Types of Depository Institutions

Depository institutions, which are usually just called banks, are categorized as such because their primary source of funding is the deposits of savers. Their savings accounts are insured by the Federal Deposit Insurance Corporation (FDIC) up to certain limits. Banks are further subcategorized depending on the markets they serve, their primary sources of funding, type of ownership, how they are regulated, and the geographic extent of their market.

These categories of banks arose because they were established to serve different markets at different times. What state and federal regulations governed a particular bank also depended on its type, and whether it had a state or federal charter. States, especially, restricted the banks' ability to compete and to expand geographically. However, modern technology and deregulation are blurring these traditional distinctions, with categories overlapping even more than in the past.

Savings Institutions

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Savings institutions, sometimes called thrift institutions, are banks that serve a local community. They take the deposits of local residents and lend the money back in the form of consumer loans, mortgages, and small business loans. Savings institutions include savings and loan institutions, savings banks, and credit unions. Most savings institutions are regulated by the Office of Thrift Supervision (OTS), which was created by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). The FIRREA empowered the OTS to enact rules and regulations for savings institutions, manage the Savings Association Insurance Fund (SAIF), which insures the deposits of savings institutions, and to charter federal savings banks and savings and loans associations.

Prior to 1980, savings institutions were mostly limited to the residential mortgage market, but the Depository Institutions Deregulation and Monetary Control Act of 1980 deregulated banking by removing interest rate ceilings and allowing savings institutions to offer more services, including commercial and consumer lending. The Act also eliminated dollar limits on mortgages, allowed second mortgages, and eliminated the territorial restrictions on mortgage lending and permitted savings institutions to offer interest-paying Negotiable Order of Withdrawal (NOW) accounts—basically, checking accounts paying interest.

Savings and Loan Associations (SLAs, S&Ls) first appeared in the 1800s so that factory workers could save money to buy a home. They were loosely regulated until the Great Depression, when Congress passed several major laws to shore up the banking industry and to restore the public's trust in them. Before 1980, SLAs were restricted to mortgages and savings and time deposits, but the Monetary Control Act extended their permitted activities to commercial loans, non-mortgage consumer lending, and trust services.

Many S&Ls have been owned by depositors, which was their main source of funding—thus they were called Mutual Savings and Loans Associations or just Mutual Associations. Mutual S&Ls, like credit unions, used their earnings to lower future loan rates, raise deposit rates, or to reinvest while corporate S&Ls either reinvested profits or returned profits to their owners by paying dividends. Nowadays, most S&Ls are corporations, giving them access to additional capital funding to compete more successfully and to facilitate mergers and acquisitions.

Savings banks (aka mutual savings banks, MSBs) began as mutual companies first chartered in 16 states, with most in New York and New Jersey, that were owned by the depositors and were restricted to mortgages. They were governed by a local board of trustees. When interest rates were limited by law, mutual savings banks distributed their earnings back to the depositors. The Garn-St. Germain Depository Institutions Act of 1982 gave savings banks the option of a federal charter and allowed them to convert to corporations, which many of them did since it extended their funding options and facilitated mergers and acquisitions.

Credit unions are nonprofit depository institutions that are financial cooperatives owned by people belonging to a particular group, such as the employees of a particular company, a union, or a religious group, or who live in a specific area such as a county, and they are governed by a board of volunteers. Because they are nonprofits and owned by their customers, they charge lower loan rates and pay higher interest rates on savings, and they offer a wide variety of financial services for their owners. All credit unions with federal charters and most with state charters are regulated and insured by the National Credit Union Administration. Deposit insurance is provided by the National Credit Union Share Insurance Fund.

Commercial Banks

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The primary business of commercial banks is to serve businesses, although with banking deregulation they have entered into the consumer business as well. Commercial banks provide the widest variety of banking services. In addition to savings accounts, checking services, consumer loans, commercial and industrial (C&I) loans, and credit cards, commercial banks may also offer trust services, trade financing, investment banking and management for corporations, governments and their agencies, and treasury services.

Before 2005, deposits were insured by the Bank Insurance Fund (BIF), but it was merged with the SAIF, the fund used to insure thrifts, into a single fund—the Deposit Insurance Fund (DIF).

Commercial banks are the largest banks, both in assets and in geographic extent. Community banks, however, are smaller commercial banks with assets of less than $1 billion that generally serve their immediate community of consumers and small businesses. Community banks are also the most numerous by a large margin.

Some commercial banks, often called regional and super-regional banks, cover a much wider geographic area and usually have assets in the hundreds of billions of dollars. They have many branches that extend into several states and many ATM machines at convenient locations throughout their area. Global banks also offer international services, such as letters of credit, and currency exchange. These larger banks use short-term borrowing in the money markets to supplement their deposits and often require loans from the smaller community banks. These correspondent banks have accounts at the larger banks, which facilitates the frequent transfers of funds with the big banks. Some banks—money center banks—borrow for their funding instead of relying on deposits. However, the recent credit crisis has forced money center banks to become depository institutions because they could not sell their commercial paper or bonds in financial markets that have been greatly diminished by investors' fear of defaults.

Bank and Financial Holding Companies

Many of the largest banks are actually bank holding companies, which is a company that controls 2 or more banks. A holding company is a company whose only purpose is to own a controlling interest in other companies. A bank holding company can more easily expand its market through acquisitions than a bank can. The Bank Holding Company Act of 1956 requires that bank holding companies register with the Board of Governors of the Federal Reserve System. A 1966 amendment to the Act set standards for acquisitions and a 1970 amendment restricted bank holding companies to banking.

Another benefit enjoyed by bank holding companies is the removal of the geographic restriction imposed by most state laws on banks that required all branches of a bank to be within a certain geographic location. The advantages of bank holding companies are evidenced by the fact that, in 2000, 76% of banks were owned by bank holding companies.

The Financial Services Modernization Act of 1999 deregulated the financial industry even more by creating the legal entity known as the financial holding company that can control banks, securities firms, and insurance companies. Previous to this Act, banks were restricted to banking by the Glass-Steagall Act of 1933 and the Bank Holding Company Act. The primary purpose of restricting banks to banking is to limit their risk because the federal government insures their customers' deposits and because solvent banks are essential to any modern economy as best evidenced by the 2007-2009 credit crises. Consequently, for a bank holding company to qualify as a financial holding company, its subsidiaries must be well managed and well capitalized. All of its depository institutions must have satisfactory Community Reinvestment Act (CRA) ratings, which requires banks to lend back to the community of its depositors. The bank holding company must register with the Federal Reserve, declaring and certifying that it is qualified as a financial holding company under the Act.

The largest financial holding company is J.P. Morgan Chase & Co., with assets totaling $2.1 trillion in 2009. According to the Federal Reserve, at the end of 2007, the top 10 banks held 53% of all assets held by banks, while the top 100 banks held 80%.

Conclusion

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The deregulation of financial institutions caused many to take outsized risks in the hope of earning huge profits. Many took these risks because they considered themselves too big to fail and because they could pass their credit default risks to investors of their securitized loans. Of course, it was deregulation that allowed these companies to become so large, so the government could not allow them to fail since it could cause many other financial institutions to fail through a domino effect caused by credit default swaps. Consequently, many governments were forced to pump trillions of dollars into their banks and their economy to prevent a death spiral of deflation caused by limited credit. There will probably be more restrictions on banks in the future to limit their risk both to themselves and to the economy. One thing that seems certain is that the different regulatory agencies will be consolidated to prevent banks from shopping around for the most lenient regulator.