Self-Library

Insurance Companies

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Insurance Companies: Differences in services provided by:
- Life Insurance Companies
- Property and Casualty Insurance

Life Insurance Companies:
- Size, Structure and Composition of the Industry:
In 1988: 2,300 life insurance companies with aggregate assets of $1.12 trillion
In early 2000s: 1,500 companies / $3.4 trillion
4 largest wrote 19% of new premium business
Increasing involvement of commercial banks in insurance policy sales
- Large scale mergers

Life Insurance: Issues
- Demutualization
- Adverse selection
Insured have higher risk than general population
Alleviated by grouping of policyholders into risk pools
Life Insurance Products:
Ordinary life
Term life, Whole life, Endowment life.
Variable life, Universal life, Variable universal life.
Group life
Industrial life
Credit life

Other Life Insurer Activities
Annuities
Reverse of life insurance activities.
Private pension funds
Compete with other financial service companies.
Accident and health insurance
Morbidity insurance
Effects of growth in HMO enrollment

Depository Institutions

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Depository Institutions:
- Commercial Banks
Largest depository institutions are commercial banks.
Differences in operating characteristics and profitability across size classes.
Notable differences in ROE and ROA as well as the spread
- Thrifts
S&Ls
Savings Banks
Credit Unions
- Mix of very large banks with very small banks

Functions & Structural Differences:
Functions of depository institutions
Regulatory sources of differences across types of depository institutions.
Structural changes generally resulted from changes in regulatory policy.
Example: changes permitting interstate branching
Reigle-Neal Act

Commercial Banks:
Primary assets:
Real Estate Loans: $2,272.3 billion
C&I loans: $870.6 billion
Loans to individuals: $770.5 billion
Investment security portfolio: $1,789.3 billion Of which, Treasury bonds: $1,005.8 billion
Inference: Importance of Credit Risk
Primary liabilities:
Deposits: $5,028.9 billion
Borrowings: $1,643.3 billion
Other liabilities: $238.2 billion
Inference: Highly leveraged

Balance Sheet and Trends
Business loans have declined in importance
Offsetting increase in securities and mortgages
Increased importance of funding via commercial paper market
Securitization of mortgage loans

Some Terminology:
-Transaction accounts
-Negotiable Order of Withdrawal (NOW) accounts
-Money Market Mutual Fund
-Negotiable CDs: Fixed-maturity interest bearing deposits with face values over $100,000 that can be resold in the secondary market.

Off-balance Sheet Activities
Heightened importance of off-balance sheet items
Large increase in derivatives positions is a major issue
Standby letters of credit
Loan commitments
When-issued securities
Loans sold

Other Fee-generating Activities
- Trust services
Correspondent banking
Check clearing
Foreign exchange trading
Hedging
Participation in large loan and security issuances
Payment usually in terms of noninterest bearing deposits

Savings Banks
Mutual organizations
Primarily East Coast
Not exposed to the oil-based shocks of 1980s
Real estate price exposure
Demutualization
May be regulated at both state and federal level

An Economic Analysis of Financial Structure

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Eight Basic Facts
1 Stocks are not the most important sources of external financing for businesses
2 Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations
3 Indirect finance is many times more important than direct finance
4 Financial intermediaries are the most important source of external funds
5 The financial system is among the most heavily regulated sectors of the economy
6 Only large, well-established corporations have easy access to securities markets to finance their activities
7 Collateral is a prevalent feature of debt contracts
8 Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers

Transaction Costs
Financial intermediaries have evolved to reduce transaction costs
- Economies of scale
- Expertise

Asymmetric Information
Adverse selection occurs before the transaction
Moral hazard arises after the transaction
Agency theory analyses how asymmetric information problems affect economic behavior

Adverse Selection: The Lemons Problem
If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality
Sellers of good quality items will not want to sell at the price for average quality
The buyer will decide not to buy at all because all that is left in the market is poor quality items
This problem explains fact 2 and partially explains fact 1
Adverse Selection: Solutions
Private production and sale of information
Free-rider problem
Government regulation to increase information
Fact 5
Financial intermediation
Facts 3, 4, & 6
Collateral and net worth
Fact 7

Conflicts of Interest
Type of moral hazard problem caused by economies of scope
Arise when an institution has multiple objectives and, as a result, has conflicts between those objectives
A reduction in the quality of information in financial markets increases asymmetric information problems
Financial markets do not channel funds into productive investment opportunities
The economy is not as efficient as it could be

Why Do Conflicts of Interest Arise?
Underwriting and Research in Investment Banking
Information produced by researching companies is used to underwrite the securities. The bank is attempting to simultaneously serve two client groups whose information needs differ.
Spinning occurs when an investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies’ future business
Auditing and Consulting in Accounting Firms
Auditors may be willing to skew their judgments and opinions to win consulting business
Auditors may be auditing information systems or tax and financial plans put in place by their nonaudit counterparts
Auditors may provide an overly favorable audit to solicit or retain audit business

Financial Crises and Aggregate Economic Activity
Crises can be caused by:
- Increases in interest rates
- Increases in uncertainty
- Asset market effects on balance sheets
- Problems in the banking sector
- Government fiscal imbalances

