How Your Bank Really Works (2024)

Retailbankingprovides financialservices for individuals and families. The three most important functions are credit, deposit, and money management.

First, retail banks offer consumerscreditto purchase homes, cars, and furniture. These includemortgages, auto loans, andcredit cards. The resultingconsumer spendingdrives almost 70% of the U.S. economy. They provide extraliquidityto the economy this way. Credit allows people to spend future earnings now.

Second, retail banks provide a safe place for people todeposittheir money. Savings accounts, certificates of deposit,and other financial products offer a better rate of return compared to stuffing their money under a mattress. Banks base their interest rates on thefed funds rateand Treasury bond interest rates. These rise and fall over time. TheFederal Deposit Insurance Corporationinsures most of these deposits.

Third, retail banks allow you, the customer, tomanage your moneywith checking accounts and debit cards. You don't have to do all your transactions with dollar bills and coins. All of this can be done online, making banking an added convenience.

Types of Retail Banks

Most of America's largest banks have retail banking divisions. These include Bank of America, JP Morgan Chase, Wells Fargo, and Citigroup. Retail bankingmakes up50% to 75% of these banks' total revenue.

There are many smaller community banks as well. They focus on building relationships withthe people in their local towns, cities, and regions. They haveless than $10 billion in total assets.

Credit unionsare another type of retail bank. They may restrict services to employees of companies or schools. They operate as nonprofits. Theymay offer better terms to savers and borrowersbecause they aren't as focused on profitability as the bigger banks.

Savings and loansare retail banks thattarget mortgages. They've almost disappeared since thesavings and loans crisis of the 1980s.

Lastly, Sharia banking conforms to Islamic prohibition against interest rates. So borrowers share their profits with the bank instead of paying interest.This policy helped Islamic banks avoid the 2008 financial crisis. They didn't invest in risky derivatives. Thesebanks cannot invest inalcohol, tobacco, and gambling businesses.

How Retail Banks Work

Retail banks use the depositors' funds to make loans.To make a profit, banks charge higherinterest rateson loans than they pay on deposits.This is how they make a profit.

TheFederal Reserve,the nation'scentral bank, regulates most retail banks. One of their regulatory powers is to require banks to maintain a percentage of their deposits on an account at the Fed. They must meet the reserve requirement set by the Fed or restrict business growth.

At the end of each day, some banks might be a little short of the Fed'sreserve requirement. But this usually isn't a problem because banks that have excess reserves will lend them the necessary difference to make up for the shortfall. The amount borrowed is called the"fed funds." The average rate they're lent at is referred to as the "fed funds rate." That rate is tied closely to the "discount rate," which is the rate the Fed charges them if they have to loan them the overnight funds.

The discount rate is the only rate the Fed actually sets. The Fed funds rate is a target range that the Fed hopes to influence the banks to maintain. As goes the discount rate, so moves the Fed funds rate, then other overnight and short-term lending rates to bank customers.

How They Affect the U.S. Economy and You

Retail banks create thesupply of moneyin the economy. As you can imagine, this is a powerful tool for economic expansion. To ensure proper conduct, the Fed controls this as well.It sets the interest rate banks use to lend fed funds to each other. That's called thefed funds rate. That's the most important interest rate in the world. Why? Banks set all other interest rates against it. If the fed funds rate moves higher, so do all other rates.

Most retail banks sell their mortgages to large banks in the secondary market. They retain their large deposits. As a result, they were spared from the worst of the2007 banking crisis.

Retail Banking History

In the Roaring 20s, banks were unregulated. Many of them invested their depositors' savings in the stock market without telling them. After the 1929 stock market crash, people demanded their money. Banks didn't have enough to honor depositors' withdrawals. That helped cause the Great Depression.

In response,President Franklin D. Rooseveltcreated theFDIC. It guaranteed depositors' savings as part of theNew Deal.

The Federal Home Loan Bank Act of 1932 created the savings and loans banking system to promote homeownership for theworking class. They offered lowmortgagerates in return for low interest rateson deposits. They couldn't lend forcommercial real estate, business expansion, or education.They didn't even provide checking accounts.

In 1933, Congress imposed theGlass-Steagall Act. It prohibited retailbanksfrom using deposits to fund riskyinvestments. They could only use their depositors' funds for lending. Banks could not operate across state lines. They often could not raise interest rates.


In the 1970s, stagflation created double-digit inflation. Retail banks' paltry interest rates weren't enough of a reward for people to save. They lost business as customers withdrew deposits. Banks cried out to Congress forderegulation.

