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The Role of the Banking Industry in the Economy Nearly everyone in the United States uses a bank to some

extent to maintain his or her finances. Banks have been a staple in the American economy since the establishment of the First Bank of the United States in 1791 (Federal Reserve Bank of Philadelphia, 2009). Most people may only recognize a bank as a place to deposit and withdraw funds or to make loans for a car, home, business, or some other asset. However, the banking industry is not this simple. PNC Financial Services, Bank of America, Citigroup, JPMorgan Chase, Wells Fargo, Comerica, and the thousands of community banks across the United States, such as Shelby State Bank in west Michigan and the Bank of Southern California, provide extremely important services to their customers as well as regional and national economies. A bank is, by definition, a financial intermediary that uses liquid assets (deposits) to finance the illiquid investments of borrowers in the form of loans (Krugman and Wells, 2009). Due to the establishment of the Federal Deposit Insurance Corporation in 1933, depositors are confident that their money is secure when it is deposited into a bank. Banks pay interest to these depositors for allowing the bank to access their money. The banks will then use these funds to make loans to borrowers who pay interest to the banks (Krugman et al., 2009). A number of entities act as borrowers: households seeking mortgage or consumer loans; federal, state, and local governments financing their outstanding debt; and nonfinancial businesses seeking to finance their business activities and investments (Samolyk, 2004). Through the process of making loans, banks perform a special role in financial markets: they allow for the facilitation of paying in installments; and they

produce credit for households and businesses, which can affect future borrowing by the businesses or households (Samolyk, 2004). The U.S. banking system consists of a small number of very large banks and a large amount of relatively small community banks. Large, commercial banks are defined as those owned by an organization with more than $1 billion in total banking assets, whereas community banks are owned by an organization with less than $1 billion in total banking assets (Federal Reserve Bank of Kansas City, 2003). Large banks often prefer specializing in impersonal, transaction-based deposit services, because they have a comparative advantage (read: more efficient/lower cost per unit) over community banks in these fields due to their size and access to technology (Federal Reserve Bank of Kansas City, 2003). Community banks are more interested than large banking organizations in offering personal service to depositors and borrowers of low to moderate wealth, because these types of banks depend more heavily on retail deposits for their funds than large banks and providing loans to people of low or moderate wealth requires a long-term relationship with the clients (Federal Reserve Bank of Kansas City, 2003). However, advances in information technology and the spread of online banking are likely to eliminate the demand for relationship-based services from community banks; as the financial information for small businesses becomes available online and creditscoring techniques improve due to the Internet, there will be less need for loan officers to collect subjective information on a loan applicant s prospects (Federal Reserve Bank of Kansas City, 2003). Large banks have also made a much bigger

commitment to online banking than community banks, as they provide a much wider array of services on their websites. Banks are operated much like any other business. They must profit in order to survive, and there are a number of ways that banks produce revenue. According to Senior Vice President of Corporate Banking for PNC Muskegon and Lakeshore 504 s (a non-profit corporation promoting economic development and job creation in West Michigan) Banker of the Year Tim Davison, interest on commercial, retail (individual), and mortgage loans makes up the largest source of revenue. Banks also earn revenue from deposit account fees, money management fees, trust activities, asset sales, trading, and investment banking (Samolyk, 2004). If a bank fails, the FDIC secures deposits. However, the federal government is not the one paying depositors when a bank fails: regulations require that the owners of banks hold substantially more assets than the value of bank deposits so that there is money available to depositors if the bank fails (Krugman et al., 2003). There are certainly regulations and limitations imposed by the Federal Reserve, federal, and state governments to restrict bank activity. These regulations are designed to stabilize the growth of the economy and to protect individuals and businesses from unfair practices. The Federal Reserve limits the amount of money banks can loan by setting a required amount of deposits a bank must reserve (reserve requirement/ratio) so that depositors have access to their money upon demand (Board of Governors of the Federal Reserve System, 2010). A high (low) reserve ratio prevents banks from loaning too much (little) money, which can cause inflation (recession). The Federal Reserve also charges an interest rate to banks