The Risk and Term Structure of Interest Rates

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Risk Structure of Interest Rates
Default risk—occurs when the issuer of the bond is unable or unwilling to make interest payments or pay off the face value
U.S. T-bonds are considered default free
Risk premium—the spread between the interest rates on bonds with default risk and the interest rates on T-bonds
Liquidity—the ease with which an asset can be converted into cash
Income tax considerations

Term Structure of Interest Rates
Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different
Yield curve—a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations
Upward-sloping  long-term rates are above short-term rates
Flat  short- and long-term rates are the same
Inverted  long-term rates are below short-term rates

Facts Theory of the Term Structure of Interest Rates Must Explain
Interest rates on bonds of different maturities move together over time
When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted
Yield curves almost always slope upward

Three Theories to Explain the Three Facts
- Expectations Theory
The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond
Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity
Bonds like these are said to be perfect substitutes
Expectations Theory—Example
Let the current rate on one-year bond be 6%.
You expect the interest rate on a one-year bond to be 8% next year.
Then the expected return for buying two one-year bonds averages (6% + 8%)/2 = 7%.
The interest rate on a two-year bond must be 7% for you to be willing to purchase it.
- Segmented Markets Theory
Bonds of different maturities are not substitutes at all
The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond
Investors have preferences for bonds of one maturity over another
If investors have short desired holding periods and generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3)
- Liquidity Premium & Preferred Habitat Theories
The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond
Bonds of different maturities are substitutes but not perfect substitutes

The Behavior of Interest Rates

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Determining the Quantity Demanded of an Asset
Wealth—the total resources owned by the individual, including all assets
Expected Return—the return expected over the next period on one asset relative to alternative assets
Risk—the degree of uncertainty associated with the return on one asset relative to alternative assets
Liquidity—the ease and speed with which an asset can be turned into cash relative to alternative assets

Theory of Asset Demand
Holding all other factors constant:
The quantity demanded of an asset is positively related to wealth
The quantity demanded of an asset is positively related to its expected return relative to alternative assets
The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets
The quantity demanded of an asset is positively related to its liquidity relative to alternative assets

Supply and Demand for Bonds
At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher—an inverse relationship
At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower—a positive relationship

Understanding Interest Rates

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Present Value:A dollar paid to you one year from now is less valuable than a dollar paid to you today

Four Types of Credit Market Instruments
- Simple Loan
- Fixed Payment Loan
- Coupon Bond
- Discount Bond

Yield to Maturity:The interest rate that equates the present value of cash flow payments received from a debt instrument with its value today

Rate of Return and Interest Rates
The return equals the yield to maturity only if the holding period equals the time to maturity
A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to maturity is longer than the holding period
The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change
Real and Nominal Interest Rates
Nominal interest rate makes no allowance for inflation
Real interest rate is adjusted for changes in price level so it more accurately reflects the cost of borrowing
Ex ante real interest rate is adjusted for expected changes in the price level
Ex post real interest rate is adjusted for actual changes in the price level

What Is Money?

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Meaning of Money
Money (money supply)—anything that is generally accepted in payment for goods or services or in the repayment of debts; a stock concept
Wealth—the total collection of pieces of property that serve to store value
Income—flow of earnings per unit of time

Functions of Money
Medium of Exchange—promotes economic efficiency by minimizing the time spent in exchanging goods and services
Must be easily standardized
Must be widely accepted
Must be divisible
Must be easy to carry
Must not deteriorate quickly
Unit of Account—used to measure value in the economy
Store of Value—used to save purchasing power; most liquid of all assets but loses value during inflation

Evolution of the Payments System
Commodity Money
Fiat Money
Checks
Electronic Payment
E-Money

An Overview of the Financial System

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Function of Financial Markets
Channel funds from economic agents that have saved surplus funds to those that have a shortage of funds
Promote economic efficiency by producing an efficient allocation of capital
Directly improve the well-being of consumers by allowing them to time purchases better (e.g., spend now against future income)

Structure of Financial Markets
Debt and Equity Markets
Primary and Secondary Markets
Investment Banks underwrite securities in primary markets
Brokers and dealers work in secondary markets
Exchanges and Over-the-Counter (OTC) Markets
Money and Capital Markets
Money markets deal in short-term debt instruments
Capital markets deal in longer-term debt and equity instruments

Internationalization of Financial Markets
Foreign Bonds—sold in a foreign country and denominated in that country’s currency
Eurobond—bond denominated in a currency other than that of the country in which it is sold
Eurocurrencies—foreign currencies deposited in banks outside the home country
Eurodollars—U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks
World Stock Markets

Function of Financial Intermediaries: Indirect Finance
Lower transaction costs
Economies of scale
Liquidity services
Reduce Risk
Risk Sharing (Asset Transformation)
Diversification
Address Asymmetric Information problems
Adverse Selection (before the transaction)—more likely to select risky borrower
Moral Hazard (after the transaction)—less likely borrower will repay loan

