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Banking system in the United States
A brief History of Banking
The first banks were probably the religious temples of the ancient world, and were probably established sometime during the third millennium B.C. Banks probably predated the invention of money.
Deposits initially consisted of grain and later other goods including cattle, agricultural implements, and eventually precious metals such as gold, in the form of easy-to-carry compressed plates.
Temples and palaces were the safest places to store gold as they were constantly attended and well built. As sacred places, temples presented an extra deterrent to would-be thieves. There are extant records of loans from the 18th century BC in Babylon that were made by temple priests/monks to merchants. During those days when currency was not used merchants would close a deal by exchanging goods. For eg: A mango merchant and a rice merchant would trade by exchanging mango and rice. The process of trading products, goods or services, for other products, goods or services is called Barter system. It is a simple method of transaction in which no money is exchanged.
What exactly is a bank?
A financial institute which borrows and lends money to and from customers and derives a profit from the difference in the interest rates paid and charged. The name bank derives from the Italian word banco meaning ‘desk’ or ‘bench’, used during the Renaissance by Florentines bankers, who made their transactions above a desk. The word traces its origins back to the Ancient Roman Empire, where moneylenders would set up their stalls in the middle of enclosed courtyards called macella on a long bench called a bancu, from which the words banco and bank are derived. The first modern bank, ‘Banco di San Giorgio’ (Bank of St. George), was founded in Italy in Genoa in 1406.
How did the US banking system evolve to its current form?
1781: Bank of North America chartered - Prior to the American Revolutionary war, private banks printed their own bank notes, backed by deposits of gold and/or silver. The Bank of North America was given a monopoly on currency during the American Revolutionary War.
1784: Bank of New York & Bank of Massachusetts chartered
1791: First Bank of United States chartered - First bank of US succeeded the Bank of North America. The charter expired in 1811 and hence the bank was shut down.
1816: Second bank of United States chartered -The second bank shut down in 1836 as the chartered expired that year
History of US Banking
After the second Bank of the United States went out of business in 1836, state governments started supervising banks. This supervision often proved inadequate. In those days banks made loans by issuing their own currency. These bank notes were supposed to be convertible on demand to cash—that is to gold or silver. It was the bank examiner’s job to visit the bank and certify that it had enough cash on hand to redeem its outstanding currency. Because this was not always done, many bank note holders found themselves stuck with worthless paper. It was sometimes difficult or impossible to detect which notes were sound and which were not, because of their staggering variety. By 1860 more than 10,000 different bank notes circulated throughout the country. Commerce suffered as a result. Hundreds of banks failed. Throughout the country there was an insistent demand for a uniform national currency acceptable anywhere without risk.
1864: National Bank Act passed - National bank act opened up the option of chartering banks nationally.
1865: Taxing of State Bank issued notes - Congress began taxing any issue of state bank notes a standard rate of 10% which encouraged many state banks to become national.
National Banks are the banks that have the word "National" or "N.A." in the name of the bank (i.e. First National Bank, or Citibank N.A.). National Banks are regulated by the Office of the Comptroller of the Currency, Department of the Treasury. The new system worked well. National banks bought U.S. government securities, deposited them with the Comptroller, and received national bank notes in return. By being lent to borrowers, the notes gradually entered circulation. On the rare occasion that a national bank failed, the government sold the securities held on deposit and reimbursed the note holders. No owner of a national bank note ever lost his or her money. National bank notes were the mainstay of the nation's money supply until Federal Reserve notes appeared in 1914.
1913 – till date: Federal Reserve system
1929 – 1933 : The banking crisis
The onset of the worldwide depression in 1929 was a disaster for the banking system. In the last quarter of 1931 alone, more than 1,000 U.S. banks failed, as borrowers defaulted and bank assets declined in value. This led to scenes of panic throughout the country, with long lines of customers queuing up before dawn in hopes of withdrawing cash before the bank had no more to pay out. In June 1933, Congress enacted federal deposit insurance. Accounts were covered up to $2,500 per depositor (now $100,000).
Retail banking refers to banking in which banking institutions execute transactions directly with consumers, rather than corporations or other banks. Services offered include: savings and checking accounts, mortgages, personal loans, debit cards, credit cards, and so forth.
Commercial Banking refers to a bank or a division of a bank primarily dealing with deposits and loans from corporations or large businesses. Commercial banking is also known as business banking. Business banks provide services to businesses and other organizations that are medium sized, whereas the clients of corporate banks are usually major business entities.
