business in either new customer
deposits and consumer loans. The American Banker conducted a customer survey
CH 9]
Business 101 — The Basics
Figure 9.3 Emphasizing Service Quality with Guarantee Programs
Source: Reprinted with the permission of NCNB Corporation.
and found that the primary reason people switch banks is because of poor service,
especially as it related to account errors.10 To prevent customers from switching, a
number of banks have instituted a competitive tactic, the warranty. National
Westminster Bank USA advertised that if a customer who applies by phone for a
personal or car loan and did not get an answer by the end of the next business day,
they would pay them $50.11 The advertisement from North Carolina's NCNB in
Figure 9.3 shows the bank will give a $10 apology for any mistake on a depositors'
accounts.12
First National Bank of Chicago tied its managerial bonuses to service quality
related. Rosemarie B. Greco, president of Philadelphia's Fidelity Bank, and a
former nun, sent 25 of her managers to visit companies known for excellent
customer service such as American Express, and L. L. Bean. This resulted in
complaint-handling systems being consolidated, and management becoming more
personally involved with customer problems. 87 percent of Fidelity's customers
now report either being satisfied or highly satisfied with service, compared with 57
percent in 1986.13
Financial institutions do not offer their services at no-charge, rather their
services is their product and they will charge a price for their product to assure
profitability. Atlanta's Citizens & Southern Bank charges 75 cents for each check
written after the seventh check a customer writes in each month. Mellon Bank
assesses a $20 as a bounced-check charge and depositors pay $10 for each stoppayment order. Although Bank of America in Los Angeles charges no fees for
depositors who use the bank's own ATM, a $1 charge is levied on depositors who
use other ATMs in the bank's network. These fees are designed to generate
additional revenue for banks and to charge the depositors for the services rendered.
Customers, of course, want the bank services at no additional charge, and may
even resent bank fees. So banks have begun offering package deals called bundled
accounts for customers who are will to maintain large account balances, $1,000 or
more per month, and will wave service fees and check charges. For a minimum
9-13
9-14
Money, Banking & Financial Institutions
[CH 9
Figure 9.4 A Bank Service for Business Customers
balance of $1,000 spread between any two or more accounts (such as checking,
savings, money market, CDs, and IRAs), participants in the ChemPlus package at
New York's Chemical Bank get free checking, a 16.8 percent combined
MasterCard and Visa account (free for the first year), reduced rates on loans and
mortgage fees, and free 24-hour banking from their ATM network around the
country. "We are devouring market share with this new product," boasts one
Chemical Bank official. "New Yorkers are always chasing around to get that last
one-hundredth of a point interest, but we offer them free checking, loads of
convenience, and a guarantee that our rates will always be near the top.''14
Commercial banks also provide a wide range of financial services to assist
business engaged in international trade. Well’s Fargo and Bank of America offer
assistance in financing trade in a variety of countries for multinational firms. The
advertisement in Figure 9.4 illustrates Citicorp's foreign exchange service, which
handles more than 150 currencies, assists firms in transactions that cross national
borders. Fees charged for such services produce substantial earnings for Citicorp.
Other Financial Institutions
There are other financial institutions that exist as sources and users of funds
besides commercial banks. The U.S. financial system is categorized into two
broad groups: deposit institutions and non-deposit institutions.
Deposit Institutions
Savings and loan associations, savings banks, and credit unions, in addition to
commercial banks, are considered deposit institutions because they accept
deposits from customers and provide some form of checking account. While each
of these institutions has traditionally served specific financial needs of
individuals and businesses, deregulation has blurred the distinctions among them.
CH 9]
Business 101 — The Basics
9-15
Figure 9.5 Consumer Lending Promoted by a Savings Bank
Source: Courtesy of Great American Bank/Ad Agency: Franklin and Associates, San Diego, CA.
For example, at one time only commercial banks offered checking accounts.
However, savings and loan associations and savings banks currently offer interestpaying NOW accounts. Credit unions offer their own variant in the form of share
draft accounts. Although thrifts, as savings and loan associations and savings banks
are commonly called, have traditionally served as sources of home mortgages,
many commercial banks now compete in the home mortgage market. All of these
institutions compete by offering passbook accounts, time deposits, traveler's checks,
and a variety of other banking services with competitive rates.
Thrifts: Savings and Loan Associations and Savings Banks. A savings and
loan association (S&L) is a financial institution offering both savings and checking
accounts and using most of its funds to make home mortgage loans. Their original
purpose was to encourage family thrift and home ownership, and for years, S&Ls
were permitted to pay slightly higher interest rates to savers than could commercial
banks. Deposited funds were then used to make long-term, fixed-rate mortgages at
prevailing mortgage rates. Fifteen years ago, thrifts originated 60 percent of all
residential mortgages. Today, S&Ls and savings banks hold only one-third of
outstanding residential loans.15 Approximately 44 percent of the nation's savings
and loan associations are incorporated under federal regulations and must use the
word federal in their names. The remaining 56 percent are state chartered.
Savings banks, also known as mutual savings banks, are virtually identical to
S&Ls. Their origins can be traced to the early 1800s in Boston and Philadelphia,
where they were established to provide interest on savings accounts. The early U.S.
banks did not provide such accounts, and the first savings banks were designed to
meet the savings and borrowing needs of individual households. Their early
missions are suggested by such names as Emigrant Savings Bank, Dime Savings
Bank, and Seamans Bank for Savings.
The approximately 600 savings banks are concentrated in 16 states including the
New England states, New York, and New Jersey. They operate much like S&Ls in
offering NOW accounts and other savings accounts and in making home mortgage
loans, and they have faced similar competitive pressures. Like the S&Ls, they are
now permitted to make consumer and some business loans. To gain competitive
advantages in loan production, Great American First Savings Bank, headquartered
savings and loan
association (S&L)
Financial institution offering
savings and checking
accounts and using most of
its funds to make home
mortgage loans; also called
thrift institution.
savings banks
State-chartered banks with
operations similar to
savings and loan
associations.
9-16
Money, Banking & Financial Institutions
[CH 9
in San Diego, California, is developing new products and promotional strategies for
its banking offices in California, Arizona, Washington, Colorado, and Montana. An
aggressive promotional effort, including advertisements such as the one in Figure
9.5, is helping Great American increase its consumer loan business.
Traditionally, both S&Ls and savings banks earned money by attracting savings
deposits at interest rates of perhaps 6 percent and then making home mortgages at
10 percent, generating a 4 percentage point differential to use in covering operating
costs and earning a profit. As long as this spread existed between the cost of funds
and the interest earned on loans, the thrifts prospered.
Rising interest rates during the early 1980s devastated the S&Ls, whose mission
was to use short-term deposits to make long-term, fixed-rate mortgage loans. In
1982, for example, S&Ls were paying an average of 11.5 percent interest on their
deposits while earning only 10.4 percent on their loans.
In an attempt to correct the impending disaster, Congress and many state
regulatory bodies permitted S&Ls to engage in activities never before allowed.
They were permitted to make commercial loans, engage in consumer leasing,
provide trust services, and issue credit cards. This new freedom, combined with the
removal of maximum interest levels S&Ls could pay depositors, created a monster
by allowing S&Ls to raise endless amounts of money to fund disastrous
investments. For example, American Diversified of Costa Mesa, California,
solicited deposits by telephone, offering interest rates of more than 8.5 percent as a
lure. The thrift, headed by Ranbir Sahni, a former pilot in the Indian Air Force,
funneled these deposits into such risky investments as wind farms and ethanol
plants. When Sahni's operation and nearby North America Savings and Loan
Association were closed by federal regulators in 1988, no depositors lost money, but
the federal agency guaranteeing these accounts had to come up with $1.35 billion—
the largest cash payoff in U.S. banking history.16
Between 1980 and 1990, the number of S&Ls declined nearly 40 percent, to
3,000. Of these, approximately one-third are losing money. The number of S&Ls
will continue to decline as regulatory authorities authorize the sale, merger, or
liquidation of troubled thrifts. The survivors are likely to be similar to commercial
banks in their operations.17
credit union
Member-owned financial cooperative that pays interest to
depositors, offers share draft
accounts, and makes short
term loans and some home
mortgage loans.
insurance company
Business that provides
protection for policyholders
in return for premium
payments.
pension fund
Funds accumulated by a
company, union, or nonprofit
organization for the
retirement income needs of
its employees or members.
Credit Unions. The nation's 14,000 federally insured credit unions serve as
sources of consumer loans at competitive rates for their members. A credit union is
actually a form of savings cooperative and is typically sponsored by a company,
union, or professional or religious group. The credit union pays interest to its
member depositors. While credit unions tend to be relatively small, with only 30
percent having assets of $5 million or more, they exist in every state and claim
nearly 52 million members. Credit unions today have outstanding loans of more
than $105 billion.18
While credit unions have traditionally concentrated on short-term consumer
loans and savings deposits, their operating flexibility has been increased as a result
of deregulation. As mentioned earlier, they offer an interest-bearing checking
account called a share draft account and can make long-term mortgage loans. Other
services available to member depositors and borrowers typically include life
insurance at competitive rates and financial counseling.
Non-deposit Institutions
Other sources and users of funds include insurance companies, pension funds,
consumer and commercial finance companies. An insurance company provides
financial protection for policyholders who pay premiums. Insurance companies use
the funds generated by premiums to make long-term loans to corporations and
commercial real estate mortgages and to purchase government bonds.
A pension fund is a large pool of money set up by a company, union, or
nonprofit organization for the retirement income needs of its employees or
CH 9]
Business 101 — The Basics
members. According to the pension fund's rules, a member may begin to collect a
monthly allotment on retirement or on reaching a certain age. Pension fund
managers, like managers of insurance companies, are able to predict the
approximate amount of money they will have to pay in benefits over a given period.
Like insurance companies, pension funds invest in long-term term mortgages on
commercial property, business loans, and government bonds. In addition, they often
purchase common stock in major firms. When a corporation establishes a pension
fund, a portion of the fund is likely to be invested in the firm's stock. Total assets of
all private, state, and local government pension plans are more than $1.1 trillion.
Consumer and commercial finance companies offer short-term loans to
borrowers who pledge tangible items such as inventory, machinery, property, or
accounts receivable as security against nonpayment. A commercial finance
company, such as Commercial Credit or CIT, supplies short-term funds to
businesses unable to borrow enough needed funds from banks. In some cases, these
businesses cannot secure bank loans because they are relatively new and lack
sufficient credit history or otherwise fail to meet the bank's lending standards. In
other instances, firms may have borrowed to the limit from banks and, therefore,
must turn to other sources for additional funds. Since these loans typically involve
greater risks, commercial finance companies typically charge higher interest rates
than commercial banks and thrift institutions. The consumer finance company
(frequently called a personal finance or small loan company) has traditionally
served a similar role for personal loans. In recent years, they have become
increasingly competitive with banks and thrift institutions and are frequently able to
offer more attractive loans with longer terms. Beneficial Finance and Household
Finance are two major consumer finance companies. Consumer and commercial
finance companies obtain their funds from the sale of bonds and from short-term
loans from other firms.