Regulation of the Financial System
To increase the information available to investors:
Reduce adverse selection and moral hazard problems
Reduce insider trading
To ensure the soundness of financial intermediaries:
Restrictions on entry
Disclosure
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates

Introduction to Money, Banking, and Financial Market

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Why Study Money, Banking, and Financial Markets
To examine:
how financial markets work (bond, stock and foreign exchange markets)
how financial institutions work (banks and insurance companies
the role of money in the economy

Financial Market
What is a financial market?
These are markets in which funds are transferred from people who have an excess of available funds to people who have a shortage of funds

The Bond Market and Interest Rates
Securities or Financial Instruments: A security (financial instrument) is a claim on the issuer’s future income or assets
A bond is a debt security that promises to make payments periodically for a specified period of time
An interest rate is the cost of borrowing or the price paid for the rental of funds

The Stock Market
Common stock represents a share of ownership in a corporation
A share of stock is a claim on the earnings and assets of the corporation

The Foreign Exchange Market
The foreign exchange market is where funds are converted from one currency into another
The foreign exchange rate is the price of one currency in terms of another currency
The foreign exchange market determines the foreign exchange rate

Banking and Financial Institutions
Financial Intermediaries—institutions that borrow funds from people who have saved and make loans to other people
Banks—institutions that accept deposits and make loans
Other Financial Institutions—insurance companies, finance companies, pension funds, mutual funds and investment banks
Financial Innovation—in particular, the advent of the information age and e-finance

Money and Business Cycles
Evidence suggests that money plays an important role in generating business cycles
Recessions (unemployment) and booms (inflation) affect all of us
Monetary Theory ties changes in the money supply to changes in aggregate economic activity and the price level

Money and Inflation
The aggregate price level is the average price of goods and services in an economy
A continual rise in the price level (inflation) affects all economic players
Data shows a connection between the money supply and the price level

Money and Interest Rates
Interest rates are the price of money
Prior to 1980, the rate of money growth and the interest rate on long-term Treasure bonds were closely tied
Since then, the relationship is less clear but still an important determinant of interest rates

Monetary and Fiscal Policy
Monetary policy is the management of the money supply and interest rates
Conducted in the U.S. by the Federal Reserve Bank (Fed)
Fiscal policy is government spending and taxation
Budget deficit is the excess of expenditures over revenues for a particular year
Budget surplus is the excess of revenues over expenditures for a particular year
Any deficit must be financed by borrowing

Banking Basics

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What's bank?

How do people start Banks ?

How did banking begin ?

Why are there so many different types of banks ?

How do I choose a bank ?

What types of accounts do banks offer ?

Is it difficult to open a bank account ?

What happens to money after you deposit it ?

What happens when you apply for a loan ?

What are checks, and how do they work ?

What's electronic banking ?

Credit cards, debit cards, stored value cards: What's the difference ?

Do banks keep large amounts of gold and silver in their vaults ?

Why do banks fail ?

Do you lose money if your bank fails ?

How does the Federal Reserve fit into the U.S. banking system ?

How does the Federal Reserve fit into the U.S. banking system?

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Although the Federal Reserve is often in the news, not everyone understands what it is and what it does. Perhaps the best way to clear things up is to have a Federal Reserve “Q & A” to cover some of the most common questions that people ask.
What is the Federal Reserve?

It is the central banking system of the United States.
What does it do?
The short answer is that the Federal Reserve is:
• a bank for other banks,
• a bank for the U.S. government, and
• responsible for U.S. monetary policy, which influences
how much money and credit will be available to the U.S. economy.
It also helps to:
• supervise and regulate banking institutions to ensure the safety
and soundness of the nation’s banking and financial system
• protect the credit rights of consumers, and
• maintain the stability of the financial system by helping to
contain risks that may arise in financial markets.

When was the Federal Reserve established? Congress created the Federal Reserve System in 1913 to help make the U.S. banking system safer and more efficient.
How many Federal Reserve Banks are there?

There are twelve Federal Reserve Banks. Each of the twelve Reserve Banks serves its own Federal Reserve District.
Where is the headquarters for the Federal Reserve?
The System’s headquarters is in Washington, D.C. It is called the Board of Governors of the Federal Reserve System.
Does the Federal Reserve lend money to businesses and consumers?
No. The Federal Reserve does not lend money to private borrowers, but it sometimes lends money to banks when the need arises.
Does the Federal Reserve print U.S. paper money?
No. Although Federal Reserve Notes account for almost 100 percent of the U.S. paper money in circulation, the notes are actually printed by the Bureau of Engraving and Printing, which
is part of the U.S. Treasury Department. The paper money is then shipped to the Federal Reserve Banks and their branches. When banks need cash for their customers’ needs, they order it from the Federal Reserve Bank in their District. Also, since money gradually wears out, the Federal Reserve Banks process cash in order to determine its fitness. Worn out bills are
shredded; new bills are introduced into the system to replace the old ones.
Do all Federal Reserve Banks store gold bars in their vaults?
Only the Federal Reserve Bank of New York has a working gold vault, and almost all of the gold in its vault is foreign-owned. The U.S. government’s gold is held at Fort Knox, Kentucky, the U.S. Mints in Denver and Philadelphia, the San Francisco Assay Office of the U.S. Mint, and the U.S. Bullion Depository in West Point, New York.