Private banking is a term for banking, investment and other financial services provided by banks to private individuals investing sizable assets. The term "private" refers to the customer service being rendered on a more personal basis than in mass-market retail banking, usually via dedicated bank advisers.
An Investment Bank is a financial institution that deals with raising capital, trading in securities and managing corporate mergers and acquisitions. Investment banks profit from companies and governments by raising money through issuing and selling securities in the capital markets and insuring, as well as providing advice on transactions such as mergers and acquisitions. A majority of investment banks offer advisory services for mergers, acquisitions or other financial services, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities.
A customer can connect to a bank through the following channels:
- Branch - Provides face-to-face customer service at a branch bank.
- ATM - A computerized interface for the customer that provides a wide range of services.
- Mail - Used to receive written requests from the customer and to send periodic account statements and information to the customer.
- Phone - Customer uses this system to perform transactions over the phone.
- Online - Customer can use this system to perform banking transactions on a secure website.
How does a bank work?
Lets assume that you deposited $1000 in your bank and the bank would pay an annual interest of 10% on the deposited amount. If you keep this money with the bank for an year, the bank would have to pay $100 extra to you. This means after one year you would earn $100. The total amount of deposit after one year would be $1100. If the bank has to pay $100 extra, where would the bank get this amount from? Would the bank not go bankrupt if it does this for everyone? The way it works is….
The bank keeps a part of this amount as reserve and uses the remaining money for an year and hence earns interest on lending it to other customers. If the bank puts aside a 10% as reserve, the bank would have $900 available to lend to some other customer. The bank would earn $180 annually, if it lends the $900 to another customer at a rate of 20%. The bank would have to pay $100 to you on the deposited amount when it earned $180 by lending your deposited amount. The total profit that the bank earns is $80. This way the bank ends up earning billions of money from thousands of customer.
The deposits can be classified as:
Demand Deposits - An account from which deposited funds can be withdrawn at any time without any notice to the depository institution. This account allows you to ‘demand’ your money at any time. Most checking and savings accounts are demand deposits, accessible by the account holder at any time.
Time Deposits - Money deposited at a banking institution that cannot be withdrawn for a certain ‘term’ or period of time. When the term is over, it can be withdrawn or it can be held for another term. The longer the term the better the yield on the money. A certificate of deposit is a time-deposit product.
Savings accounts are accounts maintained by financial institutions that pay interest but can not be used directly as money. These accounts let customers set aside a portion of their liquid assets and earn a monetary return.
Checking accounts are accounts provided by financial institutions which allows customers to deposit money and withdraw funds from a federally-protected account. The account holder gets official checks which contain all of the essential routing and mailing information.
Money market deposit accounts Money market deposit accounts offer many of the same services as checking accounts although transactions are somewhat limited. These accounts are usually managed by banks or brokerages, and can be a convenient place to store money that is to be used for upcoming investments or has been received from the sale of recent investments.
Certificates of Deposits are similar to savings accounts in that they are insured and thus virtually risk-free. They are different from savings accounts in that the CD has a specific term (three months, six months, or one to five years), and a fixed interest rate.
IRAs are type of accounts that require one to keep the money in the bank until one reaches a certain age.
Federal deposit Insurance Corporation
The FDIC is an independent agency of the federal government created in 1933 in response to the thousands of bank failures that occurred in the 1920's and early 1930's. The FDIC preserves public confidence in the U.S. financial system by insuring deposits in banks and thrifts. The FDIC insures deposits only. It does not insure securities, mutual funds or similar types of investments that banks and thrifts offer. It does not insure funds in any institutions that do not fit the definition of a bank or thrift. Financial institutions such as brokerage firms or investment banks do not meet the statutory definition of a bank or thrift.
The FDIC is funded by premiums that banks and thrifts pay for deposit insurance coverage and from earnings on investments in U.S. Treasury securities. Savings, checking and other deposit accounts, when combined, are generally insured to $100,000 per depositor in each bank or thrift the FDIC insures.
What is a ‘Check’?
A check is a negotiable instrument instructing a financial institution to pay a specific amount of a specific currency from a specified demand account held in the maker/depositor's name with that institution. Both the maker and payee may be natural persons or legal entities.