The sources and uses of funds available to deposit and non-deposit institutions
and the types of accounts offered to depositors are summarized in Table 9.2.
The Federal Reserve System
All deposit institutions—commercial banks, savings and loan associations,
savings banks, and credit unions—use deposits as the basis of the loans they make
to borrowers. Because their income is derived from loans, these financial
institutions must lend at a higher interest rate than the interest rate paid to
depositors. Approximately 15 percent of a commercial bank's total deposits are kept
on hand at the commercial bank or at the nearest Federal Reserve District Bank to
cover withdrawals; the remainder is used for loans. Other types of deposit
institutions retain less in reserve because a smaller percentage of their deposits are
held in accounts on which checks can be written.
The Structure of the Federal Reserve System
What would happen if all of a commercial bank's depositors decided to
withdraw their funds at once? The bank would be unable to return the depositors'
money—unless it could borrow the needed funds from another bank. But if the
demand for currency instead of checking and savings accounts spread to other
banks, the result would be a bank panic. Banks would have to close their doors
(sometimes referred to as a bank holiday) until they could obtain loan payments
from their borrowers. Such panics in the past resulted in the failure of numerous
commercial banks and plunged the economy into major depressions.
Economic depressions occurred in the United States four times between the end
of the Civil War and 1907, and most of them began with bank panics. The severe
depression of 1907 prompted Congress to appoint a commission to study the
banking system and to recommend changes. The commission's recommendations
became the basis of the Federal Reserve Act, which President Woodrow Wilson
signed in 1913.
9-17
commercial finance
company
Financial institution that
makes short-term loans to
businesses that pledge
tangible items such as
inventory, machinery, or
property as collateral.
consumer finance company
Financial institution that
makes short-term loans to
individuals, typically
requiring collateral; also
called personal finance or
small loan company.
9-18
Money, Banking & Financial Institutions
[CH 9
Figure 9.6 The Federal Reserve System’s Districts and Headquarters. Courtesy Federal Reserve Board.
Federal Reserve
System
Network of 12 regional
banks that regulates
banking in the United
States.
The Federal Reserve System is a network of 12 district banks, controlled by a
board of governors, that regulates banking in the United States. In practice, it acts as
a banker's bank. The "Fed" holds the deposits of member banks, acts as a
clearinghouse for checks, and regulates the commercial banking system. Figure 9.6
illustrates the regions and headquarters for each of the Federal Reserve districts.
The Board of Governors of the Federal Reserve System consists of seven
members appointed by the President of the United States from a recommendation of
the Federal Reserves Board of Governors, and then confirmed by the Senate.
Political pressures are reduced by a 14-year term of office for each member, with
one term expiring every two years.
Each of the 12 Federal Reserve district banks is managed by a president and a
nine-member board of directors. Federal Reserve System member banks in a district
own stock in the district bank and elect some of the board members. The other
directors, of whom at least three must be businesspersons and another three must
represent the general public, are appointed by the Board of Governors.
The relationship between the Washington, D.C.-based Board of Governors and
the 12 district banks is analogous to that of the federal government and the 50 state
governments. The Board of Governors sets the general direction for the member
banks, while the district banks typically concentrate on banking issues of
importance within their district.
While all national banks are required to be members of the Federal Reserve
System, membership is optional for state-chartered banks. In all, there are
approximately 5,800 member banks.
Control of the Money Supply: The FED's Basic Function
The most essential function of the Federal Reserve System is to control the
supply of money and credit in order to promote a stable dollar and economic
growth, both at home and in international markets. It performs this function through
the use of three important tools: reserve requirements, open market operations, and
the discount rate.
CH 9]
Business 101 — The Basics
Reserve Requirements. The Federal Reserve System's most powerful tool is the
reserve requirement—the percentage of a bank's checking and savings deposits
that must be kept in the bank or on deposit at the local Federal Reserve district
bank; this requirement is 3% to 10%. By changing the percentage of required
reserves, the Federal Reserve System can affect the amount of money available for
making loans. Should the Board of Governors choose to stimulate the economy by
increasing the amount of funds available for borrowing, it can lower the reserve
requirement.
Changing the reserve requirement is a drastic means of changing the money
supply. Even a 1 percent variation in the reserve requirement means a potential
fluctuation of billions of dollars in the money supply. Because of this, the board of
governors would prefer to rely more often on the other two tools at its disposal—
open market operations and changes in the discount rate.
Open Market Operations. A far more common method used by the Federal
Reserve System to control the money supply is open market operations— the
technique of controlling the money supply by purchasing and selling government
bonds. When the Board of Governors decides to increase the money supply, it buys
government bonds on the open market. The exchange of money for bonds places
more money in the economy and makes it available to member banks. A decision to
sell bonds serves to reduce the overall money supply.
The Federal Reserve Board often uses open market operations when small
adjustments in the money supply are desired. These operations do not produce the
psychological effect that often results from announcements of changes in reserve
requirements. Such announcements make newspaper headlines and are widely
interpreted by commercial banks, businesspeople, and the stock market as a signal
by the Federal Reserve System of "tighter" or "easier" money. Over the years, open
market operations have been increasingly used as a flexible means of expanding
and contracting the money supply.
The Discount Rate. Earlier the Federal Reserve System was referred to as a
"banker's bank." When member banks need extra money to lend, they turn to a
Federal Reserve bank, presenting either IOUs drawn against themselves or
promissory notes from their borrowers. The interest rate the Federal Reserve
System charges on loans to member banks is called the discount rate.
Commercial banks choose to borrow from the Federal Reserve System when the
discount rate is lower than rates charged by other sources of funds: A high discount
rate may motivate bankers to reduce the number of new loans made to individuals
and businesses due to higher costs of obtaining loanable funds. When the Fed raised
the discount rate in 1988, the response was immediate. Stock prices plunged,
interest rates moved up, and the value of the dollar increased as foreign investors
gobbled up greenbacks. It was a spectacular display of the effectiveness of this
little-known tool.19
The Federal Reserve may choose to stimulate the economy by reducing the
discount rate. Because the rate is treated as a cost by commercial banks, a rate
reduction encourages them to increase the number of loans to individuals and
businesses. In a 12 month period between 1991 and 1992 the discount was lowered
six times in an effort to stimulate a sluggish economy.
The discount rate has been used several times in recent years in controlling the
money supply, attempting to stimulate economic growth, and matching changes in
discount rates made by central banks in such nations as Japan and West Germany.
Like the reserve requirement, it has considerable impact on such interest-sensitive
industries as automobiles and housing. Use of the discount rate also communicates
to banks and to the general public the Federal Reserve Board's attitude concerning
the money supply. An announcement of a reduction in the discount rate is
9-19
reserve requirement
Percentage of a bank's
checking and savings
accounts that must be
kept in the bank or on
deposit at the local
Federal Reserve district
bank.
open market operations
Federal Reserve System
method of controlling the
money supply through the
purchase and sale of
government bonds.
discount rate
Interest rate charged by
the Federal Reserve
System on loans to
member banks.
Money, Banking & Financial Institutions
9-20
[CH 9
interpreted as an indication that the Federal Reserve Board believes the money
supply should be increased and credit should be expanded.
Table 9.3 shows how each of the tools of the Federal Reserve System can be
used to stimulate or slow the economy.
selective credit controls
Federal Reserve System
authority to regulate
availability of credit by
setting margin
requirements on credit
purchases of stocks and
bonds and credit rules for
consumer purchases.
check
Written order to a
financial institution to pay
the amount specified from
funds on deposit.
Selective Credit Controls
In addition to the three general monetary controls, the Federal Reserve System
also has the authority to exercise a number of selective credit controls. These
include the power to set margin requirements on credit purchases of stocks and
bonds and to set credit rules for consumer purchases. The margin requirement is the
percentage of the purchase price of a security that must be paid in cash by the
investor. In 1929, for instance, the margin requirement was set at 10 percent and an
investor could purchase $10,000 in stocks or bonds by depositing $1,000 with a
stockbroker. The brokerage firm would then lend the investor the other $9,000.
Today, the margin requirement is 50 percent; it has remained at this level since the
late 1960s.
Although it has been a number of years since the Federal Reserve System has
imposed minimum terms on loans made by financial institutions, it retains the
authority to utilize its powers in this area as a means of controlling credit purchases.
By establishing specific rules for minimum down-payment requirements and
repayment periods for purchases of such products as automobiles, boats, or
appliances, the Fed could stimulate or restrict purchases of major items that typically
involve credit.
Check Processing
Check processing begins with a check—a piece of paper addressed to a bank or
financial institution on which is written a legal authorization to withdraw a specified
amount of money from an account and to pay that amount to someone. Because $19
of every $20 of business transactions are accomplished in the form of checks, it is
important to understand how checks are processed and the role played by the Federal
Reserve System in the processing.
Table 9.3 Tools of the Federal Reserve System
Effect on
Money Supply
Tool
Action
Reserve
requirements
Increase reserve
requirements
Reduces money supply
Results in increased interest rates and a slowing of
economic activity
Decrease reserve
requirements
Increases money supply
Results in reduced interest rates and an increase in
economic activity
Increase discount
rate
Reduces money supply
Results in increased interest rates and a slowing of
economic activity
Decrease discount
rate
Increases money supply
Results in reduced interest rates and an increase in
economic activity
Purchase government securities
Sell government
bonds
Increases money supply
Results in reduced interest rates and an increase in
economic activity
Results in increased interest rates and a slowing of
economic activity
Discount
rate
Open market
operations
Margin
requirements
Reduces money supply
Short-Term Impact on the Economy
Increase margin
requirements
Reduced credit purchase of securities; negative impact on securities exchanges and on securities prices.
Reduce margin
requirements
Increased credit purchase of securities; positive impact on securities exchanges and on securities prices.
CH 9]
Business 101 — The Basics
9-21
In Figure 9.7, the purchasing agent for Sierra Canner buys a $150 wet/dry
vacuum machine from Sears. The check used to pay for the machine authorizes the
Bank of America of Sacramento, where Sierra Canner has a checking account, to
reduce Sierra Canner's balance by $150. This sum is to be paid to Sears to cover the
cost of the machine. If both parties have checking accounts in the same bank, check
processing is simple. In such a case, the bank increases Sears' balance by $150 and
reduces Sierra Canner's balance by the same amount.