Does the Federal Reserve process all the checks Americans write?
No. The Federal Reserve Banks handle less than one-third of all U.S. checks. Private entities process the rest.

Is the Federal Reserve responsible for regulating and supervising the entire U.S.
banking system?
No. It shares this responsibility with other federal and state regulatory agencies.

Does the Federal Reserve set interest rates?
The Federal Reserve is responsible for U.S. monetary policy. This means it makes policies that influence how much money and credit will be available to the U.S. economy. Interest rates often go up or down in response to the Federal Reserve’s monetary policy decisions, but only the discount rate is set directly by the Federal Reserve. The discount rate is the rate banks pay when they borrow from the Federal Reserve.

Do you lose money if your bank is robbed?

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No. Nearly all banks have private insurance that covers them if they are robbed. (It is not the same as federal deposit insurance.)
In addition, most banks take elaborate measures to safeguard the cash and other valuable items left in their care. Bank vaults have long been protected by reinforced concrete walls, time locks, and metal alloy doors that resist drilling and explosions. At one time, armed security guards stood watch over banks, but today most banks seem to have decided (wisely) that they would rather not expose their customers and employees to gunplay. Shotguns and revolvers have been replaced by closed-circuit television cameras that maintain a constant watch over everyone who enters or exits the bank.

Another innovation is the exploding dye pack. In certain cases, bank employees are able to place a package of red dye in with the robber’s stash of stolen cash. Later, when the crook opens the stash, the concealed dye pack explodes, covering the robber and the ill-gotten money with dye that won’t wash off.

Do you lose money if your bank fails?

2011-02-06T02:02:00.000-08:00

The Federal Deposit Insurance Corporation (FDIC) has protected bank deposits since 1934. In all that time, no one has lost money that was FDIC-insured. Federal deposit insurance covers most types of deposits, including savings deposits, checking deposits, and certificates of deposit.

The basic insured amount is $100,000.
In the days before federal deposit insurance, the U.S. banking system was plagued by bank “runs” or “panics.” At the slightest hint of trouble, depositors would run to the bank and line up to withdraw their money. All too often, only the first few people in line had any hope of ever seeing their money again; others lost everything. Even healthy banks sometimes failed after rumors caused depositors to panic and withdraw their money. For many years, the public seemed willing to accept the losses. But then came the Great Depression of the 1930s, and financial pressures forced thousands of banks to close their doors forever. Losses ran into the hundreds of millions of dollars, and many people lost their life savings.

The wave of bank failures shattered public confidence in the banking system, and Americans looked to the federal government for help. Congress responded by establishing the FDIC, which provided deposit insurance coverage of up to $2,500 per depositor. Public confidence rebounded, and bank failures declined from approximately 4,000 in 1933 to 62 in 1934. Over the years, the federal deposit insurance limit has increased, and federal deposit insurance has helped to maintain public confidence in the U.S. banking system. Bank failures have not been eliminated, but long lines of panic-stricken depositors have become an uncommon sight.

Why do banks fail?

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A bank is a business, and like other businesses, they can fail. Sometimes they fail because the people who run them make poor business decisions such as expanding too quickly or putting too much money into one type of loan.

Sometimes they fail because of fraud. Maybe the president makes questionable loans to friends or hires unqualified relatives and pays them huge salaries. But banks also go out of business because changing economic conditions make it difficult or impossible for borrowers to repay their loans. Here’s an example.

Gusher National Bank Slips on Falling Oil Prices Falling energy prices mean cheaper gasoline and lower home heating bills. So, falling oil prices must be good, right?
Not for everyone! Take the case of Gusher National Bank. Gusher was very aggressive in making loans to oil and natural gas companies that had no problem repaying their loans when energy prices were high. The loans spelled big profits for Gusher, and everyone agreed that Gusher’s executives were smart business people who really knew how to make money.

Then the economy slowed down, and the demand for energy fell. Factories burned less oil and natural gas. Truck drivers, commuters, and vacationers drove fewer miles and burned less fuel. As a result, energy prices dropped sharply, and many energy companies fell behind on their loan payments. Some even stopped making payments altogether. Months passed, oil prices remained low, and more energy companies fell
behind on their payments. Finally, Gusher lost so much money to bad loans that government regulators had to step in and close the bank. Gusher had fallen victim to changing economic conditions—falling energy prices and a high concentration of loans to energy companies.
Or take the case of Bedrock Bank . . . Bedrock Bank Gets Too Big Too Fast Bedrock Bank’s new president was determined to turn his bank into the region’s biggest lender. Bedrock’s loan officers got the message and started making as many loans as they could for condominium developments, shopping centers, office buildings, and high-priced suburban
housing developments. Loan applications were not always checked as closely as they had been in the past, and some of the loans were approved more quickly than they had been in the old days. But nobody seemed concerned because the local economy was strong and real estate values were rising rapidly.
Everything seemed fine; everyone was making money. But then the economy slowed down, and things took a turn for the worse. The weak economy forced many businesses to close, leaving lots of vacant office space. Real estate values plummeted, and many developers fell behind on their loan payments.
In the end, Bedrock Bank was losing so much money on bad real estate loans that government regulators were forced to step in and close it. The regulators tried to find a buyer for Bedrock, but no other bank wanted to get stuck with all the loans that had gone bad. Eventually, another bank agreed to buy Bedrock if the federal government would agree to keep many of the problem loans.

