This document gathers and organizes information about banking, wit an emphasis on the products provided to consumers
My research in this area has been very shallow, just enough to gain a basic familiarity. I may return to the topic later, do a bit more research and better organize my notes. For now, this is it.
Banking began as a form of warehousing: those with wealth needed a place to store it (or were required to store it in a public vault) and paid a fee to a service that provided a secure physical facility.
Banks got into the business of money-lending, sometimes lending out funds without permission, though this process was legitimized in 1848 (the Foley case), and banks later got in the business of helping governments to regulate their money supply.
Their core services (deposit accounts and loans) remain largely the same to this day, though additional investment-like products (such as CDs) have been devised over time.
Government and banking are joined at the hip, and much of what constitutes common practice in the banking industry is done in compliance to legal requirements, within which banks themselves have limited discretion to manage their own business operations.
I probably won't dwell on it too much - the degree to which government is or should be involved in the industry is hotly debated - and I want to skip all this for now and focus on banking as a business, focusing on the services it provides for consumers.
There are two basic kinds of bank account: a demand account (checking) and a deposit account (savings)
A demand account provides customers with the ability to store money with a bank and then write checks (or use debit cards, a recent development) that give other parties the right to withdraw a specific amount of money from that account. Because this money is constantly in motion, the bank cannot loan it out, so it generally pays no interest or very little interest to account holders, and carries a significant number of fees. Most banks, in fact, make the majority of their profit on these fees.
A deposit account works roughly the same way, but the bank expects funds to remain in these accounts for a longer period of time, so that the bank can float loans based on these funds. For that reason, account holders are discouraged from writing checks on deposit accounts - check writing privileges may not be provided at all, and the account holder may be limited to a specific number of withdrawals per month (or else the account converts into a demand account). On the bright side, the customer earns interest on deposited funds.
There are a myriad of specialty accounts that blend the features of a demand account and a deposit account in order to provide customers a balance between convenience and interest earnings.
Also, banks have taken various steps to implement various whips and carrots to attract and retain customers and their funds, such as checking accounts that bear interest, savings accounts that provide higher interest rates for keeping a specific minimum balance, penalties for failure to maintain an absolute minimum balance, etc.
Interest rates are generally set by the Federal Reserve, but banks will exceed the mandatory minimum in order to attract and retain customers (a bank that offers higher interest rates attracts more customers), much in the way that retailers manage their merchandise prices (only instead of a discount, customers are lured by premiums).
CERTIFICATES OF DEPOSIT (CDs)
Banks offer investors the ability to purchase a Certificate of Deposit (or CD), which is a deposit that is attached to a contract that guarantees that the funds will not be withdrawn for a specific amount of time (3-month, 6-month, and 1-year terms are common).
The investor then collects interest payments from the bank at fixed intervals (usually monthly, though the interval specified by the contract) and, at the expiration date, receives their principal back from the bank (though many banks set up "automatic renewal," rolling the funds into another CD, unless the investor informs them in advance not to do so).
The benefit to a bank of issuing a CD is to lock down funds so that the bank can use these funds as a reserve to float more loans. The benefit to the depositor is a higher rate of return than he could earn by keeping the funds in a regular deposit account. CDs are considered one of the safest form of investment (the principal is insured by the FSDIC, and there is no chance it will lose its dollar-value), and generally do not offer high returns.
The one drawback for the investor is that their funds are inaccessible for the duration of the contract. To obtain funds, they may have to sell their CD to a third party, though there is a usually a clause in the CD contract allowing for the premature withdrawal of funds, albeit at significant penalties.
One of the ways in which banks earn a profit is by loaning out money, charging a higher interest rate to the borrowers than it pays to account holders. This was originally the primary source of income for banks, though it has been surpassed by service fees.
Interest rates for loans are competitive, but are capped by federal and state limits (usury laws). Generally, a bank publicizes a general rate (usually the one available to its most qualified customers), but assesses each applicant to determine the rate they will receive for any given kind of loan. The criteria considered include the borrower's assets, income, and credit history - with a more financially stable individual with a good record of repaying loans being preferred.
Historically, banks provided loans only to businesses and wealthy individuals, though this changed in the twentieth century with the advent of auto loans, credit cards, and other forms of loans extended to the general public.