However, the purchase was made from a Sears catalog and involves the firm's
Chicago checking account. In such a situation, the Federal Reserve System acts as a
collector for intercity transactions. The Federal Reserve handles a large number of
the 180 million checks written every business day. You can trace the route a check
has taken by examining the endorsement stamps on the reverse side.
Figure 9.7 A Check's Journey through the Federal Reserve System
Sierra Canner
Sacramento, California
October 11 2015
Pay to the
Order of
Sears Roebuck
$ 150.00
One Hundred Fifty & 00/xx
For Wet/Dry Vac
8. Sierra Canner receives the canceled
check at the end of the month from its
bank.
7. Funds are shifted from the San
Francisco Reserve Bank to the Federal
Reserve Bank of Chicago. It credits the
Chicago bank's account. The Chicago
bank, in turn, adds $150 to the Sears
account.
6. The Bank of America of Sacramento
authorizes the San Francisco Reserve
Bank to deduct the $150 from its deposit
account with the reserve bank.
5. The Federal Reserve Bank of Atlanta
forwards the check to the Bank of
America of Sacramento, which deducts
$150 from Sierra Canner' account.
Dollars
Joe Acosta
1. Sierra Canner in Sacramento, California,
purchases a $150 wet/dry vaccum
machine from the Sears mail-order
catalog. A $150 check is sent to Chicago.
2. Sears deposits the check in its account at
a Chicago bank.
3. The Chicago bank deposits the check for
credit in its account at the Federal
Reserve bank of Chicago.
4. The Federal Reserve Bank of Chicago
sends the check to the Federal Reserve
Bank of Atlanta for collection.
9-22
Money, Banking & Financial Institutions
float
Time delay between writing
a check and the transfer of
funds to the recipient's
account.
[CH 9
Reducing Float by Speeding Up Check Processing. Until recently, an average
check written in the United States took 4 days to clear the bank. When a financial
manager wrote a check to a supplier, lender, or other payee on Monday and the
firm's account was not debited until Thursday, the check writer could earn interest
on these funds for three days. This time period is referred to as float. Since an extra
day of float on a $1 million payment is worth $274 if interest rates are 10 percent,
many astute financial managers established checking accounts at banks in different
parts of the country to take advantage of float. For example, one survey of check
clearance times between cities revealed that checks drawn on banks in Grand
Junction, Colorado; Midland, Texas; and Helena, Montana, generated the greatest
amount of float from New York City.
In 1988, the Federal Reserve System enacted a series of rules designed to reduce
float by specifying exactly when a bank, thrift, or credit union must clear a deposited
check. The new regulations require next-business-day availability for cashier's
checks; certified checks; local, state, and federal government checks; and checks
written on other accounts at the same institution. If the checks are written on some
other institution within the same metropolitan area and the same Federal Reserve
check-processing region, the institution must make the funds available by the third
business day after the day of the deposit. If the check is written on a non-local
institution, the funds must be made available by the seventh business day after the
day of deposit. These maximum holding periods will continue to be reduced as the
Fed improves the speed and efficiency of the check-clearing system.20
CREATION OF MONEY
Knowing that money can be anything, we still have to explain how banks and the
federal reserve create their money. Part of the explanation is simple. Currency must
be printed. Some nations use private printers for this purpose, but all U.S. currency
is printed by the Bureau of Engraving and Printing in Washington, D.C. Coins come
from the U.S. mints located in Philadelphia and Denver. However, currency is a
small fraction of our total money supply. So we need to look elsewhere for the
origins of most money. For this we need to discuss transactions accounts. How do
people acquire transactions deposits? How does the total amount of such deposits—
and therefore the money supply of the economy—change?
Deposit Creation
deposit creation: The
creation of transactions
deposits by bank lending.
Most people assume that all transactions-account balances come from cash
deposits. But this is not the case. Direct deposits of paychecks, for example, are
carried out by computer, not by the movement of cash. Moreover, the employer who
issues the paycheck probably didn't make any cash deposits. It is more likely that he
covered those paychecks with customers' checks that he deposited or with loans
granted by the bank itself.
The ability of banks to lend money opens up a whole new set of possibilities for
creating money. When a bank lends someone money, it simply credits that
individual's bank account. The money appears in your account just like it would
have with a cash deposit. And you are free to spend that money just as you could any
positive balance. Hence, in making a loan, a bank effectively creates money
because transactions-account balances are counted as part of the money supply.
To understand the origins of our money supply, then, we must recognize two
basic principles:
• Transactions-account balances are a large portion of our money supply.
• Banks can create transactions-account balances by making loans.
In the following sections we shall examine this process of deposit creation more
closely. What we want to determine is how banks actually create deposits and what
forces might limit the process of deposit creation.
CH 9]
Business 101 — The Basics
9-23
TABLE 9.5 What Is a Bank?
The essential functions of a bank are to
• Accept deposits
• Offer drafts (check-writing privileges)
• Make loans
In the United States, roughly 30,000 "depository institutions" fulfill these functions. These "banks" are typically classified
into four general categories, even though most "banks" (and many other financial institutions) now offer similar services.
Type of Bank
Characteristics
Commercial banks
The nearly 10,000 commercial banks in the United States provide a full range of
banking services, including savings ("time") and checking accounts and loans for
all purposes. They hold nearly all demand deposits and nearly half of total savings
deposits.
Savings and loan associations
Begun in 1831 as a mechanism for pooling the savings of a neighborhood in order
to provide funds for home purchases, which is still the basic function of such banks.
The nearly 700 S&Ls channel virtually all of their savings deposits into home
mortgages.
Mutual savings banks
Originally intended to serve very small savers (e.g., the Boston Five Cents Savings
Bank). They now use their deposits for a wider variety of purposes, including
investment bonds and "blue chip" stocks. Almost all of the 738 mutual savings
banks are located in only five states (New York, Massachusetts, Connecticut,
Pennsylvania, and New Jersey).
Credit unions
A cooperative society formed by individuals bound together by some common tie,
such as a common employer or labor union. Credit union members hold savings
accounts and enjoy access to the pooled savings of all members. Most credit union
loans are for consumer purchases. Although there are close to 20,000 credit unions
in the United States, they hold less than 5 percent of total savings deposits.
Bank Regulation. The deposit-creation activities of banks are regulated by the
government. The most important agency in this regard is the Federal Reserve
System. The Fed puts limits on the amount of bank lending, thereby controlling the
basic money supply. The functions of a bank are described in Table 9.5.
A Monopoly Bank
To keep things simple let us assume that there is only one bank in town, Farmers
Bank. Imagine also that you have been saving some of your earnings by putting
loose change into a piggy bank. Now, after months of saving, you open your piggy
bank and discover that your diligent thrift has yielded $100. You then decide to open
a checking account, depositing your money at Farmers Bank for your checking
account. How will this deposit affect the money supply?
Your initial deposit will have no immediate effect on the money supply. The
coins in your piggy bank were already counted as part of the money supply (M1 and
M2) because they represented cash held by the public. When you deposit cash or
coins in a bank, you are simply changing the composition of the money supply.
The public (you) now holds $100 less of coins but $100 more of transactions
deposits. Accordingly, no money is created by the demise of your piggy bank (the
initial deposit).
Banks are not in business for your convenience; they are in business to earn a
profit. To earn a profit on your deposit, Farmers Bank will put your money to work.
This means using your deposit as the basis for making a loan to someone who is
willing to pay the bank interest for the use of money. If the function of banks was
merely to store money, they would not pay interest on their accounts or offer free
Money, Banking & Financial Institutions
9-24
[CH 9
TABLE 9.6
Deposit Creation: Excess reserves (Step 1) are the basis of bank loans. When a bank uses its excess reserves to make a loan, it
creates a deposit (Step 2). When the loan is spent, a deposit will be made somewhere else (Step 3). This new deposit creates
additional excess reserves (Step 3) that can be used for further loans (Step 4, etc.). The process of deposit creation continues until
the money supply has increased by a multiple of the initial deposit.
Step 1: You deposit cash at Farmers Bank. The deposit creates $100 of reserves, $20 of which are designated as required
reserves.
Farmers Bank
Banking System
Assets
Required reserves
Excess reserves
Total
Change in
Transactions Deposits
Liabilities
$ 20
80
$100
Your deposit
$100
Change
in M
+$100
$0
$100
Step 2: The bank uses its excess reserves ($80) to make a loan to Scataglia Farms. Total deposits now equal $180. The money
supply has increased.
Farmers Bank
Banking System
Assets
Required reserves
Excess reserves
Loans
Total
D Deposits
Liabilities
$ 36
64
80
$180
Your deposit
$100
Scataglia Farms account
80
DM
+$ 80
+$ 80
$180
Step 3: Scataglia Farms buys an loading gate. This depletes Scataglia Farms's account but increases Powder River's balance.
American Savings gets $80 of reserves when the Scataglia Farms check clears.
Farmers Bank
Assets
Required
reserves $ 20
Excess
reserves
0
Loan
80
Total
$100
American Savings
Liabilities
Your account
$100
Scataglia Farms
account
Total
Assets
0
$100
D Deposits
Liabilities
Required
reserves $ 16
Excess
reserves
64
Total
Banking System
$ 80
Powder River
account
Total
$80
$0
DM
$0
$80
Step 4: American Savings lends money to Orchard Supply. Deposits, loans, and M all increase by $64.
Farmers Bank
Assets
American Savings
Liabilities
Required
Your account
$100
reserves $ 20
Excess
Scataglia Farms
reserves
0
account
0
Loan
80
Total
$100
Total
$100
:
:
:
Nth step: Some bank lends $1.00
Cumulative Change in Banking System
Bank Reserves
+$100
Transactions Deposits
+$500
Assets
Required
reserves $ 29
Excess
reserves
51
Loans
64
Total
$144
Banking System
Liabilities
Powder River
account
$80
Orchard
Supply
account
64
Total
$144
D Deposits
+$ 64
:
:
:
+1
DM
+$ 64
:
:
:
+1
Money
Supply
+$400
CH 9]
Business 101 — The Basics
checking services. Instead, you would have to pay them for these services. Banks
pay you interest and offer free (or inexpensive) checking because they can use your
money to make loans that earn interest (yield a profit for the bank).
The Initial Loan. Typically, banks do not have difficulty finding someone
wanting to borrow money. Many firms and individuals have expenditure desires
exceeding their current money balances and are eager to borrow money. The
question is, how much money can a bank lend? Can it lend your entire deposit? Or
must Farmers Bank keep some of your coins in reserve, in case you want to
withdraw them?
