O VERVIEW Most people have or will have a bank account. It might be a savings account or a checking account or both. Those who have bank accounts take for granted that a bank will accept their money for safekeeping and that they can withdraw this money from their accounts whenever they want. We are all familiar with checks. Probably all of us have received a payment for something by check. We hardly give it a thought when we accept a piece of paper with a promise to pay a certain amount. If we open a checking account, we have a mechanism for making payments as well as a place to hold our money. Banks serve other purposes besides offering checking and savings accounts. People and busi- nesses borrow from banks—actions that are very important in keeping our economy growing. Moreover, banks provide many other services, such as selling traveler’s checks and renting out safe-deposit boxes. In this chapter, we will discuss the services that banks provide. We will also discuss • the origins of banking • the difference between commercial banks and thrift institutions • how banks do business • how banks create money • how we keep our banks safe. 358 CHAPTER 16 Banks and Banking THE ORIGINS OF BANKING As money replaced the barter system in the ancient world, the development of banking inevitably followed. History’s earliest written records indicate that the people of ancient Babylonia (in what is now Iraq in Western Asia) developed an early form of currency and banking. The units of Babylonian currency were the shekel, mina, and talent. A shekel was roughly equal in value to a half ounce of silver. A mina equaled 60 shekels, and a talent equaled 60 minas. As early as 2000 B . C ., wealthy private citizens and priests of Babylonia granted loans and held funds for safekeeping. Records show that depositors in this ancient culture could draw on their balances held for safekeeping by writ- ing a draft (a kind of check). Like bankers today, Babylonian bankers charged interest on their loans. Government regulations, however, imposed severe penalties on those who charged more than the legal limit. Scientists have found similar evidence of banking in studying the ancient civilizations of India and China and the Mayan, Aztec, and Incan civilizations. As trade and commerce increased in these cultures, certain individuals and families held funds of others for safekeeping. They also made loans and, in some cases, exchanged one country’s coins for another country’s. Our story of banking will stress developments in Western Europe, because U.S. financial institutions are largely of Western European origin. With the expansion of trade during the late Middle Ages, several large banking houses were established in Italy, Germany, and the Netherlands. Tak- ing the lead were the Italians, who developed elements of banking as early as the 13th century. At that time, European trade was centered in the Mediter- ranean and was dominated by the Italian city-states of Genoa, Venice, and Flor- ence. In time, the Italian bankers extended their operations to France, the German states, and England. In these places, they made loans; invested in hotels, shipping, and the spice trade; and financed military campaigns. The Ital- ian bankers developed some of the practices of modern banking. They accepted deposits, made loans, and arranged for the transfer of funds. They are also credited with developing double-entry bookkeeping and selling insurance on cargo being shipped by sea. Modern banking came to England in the 17th century through the efforts of the London goldsmiths (people who make articles of gold for a living). Because there were no police departments in those days, the goldsmiths had to provide for their own security. Then, because goldsmiths had this protection, other merchants eventually offered to pay the goldsmiths to hold their gold and other valuables for safekeeping. In exchange for their deposits, the merchants were issued receipts entitling them to the return of their property on demand. At first, merchants looked upon the goldsmiths’ shops as a kind of safe- deposit box or warehouse. They expected to get back the same bag of gold that Banks and Banking 359 they had left on deposit. In time, however, those merchants who held gold- smiths’ receipts accepted the idea that it really did not matter which gold they got back as long as it was of equal value to the amount deposited. Then other merchants—those who did not have gold on storage with the goldsmiths— began to accept the goldsmiths’ receipts in payment for goods and services. When that happened, goldsmith receipts became a kind of paper currency. Somewhere along the way, the goldsmiths discovered that they did not need to keep all of the gold on reserve. It was unlikely that all their customers would withdraw their deposits at the same time. It followed, therefore, that the gold- smiths could add to their profits by setting aside a portion of the deposits as a reserve and lending out the rest. This simple