Chapter Nineteen

Understanding Money, Banking,

and Credit

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The Functions of Money

• Medium of exchange– Anything accepted as payment for products,

services, and resources

• Measure of value– A single standard or “yardstick” used to assign

values to, and compare the values of, products, services, and resources

• Store of value– A means of retaining and accumulating wealth– The Consumer Price Index measures the effects

of inflation

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The Consumer Price Index and the Purchasing Power of the Consumer Dollar (Base Period 1982–1984 = 100)

Source: U.S. Bureau of Labor Statistics website, www.bls.gov, January 6, 2003.

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The Supply of Money: M1, M2, and M3

• Demand deposit– An amount on deposit in a checking account

• Time deposit– An amount on deposit in an interest-bearing savings

account

• Three main measures of the supply of money– M1

• Currency, demand deposits, and travelers checks

– M2

• M1 plus certain money-market securities and small-denomination time deposits or certificates of deposit of less than $100,000

– M3

• M1 and M2 supplies of money plus time deposits or certificates of deposit of $100,000 or more

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The Supply of Money

Source: The Federal Reserve website, www.federalreserve.gov, January 8, 2003.

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The Federal Reserve System

• The central bank of the United States responsible for regulating the banking industry– Controlled by a 7-member board of governors who

are appointed by the president and confirmed by the Senate to serve 14-year terms

– Composed of 12 district banks and 25 branch banks

– District banks are owned by commercial banks that are members of the Federal Reserve system

– Main function is to regulate the nation’s money supply by controlling bank reserves requirements, regulating the discount rate, and running open-market operations

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Federal Reserve System

Source: Federal Reserve Bulletin, May 2002, pp. A84-86.

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The Federal Reserve System (cont’d)

• Regulation of reserve requirements– Reserve requirement—the percentage of

its deposits a bank must retain, either in its own vault or on deposit with its Federal Reserve District Bank

– More required reserves = less money in circulation

– Less required reserves = more money in circulation to stimulate the economy

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The Federal Reserve System (cont’d)

• Regulation of the discount rate– Discount rate—the interest rate the Federal

Reserve System charges for loans to its member banks

– Lower loan rates allow banks to lend more and stimulate the economy

– Higher rates slow the economy and check inflation

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The Federal Reserve System (cont’d)

• Open-market operations– The buying and selling of U.S. government

securities by the Federal Reserve System for the purpose of controlling the supply of money

– To reduce the money supply, the Fed sells government securities on the open market to take money out of circulation

– To increase the money supply, the Fed buys government securities

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The Federal Reserve System (cont’d)

• Other Fed responsibilities– Serving as the U.S. government bank– Clearing checks and electronic transfers of

funds between banks– Inspection and replacement of worn and

unfit currency– Selective credit controls

• Truth-in-Lending Act enforcement• Stock purchase margin requirements

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Clearing a Check Through the Federal Reserve System

Source: Federal Reserve Bank of New York, The Story of Checks, 7th ed. New York, 1995, p. 11.

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The American Banking Industry

• Commercial bank– A profit-making organization that

accepts deposits, makes loans, and provides related services to its customers

– National bank—a commercial bank chartered by the U.S. Comptroller of the Currency

– State bank—a commercial bank chartered by the banking authorities in the state in which it operates

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The American Banking Industry (cont’d)

• Other financial institutions– Savings and loan association (S&L)

• A financial institution that offers checking and savings accounts and certificates of deposit and that invests most of its assets in home-mortgage loans and other consumer loans

– Credit union• A financial institution that accepts deposits from and

lends money to only those people who are its members• Members are usually employees of a particular firm,

people in a particular profession, or those who live in a community served by a a local credit union

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The American Banking Industry (cont’d)

• Other financial institutions (cont’d)– Mutual savings banks– Insurance companies– Pension funds– Brokerage firms– Finance companies– Investment banking firms

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Careers in Banking

• The 7 largest banks in the U.S. employ approx. 620,000 people

• The U.S. Department of Labor expects the number of people employed in banking to decrease by 2% by 2010

• Traits of successful bankers– Honesty– Ability to interact with people– Strong background in accounting– Appreciation for the banking-finance relationship– Basic computer skills

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Traditional Services Provided by Financial Institutions

• Checking accounts– Check—a written order for a bank or other financial institution to

pay a stated dollar amount to the business or person indicated on the check

– NOW account—an interest-bearing checking account

• Savings accounts– Passbook savings account– Certificate of deposit (CD)—a document stating that a bank will

pay the depositor a guaranteed interest rate for money left on deposit for a specified period of time