To answer this question, suppose that Farmers Bank decided to lend the entire
$100 to Scataglia Farms. Scataglia Farms wants to buy a new loading gate but
doesn't have any money in its own checking account. To acquire the loading gate,
Scataglia Farms must take out a loan.
When Farmers Bank agrees to lend Scataglia Farms $100, it does so by crediting
the account of Scataglia Farms. Instead of giving Scataglia Farms $100 cash,
Farmers Bank simply adds $100 to Scataglia Farm's checking-account balance. That
is to say, the loan is made with a simple bookkeeping entry.
This simple bookkeeping procedure has important implications. When Farmers
Bank lends $100 to the Scataglia Farms account, it "creates" money. Keep in mind
that transactions deposits are counted as part of the money supply. Moreover,
Scataglia Farms can use this new money to purchase its desired loading gate,
without worrying that its check will bounce.
Or can it? Once Farmers Bank grants a loan to Scataglia Farms, both you and
Scataglia Farms have $100 in your checking accounts to spend. But the bank is
holding only $100 of bank reserves (your coins). In other words, the increased
account balance obtained by Scataglia Farms does not limit your ability to write
checks. There has been a net increase in the value of transactions deposits, but no
increase in bank reserves.
Secondary Deposits. What happens if Scataglia Farms actually spends the $100
on a new loading gate? Won't this "use up" all the reserves held by the bank,
endangering your check-writing privileges? The answer is no.
Consider what happens when Powder River Gates receives the check from
Scataglia Farms. What will Powder River do with the check? Powder River could go
to Farmers Bank and exchange the check for $100 of cash (your coins). But Powder
River may prefer to deposit the check in its own checking account at Farmers Bank
(still the only bank in town). In this way, Powder River not only avoids the necessity
of going to the bank (it can deposit the check by mail) but also keeps its money in a
safe place. Should Powder River later want to spend the money, it can simply write a
check. In the meantime, the bank continues to hold its entire reserves (your coins)
and both you and Powder River have $100 to spend.
Fractional Reserves. Notice what has happened here. The money supply has
increased by $100 as a result of deposit creation (the loan to Scataglia Farms).
Moreover, the bank has been able to support $200 of transaction deposits (your
account and either the Scataglia Farms or Powder River account) with only $100 of
reserves (your coins). In other words, bank reserves are only a fraction of total
deposits. In this case, Farmers Bank's reserves (your $100 in coins) are only 50
percent of total deposits. Thus the bank's reserve ratio is 50 percent, rather than 100
percent—that is
Reserve ratio = (bank reserves) / (total deposits)
The ability of Farmers Bank to hold reserves that are only a fraction of total
deposits results from two facts: (1) people use checks for most transactions, and (2)
there is no other bank. Accordingly, reserves are rarely withdrawn from this
monopoly bank. In fact, if people never withdrew their deposits and all transactions
accounts were held at Farmers Bank, Farmers Bank would not need any reserves. In
this most unusual case, Farmers Bank could make as many loans as it wanted. Every
loan it made would increase the supply of money.
9-25
bank reserves: Assets held
by a bank to fulfill its
deposit obligations.
reserve ratio: The ratio of a
bank's reserves to its total
transactions deposits.
9-26
Money, Banking & Financial Institutions
required reserves: The
mi ni mum amount of
reserves a bank is required
to hold; equal to required
reserve ratio times
transactions deposits.
[CH 9
In reality, many banks are available, and people both withdraw cash from their
accounts and write checks to people who have accounts in other banks. In addition,
bank lending practices are regulated by the Federal Reserve System. The Federal
Reserve System requires banks to maintain some minimum reserve ratio. This
reserve requirement directly limits the ability of banks to grant new loans.
Required Reserves. Consider if the Federal Reserve imposes a minimum
reserve requirement of 75 percent on Farmers Bank. Such a requirement would have
prohibited Farmers Bank from lending $100 to Scataglia Farms. That loan would
have resulted in $200 of deposits, supported by only $100 of reserves. The actual
ratio of reserves to deposits would have been 50 percent ($100 of reserves . $200 of
deposits). That would have violated the Fed's assumed 75 percent reserve
requirement. A 75 percent reserve requirement means that Farmers Bank must hold
required reserves equal to 75 percent of total deposits, including those created
through loans.
The bank's dilemma is evident in the following equation:
Required reserves = (minimum reserve ratio) x (total deposits)
To support $200 of total deposits, Farmers Bank would need to satisfy this
equation:
Required reserves
=
0.75
x
$200
=
$150
But the bank has only $100 of reserves (your coins) and so would violate the
reserve requirement if it increased total deposits to $200 by lending $100 to
Scataglia Farms.
Farmers Bank can still issue a loan to Scataglia Farms. But the loan must be less
than $100 in order to keep the bank within the limits of the required reserve formula.
Thus a minimum reserve requirement directly limits deposit-creation possibilities.
It is still true, however, as we shall now illustrate, that the banking system, taken as a
whole, can create multiple loans (money) from a single deposit.
A Multibank World
The process of deposit creation in a multibank world with a required reserve ratio
is illustrated in Table 9.6. In this case, we assume that legally required reserves must
equal at least 20 percent of transactions deposits. Now when you deposit $100 in
your checking account, Farmers Bank must hold at least $20 as required reserves.
(The reserves themselves may be held in the form of cash in the bank's vault but are
usually held as credits with one of the regional Federal Reserve banks.)
excess reserves: Bank
reserves in excess of
required reserves.
Excess Reserves. The remaining $80 the bank obtains from your deposit is
regarded as excess reserves. These reserves are "excess" in that your bank is
required to hold in reserve only $20 (equal to 20 percent of your initial $100
deposit).
Excess reserves = (total reserves) - (required reserves)
The $80 of excess reserves is not required and may be used to support additional
loans. Hence the bank can now lend $80. In view of the fact that banks earn profits
(interest) by making loans, we assume that Farmers Bank will try to use these excess
reserves as soon as possible.
To keep track of the changes in reserves, deposit balances, and loans that occur
in a multibank world we shall have to do some bookkeeping. For this purpose we
will use the same balance sheet, or "T-account," that banks themselves use. On the
CH 9]
Business 101 — The Basics
9-27
left side of the balance sheet, a bank lists all its assets. Assets are things the bank
owns or is owed by others. These assets include cash held in a bank's vaults, IOUs
(loan obligations) from bank customers, reserve credits at the Federal Reserve
(essentially the bank's own deposits at the central bank), and securities (bonds) the
bank has purchased.
On the right side of the balance sheet a bank lists all its liabilities. Liabilities are
things the bank owes to others. The largest liability is represented by the deposits of
bank customers. The bank owes these deposits to its customers and must return them
"on demand."
The use of balance sheets is illustrated in Table 9.6. Notice how the balance of
Farmers Bank looks immediately after it receives your initial deposit (Step I of Table
9.6). Your deposit of coins is entered on both sides of Farmers' balance sheet. On the
left side, your deposit is regarded as an asset, because your piggy bank's coins have
an immediate market value and can be used to pay off the bank's liabilities. The
reserves these coins represent are divided into required reserves ($20, or 20 percent
of your deposit) and excess reserves ($80).
On the right side of the balance sheet, the bank reminds itself that it has an
obligation (liability) to return your deposit when you so demand. Thus the bank's
accounts balance, with assets and liabilities being equal. In fact, a bank's books
must always balance, because all of the bank's assets must belong to someone (its
depositors or its owners).
Farmers Bank wants to do more than balance its books, however; it wants to earn
profits. To do so, it will have to make loans—that is, put its excess reserves to work.
Suppose that it lends $80 to Scataglia Farms. (Because of the Fed's assumed
minimum reserve requirement (20 percent), Farmers Bank can now lend only $80
rather than $100, as before.) As Step 2 in Table 9.6 illustrates, this loan alters both
sides of Farmers Bank's balance sheet. On the right-hand side, the bank creates a
new transactions deposit for (credits the account of) Scataglia Farms; this item
The Public
FIGURE 9.8
The Money-Multiplier Process
Part of every new bank deposit leaks into
required reserves. The rest—excess reserves—
can be used to make loans. These loans, in turn,
become deposits elsewhere. The process of
money creation continues until all available
reserves become required reserves.
Transactions
deposits
Banks
Loans
Excess reserves
Leakage into
Required
reserves
9-28
Money, Banking & Financial Institutions
[CH 9
represents an additional liability (promise to pay). On the left-hand side of the
balance sheet, two things happen. First, the bank notes that Scataglia Farms owes it
$80 ("loans"). Second, the bank recognizes that it is now required to hold $36 in
required reserves, in accordance with its higher level of transactions deposits ($180).
(Recall we are assuming that required reserves are 20 percent of total transactions
deposits.) Since its total reserves are still $100, $64 is left as excess reserves. Note
again that excess reserves are reserves a bank is not required to hold.
Changes in the Money Supply. Before examining further changes in the
balance sheet of Farmers Bank, consider what has happened to the economy's money
supply during these first two steps. In the first step, you deposited $100 of cash in
your checking account. This initial transaction did not change the value of the
money supply. Only the composition of the money supply (M1 or M2) was affected
($100 less cash held by the public, $100 more in transactions accounts).
It is not until Step 2—when the bank makes a loan—that all the excitement
begins. In making a loan, the bank automatically increases the total money supply by
$80. Why? Because someone (Scataglia Farms) now has more money (a transactions
deposit) than it did before, and no one else has any less. And Scataglia Farms can
use its money to buy goods and services, just like anybody else.
This second step is the heart of money creation. Money effectively appears out of
thin air when a bank makes a loan. To understand how this works, you have to keep
TABLE 9.7
The Money Multiplier at Work
The process of deposit creation continues as money passes through different banks in the form of multiple deposits and loans.
At each step, excess reserves and new loans are created. The lending capacity of this system equals the money multiplier times
excess reserves. In this case, initial excess reserves of $80 create the possibility for $400 of new loans.
Change in
Transactions
Deposits
If $100 in cash is deposited in Bank A,
Bank A acquires
If loan made and deposited elsewhere,
Bank B acquires
If loan made and deposited elsewhere,
Bank C acquires
If loan made and deposited elsewhere,
Bank D acquires
If loan made and deposited elsewhere,
Bank E acquires
If loan made and deposited elsewhere,
Bank F acquires
If loan made and deposited elsewhere,
Bank G acquires
.
.
If loan made and deposited elsewhere,
Bank Z acquires
Cumulative, through Bank Z
And if the process continues indefinitely
Change
in Total
Reserves
Change in
Required
Reserves
Change in
Excess
Reserves
Change in
Lending
Capacity
$100.00
$100.00
$20.00
$80.00
$80.00
$80.00
80.00
16.00
64.00
64.00
64.00
64.00
12.80
51.20
51.20
51.20
51.20
10.24
40.96
40.96
40.96
40.96
8.19
32.77
32.77
32.77
32.77
6.55
26.21
26.21
26.21
26.21
5.24
20.97
20.97
0.38
$498.49
.