A loan is a type of debt. The borrower initially receives an amount of money from the bank, to be paid back, in regular installments, to the bank. The bank generally charges the borrower a fee, referred to as interest on the debt, for the privilege of using the money.
Types of Loans:
Secured - A secured loan is a loan in which the borrower pledges some asset (car or property) as collateral for the loan. A mortgage loan is a very common type of debt instrument, used by many individuals to purchase housing. In this arrangement, the money is used to purchase the property. The financial institution is given security — a lien on the title to the house — until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it.
Unsecured - Unsecured loans are monetary loans that are not secured against the borrowers assets. These may be available from financial institutions under many different guises or marketing packages. Personal loans, bank overdrafts, credit cards are the examples of unsecured loans.
Secured Loans :
Home Equity - A loan in which the borrower uses the equity in their home as collateral. These loans are sometimes useful to help finance major home repairs, medical bills or college education. A home equity loan creates a lien against the borrower's house, and reduces actual home equity. Home equity is the difference between the home's market value and the unpaid balance of the mortgage and any outstanding debt over the home.
Mortgage - A mortgage is defined as the conditional pledge to ones’ property secured against the performance of an obligation or the repayment of a debt. A mortgage loan is a loan secured by a property.
Credit Card - It is a card entitling its holder to buy goods and services based on the holders promise to pay for these goods and services. The issuer of the card grants a line of credit to the user from which the user can borrow money for payment to a merchant or as a cash advance to the user. Credit cards allow the consumers to 'revolve' their balance, at the cost of having interest charged.
Overdraft - An agreement by which a person can withdraw money up to an authorized limit. In return the bank charges interest on the amount used.
Commercial loans :
Line of Credit - A line of credit is any credit facility extended to a business by a bank or financial institution. A line of credit may take several forms such as cash credit, overdraft, demand loan, or purchase of commercial bills etc. It is like an account that can readily be tapped into if the need arises or not touched at all and be saved for emergencies. Interest is only paid on the money actually taken out.
Term Loan - A loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate.
Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductable payments.
Mezzanine Financing - A hybrid of debt and equity financing that is used to finance the expansion of existing companies. Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full.
The Fed Reserve
Created in 1913 by the enactment of the Federal Reserve Act, it is a quasi-public banking system that comprises the presidentially appointed Board of Governors of the Federal Reserve System in Washington, D.C. There are 12 regional Federal Reserve Banks with 25 branches, which serve as the operating arms of the system. Reserve Bank boards consist of nine members: six serving as representatives of nonbanking enterprises and the public (nonbankers) and three as representatives of banking. These member banks must maintain fractional reserves either as vault cash or on account at its Reserve Bank; member banks earn no interest on either of these. The dividends paid by the Federal Reserve Banks to member banks are considered partial compensation for the lack of interest paid on the required reserves.
Investment banking is a particular form of banking which finances capital requirements of an enterprise. Investment banking performs IPOs, private placement and bond offerings, acts as broker and carries through mergers and acquisitions.
Investment banking help public and private corporations in issuing securities in the primary market, guarantee by standby underwriting or best efforts selling and foreign exchange management. Investment banking provides financial advice to investors and serves them by assisting in purchasing securities, managing financial assets and trading securities. Investment banking differ from commercial banking in the sense that they don't accept deposits and grant retail loans. Small firms providing services of investment banking are called boutiques. They mainly specialize in bond trading, advising for mergers and acquisitions, providing technical analysis.
Wealth management is an investment advisory service provided by a bank/financial institute, which provides financial planning and specialist financial services to high net worth client. Wealth management is an integral part of financial planning. It is a systematic process of maintaining wealth over a long period of time. Wealth management if done in a proper way can save your family from future liabilities. It protects your assets from harms that may come up all of a sudden. Wealth management also involves planning for post retirement period, in advance. Besides fulfilling day-to-day financial needs it makes arrangements for savings and investments.
A trust is a legal arrangement in which the grantor places property in trust for the benefit of one or more beneficiaries. A trust is established by a trust agreement drawn up by your attorney in which you name someone (‘trustee’) to manage the assets placed in the trust. The trust agreement also contains your instructions on how distributions are to be made to beneficiaries. Trusts can range from simple to complex depending on their purpose. When you create a trust, you transfer money or other assets to the trust. You give up ownership of those assets in order to accomplish a specific financial goal or goals, such as protecting assets from estate taxes, simplifying the transfer of property, or making provision for a minor or other dependents
What is a mutual Fund?