Some of the specific loan products offered by banks are as follows:
Secured Loans are loans made to individuals that are secured by collateral (property the bank is entitled to seize if the loan is not repaid). The most common forms of secured loans are used to finance the purchase of specific items, most often automobiles and real estate, in which the title to the item is held in escrow by the bank until the loan is repaid. It is also possible, though less common, for an individual to put up assets they own outright to obtain a loan to be used for other purposes (though technically, second mortgages fall into this category).
Unsecured Loans are loans made to individuals, on good faith (the borrower does not have to secure the loan with specific collateral). The term "personal loan" is generally used for loans consumers take for general reasons (the bank doesn't ask and doesn't care), but there are specific kinds of unsecured loan for specific purposes, such as student loans to pay for educational expenses.
Credit Cards are a form of unsecured loan (see below) that involves a standing line of credit, allowing the borrower to obtain loans in small amounts to cover everyday purchases. There is typically an annual fee for the convenience of using the credit card and/or interest that accrues if balances are not paid off when a statement is received. The main difference between a credit card and debit card is that a debit card makes withdrawals from a funded account (it's more in the nature of a check transaction) whereas a credit card is a borrowing instrument.
Safe Deposit Boxes are still offered by most brick-and-mortar banks, providing customers a drawer in an on-site vault for the storage of valuable items and important documents for a monthly fee. (Worth mentioning: storage of valuables was, historically, the original service of banks offered.)
Banks also assist in financial transactions such as providing cashier's checks (checks backed by the bank rather than an individual accounts), wire transfers (electronic transfers of funds), and foreign currency exchange.
Some banks are offering additional products and services such as insurance and investments. These are not, strictly speaking, "banking" products, so research on them is not included in the present document.
Objectively speaking, a bank must keep a certain amount of money on hand to honor withdrawals and checks written on their accounts, to avoid the risk of not having the funds to cover these demands.
The central bank (federal reserve) also stipulates that a bank may float loans for more money than it has in reserve (or even in deposit) by specifying a percentage rate that dictates the ratio of funds banks must maintain in reserve.
After the failure of banks in the 1930's, the federal government established a service to provide security to depositors: the Federal Deposit Insurance Corporation is a government agency that provides assurance that individuals who deposit funds with member banks will be able to retrieve their funds even if that specific bank fails. The (mandatory) premiums are usually paid by the bank rather than by the consumer.
Also, not all accounts and investments are covered by this insurance. Banks are required to inform customers of any account or investment they provide that is *not* covered by FDIC protection.
OTHER TYPES OF BANK
The kind of banking studied above is commonly referred to as "retail banking," which deals directly with individuals and small businesses. Since the purpose of this study is to become familiar with consumer products, no further study into other kinds of banks will be conducted at this time, though some are enumerated below.
There are also commercial banks (for larger businesses an corporations) private banks (for high-net-worth individuals), investment banks (relating to activities on financial markets), central banks (government entities that control currency), and so on.
From a consumer's perspective, credit unions provide similar services to banks. In many respects, they are functionally identical in the services they provide.
The difference is structural: whereas a bank is a commercial entity (a business), a credit union is a nonprofit organization in which the amount a person contributes to the pool of resources buys shares of ownership in the organization, for which they receive dividends as their share of profits from loans made by the organization.
In practice, this is the same as making deposits and earning interest - although, since the organization is not looking to earn a profit, members earn a better return on their deposits and/or pay a lower rate on their loans.
There are also differences in the way that these organizations are regulated, but that gets pretty abstract. The main effect of that is some credit unions are restrictive in their membership (example a teachers' credit union may only allow teachers to join).
In a fundamental sense, banks generate a profit on the difference between the amount of interest collected on loans and the amount of interest paid on deposits, which is significantly lower. A bank is required to keep a small percentage of the funds on deposit in reserve to cover transactions, but loans out the rest.
Another source of funds, which may in some instances exceed the profit generated from savings and loan activities, is in fees charged to customers. These fees may be charged for ancillary services or as penalties for things such as late payments or overdrawn accounts. One source listed over fifty fees charged by a single bank for a wide array of reasons.
Many banks also generate significant revenue from their credit and debit card operations: an issuing bank receives a portion of the fee charged by credit card companies to merchants who accept payment cards.
The expenses for banks, aside of interest paid on deposits, are typical business costs: salaries for personnel, maintenance of facilities, and services purchased from other banks.