.
.
$500.00
0.38
$498.49
.
.
.
$100.00
0.08
$99.70
.
.
.
$100.00
0.30
$398.79
.
.
.
$0.00
0.30
$398.79
.
.
.
$400.00
A $100 cash deposit creates $400 of new lending capacity when the required reserve ratio is 0.20. Initial excess reserves are $80 (= $100
deposit - $20 required reserves). The money multiplier is 5 (= 1 ÷ 0.20). New lending potential equals $400 (= $80 excess reserves x 5).
CH 9]
Business 101 — The Basics
9-29
reminding yourself that money is more than the coins and currency we carry
around. Transactions deposits are money too. Hence the creation of transactions
deposits via new loans is the same thing as creating money.
More Deposit Creation. Suppose again that Scataglia Farms actually uses its
$80 loan to buy an loading gate. The rest of Table 9.6 illustrates how this additional
transaction leads to further changes in balance sheets and the money supply.
In Step 3, we see that when Scataglia Farms buys the $80 loading gate, the
balance in its checking account at Farmers Bank drops to zero, because it has spent
all its money. As Farmers Bank's liabilities fall (from $180 to $100), so does the
level of its required reserves (from $36 to $20). (Note that required reserves are still
20 percent of its remaining transactions deposits). But Farmers Bank's excess
reserves have disappeared completely! This disappearance reflects the fact that
Powder River Loading gate keeps its transactions account at another bank
(American Savings). When Powder River deposits the check it received from
Scataglia Farms, American Savings does two things. First it credits Powder River's
account by $80. Second, it goes to Farmers Bank to get the reserves that support
that deposit.(1n actuality, banks rarely "go" anywhere; such interbank reserve
movements are handled by bank clearinghouses and regional Federal Reserve
banks. The effect is the same, however.) The reserves later appear on the balance
sheet of American Savings as both required ($16) and excess ($64) reserves.
Observe that the money supply has not changed during Step 3. The increase in
the value of Powder River Loading gate's transactions-account balance exactly
offsets the drop in the value of Scataglia Farms' transactions account. Ownership of
the money supply is the only thing that has changed.
In Step 4, American Savings takes advantage of its newly acquired excess
reserves by making a loan to Orchard Supply. As before, the loan itself has two
primary effects. First, it creates a transactions deposit of $64 for Orchard Supply
and thereby increases the money supply by the same amount. Second, it increases
the required level of reserves at American Savings. (To how much? Why?)
THE MONEY MULTIPLIER
By now it is perhaps obvious that the process of deposit creation will not come
to an end quickly. On the contrary, it can continue indefinitely, just like the income
multiplier process of Chapter 10. Indeed, people often refer to deposit creation as
the money-multiplier process, with the money multiplier expressed as the
reciprocal of the required reserve ratio. (The money multiplier (1/r) is the sum of the
2
3
n
infinite geometric progression 1 + (1 - r) + (1 - r) + (1 - r) + ... + (1 - r) .) That is
Money multiplier = (1) / (required reserve ratio)
The money-multiplier process is illustrated in Figure 9.8. When a new deposit
enters the banking system, it creates both excess and required reserves. The required
reserves represent leakage from the flow of money, since they cannot be used to
create new loans. Excess reserves, on the other hand, can be used for new loans.
Once those loans are made, they typically become transactions deposits elsewhere
in the banking system. Then some additional leakage into required reserve occurs,
and further loans are made. The process continues until all excess reserves have
leaked into required reserves. Once excess reserves have completely disappeared,
the total value of new loans will equal initial excess reserves multiplied by the
money multiplier.
The potential of the money multiplier to create loans is summarized by the
equation:
(Excess reserves of Banking system) x (money multiplier) = (potential deposit creation)
money multiplier: The
number of deposit (loan)
dollars that the banking
system can create from $1 of
excess reserves; equal to 1 ÷
(required reserve ratio).
9-30
Money, Banking & Financial Institutions
[CH 9
FIGURE 9.9
Banks in the Circular Flow
Banks help to transfer income
from savers to spenders. They
do this by using their deposits
to make loans to business firms
and consumers who desire to
spend more money than they
have. By lending money, banks
help to maintain any desired
rate of aggregate spending.
Consumer
Domestic
consumption
Income
Product
markets
Factor
markets
BANKS
Sales receipts
Wages,
dividends, etc.
Investment
expenditures
Business firm
Notice how the money multiplier worked in our previous example. The value of the
money multiplier was equal to 5, since we assumed that the required reserve ratio
was 0.9. Moreover, the initial level of excess reserves was $80, as a consequence of
your original deposit (Step 1). According to the money multiplier, then, the
deposit-creation potential of the banking system was
Excess reserves
($80)
x
money multiplier
(5)
=
Potential deposit creation
($400)
When all the banks fully utilized their excess reserves at each step of the money
multiplier process, the ultimate increase in the money supply was in fact $400 (see
the last row of Table 9.6).
While you are struggling through Table 9.6, notice the critical role that excess
reserves play in the process of deposit creation. A bank can make additional loans
only if it has excess reserves. Without excess reserves, all of a bank's reserves are
required, and no further liabilities (transactions deposits) can be created with new
loans. On the other hand, a bank with excess reserves can make additional loans. In
fact
• Each bank may lend an amount equal to its excess reserves and no more.
As such loans enter the circular flow and become deposits elsewhere, they create
new excess reserves and further lending capacity. As a consequence
• The entire banking system can increase the volume of loans by the amount of
excess reserves multiplied by the money multiplier.
By keeping track of excess reserves, then, we can gauge the lending capacity of any
bank or, with the aid of the money multiplier, the entire banking system.
Table 9.7 summarizes the entire money-multiplier process. In this case, we
assume that all banks are initially "loaned up"—that is, without any excess reserves.
The money-multiplier process begins when someone deposits $100 in cash into a
transactions account at Bank A. If the required reserve ratio is 20 percent, this initial
CH 9]
Business 101 — The Basics
9-31
When the Central Bank of New York failed in 1987, depositors (in photo at left) received the full amount of their
FDIC-insured deposits. Before the Federal Deposit Insurance Corporation was formed in 1934, depositors had no
protection against bank failures. Few of the people lined up at a Cleveland bank in 1933 (photo at right) got their money
back when the bank failed. The Cleveland bank was one of nearly 4,000 financial institutions that failed in 1933.
Photo source: AP-Wide World Photos, Inc.
deposit creates $80 of excess reserves at Bank A while adding $100 to total
transactions deposits.
If Bank A uses its newly acquired excess reserves to make a loan that ultimately
ends up in Bank B, two things happen. Bank B acquires $64 in excess reserves (0.80
X $80), and total transactions deposits increase by another $80.
The money-multiplier process continues with a series of loans and deposits.
When the twenty-sixth loan is made (by bank Z), total loans grow by only $0.32 and
transactions deposits by an equal amount. Should the process continue further, the
cumulative change in loans will ultimately equal $400, that is, the money multiplier
times initial excess reserves. The money supply will increase by the same amount.
BANKS AND THE CIRCULAR FLOW
The bookkeeping details of bank deposits and loans are rarely exciting and often
confusing. But they do demonstrate convincingly that banks can create money. In
that capacity, banks perform two essential functions for the macro economy:
•
Banks transfer money from savers to spenders by lending funds (reserves) held
on deposit.
• The banking system creates additional money by making loans in excess of
total reserves.
In performing these two functions, banks change the size of the money supply— that
is, the amount of purchasing power available for buying goods and services. Market
participants may respond to these changes in the money supply by altering their
spending behavior and shifting the aggregate demand curve.
Figure 9.9 provides a simplified perspective on the role of banks in the circular
flow. As before, income flows from product markets through business firms to factor
markets and returns to consumers in the form of disposable income. Consumers
spend most of their income but also save (don't spend) some of it.
Suppose for the moment that all consumer saving was deposited in piggy banks
rather than depository institutions (banks) and that no one used checks. Under these
circumstances, banks could not transfer money from savers to spenders by holding
deposits and making loans. In reality, a substantial portion of consumer saving is
deposited in banks. These and other bank deposits can be used as the basis of loans,
thereby returning purchasing power to the circular flow. In fact, the primary
9-32
Money, Banking & Financial Institutions
[CH 9
economic function of banks is not to store money but to transfer purchasing power
from savers to spenders. They do so by lending money to businesses for new plant
and equipment, to consumers for new homes or cars, and to government entities that
desire greater purchasing power. Moreover, because the banking system can make
multiple loans from available reserves, banks don't have to receive all consumer
saving in order to carry out their function. On the contrary, the banking system can
create any desired level of money supply if allowed to expand or reduce loan
activity at will.
Deposit Insurance Provided by the FDIC and the FSLIC
Federal Deposit Insurance
Corporation (FDIC)
Corporation that insures bank
depositors' accounts up to a
maximum of $100,000 and
sets requirements for sound
banking practices.
A little history: Prior to the depression of the 1930s, bank failures were
catastrophic for depositors. Small Unit (one office) banks accounted for about 90
percent of bank failures, and it was these small unit banks that began lobbying for
federal deposit insurance. They saw deposit insurance as an assurance for customers
rely on their home town bank.20 Big banks with many branches didn’t seek such
insurance since they had diversified their business both geographically and in
services provided, thus they were financially sound. Federal deposit insurance
became the cause of Henry Steagall, chairman of the House Banking and Currency
Committee, and was a representative from Ozark, Alabama.
The depression era bank failures spurred lobbying for federal deposit insurance,
an idea that had been first proposed back in 1886. The idea behind it is that all
taxpayers insure the banks through the taxes that they pay. Because deposit
insurance had been tried before in a number of states, congress understood the
issues involved. Fourteen state governments, every one with unit banking laws, had
previously offered deposit insurance, and all but three were associated with large
bank failures. The three exceptions, Indiana, Iowa, and Ohio had an agreement that
if one of them incurred losses, depositors would be paid in full by the other banks.
Consequently, there was a strong incentive to minimize losses and they experienced
a small number of bank failures.20
Congressional debates on deposit insurance revolved around fixed rates and
little regulation. In effect, high risk banks would have been under-charged, and lowrisk banks would have been overcharged. Such proposals came from unit banking
states concerned about the vulnerability of their banks, whose loans and deposits
could be devastated by local economic problems.21 Their issue was that
overcharging less risky banks (to subsidize the more risky banks) would give less
risky banks an incentive to drop the insurance, jeopardizing the funds available to
pay insurance claims.