Do banks keep large amounts of gold and silver in their vaults?

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Today, banks rarely keep gold or silver in their vaults. That’s because our paper money is no longer backed by gold or silver, and our coins don’t contain precious metal.

The U.S. government still holds millions of ounces of gold and silver, but citizens and foreign governments can no longer exchange their U.S. paper money for it. The government’s gold and silver are considered valuable assets rather than forms of money. Today’s coins and paper money are backed by the “full faith and credit” of the U.S. government.

If that makes you a little uneasy, try the following exercise. Put a ten-dollar bill and a blank piece of paper on a tabletop, and ask people to choose between the two. Chances are everyone will choose the ten-dollar bill. Why? After all, neither the ten-dollar bill nor the blank piece of paper is backed by gold or silver.

The difference is that people all over the United States will accept the ten-dollar bill as payment if you want to buy something. But you would have a hard time finding someone willing to accept the blank piece of paper. That’s because the ten-dollar bill is backed by the promise of the United States government, and to most people, that promise is as good as gold.

Credit cards, debit cards, stored value cards: What’s the difference?

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Credit cards are not a form of money, even though people often refer to them as “plastic money.” When you use a credit card you are actually taking out a loan—buying something now and agreeing to pay for it later—and sooner or later you will have to pay the bill for all those things you’ve bought.
Many banks issue credit cards, even to people who aren’t regular customers. Before issuing you a credit card, a bank will require you to complete an application form and will examine your credit record to see if you have a history of paying back your debts on time. Sometimes people run up credit card bills that are too big to pay off every month. When that happens, they must pay a monthly finance charge that can sometimes top 20 percent a year.
In addition, banks (and other companies that issue credit cards) sometimes charge their cardholders an annual fee.
They also charge merchants a fee for making the credit card service available. Finance charges, annual fees, and merchant fees have become an important source of income for banks.
Debit cards look like credit cards, but they are very different. When you use a debit card at the gas pump or at a store, the amount of the purchase is electronically deducted from your bank balance. It will show up on your monthly bank statement, but there’s no monthly bill because the amount of each purchase is deducted almost immediately from your account.
Some merchants offer you the opportunity to get additional cash back when you pay for a purchase with your debit card. You can also use your debit card at an ATM if you need to withdraw cash from your account, but if the ATM is not part of your bank’s network, you may have to pay a fee.
One other major difference between debit cards and credit cards is that you don’t have as much legal protection if your debit card is lost or stolen. On a lost or stolen credit card, the most you’re responsible for is $50. But if someone steals your debit card, you could be responsible for up to $500 in fraudulent charges or transfers unless you report the loss or theft of your card within two business days. You risk unlimited loss if an unauthorized charge or withdrawal appears on your statement, and you don’t report it within 60 days. So always be sure to check your monthly bank statements!
The card that may come closest to being “plastic money” is the stored value card. Gift cards and phone cards are the two types that most people know best. The cards are “loaded” with a certain dollar amount—$10, $50, $100, or any other amount—and that amount decreases with each use. For example, if someone gives you a $50 gift card to Bob’s Big Buy, and you buy something there for $30, you will still have $20 “stored” on the card. Two things to keep in mind about stored value cards: 1) You can’t use them in as many places as credit cards or debit
cards. If you receive a gift card to Bob’s Big Buy, that’s the only place you can use it, and 2) They really are “just like cash” in that you’re pretty much out of luck if they are lost or stolen.

What is electronic banking?

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The bank closes in ten minutes. Even if you make it there in time to cash your check, your nerves will be frazzled. Isn’t there an easier way?
Yes, there is. Electronics and computers have turned banking into a round-the-clock business.

Automated teller machines (ATMs) now make it possible for you to do much of your banking whenever you choose.
ATMs are computers that are much like limited-service bank branches. You can use them to make a withdrawal, make a deposit, make a loan payment, transfer money from one account to another, or check your account balance. In many cases, automated teller machines of different banks are linked together in networks so you can use them when you travel to a different part of town, another state, or even another country. All you need is a plastic card from your bank and your own password.
Tired of rushing to the bank to cash your paycheck? Ask your employer about direct deposit, a banking service that makes it possible for you to have your money electronically added to your checking account every payday. Instead of receiving a paycheck, you receive a statement that tells you your money has been deposited in your account. Direct deposit is popular among people who receive Social Security checks or pension checks because it saves them the bother of standing in line at the bank, battling bad weather, or worrying about being robbed on the way home from the bank.

Another electronic banking service is called electronic funds transfer, or EFT. By using EFT, a
bank can transfer large amounts of money to another bank by sending an electronic message. Electronic transfers take only an instant. An electronic message instructs a computer to deduct a certain amount of money from one bank account and then add the same amount to another bank account. The message is sent, and the appropriate amount is transferred. No cash or paper changes hands, but money is transferred just the same.

