Understanding Money, Banking, and Credit: Key Concepts and Functions

1. Chapter Nineteen Understanding Money, Banking, and Credit

2. 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

3. 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.

4. 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

5. The Supply of Money Source: The Federal Reserve website, www.federalreserve.gov, January 8, 2003.

6. 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

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

8. 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

9. 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

10. 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

11. 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

12. 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.

13. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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 How Do You Get Money From a Bank or Lender?

26. 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

27. 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

28. Effective Credit Management (cont’d) • Sound collection procedures • Firm • Fair, allowing for compromise • Not harassing • Techniques • Subtle reminders • Telephone calls • Personal visits • Legal action