The Banking Act of 1933, which became known as the Glass-Steagall Act, set
up the Federal Deposit Insurance Corporation on a temporary basis to guarantee the
first $2,500 of deposits, in Federal Reserve System member banks rising to $5,000
after July 1, 1934. The FDIC was permanently established by the Banking Act of
1935. Economist Carter Colembe observed, “Deposit insurance was not a novel
idea. It was not untried. Protection of the small depositor, while important, was not
its primary purpose. And finally, it was the only important piece of legislation
during the New Deal’s famous 100 Days, which was neither requested nor
supported by the administration.”21
It should be noted that Federal deposit insurance did not prevent bank failures.
However, since depositors no longer worried about losing their money in a bank
that might fail, there weren’t any more serious bank panics.
What deposit insurance did accomplish was to transfer the cost of bank failures
from depositors to taxpayers.22 The full consequences of federal deposit insurance
didn’t become apparent until the 1980s, when bailing out savings and loan
associations cost $519 billion.
So, the Federal Deposit Insurance Corporation (FDIC) began operating
January 1, 1934, and today it insures depositors' accounts up to a maximum of
CH 9]
Business 101 — The Basics
9-33
Commercial Federal
Corporation, an Omaha,
Nebraska based savings and
loan association, took
advantage of the growth
opportunities provided by
deregulation of the financial
industry by offering checking
accounts, introducing a
telephone bill-paying service,
and installing Cash box
automated teller machines. In
1985, it became the first
financial institution in the
nation to introduce personal
banking machines in branch
offices. In 1987, it broadened
its regional base by acquiring
Empire Savings of Denver, the
largest S&L in Colorado. The
acquisition gave Commercial
Federal access to a consumer
market about twice the size of
its Nebraska market.
Photo source: Courtesy of Commercial Federal Corporation
$250,000 and sets requirements for sound banking practices. All commercial banks
that are members of the Federal Reserve System must also subscribe to the FDIC;
most other banks are FDIC members as well. In addition, deposits at savings banks
and some savings and loan associations are insured by the FDIC. The Federal
Savings and Loan Insurance Corporation (FSLIC) provides similar protection for
most savings and loan associations, and the National Credit Union Administration
(NCUA) insures deposits at federally chartered credit unions. All but 6 percent of the
nearly 17,000 commercial banks and thrifts carry federal insurance protection for
depositors. Deposits in different banks are separately insured, so there is no limit to
the number of $250,000 deposits that can be fully protected in different banks in the
same town or throughout the country. In addition, joint accounts opened by one
person in combination with a number of other people (a spouse, a son, or a daughter)
are all eligible for insurance coverage, even when opened in the same bank. A
drawback to this insurance policy is that $250,000 in 1934 could purchase much
more than $250,000 can today.
Federal Savings and Loan
Insurance Corporation
(FSLIC)
Corporation that provides
deposit insurance and
establishes regulations for
thrifts.
Bank Examiners
The FDIC and FSLIC have improved the stability of the commercial banking
system and federally insured thrifts. The primary technique for guaranteeing the
safety and soundness of commercial banks and thrifts is the use of unannounced
inspections of individual banks and thrifts at least once a year by bank examiners. A
bank examiner is a trained representative who inspects the financial records and
management practices of each federally insured financial institution. Other
commercial banks are inspected by examiners from the Comptroller of the Currency,
the Federal Reserve System, or state regulatory authorities such as the state banking
commission. These examinations are unannounced and may last from a week to
several months. During the examination, the following areas are evaluated: ability of
the bank's management; level of earnings and sources of earnings; adequacy of
properties pledged to secure loans made by the bank; capital; and current level of
liquidity.
If the bank examiners believe serious problems exist in one or more of these
areas, they include the bank on a "problem list." Such banks are viewed as candidates
for failure unless corrective actions are taken immediately. Needed improvements are
bank examiner
Representative of financial
regulatory agency who
conducts periodic
unannounced inspections of
individual financial
institutions to guarantee
safety and soundness.
9-34
Money, Banking & Financial Institutions
[CH 9
typically discussed in the written examination report and in meetings with the bank's
top management and board members. More frequent examinations are also
conducted to determine whether these problems are being remedied. Should the
problems uncovered during an examination require immediate action, more drastic
measures can be taken. However, the problem list is confidential, and most
depositors are likely to be unaware of actions taken by the FDIC or FSLIC.
What Happens When a Bank or Thrift Fails?
Even though bank and thrift failures were rare events by 1979 when only ten
failed, they were running at a post-Depression high a decade later, with failures
occurring daily. Almost 200 commercial banks failed in 1987, 95 of them in the
depressed oil-producing states of Texas, Oklahoma, and Louisiana. That same year,
the nation's 2,000 profitable S&Ls reported earnings of $6.6 billion, while the 1,000
unprofitable thrifts combined to generate losses of $13.4 billion. Some 150 of the
weakest S&Ls were merged or liquidated in 1988; another 200 were closed the next
year. Increased competition with other financial institutions coupled with excessive
losses on business loans resulted in this disturbing number of failures among
financial institutions.
At the first sign of trouble, FDIC or FSLIC regulators assess the problem and
may use special loans and management assistance to remedy the situation. In 1988,
to save the largest bank in Texas from closing, the FDIC granted First Republic
Bank an emergency loan of $1 billion. Four years earlier, the FDIC had provided
$4.5 billion to prevent the collapse of Chicago's Continental Illinois National Bank.
It also replaced the bank's senior directors with new management. By 1988,
Continental was once again earning profits for its stockholders.21
If additional funding or new management appears unlikely to reverse matters,
regulators attempt to negotiate a merger of the weak bank or thrift with a stronger
one. Even after the FDIC emergency loan, First Republic Bank continued to have
problems. In 1988, the organization arranged its merger with North Carolina
National Bank, a highly profitable, well-managed bank headquartered in Charlotte,
North Carolina. If no merger partner or outright purchaser can be found, the
institution is closed.
Once the financial institution closes, federal or state officials immediately secure
control of the financial records and physical facilities. Typically, authorities take
control after business hours on Friday and freeze accounts. By the following
Monday, they have either allowed another bank to assume control or have paid off
depositors up to the $100,000 limit of the deposit insurance. Any assets held by the
failed institution are sold, and proceeds are divided among creditors and holders of
accounts exceeding the $100,000 insurance maximum.
The 1988 failure of North American Savings and Loan Association in Southern
California illustrates these steps. After FSLIC examiners uncovered a high
percentage of bad loans in the thrift's portfolio, federal regulators took over the thrift
and accused management of mismanagement. The financial status of the S&L made
its sale or merger with a solvent institution impossible, and North American was
liquidated in 1988. Depositor Joan Steen, a Huntington Beach marketing consultant,
received a notice to come to the S&L on a specific day to reclaim her deposit. Fortyfive minutes after its 9 a.m. opening, she was on her way out with a check for
$90,000. "I chuckled to myself about it," she says. "They were not only validating
parking tickets, they were also serving coffee and doughnuts." Steen was not alone;
all depositors were reimbursed.22 In this case, and in all other failures of insured
banks and thrifts, depositors have not lost a penny of their insured accounts and
have received 98 percent of their uninsured deposits.
Privately Insured Thrifts
Although more than eight out of ten thrift institutions are federally insured, 30
states give thrifts the option of obtaining protection for deposit money through
CH 9]
Business 101 — The Basics
9-35
private, local insurance funds. These funds offer thrifts the advantage of freedom
from federal regulation and less stringent requirements that enable them to grow
more rapidly.
In 1985, these funds became a focus of concern when Cincinnati's Home State
Savings Bank and the Old Court Savings and Loan in Baltimore faced serious
financial problems that threatened their solvency. Fearing that private insurance
funds would be unable to meet depositor demand, the governors of Ohio and
Maryland took control of the thrifts to avoid depositor panic. Sixty-nine privately
insured thrifts in Ohio were temporarily closed until the crisis eased, and Maryland's
governor ordered a $1,000-a-month limit on withdrawals from the 102 thrifts in the
state. Depositors in both states had reason to worry. Although total assets of the
Maryland Savings-Share Insurance Corporation were $286 million, it was supposed
to be providing insurance protection for $7.2 billion in deposits. Clearly, a bank
panic would have brought about a system-wide collapse.
These crises have caused thousands of depositors throughout the nation to
withdraw funds from privately insured institutions. As a result, many of these
institutions have voluntarily sought federal deposit insurance coverage—a move that
will put the guarantee of the federal government behind an increasing number of
thrift institutions.
Financial Deregulation
A decade ago, the institutions that comprised the U.S. financial system were
easily distinguishable. Commercial banks offered checking accounts and made shortterm business and consumer loans. Savings banks and savings and loan associations
were primarily in the business of making home mortgage loans and offering several
types of savings accounts. Credit unions served their members with savings accounts
and short-term consumer loans.
An intricate network of federal and state laws specified the types of loans and
accounts each financial institution could offer, how much they could pay in the form
of interest, and where they could operate. These rules were a carryover from the
Great Depression years, and they produced a highly regulated industry in which
specific types of financial institutions offered predetermined services in specific
geographic areas.
This fragmented financial system began to unravel in the high-inflation era of the
late 1970s. As investors shifted their funds from commercial banks and thrifts in
search of higher interest rates offered by newly created investment outlets such as
money market mutual funds, banks and thrifts suffered. Since they were operating
under government-imposed interest rate ceilings, the banks and thrifts were unable to
compete. During this same period, the giant brokerage firm Merrill Lynch introduced
its Cash Management Account, which combined a money market mutual fund with a
checking account, credit card, and securities account. Increasing complaints by bank
and thrift management about their inability to compete for deposits resulted in
deregulatory actions aimed at increasing competition among different types of
financial institutions. These moves also blurred the distinctions between banks and
other depository institutions.
This blurring began in 1981 with passage of the Depository Institution Monetary
Control Act. This act, commonly known as the Banking Act of 1980, removed many
of the barriers that had minimized direct competition among the different types of
financial institutions. The act's major feature permitted all deposit institutions to offer
checking accounts. Where once only commercial banks could offer them, today all
deposit institutions directly compete for depositor business by offering NOW
accounts and share draft accounts. A second major feature of the Banking Act of
1980 was to expand the services and lending powers of the thrifts in competing with
commercial banks. Savings and loan associations and savings banks were authorized
to make consumer and business loans, to issue credit cards, and to establish remote
service units. Credit unions can now make mortgage loans. In addition, interest rate
ceilings on all types of deposits at these financial institutions have been eliminated.
Although the Banking Act of 1980 was designed primarily to increase
Banking Act of 1980
Legislation deregulating
financial institutions by
permitting all deposit
institutions to offer
checking accounts;
expanding services and
lending powers of thrifts;
and phasing out
interest-rate ceilings.