Technology has made it possible to bank from the comfort of your own home. Banks offer software packages that allow customers to debit or credit their accounts, check their account balances, or even apply for a loan. Consumers can make these transactions online.

What are checks, and how do they work?

2011-02-06T01:44:00.000-08:00

You reach for your wallet and it’s not there. Panic gives way to despair when you realize that your wallet is gone and so is your cash. Chances are you’ll never see the cash again. The consequences are not nearly as serious if you lose your checkbook. All you do in that case is close your checking account and open a new one. After that, your lost or stolen checks are worthless to anyone who might try to use them. Because they are safe and convenient, checks have become a popular method of paying for things or transferring money. But what exactly is a check?
In simple terms, a check is a written set of instructions to your bank. When you write a check, you are instructing your bank to transfer a specific amount of money from your checking account to another person or an organization. You can even write a check to convert some of the money on deposit in your checking account into cash.
When you fill in the blank spaces on one of your checks, you are telling your bank three things:
1) how much of your money you want to transfer, 2) when you want to transfer it, and 3) to whom you want it to go. You authorize the transfer by signing the check.
So, if your favorite aunt sends you a $50 check for your birthday, she’s actually telling her bank to transfer $50 from her account to you. But when you go to cash her check or deposit it in your account, how does your bank know if your aunt actually has enough money in her account to cover the check?
The answer to this question isn’t what it used to be.
Up until 2004, the check had to travel all the way back to your aunt’s bank by truck or by plane. If there was enough money in her account to cover it, her bank would “clear” the check. If there wasn’t enough, her bank would stamp it “NSF”—Not Sufficient Funds—and “bounce” it back to your bank. And on top of all that, your aunt’s bank had to send her cancelled checks back to her every month, along with her account statement. All that paperwork might have been OK back in 1940, or even 1970, when Americans wrote fewer checks. But as checks became more popular, banks spent more and more time and money moving billions of pieces of paper around the country each year—not the best use of resources, especially when new technology offered a more efficient way to do things. In 2004, Check 21 went into effect. The new federal law made it possible for banks to handle more checks electronically. Instead of physically moving checks from one bank to another, banks can now electronically transmit images of the checks they process. It’s a lot faster and less costly.

What happens when you apply for a loan?

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Last week your mechanic advised you not to spend any more money on the faithful old car that has carried you over many miles of highway. The time has come to shop around for a new one. But cars were a lot cheaper when you last bought one. This time you’ll have to take out a big loan.
You don’t necessarily have to borrow from the bank where you have an account. You should shop around for a lender that offers the best deal, including the lowest interest rate. Sometimes car companies offer low-interest, or even no-interest loans. And don’t forget the internet. You can research a wealth of online resources from the comfort of your home or office. Your first step is to figure out how much you can afford to borrow. You will not know if you can afford the new car— or if a lender will let you borrow the amount want—until after you complete a loan application. In addition to routine personal information such as your name,
address, telephone number, and Social Security number, a loan application also asks for information on how much money you earn, how long you have worked at your current job, and how much money you already owe on credit card bills and other debts.
The next step is for the lender to evaluate your application and decide if you are a “good risk.”
Before they lend you money, lenders want to be as certain as possible that you will be able to pay them back. Do you earn enough money to keep up with your loan payments? Do you have a history of paying your debts on time? To answer these questions, lenders rely heavily
on credit bureaus and credit reports. There are approximately 1200 local and regional credit bureaus in the United States. All are private companies (not government agencies), and most are linked by computer to three nationwide credit bureaus. They provide much of the information that lenders need to evaluate loan applications.

When you apply for a loan, your bank contacts a credit bureau and asks for a copy of your credit report, which is basically a summary of your payment habits—information about loans, charge accounts, credit card accounts, bankruptcies, and court judgments that might require a potential borrower to pay a large sum of money as a settlement. How the information gets into your credit report is no mystery. When you apply for a new charge account or credit card, clerks transfer information from your application to electronic records that are forwarded to one or more of the nationwide credit bureaus. If you are late in paying your bills, or if you miss
a payment, the information goes into your credit report. Lenders then evaluate your report and try to decide if you are a “good risk.”
After weighing all the information, your bank will either approve or deny your loan request. If your request is denied, the bank must notify you in writing within 30 days, and the letter must state the reason for denying your loan. If your loan is approved, the bank will give you a check made out to your auto dealer or transfer the funds to your account. To protect itself in case you fail to repay the loan, your bank will hold the legal title (ownership papers) to your purchase until you pay off the loan.

What happens to money after you deposit it?

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What happens to a $10 bill after you deposit it in your savings account? Does the

bank teller take it to a vault and put it into a separate compartment or cubbyhole

marked with your name and account number? No.

The bank begins by adding $10 to the amount that is already in your account (your

existing balance). Your $10 deposit and your new balance are then recorded in your

bank book and in the bank’s computer system. The $10 bill you deposited is mixed in

with all the other cash your bank receives that day.