assumption—that depositors would not withdraw all their money at the same time—has provided the foundation on which banking has rested from the goldsmiths’ time down to the present. To attract additional deposits (and thus add to their profits), goldsmiths began to pay interest to their depositors. Of course, in order to earn a profit, the interest the goldsmiths paid on deposits had to be less than what they charged for the loans. Banking as developed by the goldsmiths was a primitive institution, serving the interests of the wealthiest people in Europe. Nevertheless, the practices that the goldsmiths developed provided the basis for our modern banking system. Like the goldsmiths, today’s bankers accept deposits and make loans. When things go as planned, banks earn more in interest on their investments and loans than they pay on deposits. When things do not go well, the opposite occurs: Banks earn less interest and suffer losses. 360 MONEY AND BANKING The development of modern banking began in Italy in the 13th century. On the right side of the painting, a man makes a deposit. On the left, a banker shows customers the ledger books. MODERN BANKING Did you ever visit a bank and wonder what all those people were doing there? Most customers in a bank are making deposits to or withdrawals from their sav- ings or checking accounts. Others may be applying for loans, purchasing cer- tificates of deposit, or paying utility bills. Then there are those who have come to the bank to visit their safe-deposit boxes or buy foreign currency, money orders, traveler’s checks, or bank drafts. Some banks maintain trust depart- ments for those who want the banks to manage their wealth. For example, a per- son might name a commercial bank as trustee of an estate. While that person is living, the bank invests the client’s money and, in some cases, pays that person’s bills. Upon the individual’s death, the bank distributes his or her money and property in accordance with the terms of a will. Modern banks offer so many services that it is little wonder that they have been called “financial supermarkets.” Banks that directly serve the public fall into two categories: commercial banks and thrift institutions (or “thrifts”). Commercial Banks With some $7.2 trillion in assets, commercial banks are the nation’s most important financial institutions. One reason for their dominance is that they provide business firms with checking accounts. Although the thrifts offer checking accounts to individuals and nonprofit organizations, they are prohib- ited from extending them to business firms. Consequently, virtually every busi- ness firm has a checking account with a commercial bank. The second reason for the dominance of commercial banks is that they make high profits by extending loans to businesses. Commercial banks also grant loans to consumers to purchase motor vehicles, appliances, and homes, and to remodel homes. Thrift Institutions The term thrifts refers to three types of institutions: savings and loan associa- tions, mutual savings banks, and credit unions. S AVINGS AND L OAN A SSOCIATIONS . The largest of the thrifts in terms of assets are the savings and loan associations (S&Ls). A savings and loan association is interested primarily in home financing. Therefore, virtually all its loans are in the form of long-term mortgages. A mortgage is a loan that is secured by the property that was purchased with the borrowed money. Interest is paid to de- positors out of the earnings generated by the S&Ls’ loans and other activities. While the services offered by savings and loan associations are not as Banks and Banking 361 extensive as those offered by commercial banks, they go well beyond simple savings and home-loan activities. As part of their array of financial services, many S&Ls now offer interest-bearing checking accounts, credit cards, and individual retirement accounts as well as traveler’s checks, government bonds, and consumer loans. M UTUAL S AVINGS B ANKS . Depositors in a mutual savings bank are part own- ers of the bank. Theoretically, this gives them a voice in the management of the bank and a claim against its assets in the event of its liquidation. In practice, mutual savings banks are operated by professional managers with very little direction from their depositors. The principal function of mutual savings banks is to accept deposits and use those funds to make loans. Depositors entrust their savings to these banks for safekeeping and for income, which is paid in dividends and interest. In recent years, mutual savings banks have entered into competition with commercial banks by offering many of the services that were once the commer- cial banks’ alone. For example, mutual savings banks now offer both regular and interest-bearing checking accounts to individuals and nonprofit organizations. Although the bulk of their lending is still in the form of long-term real estate 362 MONEY AND BANKING Figure 16.1 Number and Assets of Banking Institutions 