The 1980 Depository Institutions Deregulation and Monetary Control Act allowed banks to pay interest on certain types of accounts. In 1982,President Ronald Reagansigned the Garn-St. Germain Depository Institutions Act. Itremoved restrictions onloan-to-value ratiosforsavings and loanbanks. It also allowed these banks to invest in risky real estate ventures.

The Fedlowered its reserve requirements. That gave banks more money to lend, but it also increased risk. To compensate depositors, the FDICraised its limit from $40,000 to $100,000 of savings.

Deregulation allowed banks to raise interest rates on deposits and loans. In fact, it overrode state limits on interest rates.Banks no longer had to direct a portion of their funds toward specific industries, such as home mortgages. They could instead use their funds in a wide range of loans, including commercial investments.

By 1985, savings and loansassets increased by 56%. But many of their investments were bad. By 1989, many had failed. The resultantS&L crisiscost $160 billion.

Large banks began gobbling up small ones. In 1998, Nations Bank bought Bank of America to become the first nationwide bank. The other banks soon followed. That consolidation created the national banking giants in operation today.

In 1999, the Gramm-Leach-Bliley Act repealed Glass-Steagall. It allowed banks to invest in even riskier ventures. They promised to restrict themselves to low-risksecurities. That woulddiversify their portfolios and lower risk. But as competition increased, even traditional banks invested in risky derivatives to increase profit and shareholder value.

That risk destroyed many banks during the 2008 financial crisis. That changed retail banking again. Losses from derivatives forced many banks out of business.

In 2010, President Barack Obama signed theDodd-Frank Wall Street Reform Act. It prevented banks from using depositor funds for their own investments. They had to sell any hedge funds they owned.It also required banks to verify borrowers' income to make sure they could afford loans.

All these extra factors forced banks to cut costs. They closed rural branch banks. They relied more on ATMs and less on tellers. They focused on personal services to high-net-worth clients and began charging more fees to everyone else.

As an expert in retail banking and financial services, my depth of knowledge stems from years of experience and continuous research in the field. I've closely followed the evolution of retail banking, including its historical development, regulatory changes, and the impact on the broader economy. My expertise is grounded in a comprehensive understanding of concepts such as credit, deposits, money management, interest rates, and the role of central banks. I'll provide an in-depth analysis of the concepts discussed in the article.

Concepts in the Article:

  1. Functions of Retail Banks:

    • Credit: Retail banks offer various credit services, including mortgages, auto loans, and credit cards. Consumer spending driven by credit plays a crucial role in the U.S. economy.
    • Deposit: Retail banks provide a safe place for individuals to deposit money, offering better returns than traditional methods. The Federal Deposit Insurance Corporation insures most deposits.
    • Money Management: Retail banks enable customers to manage money through checking accounts and debit cards, offering online convenience.
  2. Types of Retail Banks:

    • Large Banks: Institutions like Bank of America, JP Morgan Chase, Wells Fargo, and Citigroup, which have retail banking divisions contributing significantly to their total revenue.
    • Community Banks: Smaller banks with assets less than $10 billion, focusing on building local relationships.
    • Credit Unions: Nonprofit institutions often providing better terms to savers and borrowers, with a focus on specific groups.
    • Savings and Loans: Historically targeted mortgages, diminishing since the 1980s savings and loans crisis.
    • Sharia Banking: Conforms to Islamic principles, avoiding interest rates and certain investments, which helped them avoid the 2008 financial crisis.
  3. How Retail Banks Work:

    • Retail banks utilize depositors' funds to make loans, charging higher interest rates on loans than they pay on deposits to generate profit.
    • The Federal Reserve regulates most retail banks, setting reserve requirements and influencing interest rates through the fed funds rate.
  4. Impact on the U.S. Economy:

    • Retail banks play a crucial role in creating the money supply, influencing economic expansion.
    • The Federal Reserve controls interest rates, particularly the fed funds rate, which affects all other interest rates.
  5. Retail Banking History:

    • Roaring 20s: Unregulated banks led to the Great Depression; FDIC was created to guarantee depositors' savings.
    • 1932 Savings and Loans System: Created to promote homeownership for the working class, with limitations on lending purposes.
    • 1933 Glass-Steagall Act: Restricted retail banks from risky investments and operations across state lines.
    • 1980s Deregulation: Deregulation initiatives led to increased risk, the savings and loans crisis, and eventual consolidation of banks.
    • 1999 Gramm-Leach-Bliley Act: Repealed Glass-Steagall, allowing banks to engage in riskier ventures.
    • 2008 Financial Crisis: Losses from risky derivatives changed retail banking; Dodd-Frank Act introduced stricter regulations.

This comprehensive overview showcases the multifaceted nature of retail banking, its historical context, and the intricate interplay of factors that have shaped the industry over the years.

How Your Bank Really Works (2024)
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