Depository Institutions (Banks)

Depository institutions (aka banks), including commercial banks, savings and loans, and credit unions, receive money from depositors to lend out to borrowers. Nondepository institutions, such as finance companies, rely on other sources of funding, such as the commercial paper market. Because depository institutions receive funds from the public for safekeeping and are major sources of credit and the main providers of a payment system, these institutions are more heavily regulated than nondepository institutions.

Depository institutions provide 4 important services to the economy:

  1. they provide safekeeping services and liquidity;
  2. they provide a payment system consisting of checks and electronic funds transfers;
  3. they pool the money of many savers and lend it out to people and businesses; and
  4. they invest in securities.

The 1st 3 services are so important in any economy that when banks fail, the economy suffers. The Great Recession of2008 and 2009 underscored the primary importance of banks and why governments all over the world propped up their banks with trillions of dollars.

Balance Sheet of Banks

A bank receives money from the deposits of its customers and from the fees that it charges for its services, and from borrowing either from other banks or by selling securities in the financial markets. It uses the money to make loans and to buy securities. A bank profits from the interest rate spread of what it earns on its assets and what it pays in liabilities, and from banking fees.

The net worth of a bank = its bank capital, which equals total assets minus its total liabilities.

Net Worth ≡ Owners Equity ≡ Bank Capital = Total Assets − Total Liabilities

Bank Assets — Uses of Funds

Most of the assets of banks can be grouped into 4 categories:

  1. cash,
  2. securities,
  3. loans,
  4. other assets, including real property, such as equipment, buildings, land, and repossessed collateral from borrowers who have defaulted.

Most of a bank's assets are loans and a large portion of securities since these are the main sources of income for a bank.

Cash is obviously an asset to a bank, but it's an expensive asset in terms of opportunity cost because it earns no interest — therefore, banks try to minimize the cash they hold. They must keep some cash to conduct business, including being able to meet withdrawal requests.

Before ATM machines or the Federal Reserve, banks kept most of their cash in their vaults, which is why it is called vault cash. Nowadays, vault cash also includes cash kept at the bank's account at the Federal Reserve and in the bank's ATM machines. Cash kept in vaults and ATM machines allows banks to give customers cash as coin and currency. Cash kept in its account at the Federal Reserve is used to clear and settle checks and electronic funds transfers. Required reserves is the amount that must be held by law and includes vault cash and cash held in the bank's account at the Federal Reserve and equals a percentage of the bank's liabilities.

Banks also hold securities to earn additional returns. While banks in other countries can own stocks, banks in the United States are restricted to bonds, mostly Treasuries or municipal bonds, although they also held mortgage-backed securities which contributed to the 2008 - 2009 Great Recession.

Loans are the biggest assets of banks. In fact, banks are categorized by the type of loans they make. Commercial banks specialize in loans to businesses, saving and loans specialize in mortgages, and credit unions specialize in consumer loans. However since the commercial paper market offers many large businesses a lower cost of funds, commercial banks have started to enlarge their portfolios with other kinds of loans, such as mortgages and consumer loans. The securitization of these loans into asset-backed securities has eliminated their credit default risk to the bank and can easily be sold in the financial markets, making them more liquid than the underlying loans.

Loans are categorized as:

Liabilities — Sources of Funds

Besides owners' equity, the major source of funds for a bank is deposits and borrowings; deposits are the larger percentage of a bank's liabilities. Deposits are considered a liability because it is money that is owed to its customers.

Deposits are money that the banks customers place in the bank for safekeeping, to provide payment services, and to earn interest. Deposits can be classified as either checkable deposits or nontransaction deposits.

Checkable Deposits and Nontransaction Deposits

Checkable deposits (aka transaction deposits) are deposits placed in checking accounts that allow the depositors to withdraw money at will, write checks, and transfer funds electronically to and from the account. Thus, checkable deposits provide safekeeping, accounting, and payment services, but pay little or no interest. Because depositors can earn more interest elsewhere and can easily transfer money to their checking accounts when necessary, they generally keep only enough in their checking accounts to maintain the liquidity they need to pay bills or to have as a source of cash. Because technology has made transferring funds faster and easier, checkable deposits have declined as a percentage of the bank's liability, from an average above 40% in the early 1970s to less than 10% today.

Nontransaction deposits are deposits in savings and time deposit accounts, where withdrawals are limited. However since nontransaction deposits do not provide payment services, the main benefit to depositors is the interest that they pay. Banks can pay a lower rate of interest on deposits because the funds that they hold are guaranteed by the Federal Deposit Insurance Corporation (FDIC) up to a certain limit.

Years ago, most savings accounts were passbook savings accounts, where each transaction was recorded in the customer's passbook. Nowadays, transactions are recorded electronically. Most savings accounts pay a low interest rate, but allow the depositor to withdraw funds at will. However, if a depositor makes too many withdrawals within a month, the bank will charge a fee for withdrawals above the limit.

Banks also offer time deposits: certificates of deposit (CDs) with specified terms and face values equal to the amount deposited. The withdrawal of funds is restricted until the CD matures. The interest rate on a CD is commensurate with its term length. A small CD has a principal of $100,000 or less and is not generally negotiable. The bank will charge the CD holder fees for withdrawing the money before the maturity date.

Large certificates of deposit have a face value exceeding $100,000 and can easily be sold in money markets. Banks can get quick funds by selling large CDs in the money markets, in addition to selling commercial paper and bonds.

Borrowings

Most banks borrow in the interbank market, called the federal funds market, so called because the money, both lent and borrowed, is held in the banks' accounts at the Federal Reserve; these funds are called federal funds. Banks with excess reserves lend money to banks with a deficit in reserves. These loans are unsecured so banks only lend to banks they can trust. Usually, smaller banks have the excess reserves to lend while large banks in major metropolitan areas need to borrow.

Banks can also borrow directly from the Federal Reserve through its discount window if it cannot get a loan from other banks. However, this is used as a last resort since it indicates to the Federal Reserve that the bank is under financial stress.

Another way to borrow short-term is through repurchase agreements. A repurchase agreement (aka repo) is an agreement to exchange securities, usually Treasury bills, for funds, usually for a term of 1 day, after which the borrower buys back, or repurchases the securities with interest. Most repos are with corporations or financial intermediaries, such as pension funds or insurance companies, that have a temporary surplus of cash.

The Federal Reserve also uses repurchase agreements to control the money supply. When the Fed wants to increase the money supply, it buys Treasuries, and when it wants to decrease it, it sells Treasuries.