lending money from their regional Federal Reserve Bank. This interest rate, called the discount rate, prevents banks from lending too much money by restricting the amount of money banks seek from the Federal Reserve. Regulations also protect individuals and businesses from unfair lending practices. Tim Davison was able to explain some of these regulations and how they apply to the groups they affect. For personal loans, Davison says, there are usury rates that every state sets to limit the interest rates a bank can charge an individual. This helps ensure that credit is available to a large amount of people. According to Davison, there are also fair lending laws that ensure banks are treating individuals equally throughout the loan-making process and that credit standards are applied equally. This prevents things like red-lining, in which a bank loans money to everybody but a certain demographic, Davison claims. To protect companies during the commercial loan process, anti-tying laws prevent banks from placing ultimatums on their loans that require a company to do all their other business with that bank as well, according to Davison. Davison also addressed a bank s appraisal process: if I have a company that wants to finance to purchase some real estate and we need to get an appraisal of that real estate to see how much it is worth, we have to get a third party to conduct the appraisal and provide that value to make sure PNC isn t picking an appraiser that will give us the right value so that we can make the loan on the property. However, Davison is also critical of many of these regulations. Each new rule means more employees and more training. This

doesn t generate any revenue for the bank, but it is money the bank has to spend. PNC has an entire department the Compliance Department that is responsible

for ensuring that our internal policy is in compliance to federal policy. There s good reasons for most regulations, but many go overboard and end up costing the bank a lot of money. Perhaps banks most important function in regard to the economy at large is their ability to create money. Through the fractional reserve banking system, banks are only required to reserve a set fraction million in liabilities in the US 10% for banks with over $58.8

of their liabilities (deposits) and may loan out the

excess (Board of Governors of the Federal Reserve System, 2010; Murphy, 2010). These loans are deposited in another checking account (either by the borrower or whoever the borrower pays with the loan) and that money is free to be loaned out again (Murphy, 2010). For example, a deposit of $1000 at a reserve requirement of 10% means the bank can loan $900 of the initial deposit. This $900 is then deposited into a new checking account and $810 can be loaned from it. Nobel Prize winning economist Paul Krugman asserts the amount of money that can be created through this process is equal to the amount of the initial deposit multiplied by (1/reserve ratio) (Krugman et al., 2010). Therefore, a $1000 deposit with a reserve ratio of 10% can theoretically be expanded to $10,000 through the fractional reserve banking system. Banks also make certain that businesses are spending money properly. According to Tim Davison, banks track the money they ve loaned out after it is loaned because the only way a business can repay a loan is if they invest it in a cause that will make money. Davison also admits that banks sometimes make loans payable to contractors instead of the businesses borrowing the money

themselves. In this sense, banks ensure that investment occurs in an economy both by financing it in the first place and making sure it is being used responsibly. There is no need for government intervention to make sure banks are tracking their loans, because they have every incentive to do so on their own. While most people only use a bank to manage their money and keep it secure or to finance large purchases, banks have a much deeper role and responsibility. By making several loans using a single initial deposit through the fractional reserve banking system, banks effectively create money. Banks also fuel investment through financing and making sure loans are spent responsibly and effectively. Banks also do a service to depositors by paying them interest for allowing the banks to use their funds, so depositors may treat their deposits as investments as well because they are making money by depositing in a bank. While banks are formed in many sizes and for many purposes, they all provide extremely important services to individuals, businesses, and the economy-at-large.

Works Cited Davison, Tim. Personal interview. 17 Oct. 2011. Krugman, Paul, and Robin Wells. Macroeconomics. 2nd ed. New York: Worth Publishers, 2009. 381-409. Monetary Policy. Board of Governors of the Federal Reserve System, 2011. Web. 23 Oct. 2011. <http://www.federalreserve.gov/monetarypolicy/default.htm>. Murphy, Robert. "The Fractional Reserve Banking System Explained." The Market Oracle. 14 June 2010. Web. 23 Oct. 2011. <http://www.marketoracle.co.uk/Article20300.html>. Samolyk, Katherine. The Evolving Role of Commercial Banks in U.S. Credit Markets. FDIC Banking Review 16.2 (2004): 29,29-65. 23 Oct. 2011. "The Role of Community Banks in the U.S. Economy." Economic Review Federal Reserve Bank of Kansas City 88.2 (2003): 15-. 23 Oct. 2011.

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