When you and other customers deposit money in a bank, the bank “puts most of it to

work.” Part of the money is set aside and held in reserve, but much of the rest is

loaned to people who need to borrow money in order to buy a house or a car, expand a

business, buy farm equipment, or do any of the other things that require people to

borrow money. Of course, banks do not lend money just to provide a service. They do

it to make money. Here’s how it works.

When you keep your savings in a bank, the bank pays you extra money, which is called

interest. The interest is added to your account on a regular basis, usually once a

month.

Let’s say a bank pays its depositors interest of 3 percent a year on their savings.

In simple terms, that means if you keep $100 in your savings account, the bank will

add $3 to your account balance during the course of a year.

But, there is another side to interest. When someone borrows money from a bank, the

bank charges interest, and it charges borrowers a higher rate than it pays savers.

For example, it might pay savers 3 percent and charge borrowers 8 percent. The

difference, 8 percent minus 3 percent, goes to the bank. Charging interest on loans

is one of the main ways for a bank to make money.

The rate of interest a bank charges depends largely on two things:

• how many people want to borrow money, and

• how much money banks have available to lend.

If a bank has plenty of money to lend, and the demand to borrow money is not

particularly strong, interest rates will tend to be low in order to attract

borrowers. But when banks have a smaller amount of money to lend, and the demand to

borrow is fairly strong, interest rates will rise. As a depositor, you want interest

rates to be high, but as a borrower, you want them

to be low. When it comes to paying interest on savings deposits, there usually isn’t

a big difference between banks. They pay just enough to stay competitive with one

another and attract depositors. So, if one bank is offering a much better (higher)

rate than most other banks, try to find out why. And remember the old saying: If

something sounds too good to be true, it

probably is.

Is it difficult to open a bank account?

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You’ve finally decided to take the plunge. With your cash tucked deep in your

pocket, you walk into the bank and ask to open a savings account.

The bank’s receptionist directs you to a desk where a customer service representative

will help you with the paperwork. To your surprise, the only form you need to fill

out is a signature card, which requires you to sign your name and then print your

name, address, telephone number, date of birth, social security number, and your

mother’s maiden name (as a means of further identification). After you complete the

signature card, you receive a bank book (sometimes called a passbook) that lists

your account balance (the total amount of money in your account).

Whenever you make a deposit (put money in) or a withdrawal (take money out), the

transaction is recorded in your bank book. It is very important for you to keep

track of the activity in your account.

You don’t need lots of money to start a savings account. Some banks let you open one

with as little as $20. Nor do you need to wait until you are 18 years old. In most

cases, you can open a savings account as soon as you are old enough to sign your

name, or even earlier than that if you open the account with a parent or guardian.

What types of accounts do banks offer?

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People use banks for different purposes. Some have extra money to save; others need

to borrow. Some need to manage their household finances; others need to manage a

business. Banks help their customers meet those needs by offering a variety of

accounts. Savings accounts are for people who want to keep their money in a safe

place and earn interest at the same time. You don’t need a lot of money to open a

savings account, and you can withdraw your money easily.

Certificates of deposit (CDs) are savings deposits that require you to keep a

certain amount of money in the bank for a fixed period of time (example: $1,000 for

two years). As a rule, you earn a higher rate of interest if you agree to keep your

money on deposit longer, and there is usually a penalty if you withdraw your money

early.

Individual retirement accounts (IRAs) are savings deposits that offer an excellent

way to save for your later years. You don’t have to pay tax on the money you deposit

in your IRA until you withdraw it. But there is often a significant penalty if you

withdraw your funds before you reach a specified age (usually 59 or older).

Checking accounts offer safety and convenience. You keep your money in the account

and write a check when you want to pay a bill or transfer some of your money to

someone else.

If your checkbook is lost or stolen, all you need to do is close your account and

open a new one so that nobody can use your old checks. (When cash is lost or stolen,

you rarely see it again.) Another attractive feature of a checking account is that

your bank sends you a monthly record of the checks you have written, and you can use

that record if ever need to prove that you’ve made a payment. Banks sometimes charge

a fee for checking accounts, because check processing is costly.

Many banks also offer no-fee checking and checking accounts that earn interest if

you agree to keep a certain amount of money—a minimum balance—in the account. But

these accounts are limited to non-business customers. Banking laws almost always

require businesses to use regular checking accounts that do not pay interest.

Money market deposit accounts are similar to checking accounts that earn interest,

except that they usually pay a higher rate of interest and require a higher minimum

balance (often $2,500 or more). They also limit the number of checks you can write

per month.

Finally, banks do not always call their accounts by the same names. Often, they

choose distinctive names in hopes of attracting customers. But there can be a real

difference between one bank’s accounts and another’s, so shop around.

How do I choose a bank?

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Back in the 1950s, banks often gave away toasters to new depositors, and that made

choosing a bank simpler. You went to the one that gave away the best toaster.

Today banks rarely give away toasters, and choosing a bank is a little more

complicated. For starters, you should shop around to find out which banks offer the

best services and the lowest fees. Some banks charge a monthly fee if your account

falls below a certain level, and that fee can be higher than the interest your

account earns. Other banks may charge fees for many types of transactions. You don’t

want that.