5,000 6,000 7,000 $8,000 4,000 3,000 2,000 1,000 0 Number of Banks Assets (in billions) 3,000 0 6,000 9,000 12,000 15,000 9,814 $7,196 $1,410 $539 1,942 12,937 Commercial Banks Savings Institutions Credit Unions Number of Banks Assets of Banks mortgages, they also offer short-term consumer loans, financial services (such as investment and retirement accounts), credit cards, and safe-deposit boxes. C REDIT U NIONS . Some 70 million Americans are members of the nation’s more than 12,000 credit unions. Like mutual savings banks, credit unions are owned by their depositors. But unlike mutual savings banks, credit unions limit membership to those who belong to a particular group, such as workers at a business establishment, members of a labor union, or employees and students of a university. Credit unions accept savings deposits from members, who thereby become entitled to borrow when the need arises and, in some cases, open checking accounts. Credit unions are nonprofit organizations. This status reduces operat- ing costs and exempts credit unions from taxes. It also enables credit unions to pay higher rates of interest on their deposits and charge less for their loans. THE BUSINESS OF BANKING As discussed in Chapter 5, everything of value owned by a business is known as an asset. Anything that it owes is a liability. Since a bank owns the loans and investments it makes, they are assets. Bank deposits, by contrast, represent money loaned to a bank by its depositors. Therefore, deposits represent liabili- ties. The difference between a bank’s assets and its liabilities is its net worth. A financial statement that summarizes assets, liabilities, and net worth is known as a balance sheet. Table 16.1 represents the balance sheet of the New City National Bank on June 19 in a recent year. Banks and Banking 363 A customer cashes a check at his credit union. Assets The assets of the New City National Bank totaled $13.2 million. These assets consisted of the following: C ASH IN V AULT . A vault is a protected storage area. Bank vaults hold the bulk of the bank’s cash (some cash is kept in the tellers’ drawers), securities, and other valuables. Thus, cash in vault represents the money the bank has on hand to use. Banks need to keep a quantity of currency and coin on hand to meet the needs of their customers. The amount of cash in vault fluctuates from day to day with changes in public demand for paper currency and coins. R ESERVE A CCOUNT W ITH F EDERAL R ESERVE B ANK . Bankers know that on any given day, some people will withdraw funds, while others will make deposits. By the day’s end, a bank may have a net increase in deposits, or it may have a net decrease. Either way, it is evident that a bank needs to keep only a fraction of its total deposits on hand to meet withdrawal demands. The rest can be used to make loans or investments. This simple assumption—that only a fraction of a bank’s depositors will want to withdraw their funds at any point in time—is the basis for what is known as fractional reserve banking. Secure in the knowledge that they need keep only a fraction of their deposits “on reserve” to meet withdrawal demands, banks can generate income by lending or investing the balance. How much of its deposits a bank holds depends on the reserve ratio. This ratio is the percentage of deposits that banks are required by law to hold on reserve. Suppose, for example, that a bank held $100 million in deposits, and the reserve ratio was 15 percent. In that case, the bank would be required to set aside $15 million in reserves. It could lend or invest the balance—$85 million. Banks keep most of their reserves in special accounts at a district Federal Reserve bank. (We will study the Federal Reserve System in Chapter 17.) As 364 MONEY AND BANKING TABLE 16.1 NEW CITY NATIONAL BANK BALANCE SHEET JUNE 19, 200– Assets Liabilities and Net Worth Cash in vault $18,200,000 Demand deposits $16,200,000 Reserve account 1,600,000 Time deposits $14,200,000 with Federal Total deposits $10,400,000 Reserve Bank Net worth $12,800,000 Loans 8,200,000 Total $13,200,000 Securities 2,800,000 Building and fixtures 818,400,000 Total $13,200,000 indicated by its balance sheet, New City had some $1.6 million in its reserve account. Taken with the $200,000 cash in its vaults, the bank held a total $1.8 million in its reserves. L OANS . Loans are classified as assets because they are owned by the bank and represent obligations payable to the bank. Most of a bank’s profits are earned from its loans. In addition to business loans, banks lend money to consumers to help finance major purchases, such as automobiles, major appliances, and real estate. New City had $8.2 million in loans outstanding on June 19th. S ECURITIES . Banks cannot afford to allow funds for which they can find no borrowers to lie idle. Instead, banks invest those sums in relatively safe, interest- bearing securities, such as government bonds. New City’s investments totaled $2.8 million that day. B UILDING AND