• Short- and long-term loans– Line of credit—a short-term loan that is approved before the

money is actually needed– Revolving credit agreement—a guaranteed line of credit– Collateral—real estate or property pledged as security for a loan

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Traditional Services Provided by Financial Institutions (cont’d)

• Credit card and debit card transactions– Banks and other financial institutions charge merchants fees

(a percentage of each credit card transaction) for handling the

transactions for the merchant– Banks impose monthly finance charges on the unpaid

balances (essentially, a line of consumer credit) of cardholders

– Debit card—a card that electronically subtracts the amount of a purchase from the cardholder’s bank account at the moment the purchase is made

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Recent Changes in the Banking Industry

• Financial Services Modernization Banking Act (1999)– Allows banks to establish one-stop financial supermarkets

where customers can get a variety of financial services, including banking, buying and selling securities, and purchasing insurance

– Competition will increase and consumers will have more choice

• Anticipated changes– Mergers and consolidations of banks, S&Ls, credit unions, etc.– Fewer bank branch offices– Globalization of banking– Importance of customer service as a way to keep customers– Increased use of credit and debit cards; decrease in use of

checks– Increased competition from nonbank competitors– Growth in online banking

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Online Banking

• Advantages– Convenience of electronic deposits– Ability to obtain current account balances– Convenience of transferring funds– Ability to pay bills– Convenience of seeing which checks have cleared– Easy access to current interest rates– Simplified loan application procedures– For banks—lower processing costs

• Disadvantages– Not being able to discuss financial matters with a

personal banker

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Online Banking (cont’d)

• Electronic fund transfer (EFT) system– A means of performing financial

transactions through a computer terminal or telephone hookup

– Changing how banks do business• Automated teller machines (ATMs)• Automated clearinghouses (ACHs)• Point-of-sale terminals

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International Banking

• Popular methods of paying for import and export transactions– Letter of credit

• A legal document issued by a bank or other financial institution guaranteeing to pay a seller a stated amount for a specified period of time

– Banker’s acceptance• A written order for the bank to pay a third party

a stated amount of money on a specific date

• Currency exchange

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The FDIC, SAIF, BIF, NCUA

• Federal Deposit Insurance Corporation (FDIC)– As a result of the Depression, to restore public confidence in

the banking industry, the FDIC was created to insure deposits against bank failures

• FDIC reorganized into the Banking Insurance Fund (BIF) and Savings Association Insurance Fund (SAIF)– As a result of S&L failures

• FDIC provides deposit insurance of $100,000 per account

• All Federal Reserve System member banks must belong to the FDIC; nonmembers and S&Ls may join if they qualify

• National Credit Union Association (NCUA)– Insures the deposits of credit union members for up to

$100,000 per account

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How Do You Get Money From a Bank or Lender?

• For individuals– Shop around for low

interest rates, but you have a better chance at an institution where you already have an account

– Fill out a loan application– Describe how you will

use the money and how you will repay it

– Prepare for an interview– If rejected, ask the loan

officer why

• For businesses– Develop a relationship

with your banker– Apply for a preapproved

line of credit or revolving credit agreement even if you do not need the money

– Supply financial statements and tax documents

– Prepare a convincing cover letter

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Effective Credit Management• Credit

– Immediate purchasing power that is exchanged for a promise to repay borrowed money, with or without interest, at a later date.

• The five Cs of credit management– Character—the borrower’s attitude toward credit

obligations– Capacity—the borrower’s financial ability to meet credit

obligations– Capital—the extent of the borrower’s assets or net

worth– Collateral—borrower assets that can be pledged as

security for the loaned amount– Conditions—general economic conditions that can

affect a borrower’s ability to repay the loan

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Effective Credit Management (cont’d)

• Checking credit information– Credit information sources regarding businesses

• Global credit-reporting agencies• Local credit-reporting agencies• Industry associations• Other firms that have given the firm credit

– Credit information concerning individuals• Experian• Trans Union• Equifax

– Fair Credit Reporting Act (1971)• Consumers have a right to know what information is in their

credit bureau files• Consumers have a right to request that information in their

files be verified, and they can file an explanation of their side of a dispute

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Effective Credit Management (cont’d)

• Sound collection procedures– Firm– Fair, allowing for compromise– Not harassing

• Techniques– Subtle reminders– Telephone calls– Personal visits– Legal action