In certain states, such as Massachusetts, the law prohibits banks from charging fees

on savings accounts held by people under the age of 18 or over the age of 65. Find

out if your state has such a law.

Other things you might want to consider:

1. Does your bank pay depositors a competitive interest rate?

2. Is the bank in a convenient location and are its business hours convenient for

you?

3. Is your deposit insured by the FDIC (Federal Deposit Insurance Corporation)?

4. Is the bank a good corporate citizen? Does it invest in your neighborhood?

5. And last, but certainly not least, does your bank provide courteous and

efficient service? Before you open an account, ask a few people if they are happy

with their bank. And do some comparison shopping because all banks are not the same.

Why are there so many different types of banks?

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Not all banks are exactly the same. There are commercial banks, savings banks,

savings and loan associations (S&Ls), cooperative banks, and credit unions. Today

they offer many of the same services, but at one time, they were very different from

one another.

Commercial banks originally concentrated on meeting the needs of businesses. They

served as places where a business could safely deposit its funds or borrow money

when necessary.

Many commercial banks also made loans and offered accounts to individuals, but they

put most of their effort into serving business (commercial) customers.

Savings banks, S&Ls, cooperative banks, and credit unions are classified as thrift

institutions or “thrifts,” rather than banks. Originally, they concentrated on

serving people whose banking needs were ignored or unmet by commercial banks.

The first savings banks were founded in the early 1800s to give blue-collar workers,

clerks, and domestic workers a secure place to save for a “rainy day.” They were

started by publicspirited citizens who wanted to encourage efforts at saving among

people who did not earn much money.

Savings and loan associations and cooperative banks were established during the 1800s

to help factory workers and other wage earners become homeowners. S&Ls accepted

savings deposits and used the money to make loans to home buyers. Most of the loans

went to people who did not make enough money to be welcome at traditional banks.

Credit unions began as a 19th-century solution to the emergency needs of people

who were unable to borrow money from traditional lenders. Before the opening of

credit unions, ordinary citizens had no place to turn when they faced unexpected

home repairs, medical expenses, or other emergencies. Credit unions were started by

people who shared a common bond such as working in the same factory, belonging to

the same house of worship, or farming

in the same community. Members pooled their savings and used the money to make small

loans to one another.

Although there are still differences between banks and thrifts, they now offer many

of the same banking services to their customers. Most commercial banks now compete

to make car loans.

Many thrift institutions have begun to make commercial loans, and some credit unions

make loans to home buyers.

How did banking begin ?

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Imagine for a moment that you are a merchant in ancient Greece or Phoenicia. You

make your living by sailing to distant ports with boatloads of olive oil and spices.

If all goes well, you will be paid for your cargo when you reach your destination,

but before you set sail you need money to outfit your ship. And you find it by

seeking out people who have extra money sitting idle. They agree to put up the money

for your voyage in exchange for a share of your profits when you return . . . if you

return. The people with the extra money are among the world’s first lenders, and you

are among the world’s first borrowers. You complain that they’re demanding too large

a share of the profits. They reply that your voyage is perilous, and they run a risk

of losing their entire investment. Lenders and borrowers have carried on this debate

ever since.

Today, people usually borrow from banks rather than wealthy individuals. But one

thing hasn’t changed: Lenders don’t let you have their money for nothing.

Lenders have no guarantee that they will get their money back. So why do they take

the risk?

Because lending presents an opportunity to make even more money.

For example, if a bank lends $50,000 to a borrower, it is not satisfied just to get

its $50,000 back. In order to make a profit, the bank charges interest on the loan.

Interest is the price borrowers pay for using someone else’s money. If a loan seems

risky, the lender will charge more interest to offset the risk. (If you take a

bigger chance, you want a bigger pay-off.)

But the opportunity to earn lots of interest won’t count for much if a borrower

fails to repay a loan. That’s why banks often refuse to make loans that seem too

risky. Before lending you money, they look at:

• how much and what types of credit you use, such as credit cards, auto loans, or

other consumer loans;

• whether or not you have a history of repaying your loans, and

• how promptly you pay your bills. Banks also use interest to attract savers. After

all, if you have extra money you don’t have to put it in the bank. You have lots of

other choices:

• You can bury it in the backyard or stuff it in a mattress. But if you do that, the

money will just sit there. It won’t increase in value, and it won’t earn interest.

• You can buy land or invest in real estate. But if the real estate market weakens,

buildings and land can take a long time to sell. And there’s always the risk that

real estate will drop in value.

• You can invest in the stock market. But like real estate, stocks can also drop in

value, and the share price might be low when you need to sell.

• You can buy gold or invest in collectibles such as baseball cards, but gold and

collectibles fluctuate in value. Who knows what the value will be when it’s time to

sell? (In 1980, gold sold for $800 an ounce. By 1983, the price had sunk below $400.)

Or you can put the money in a bank, where it will be safe and earn interest. Many

types of bank accounts also offer quick access to your money.

Interest is the price borrowers pay for using someone else’s money.