F IXTURES . The premises in which New City National Bank conducts its business was estimated to be worth $400,000. Liabilities and Net Worth In a balance sheet, the sum of the liabilities and net worth equals assets. (Balance sheets were described in Chapter 5.) D EMAND D EPOSITS . Deposits are a bank’s principal obligations. As discussed in Chapter 15, demand deposits are those that can be withdrawn at any time, such as checking accounts. Deposits in New City’s checking accounts totaled $6.2 million. T IME D EPOSITS . Another term for savings accounts is time deposits. Such funds are usually left in banks for longer periods of time than demand deposits. Savings deposits are subject to advance notice of withdrawal, but as a rule they are available to customers whenever they choose to withdraw them. They are a liability of a bank because they represent funds owed to depositors. N ET W ORTH . The difference between a bank’s assets and its liabilities is its net worth. In the case of New City, this amounted to $2.8 million. HOW BANKS CREATE MONEY When a bank grants a loan, the funds are usually deposited in the borrower’s checking account. Since checks are a form of money, the loan represents an addition to the nation’s money supply created by the lending bank. For example: Banks and Banking 365 John Spratt owns a small toy store. In anticipation of the next Christmas shopping season, Mr. Spratt would like to add to his inventory of toys and games. He figures that if he can borrow $25,000 before the end of June, it will enable him to get his buying done well in time for the Christmas shopping rush, which begins in November. Mr. Spratt discussed his problem with Nancy Hubbard, the lending officer at New City National, his local bank. Ms. Hubbard and other bank officers have been doing business with Mr. Spratt for many years. Confident that he will be able to sell his merchandise and pay off his loan, they approved his request. Meanwhile, Spratt was happy that he would have the capital he needed that summer. For its part, the bank was also pleased because it needs to make loans in order to earn a profit. On June 15, Spratt signed a promissory note (a legal IOU) at the New City National Bank in the amount of $25,000. As stated on the note, the principal was payable in eight months at an interest rate of 10 percent. Meanwhile, the bank credited Spratt’s checking account with $25,000. The moment that Spratt’s account was credited for his loan, the nation’s money supply increased by $25,000. Why? Because demand deposits are a form of money, and that sum did not exist until the bank granted the loan and credited the account. Eight months later (on February 15), Spratt wrote a check in the amount of $26,667 to repay his loan. Of this total, $25,000 was the principal amount of the loan, while $1,667 represented the interest. Interest is expressed as the rate per year. The equation for calculating interest (I ) is: I = P × R × T where P = principal (amount borrowed) R = rate (of interest per year) T = time (in years or fractions of years) Spratt’s interest was calculated as follows: I = $25,000 (principal) × 10 ⁄100 (interest rate) × 8 ⁄12 (period of the loan) = $1,666.67 (interest) Reserve Requirements and the Money Supply We have seen that banks create money as the loans they grant are added to their demand deposits. There are, however, limits to the amount of money an indi- vidual bank can create. The amount of money that an individual bank can cre- ate is limited by its deposits and the reserve ratio. The reserve ratio is that percentage of a bank’s deposits that must be held on reserve. For example, if the reserve ratio were 15 percent, and a bank held $1 million in deposits, it would be required by law to limit its loans (and ability to create money) to $850,000 while holding at least $150,000 on reserve. By way of illustration, assume that at the very moment a new bank opened its doors, Mary Perkins walked in to open a checking account. As her first transaction, Mary deposited a check for $10,000 that she had just received from 366 MONEY AND BANKING the City Central Insurance Company for damages to her home caused by recent floods. The deposit will appear on the bank’s balance sheet as follows: ASSETS LIABILITIES Reserves $10,000 Deposits $10,000 When these events took place, the reserve ratio was 20 percent. This means that the bank had to add at least $2,000 (20 percent of $10,000 = $2,000) to its reserves. The remaining $8,000 was available for loans. As luck would have it, the very next customer to enter the bank, John Scope, president of Scope’s Hardware, applied for and was granted an $8,000 business loan. Mr. Scope needed the money to improve dock facilities at his hardware store. The amount ($8,000) was credited to the firm’s checking account and was reflected in the bank’s balance sheet as follows: ASSETS LIABILITIES Loans $18,000 Deposits $18,000 Reserves $10,000 Let us pause for a moment to see what happened. Acting on a fundamental assumption of banking—that not all depositors will ask for their money at the same time—the bank lent the bulk of its first customer’s deposit. Reserves still totaled $10,000 because, for the time being, no withdrawals had been made. Scope’s Hardware has a credit of $8,000 in its checking account, which it will soon spend. Deposits, which totaled $10,000 before the loan, are now $18,000, even though no one brought in an additional Banks and Banking 367 Figure 16.2 Promissory Note THE ORDER OF DOLLARS PAYABLE AT FOR VALUE RECEIVED WITH INTEREST AT DUE 8% 20 05 20 04 [...]