Banks and Banking CHAPTER 16 pot

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 s

O V E R V I E W

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.

358CHAPTER 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 bankTak-ing 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

they had left on deposit In time, however, those merchants who held smiths’ receipts accepted the idea that it really did not matter which gold theygot back as long as it was of equal value to the amount deposited Then othermerchants—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

gold-to keep all of the gold on reserve It was unlikely that all their cusgold-tomers wouldwithdraw 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 areserve and lending out the rest This simple assumption—that depositors wouldnot withdraw all their money at the same time—has provided the foundation onwhich banking has rested from the goldsmiths’ time down to the present

To attract additional deposits (and thus add to their profits), goldsmithsbegan to pay interest to their depositors Of course, in order to earn a profit, theinterest the goldsmiths paid on deposits had to be less than what they chargedfor the loans

Banking as developed by the goldsmiths was a primitive institution, servingthe interests of the wealthiest people in Europe Nevertheless, the practices thatthe goldsmiths developed provided the basis for our modern banking system.Like the goldsmiths, today’s bankers accept deposits and make loans Whenthings go as planned, banks earn more in interest on their investments and loansthan they pay on deposits When things do not go well, the opposite occurs:Banks earn less interest and suffer losses

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 perper-son 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

extensive as those offered by commercial banks, they go well beyond simplesavings and home-loan activities As part of their array of financial services,many S&Ls now offer interest-bearing checking accounts, credit cards, andindividual 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 thebank and a claim against its assets in the event of its liquidation In practice,mutual savings banks are operated by professional managers with very littledirection from their depositors

The principal function of mutual savings banks is to accept deposits anduse those funds to make loans Depositors entrust their savings to these banksfor safekeeping and for income, which is paid in dividends and interest

In recent years, mutual savings banks have entered into competition withcommercial banks by offering many of the services that were once the commer-cial banks’ alone For example, mutual savings banks now offer both regular andinterest-bearing checking accounts to individuals and nonprofit organizations.Although the bulk of their lending is still in the form of long-term real estate

Figure 16.1 Number and Assets of Banking Institutions

5,000 6,000 7,000

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

A customer cashes a check

at his credit union.

The assets of the New City National Bank totaled $13.2 million These assetsconsisted 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 theneeds of their customers The amount of cash in vault fluctuates from day today 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 onany given day, some people will withdraw funds, while others will makedeposits By the day’s end, a bank may have a net increase in deposits, or it mayhave a net decrease Either way, it is evident that a bank needs to keep only afraction 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 willwant 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 onreserve Suppose, for example, that a bank held $100 million in deposits, andthe reserve ratio was 15 percent In that case, the bank would be required to setaside $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 FederalReserve bank (We will study the Federal Reserve System in Chapter 17.) As

JUNE 19, 200–

Building and fixtures 818, 400,000

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:

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 theirdemand 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, ifthe reserve ratio were 15 percent, and a bank held $1 million in deposits, itwould 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 openedits doors, Mary Perkins walked in to open a checking account As her firsttransaction, Mary deposited a check for $10,000 that she had just received from

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:

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:

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

Figure 16.2 Promissory Note

THE ORDER OF

DOLLARS PAYABLE AT

FOR VALUE RECEIVED WITH INTEREST AT

DUE

8%

20 05

20 04

$8,000 Where did the additional $8,000 come from? It appeared when the bankgranted the loan Could the bank have loaned $9,000? No, because the reserveratio at that time was 20 percent (The bank could have loaned $9,000 if thereserve ratio had been 10 percent.)

We see, therefore, 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 ing system, and as they do, they expand still further

bank-How the Banking System Expands Deposits

Scope’s Hardware, the business that borrowed the $8,000, paid Hickory Dock,Inc., that amount to improve its dock facilities Hickory Dock deposited thecheck in its account at a second bank The second bank’s balance sheet reflectsthe $8,000 deposit as follows: