Chapter Eighteen

PRIDE HUGHES KAPOOR INTRODUCTION TO BUSINESS ELEVENTH EDITION Chapter Eighteen Understanding Money, Banking, and Credit 18 | 1

Learning Objectives • Identify the functions and characteristics of money. • Summarize how the Federal Reserve System regulates the money supply in order to maintain a healthy economy. • Describe the organizations involved in the banking industry. • Identify the services provided by financial institutions. 18 | 2

Learning Objectives (cont’d) • Understand how financial institutions are changing to meet the needs of domestic and international customers. • Explain how deposit insurance protects customers. • Discuss the importance of credit and credit management. 18 | 3

Introduction • The economic crisis • Described by many experts as the worst since the Great Depression • Many people lost their homes because they couldn’t pay their loans • Many people and businesses filed for bankruptcy because they couldn’t pay their loans • Many people and businesses found it harder or impossible to borrow money 18 | 4

What Is Money? • Barter system • A system of exchange in which goods or services are traded directly for other goods or services • Money • Anything a society uses to purchase products, services, or resources 18 | 5

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 18 | 6

The Consumer Price Index and the Purchasing Power of the Consumer Dollar (Base Period 1982–1984 = 100) Figure 18.1 Source:The U.S. Bureau of Labor Statistics website, www.bls.gov, June 16, 2010. 18 | 7

The Consumer Price Index and the Purchasing Power of the Consumer Dollar (Base Period 1982–1984 = 100) Figure 18.1 Source:The U.S. Bureau of Labor Statistics website, www.bls.gov, June 16, 2010. 18 | 8

Important Characteristics of Money • Divisibility • Portability • Stability • Durability • Difficulty of counterfeiting 18 | 9

The Supply of Money: M1 and M2 • Demand deposit • An amount on deposit in a checking account • Time deposit • An amount on deposit in an interest-bearing savings account • Two main measures of the supply of money • M1 • Currency, demand deposits, and travelers checks • M2 • M1 plus savings accounts, certain money-market securities and small-denomination time deposits or certificates of deposit (CDs) of less than $100,000 18 | 10

The Supply of Money Figure 18.2 Source:The Federal Reserve website, www.federalreserve.gov, accessed June 15, 2010. 18 | 11

The Federal Reserve System • The central bank of the United States responsible for regulating the banking industry • Controlled by a seven-member board of governors who are appointed by the president and confirmed by the Senate to serve a fourteen-year term • Composed of twelve district banks and twenty-four branch banks • District banks are owned by commercial banks that are members of the Federal Reserve system • Main function is to regulate the banking system and maintain a healthy economy 18 | 12

The Federal Reserve System (cont’d) Figure 18.3 Source: “91st Annual Report, 2004,” The Federal Reserve Board website, www.federalreserve.gov, accessed June 18, 2010. 18 | 13

The Federal Reserve System (cont’d) • Economic crisis and the Fed’s response • Provided liquidity • Supported troubled financial markets • Supported important financial institution • Conducted stress tests of major banks 18 | 14

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 18 | 15

The Federal Reserve System (cont’d) • Regulation of the discount rate • Discount rate—the interest rate the Federal Reserve System charges for loans to member banks • Lower loan rates allow banks to lend more and stimulate the economy • Higher rates slow the economy 18 | 16

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 to take money out of circulation • To increase the money supply, the Fed buys government securities 18 | 17

Controlling the Money Supply and the Economy Table 18.1 18 | 18

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 18 | 19

The American Banking Industry • Banking and financial reform: New regulations • Goals are • Protection from unfair, abusive financial and banking practices • Close gaps that allowed large banks and financial firms to avoid strong, comprehensive federal oversight • Curb high-risk investment strategies • Require banks and financial firms to pay back bailout funds • Provide a foundation for stable economic growth 18 | 20