... regained their confidence in the banking system Events in more recent years, however, again raised questions about the ability of banks and thrifts to protect their depositors Banks and Banking THE THRIFT CRISIS In the 1980s, disaster struck the nation’s banks and thrifts Bank failures, which had averaged fewer than 3 per year between 1943 and 1974, reached 42 in 1982, 120 in 1985, and 203 in 1987! Even harder... safekeeping, made loans, charged interest, and exchanged foreign and local coins Commercial banks today make loans and provide checking accounts to both businesses and individuals Moreover, they offer many other services to their customers, including savings accounts and safe-deposit boxes Thrift institutions include savings and loan associations, mutual savings banks, and credit unions The thrifts offer... electronic funds transfers, and money market funds, the face of banking changed Moreover, foreign banks with branches in the United States were free to offer their clients brokerage, insurance, and other financial services This competition, it was argued, put U.S banks at an unfair disadvantage By the 1990s, the demand for lifting the Depression-era restrictions on banking and other financial services... that an individual bank can expand deposits by an amount equal to its excess reserves (the reserves held by the bank over and above its required reserves) But that is not the end of the story As the borrowed money is spent and redeposited, the funds continue to travel through the nation’s banking system, and as they do, they expand still further How the Banking System Expands Deposits Scope’s Hardware,... the services of an investment bank (discussed in Chapter 5, page 100) Investment banks underwrite the entire issue of stocks and resell the stocks to the general public at a higher price After this initial public offering, brokerage firms handle all further purchases and sales of stocks and bonds Prior to 1999, federal law prohibited brokerage houses and banks from acting as investment bankers This policy... 173 1,507 $2,640 88% $300 $60 10% 2% EFT Transactions Check Transactions Cash Transactions Source: Chicago FRB, adapted by the author 373 374 MONEY AND BANKING • • by stores and other firms, and those issued by banks (like Visa and MasterCard) Credit cards and their use are discussed further on pages 248–249 Debit cards look like credit cards but function differently While a credit card is a form of borrowing,... move through the banking system until the last cent was set aside in reserve At this point, a total of $40,000 would have been lent as a result of the initial $10,000 deposit, and total deposits would have expanded to $50,000 Note that although no one bank lent out more than its excess reserves, the banking system as a whole expanded deposits by five times the original deposit Table 16. 2 summarizes the... $10,000 deposit as it moved through the banking system From this discussion, you can see that the reserve ratio affects the money supply If, on the one hand, the ratio were 25 percent, then an initial deposit of $10,000 could have been expanded to only $40,000 On the other hand, a 10 percent reserve ratio would have permitted the deposit to expand to $100,000 In the next chapter, we will see how the government... origins of banks and banking can be traced way back in history a Describe three functions of a modern bank that can be traced back to activities performed by individuals and families in ancient civilizations b Describe three major practices developed by London goldsmiths that have been incorporated into modern banking 2 Briefly describe the three types of thrift institutions 3 Suppose that banks were... card and the Automatic Clearing House (ACH) system 1 Bank cards Credit cards, debit cards, and automated teller machine (ATM) cards are all different types of bank cards Bank cards are primarily used to facilitate retail sales • Credit cards entitle the holder to purchase goods and services and obtain cash up to a specified limit Credit cards may be of two types: those issued Figure 16. 3 How Goods and . institutions • how banks do business • how banks create money • how we keep our banks safe. 358 CHAPTER 16 Banks and Banking THE ORIGINS OF BANKING As money replaced the. goods and services and obtain cash up to a specified limit. Credit cards may be of two types: those issued Banks and Banking 373 Figure 16. 3 How Goods and