Banking fundamentals refer to the concepts and principles relating to the practice of banking. Banking is an industry that deals with credit facilities, storage for cash, investments, and other financial transactions. The banking industry is one of the key drivers of most economies because it channels funds to borrowers with productive investments.
Banks perform a myriad of functions, including deposits and withdrawals, currency exchange, forex trading, and wealth management. Also, they act as a link between depositors and borrowers, and they use the funds deposited by their customers to provide credit facilities to people who want to borrow.
Banks make money by charging an interest rate on loans, where they profit by charging a higher interest rate than the interest rate they pay on customer deposits. However, they must comply with the regulations set by the central bank or national government.
A bank is an institution that accepts customer deposits and offers loans to individuals and corporate clients.
Banks make money by charging higher interest on loans than the interest they pay on customer deposits.
In the United States, banks are required to retain 10% of the customer deposits as reserves, while using the other 90% to provide loans.
Banking Fundamentals – How the Banking Industry Works
In the United States, banks are regulated by the Federal Reserve. Banks must retain at least 10% of each deposit on hand but can lend out the other 90% as loans. The reserve requirement applies to all types of banks that are licensed to operate in the United States, and they can hold the reserve as a deposit in the local Fed bank or as cash in the vault.
The actual reserve requirement is determined by the Federal Reserve Board of Governors. When the Fed reduces the reserve requirement for member banks, it is implementing an expansionary monetary policy, which increases the amount of money in the economy. On the other hand, when it increases the reserve requirement, it is implementing a contractionary monetary policy that reduces liquidity.
All the Fed’s member banks must be insured with the Federal Deposit Insurance Corporation (FDIC). The FDIC was created in 1933 after the Great Depression through the enactment of the Glass-Steagall Act. It came after multiple bank failures that resulted in banking panics, with depositors demanding all their deposits held at the bank.
The FDIC was formed to prevent such occurrences by insuring all deposits that customers keep at the bank. It insures savings accounts, checking accounts, and other deposit accounts. During the 2008 Global Financial Crisis, the FDIC raised the deposit limit to $250,000 per account to protect depositors from the crisis.
A savings account is a bank account that a customer can deposit money in that they do not need right away, but that is available for withdrawal whenever needed. The bank loans out the money to borrowers and charges interest on the amount of credit disbursed.
2. Checking account
A checking account allows customers to access their deposited funds with ease, and they can use it to make their financial transactions such as paying bills. A customer can access the funds by writing a check, using a debit card to withdraw money or make payments, or by setting up automatic transfers to another account.
3. Certificate of deposit
A certificate of deposit is a bank account that holds a fixed amount of money for a defined period of time such as six months, one year, two years, etc. It pays a fixed interest rate on the amount held.
Banking Fundamentals – Types of Banks
Below are the most common types of banks in the United States:
1. Commercial banks
Commercial banks are the most common type of bank. They provide various services such as providing business loans, accepting deposits, and offering basic investment products to both individuals and private businesses.
Commercial banks also offer other financial services such as global trade services, merchant services, insurance products, retirement products, and treasury services. They make money by providing business loans to individual and corporate borrowers and earning interest income from them, and also by charging service fees.
2. Credit unions
A credit union is a type of bank that is open to a specific category of people who are eligible for membership. It is member-owned and is operated by the members on the basis of people helping people. Traditionally, credit unions served either residents of a local community, members of a church, employees of a specific company or school, etc.
The ownership structure of credit unions allows them to offer more personalized and lower-cost banking services to their members. Due to their small operating size, credit unions may pay higher interest rates than banks, and customers can build a better relationship with the banking staff. On the downside, the credit unions’ operations are limited, and the customer’s deposits are less accessible.
3. Investment banks
Investment banks are banks that provide corporate clients access to the capital markets to raise funds for expansion. They help companies raise funds in the stock market and bond market to finance their expansion, acquisitions, or other financial plans. They also facilitate mergers and acquisitions by identifying viable companies for acquisition that meet the buyer’s criteria.
Investment banks make money by offering advisory services to corporate clients, trading in the financial markets, and representing clients in mergers and acquisitions. Some examples of large investment banks in the U.S. include Merrill Lynch, Goldman Sachs, J.P. Morgan, and Bank of America.
Thank you for reading CFI’s guide to Banking Fundamentals. To keep learning and advancing your career, the following CFI resources will be helpful: