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Understanding Banks and Banking

Updated on September 7, 2009

A bank is a business organization that receives and holds deposits of funds from others, makes loans or extends credit, and transfers funds by written order of depositors. The term is occasionally but inaccurately applied to commercial banks only, because of the peculiar types of services that commercial banks perform: they maintain and create demand deposits (checking accounts), which are part of a nation's money supply (a bank creates a demand deposit when, for instance, it lends a customer $100 by crediting that sum of his checking account - the customer immediately has $100 to spend by writing a check). The ability to maintain, create, or extinguish demand deposits is critical in the economic life of the nation.

Because the term "bank" denotes a variety of institutions of deposit, no distinction is made among categories in discussing banking services except to note when a particular activity or service is restricted to a particular type of institution. The facilities of banks are available to both individuals and businesses, whether they are depositors, borrowers, or general-service customers.

Services to Depositors

Individuals and businesses alike may maintain either demand deposits or time deposits.

'Demand deposits' represent deposits of funds (in commercial banks only) against which depositors may write checks or drafts. Checks are orders from the depositor to the bank to pay a specified sum to a designated recipient, or the bearer. Checking accounts offer depositors safety for their funds, as well as convenient transferability of deposits to pay for purchases or to satisfy debts. A checking account also gives the depositor receipts for his payments in the form of canceled checks. In addition to providing payment records to depositors, a checking account also gives them periodic (usually monthly) accounts of their financial balances. As the use of electronic accounting equipment expands, more banks furnish bill-paying services to their customers. Many offer credit-card plans whereby charges are automatically deducted from the purchasers' accounts.

Checking-account customers may be allowed overdrafts, which means that checks drawn in excess of the amount on deposit will be honored by the bank, rather than being refused payment or "bounced". Fees are assessed against the offender's account for this service. Commercial banks may regularly receive payroll checks directly, from large employers especially, and credit them to the accounts of individual employees. Individual depositors can arrange to have fixed sums transferred to savings accounts or to the purchase of U.S. savings bonds (under the payroll savings plan).

Commercial banks will certify checks drawn by depositors, which assures the payee that sufficient funds are on deposit and earmarked to cover the check. Similarly, banks will issue letters of credit to depositors for use during travel abroad.

For most services to demand depositors, commercial banks levy service charges on a "metered" or frequency basis. "Regular" checking accounts usually require a minimum balance against which service charges are measured. "Special" checking accounts, on the other hand, normally do not require a minimum balance; charges are based on so much per check, deposit, or other entry. Commercial banks in the United States are prohibited by law from paying interest on demand deposits.

'Time deposits' include savings deposits, savings accounts, share accounts—and even certificates of deposit. These normally pay interest based on the profitability of the savings institution. Interest is paid partly because the depositor gives up transferability of the funds (only the depositor may make withdrawals), and partly because the "bank" can invoke a waiting period before funds may be withdrawn. This period, varying with state or federal law, is commonly 30 days. Some time deposits, such as Christmas clubs and vacation clubs, are really a form of forced saving and do not pay interest.

'Depository services' are provided in several forms by banks and savings institutions. Deposits may be made in person during regular banking hours. In addition, "drive-in" and "walk-in" windows, open before or after regular hours, often offer convenient service to customers in such locations as shopping centers or transit terminals. Night depositories are particularly convenient and important to businessmen because they offer added protection for cash receipts. Deposits especially, but withdrawals as well, usually can be made by mail.

Services to Borrowers

Banks are in business to make money. They levy service charges and fees, but their primary source of income is interest charged on loans. This interest may be assessed at the end of specified periods ("straight interest") or it may be deducted from the principal sum at the outset ("discount"). The type of loan(s) that a specific kind of bank or financial institution may make depends on the law.

Commercial (demand deposit) departments of commercial banks typically concentrate on short-term (often self-liquidating) loans to businesses. They also make unsecured "signature" loans to individuals (with or without cosigners), as well as secured loans for the purchase and carrying of securities. These notes may have specified maturities or be payable on demand.

Savings institutions and commercial-bank savings departments make personal installment loans to finance the purchase of consumer durables, especially appliances and automobiles. Installment loans for other specific purposes such as "education loans" or "travel loans" are made for terms up to three years. Mortgage and property improvement loans are available from commercial-bank savings departments and all savings institutions.

Customers of commercial banks may often arrange lines of credit under which the bank will lend up to an agreed limit as the borrower requires.   This has long been common for business purposes; it is now accepted for personal credit.

General Services

Although banks often give deposit customers preferential treatment in granting loans or providing other services, they also perform a wide range of services to the general public for a fee. In some few instances, the services are provided free. More often, certain services offered free to customers—especially depositors—involve a charge to the general public. Check-cashing and money-exchanging are examples.

Banks usually rent safe deposit boxes. They sell travelers checks or foreign exchange at a set rate. They also sell cashiers' checks.

Particularly for customers but also for others in some instances, banks will collect noncash items such as drafts, bills of exchange, or acceptances. With increased use of electronic data-processing equipment, banks prepare payrolls, handle accounting, and prepare and collect bills for local businesses. They will also verify credit on request.

Commercial banks in particular offer investment and business counseling. Bank trust departments will manage estates and investment portfolios, usually for % of 1 percent of the market value of the capital.

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