The American Banking Industry (cont’d) • Commercial bank • A profit-making organization that accepts deposits, makes loans, and provides related services to its customers • National bank: chartered by the U.S. Comptroller of the Currency • State bank: chartered by the banking authorities in the state in which it operates 18 | 21

The Seven Largest U.S. Banks,Ranked by Total Revenues Table 18.2 Source:The Fortune website, www.fortune.com, accessed June 20, 2010. 18 | 22

The American Banking Industry (cont’d) • Other financial institutions • Savings and loan associations (S&L) • A financial institution that offers checking and savings accounts and CDs and that invests most of its assets in home mortgage loans and other consumer loans • Credit unions • 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 local credit union 18 | 23

The American Banking Industry (cont’d) • Other financial institutions (cont’d) • Organizations that perform banking functions • Mutual savings banks • Insurance companies • Pension funds • Brokerage firms • Finance companies • Investment banking firms 18 | 24

Careers in Banking • The seven largest banks in the U.S. employ approximately 1,200,000 people • The U.S. Department of Labor expects the number of people employed in banking to grow more slowly than other jobs in the economy between now and the year 2018 • Traits of successful bankers • Honesty • Ability to interact with people • Strong background in accounting • Appreciation for the banking-finance relationship • Basic computer skills 18 | 25

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 the 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 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 18 | 26

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 • 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 18 | 27

Typical Services Provided by Banks Figure 18.4 18 | 28

Innovative Banking Services • Changes in the banking industry • Anticipated changes • More emphasis on evaluating the creditworthiness of loan applicants as a result of the recent economic crisis • An increase in government regulation of the industry • A reduction in the number of banks, S&Ls, credit unions, and financial institutions because of consolidation and mergers • Globalization of the banking industry 18 | 29

Innovative Banking Services (cont’d) • Changes in the banking industry (cont’d) • Anticipated changes (cont’d) • The importance of customer service as a way to keep customers from switching to competitors • Increased use of credit and debit cards and a decrease in the number of written checks • Increased competition from nonbank competitors that provide many of the same services as banks (S&Ls, credit unions) • Continued growth in online banking 18 | 30

Online Banking • Advantages • Easy access to account regardless of time or location • 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 18 | 31

Online Banking (cont’d) • Electronic funds 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 (POS) terminals • Electronic check conversion (ECC) 18 | 32

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 18 | 33

The FDIC and NCUA • Federal Deposit Insurance Corporation (FDIC) • Created as a result of the Depression, to restore public confidence in the banking industry to insure deposits against bank failures • FDIC provides deposit insurance of $250,000 per account • National Credit Union Association (NCUA) • Insures the deposits of credit union members for up to $250,000 per account 18 | 34

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 • Borrower • Person or business wishing to make a purchase • Lender • Bank or firm selling merchandise or service on credit • Interest charged for the loan is profit 18 | 35

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 Update your business plan Prepare a convincing cover letter Getting Money from a Bank or Lender After a Credit Crisis For individuals • 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 18 | 36

The Five C’s of Credit Management • 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 a loan • Conditions—general economic conditions that can affect a borrower’s ability to repay the loan 18 | 37

Credit Application Form Figure 18.5 18 | 38

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 • 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 18 | 39

New Protection for Consumers: The Credit Card Act of 2009 • Designed to level the playing field between credit card customers and financial institutions that issue credit cards • Disclosures regarding due dates, late fees, time required to pay off balances written in plain language • Protection against arbitrary rate increases, requires 45-day notice • Increased protection for students and people under 21 • Standardized billing dates • Requires fees to be reasonable in relation to a credit agreement violation • New measures of accountability such as posting contract on the Internet review by Federal Reserve Board • Increases penalties for companies that violate the Truth in Lending Act for credit card customers 18 | 40

Sound Collection Procedures • Techniques • Subtle reminders • Telephone calls • Personal visits • Legal action • Sound collection procedures • Firm • Fair, allowing for compromise • Not harassing 18 | 41

Chapter Eighteen