9-36
Money, Banking & Financial Institutions
[CH 9
Figure 9.8 Interstate Banking Resulting from Mergers
Do Smaller businesses
need big banks?
Smaller businesses stretching to reach their goals
have unique financial challenges. But a large bank—with the
capacity to extend them credit, protect them from gyrating
rates and help them manage their cash—may seem cold and
bureaucratic.
Ideally, a bank should value close relationships and
still solve the complex financial problems that small
businesses face as they develop. Chemical is such a bank.
Over 30,000 of these relationships make Chemical
the country’s largest commercial bank in small-business and
middle-market banking. At Chemical, we study clients’
problems listen closely to their concerns and provide credit
for expansion, advice on acquisitions, foreign exchange
services and more. And our commitment to small businesses
has been strengthened by our merger with Texas Commerce
Bancshares and our plan to merge with Horizon Bancorp of
New Jersey.
As a result, small businesses can gain access to
urgently needed services, without sacrificing the personal
attention and understanding they require. With Chemical’s
support, a small business can realize its highest aspirations.
CHEMICALBANK
The bottom line is excellence.
competition among financial institutions, it also strengthened significantly the Fed's
regulatory power over nonmember deposit institutions. All such institutions—
whether Federal Reserve System members or not—are required to maintain reserves
against checking accounts, NOW accounts, and share draft accounts. However,
these nonmember institutions are now entitled to the same discount and borrowing
privileges as member banks.
FDIC-FSLIC Merger Proposals
The recent flurry of savings and loan association closings and the withdrawal of
deposits from both privately insured and FSLIC-insured thrifts have resulted in
suggestions that the two federal deposit-insurance organizations be merged. By
1989, the FSLIC was generating annual losses in excess of $8 billion as it attempted
to aid troubled S&Ls and repay depositors at failed thrifts. An estimated $100
billion in additional funds may be required to solve the thrift crisis.
James Montgomery, head of Great Western Financial Corporation, which owns
the nation's third-largest savings bank and is a profitable and strongly capitalized
California institution, is one of the growing number of industry and government
officials who would like to see a combination of the FSLIC, the FDIC, and the
National Credit Union Share Insurance Fund, which backs credit union deposits.
Not only is the FDIC in much better financial condition with almost $20 billion in
cash reserves, but also its record of supervising and monitoring shaky banks is far
better than the FSLIC's with the thrifts. In addition, banks are required by the FDIC
to have capital assets equal to at least 6 percent of their assets—twice as much as
thrifts—and to observe fairly stringent lending requirements.23 Such a merger would
also bolster depositor confidence in thrifts.
CH 9]
Business 101 — The Basics
9-37
Critics of the merger proposal argue it would be unfair for the bank insurance
fund to be used to bail out troubled thrifts. Moreover, the number of bank failures is
also higher than at any time since the Depression, thanks to questionable third world
and commercial real-estate loans. The funds required to return the thrift industry to
stability may come from taxpayers. As one industry economist put it, "It is ultimately
going to have to come from the taxpayer. There's no way around it."24
New Directions in the Banking System
The revolutionary changes in the U.S. financial system during the last decade
have eroded many of the distinct characteristics of specific financial institutions. As a
result of legislation permitting them to offer checking accounts and to increase their
lending flexibility, savings and loan associations have moved in the direction of
commercial banks. Additional developments will have a profound impact on all
financial institutions in the remaining years of the twentieth century. Three major
developments are electronic banking, the movement toward interstate banking, and
the development of the financial supermarket.
Electronic Banking
In a single year, individuals and businesses in the United States write more than
47 billion checks. The huge cost associated with processing these checks has led
companies and the banking system to explore methods to reduce the number of
checks written.
The long-awaited "cashless/checkless society" may have begun in the form of the
electronic funds transfer system (EFTS)—a computerized system for making
purchases and paying bills through electronic depositing and withdrawal of funds.
Some of these systems are operated by a push-button telephone, permitting the
account holder to transfer funds electronically from one account to another and to
pay bills. The monthly bank statement lists all telephone transactions made.
In other instances, a coded plastic debit card is used. Although debit cards
resemble credit cards, they do not allow the holder to buy now and pay later. In fact,
they require immediate payment for any cash withdrawal or purchase by deducting
the amount from the individual's account.
Debit cards are access cards; they allow the cardholder to make electronic
transactions and cash withdrawals from his or her account. They can be inserted into
automatic teller machines to make deposits, withdraw cash, switch funds from one
account to another, and pay utility bills. Automatic cash dispensers are being
installed in shopping centers, major department stores, even supermarkets—wherever
consumers write the greatest number of checks. The cash dispenser is connected to
the bank's computer, which checks the validity of the card, reduces the cardholder's
checking account total by the amount of cash requested, and provides the cash and a
printed receipt—all within 20 seconds.
By 1989, U.S. retailers had replaced over 60,000 traditional cash registers with
point-of-sale (POS) terminals linked to bank computers. By inserting the customer's
debit card number into the terminal and recording the data relating to a purchase, the
amount of the purchase can be transferred via computer from the customer's account
to the retail store's account. Shoppers at 350 Florida Publix supermarkets and 370
Lucky Stores in California are able to debit cards for grocery purchases. These cards
have been tested by fast-food giants McDonald's, Wendy's, and Burger King.
Preliminary results show debit-card purchases are 45 percent larger than those made
with cash. The creation of regional and national networks that accept debit cards
from numerous banks has led to rapid acceptance by both consumers and merchants.
Gasoline marketers Exxon, Mobil, Arco, and Amoco accept debit cards at 10,000
stations.25 Electronic banking using debit cards and point-of-sale terminals offers
advantages for both businesses and consumers. Merchants can reduce their bad-check
losses, banks can save on paperwork costs, and consumers can get money instantly.
To date, home banking has not lived up to expectations. When New York's
electronic funds transfer
system (EFTS)
Computerized method for
making purchases and
paying bills by
electronically depositing or
withdrawing funds.
debit card
Coded plastic access card
used to make electronic
transactions.
point-of-sale (POS)
terminals
Machines linked to a bank's
computer that allow funds
to be transferred from the
purchaser's account to the
seller's account when
purchases are made.
9-38
Money, Banking & Financial Institutions
[CH 9
Chemical Bank introduced Pronto, the nation's first major home banking system in
1983, bank officials expected 10 percent of their customers to eventually pay bills
and make banking transactions from their home computers. For a $12 monthly
service fee, bank customers could be linked to Pronto's computers through virtually
any brand of personal computer, a modem, and an ordinary telephone.
The response to this banking innovation has been disappointing. Today, even
though 3.3 million U.S. homes are equipped with computers and modems, only
95,000 use home banking. Even though such giants as New York's Citibank and
Manufacturers Hanover, Shawmut Bank in Boston, Boulevard Bank in Chicago,
National City in Cleveland, First Wachovia in Winston-Salem, and United
American in Memphis offer home banking, bank customers have not shown much
interest in paying $8 to $15 a month for a service that requires a home computer but
cannot accept deposits or dispense cash. In addition to business users, business
travelers, who want the convenience of leaving bill-paying instructions with their
bank, have been attracted to home banking. Chemical Bank managers eventually
decided to cut their losses by canceling the service.26
The Trend toward Interstate Banking
A bank customer in Canada has the luxury of depositing money in one bank
branch and withdrawing it from another branch in a distant corner of the country.
This is not yet possible in the United States, where the banking system is much
more fragmented than those in many other nations. In fact, many of the 14,000 U.S.
commercial banks have no branches.
The Pepper-McFadden Act, passed in 1927, prohibits U.S. banks from having
offices in more than one state unless authorized by state law and requires banks to
adhere to the branch banking laws of the state. In some states, these laws prohibit
branch banking. In 12 states, no branches are permitted even within the same city.
The Bank of California, headquartered in San Francisco, has continued to
operate branches in California, Oregon, and Washington because its interstate
operations were in effect before passage of the 1927 act. Currently, interstate
banking is possible only if individual states invite out-of-state banks to set up
branches.
While the country's 2,000 largest banks enthusiastically support interstate
banking, 12,000 of the smaller banks strongly oppose any change. They fear that
the nation's 12 to 15 largest banks would quickly seize control of the banking
industry and eliminate small, local competition. They also fear that large, out-ofstate banks would show little interest in small communities, local business, and
individual borrowers and would concentrate their holdings in large cities.
Supporters of interstate banking see little risk of diminished competition and
individualized service. They argue that such changes would increase competition
by permitting commercial banks to do what a number of non-bank institutions are
currently doing. Firms like American Express and Merrill Lynch are not subject to
the same legal restrictions as banks, and they offer the equivalent of checking and
savings accounts and other services on a nationwide scale. In addition, foreign
banks, which are free of such restrictions, have already set up interstate operations.
Another argument for interstate banking is greater convenience for people who
move to another state. In a given year, one household in six moves to a different
city or state. Finally, a broader geographic service area would reduce the likelihood
of bank failures sweeping across states such as Texas and Oklahoma where local
banks and thrifts have little opportunity to diversify.
Interstate banking on a regional basis has already begun in several New
England states and in the Southeast, Midwest, and West, where super-regionals
such as Banc One, NCNB, Wells Fargo, Sun Trust Banks, and PNC Financial are
operating across state lines. The regional compacts were ratified by a 1985 U.S.
Supreme Court ruling that sanctioned the right of groups of states to permit their
banks to operate freely within a region.
Banking boundaries are expanded to other states through mergers with existing
banks or thrifts. A merger with American Fletcher National Bank in Indianapolis
resulted in Columbus, Ohio-based Banc One expanding its operations to Indiana. As
CH 9]
Business 101 — The Basics
the text of the advertisement in Figure 9.8 states, Chemical Bank expanded into
Texas and New Jersey as a result of mergers with banks located in those states.27
Financial Supermarkets
Not only are the distinctive barriers among financial institutions crumbling, but
other non-financial operations also are joining the competitive battle. The term
financial supermarket has been used to describe a growing number of non-banks
that act like banks by offering a wide range of financial services for their customers.
Firms such as Sears, J. C. Penney, and Merrill Lynch are moving into traditional
banking territory by offering consumers such one-stop financial services as
investments, loans, interest-earning deposits, bill payments, real estate, and
insurance.
With more than 25 million active retail accounts, Sears has a solid credit base
upon which to build additional financial services. The retailing giant's Discover
Card was introduced in 1985. In addition to its use as a general purpose card for
shopping, travel, and entertainment, the Discover Card also permits the cardholder
access to other Sears financial services ranging from a savings account at a Sears
savings bank to a retirement account at Sears-owned Dean Witter. In addition, instore financial centers enable customers to obtain insurance services from Sears'
Allstate Group; real estate from Coldwell Banker; investment services from Dean
Witter; and, in California, retail banking services from Sears Savings Bank.