A fund managed by an investment company with the financial objective of generating high Rate of Returns.These asset management or investment management companies collects money from the investors and invests those money in different Stocks, Bonds and other financial securities in a diversified manner. Before investing they carry out thorough research and detailed analysis on the market conditions and market trends of stock and bond prices. These things help the fund mangers to speculate properly in the right direction
Annuity and Insurance
An annuity is an investment that you make, either in a single lump sum or through installments paid over a certain number of years, in return for which you receive a specific sum every year, every half-year or every month, either for life or for a fixed number of years. Annuities are bought to generate income during one’s retired life, which is why they are also called pension plans. An annuity contract is created when an individual gives a life insurance company money which may grow on a tax-deferred basis and then can be distributed back to the owner in several ways.
Insurance is a form of risk management primarily used to hedge against the risk of a contingent loss.Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium, and can be thought of as a guaranteed small loss to prevent a large, possibly devastating loss. An insurer is a company selling the insurance; an insured is the person or entity buying the insurance.
A safe deposit box is a type of safe usually located in groups inside a bank vault or in the back of a bank or post office. It usually holds things such as valuable gemstones, precious metals, currency, or important documents such as wills or property deeds.
ATM - A computerized device that works as a teller for a banks/financial institutes customer. The customer is identified by inserting a plastic ATM card with a magnetic stripe or a plastic smartcard with a chip, that contains a unique card number and some security information, such as an expiration date or CVC (CVV). Security is provided by the customer entering a personal identification number (PIN). Using an ATM, customers can access their bank accounts in order to make cash withdrawals (or credit card cash advances) and check their account balances as well as purchasing mobile cell phone prepaid credit.
A money order is a payment order for a pre-specified amount of money. Because it is required that the funds be prepaid for the amount shown on it, it is a more trusted method of payment than a personal check.
Traveler's check is a pre-printed, fixed-amount check designed to allow the person signing it to make an unconditional payment to someone else as a result of having paid the issuer for that privilege.
Bank official checks are normally either cashier's checks (a check drawn by a bank, signed by a bank official, and drawn against the bank itself), or a teller's check (drawn on an account at another bank).
Bank Secrecy Act (BSA)
The Bank Secrecy Act (or BSA) requires financial institutions to assist government agencies to detect and prevent money laundering. Specifically, the act requires financial institutions to keep records of cash purchases of negotiable instruments, file reports of cash transactions exceeding $10,000 (daily aggregate amount), and to report suspicious activity that might signify money laundering, tax evasion, or other criminal activities.
Fair Credit Reporting Act (FCRA)
The Fair Credit Reporting Act (or FCRA) regulates the collection, sharing, and use of customer credit information. The act allows consumers to obtain a copy of their credit report records from Credit bureaus. It requires that consumers be informed when negative information is added to their credit records, and when adverse action is taken based on a credit report.
Regulation B - Equal Credit Opportunity
The Equal Credit Opportunity Act (ECOA) states that creditors which regularly extend credit to customers, which includes banks, retailers, finance companies, and bankcard companies, should evaluate candidates on credit worthiness alone, rather than other factors- race, color, religion, national origin or sex.
Regulation O - Loans to Insiders
Regulation O establishes varying quantitative and qualitative limits and reporting requirements on extensions of credit made by a bank to its "insiders" or the insiders of the bank's affiliates. The term "insiders" includes executive officers, directors, principal shareholders and the related interests of such parties.
USA PATRIOT Act
The contrived acronym stands for Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001.The Act increases the ability of law enforcement agencies to search telephone, e-mail communications, medical, financial, and other records; eases restrictions on foreign intelligence gathering within the United States; expands the Secretary of the Treasury’s authority to regulate financial transactions, particularly those involving foreign individuals and entities; and enhances the discretion of law enforcement and immigration authorities in detaining and deporting immigrants suspected of terrorism-related acts. The act also expands the definition of terrorism to include domestic terrorism, thus enlarging the number of activities to which the USA PATRIOT Act’s expanded law enforcement powers can be applied.
Truth in Lending Act (Reg Z)
The purpose of TILA is to promote the informed use of consumer credit, by requiring disclosures about its terms, cost to standardize the manner in which costs associated with borrowing are calculated and disclosed.