Traditional commercial banks and thrifts have responded. Banking industry
representatives have sought to remove many regulations preventing them from
offering such services as underwriting stocks and bonds. National ATM networks
and geographic expansion through mergers have given banks a nationwide presence
similar to that of the non-bank financial supermarkets. First Nationwide, which
operates in 14 states, has set up over 150 kiosk-size branches in Kmart aisles, where
thousands of shoppers stroll past.28 Traditional banks like Wells Fargo are moving
banking functions into grocery stores to facilitate convenience for their customers.
Other banks and thrifts are creating their own financial supermarkets by bringing in
outside companies to help them package investment products and other new
services. As kiosks staffed by people offering insurance, stocks, bonds, real estate,
and even travel services begin to appear, the bank of the 1990s appears less like a
mahogany and marble trimmed mausoleum and more like a boutique-lined
shopping mall. In an era of one-stop shopping, banking services are being
combined with other consumer services.
Summary of Learning Goals
1.
Outline the characteristics of money and list its functions. In order to
perform its necessary functions, money should possess the following
characteristics: divisibility, portability, durability, stability, and difficulty of
counterfeiting. These characteristics allow money to perform as a medium of
exchange, a unit of account, and a temporary store of value.
2.
Explain the differences of money and near-money. Money is broadly
defined as anything generally accepted as a means of paying for goods and
services, such as coins, paper money, and checks. Near-money consists of
assets that are almost as liquid as money but that cannot be used directly as a
medium of exchange, such as time deposits, government bonds, and money
market funds.
3.
List the major categories of financial institutions and the sources and uses
of their funds. The U.S. financial system consists of deposit institutions and
9-39
financial supermarket
Non-bank that provides
financial services such as
investments, loans, real
estate, and insurance.
9-40
Money, Banking & Financial Institutions
[CH 9
non-deposit institutions. Deposit institutions, such as commercial banks, thrifts, and
credit unions, accept deposits from customers or members and offer some form of
checking account. Non-deposit institutions include insurance companies, pension
funds, and finance companies and represent sources of funds for businesses and
provide mortgage funds for financing commercial real estate.
4.
Discuss the functions of the Federal Reserve System and the tools it uses to
increase or decrease the money supply. The regulation of the banking system is
the responsibility of the Federal Reserve System through the use of reserve
requirements, open market operations, and the discount rate. Increases in the reserve
requirement or the discount rate have the effect of reducing the money supply,
while decreases have the opposite effect. Open market operations increase the
money supply by purchasing bonds and decrease the supply by selling them.
5.
Explain how banks create money. Banks have the power to create money by
making loans. In making loans, banks create new transactions deposits, which
become part of the money supply. The ability of banks to make loans — create
money — depends on their reserves. Only if a bank has excess reserves — reserves
greater than those required by federal regulation—can it make new loans. As loans
are spent, they create deposits elsewhere, making it possible for other banks to
make additional loans. The money multiplier ( 1 ÷ required reserve ratio) indicates
the total value of deposits that can be created by the banking system from excess
reserves. The role of banks in creating money includes the transfer of money from
savers to spenders as well as deposit creation in excess of deposit balances. Taken
together, these two functions give banks direct control over the amount of
purchasing power available in the marketplace.
6.
Explain the purpose and primary functions of the Federal Deposit Insurance
Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation
(FSLIC). The Federal Deposit Insurance Corporation (FDIC) regulates the banking
system, establishes rules for sound banking practices, and insures deposits up to
$100,000. Savings and loan associations receive similar deposit insurance and
regulations from the Federal Savings and Loan Insurance Corporation (FSLIC).
7.
Discuss the major provisions of the Banking Act of 1980 and its impact on
financial deregulation. Major features of the Banking Act of 1980 include (1)
permitting all deposit institutions to offer checking accounts, (2) expanding the
services and lending powers of savings and loan associations and savings banks to
allow them to better compete with commercial banks, (3) removing interest rate
ceilings, and (4) extending the Federal Reserve System's regulatory power to
nonmember financial institutions.
8.
Explain the differences between credit cards and debit cards. Credit cards
function as temporary cash substitutes, but they are actually special credit
arrangements between the issuer and the cardholder. Although debit cards resemble
credit cards, they are access cards for making electronic transactions and cash
withdrawals.
9.
Discuss the role of the electronic funds transfer system (EFTS), the trend
toward interstate banking, and the financial supermarkets in the current
competition among financial institutions. An electronic funds transfer system
(EFTS) is a computerized system of making purchases and paying bills through
electronic deposit and withdrawal of funds. It is designed to decrease paperwork
involved in processing checks. As restrictive barriers on interstate banking are
removed, the structure of U.S. banking will be altered radically. The current trend of
bank mergers will accelerate, reducing the number of commercial banks. Financial
supermarkets are non-banks that act like banks by offering a wide range of financial
services including investing, borrowing, interest-earning deposits, and insurance at
a single location.
CH 9]
Business 101 — The Basics
Questions for Review and Discussion
1.
Identify the components of the U.S. money supply. What functions are performed
by these components? Which money supply components are most efficient in
serving as a store of value?
2.
Distinguish between credit cards and debit cards. Are they part of the money
supply? Why or why not?
3.
Explain how the different types of financial institutions can be categorized and
identify the primary sources and uses of funds available in each institution.
4.
Explain the functions of the Federal Reserve System. Give an example of how
each of the following tools may be used to increase the money supply or to
stimulate economic activity:
a. Open market operations
b. Reserve requirements
c. Discount rate
d. Selective credit controls
5.
Why was the Federal Deposit Insurance Corporation created? Explain its role in
protecting the soundness of the banking system. Outline the steps that may be
taken by the FDIC to assist banks with financial problems. What actions are taken
in case of bank failure?
6.
What are the major provisions of the Banking Act of 1980? How have they
affected competition among financial institutions?
7.
Outline the processing of checks by the banking system in the United States.
8.
Summarize the arguments favoring and opposing interstate banking.
9.
What advantages do debit cards offer banks? retail merchants? debit-card users?
Why might some people choose not to use debit cards? Why do merchants prefer
point-of-sale terminals over checks and traditional credit cards?
10. Some government officials have proposed that all commercial banks and thrift
institutions be required to be FDIC-insured. Summarize the arguments favoring
and opposing merger of the FDIC and FSLIC.
11. This exercise is very much like Table 9.7 in the text, but the reserve requirement
has been changed. Assume Bank A, below, is a monopoly bank.
A. Complete Table 9.9 on the basis of the following:
$100 in cash is deposited in Bank A. (Assume cash is counted as reserves.)
The reserve requirement is 0.10.
The bank begins with zero excess reserves.
9-41
9-42
Money, Banking & Financial Institutions
[CH 9
B. The money multiplier in Table 9.7 in the text is 5 and the money multiplier in
this exercise is _______.
C. Suppose that the initial transaction had been a withdrawal of $100 in cash
(reserves) and the banking system had been all loaned up (had no excess
reserves). As a result of the initial withdrawal, __C1____ of reserves would have
been lost. Required reserves would have been reduced by __C2_____ and the
banking system would be deficient by __C3____. Assuming no other way to get
reserves, the banking system would have to call in loans of __C4____.
Table 9.9 Transactions-account balance creation
Change in
Transactions
Deposits
If $100 in cash is deposited in Bank A,
Bank A acquires
If loan made and deposited elsewhere,
Bank B acquires
If loan made and deposited elsewhere,
Bank C acquires
If loan made and deposited elsewhere,
Bank D acquires
If loan made and deposited elsewhere,
Bank E acquires
If loan made and deposited elsewhere,
Bank F acquires
If loan made and deposited elsewhere,
Bank G acquires
And if the process continues indefinitely,
changes will total
Change
in Total
Reserves
Change in
Required
Reserves
Change in
Excess
Reserves
Change in
Lending
Capacity
$ ______
$ ______
$ ______
$ ______
$ ______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
_______
$ ______
$ ___ 0.00
$ ______
$ ___ 0.00
$ ______
END NOTES
1.
1.
2.
3.
Peter S. Rose and Peter S.S. Rose, Commercial Bank Management (New York: McGraw-Hill, 2001)
King James Version, Holy Bible, Ecclesiastes 10:19.
"Heaven Express?" Fortune, October 24, 1988, pp. 9, 12.
Robert D. Manning, Credit Card Nation (New York: Basic Books, 2001)
4.
Robert E. Taylor, "Parents Would Have Appreciated Some Card Burning by Protesters," The Wall Street Journal
May 6, 1988, p. 23.
Statement by Lawrence B. Lindsey, Member, Board of Governors of the Federal Reserve System before the Forum
on Credit Card Debt U.S. House of Representatives December 14, 1995; “Is MasterCard mastering the
Possibilities?” Business Week October 10, 1988, p. 123; Barbara Mash, “American Express Chases After the Fast
Food Market,” The Wall Street Journal, April 5, 1989, p. B1.
Accessed at www. ustreas.gov, 21 May 2002.
Jim Powell, FDR’s Folly, (New York: Crown Forum, 2003), p53
Henry H. Adams, Harry Hopkins: A Biography (New York: Putnam, 19770), p50; Jim Powell, FDR’s Folly, (New
York: Crown Forum, 2003), p54
Lester V. Chandler, American Monetary Policy, p.261; Jim Powell, FDR’s Folly, (New York: Crown Forum,
2003), p54
Page Smith, Redeeming the Time: A People’s History of the 1920s and the New Deal (New York: McGraw-Hill,
1987), p. 438. Jim Powell, FDR’s Folly, (New York: Crown Forum, 2003), p54
Lester V. Chandler, American Monetary Policy, p.261; Jim Powell, FDR’s Folly, (New York: Crown Forum,
2003), p54
5.
8.
9.
10.
11.
12.
13.
9.
10.
11.
12.
13.
14.
John Hillkirk, "Smart Firms Sell Quality to Clients," USA Today, June 6, 1988, p. B1.
Judith Graham, "Bank Guarantees," Advertising Age, February 15,1988, p. 82.
Ronald Alsop, "Banks Aim New Image Ads at Consumers," The Wall Street Journal October 11, 1988, p. Bl.
Patricia Sellers, "How to Handle Customers' Gripes," Fortune, October 24, 1988, p. 92.
Hedberg, "Ways to Get the Most from Your Bank," p. 111.
Vicky Cahan, "It May Be Time for S&Ls to Just Fade Away," Business Week June 1, 1987, p. 52.