CHAPTER 18 Understanding Money, Banking, and Credit 18.1 A WORD FROM THE AUTHORS In this chapter, we begin by outlining the functions and characteristics of money that make it an acceptable means of payment for products, services, and resources. Then, we consider the role of the Federal Reserve System in maintaining a healthy economy. Next, we describe the banking industry—commercial banks, savings and loan associations, credit unions, and other institutions that offer banking services. Then, we turn our attention to how banking practices meet the needs of customers. We also describe the safeguards established by the federal government to protect depositors against losses. In closing, we examine credit transactions, sources of credit information, and effective collection procedures. 18.2 TRANSITION GUIDE New in Chapter 18: Understanding Money, Banking, and Credit • A new Inside Business feature describes how Oregon-based Umpqua Bank is using customer service and technology to become the “World’s Greatest Bank.” • Information in the introductory paragraph for Chapter 18 has been shortened and now describes how individuals and businesses use banking services. • Figure 18.1, “The Consumer Price Index and the Purchasing Power of the Consumer Dollar,” has been updated and now provides information for 2012. • A new Personal Apps feature explains how inflation can affect purchasing power for consumers. • Figure 18.2, “The Supply of Money,” has new information on the amount of M1 and M2 in the U.S. economy at the time of publication. • The “Economic Crisis and the Fed’s Response” section has been revised to include current information about the state of the economy at the time of publication. • New information about the Federal Reserve’s discount rate at the time of publication has been provided in the section “Regulation of the Discount Rate.” • New information on why the number of checks processed through the Fed is decreasing is included in the section “Clearing Checks and Electronic Transfers.” • Information about how the Fed and the new Consumer Financial Protection Bureau share responsibility for enforcing the Truth-in-Lending Act has been provided in the “Selective Credit Controls” section. • Current goals for financial regulation and the Dodd–Frank Wall Street Reform and Consumer Protection Act are explained in the section “Banking and Financial Reform: New Regulations.” • New information on the number of national banks (1,400) and state banks (4 to 1 when compared to national banks) has been added to the “Commercial Banks” section. • Table 18.2, “The Seven Largest U.S. Banks, Ranked by 2011 Total Revenues,” has been updated to include information about revenues, profits, and employees for the largest banks in the United States. • In the section “Savings and Loan Associations,” the number of savings and loan associations (1,050) has been updated. Information about how the U.S. Comptroller of the Currency is now responsible for regulating S&Ls has also been provided. • The latest statistics available at the time of publication for the number of credit unions (7,300) has been given in the section “Credit Unions.” • In the section “Careers in the Banking Industry,” current information indicates that job growth in the banking industry is expected to be “average” between now and the year 2020. • Information about current interest rates for savings accounts and CDs has been provided in the section “Savings Accounts.” • The Sustaining the Planet feature, “UN Capital Development Fund,” has been deleted. • A new Entrepreneurial Success feature describes how Kiva.org helps individuals loan small amounts of money to struggling entrepreneurs who need financing. • A new Social Media feature describes how students can protect their personal identity from scam artists. • New information about the number of credit card users in America (160 million) has been provided in the section “Credit Card and Debit Card Transactions.” • The Going for Success feature, “Mobile Banking Lets Customers Make the Call,” has been deleted. • New information on mobile banking has been provided in the section “Online, Mobile, and International Banking.” • A new Going for Success feature explains how Google, PayPal, Visa, and other big companies are already competing to run the digital wallet that could replace more traditional methods of paying for goods and services. • New examples that describe how Walmart and Best Buy use EFT are provided in the section “Electronic Funds Transfer (EFT).” • The Spotlight Feature about FDIC coverage has been deleted. • A new Personal Apps feature explains why it is important to shop for the best interest rates when choosing a credit card, an auto loan, or a home mortgage. • The section, “Effective Credit Management,” has been shortened in this edition. • The Ethical Challenges & Successful Solutions feature, “Banks as Eco-Cops?,” has been deleted. • A new Table 18.3, “The Five C’s of Credit,” provides a brief explanation of character, capacity, capital, collateral, and conditions. • A new section, “Protection for Consumers,” describes federal regulations that level the playing field between consumers and credit card companies and lenders. • The “Sound Collection Procedures” section has been deleted. • A new Return to Inside Business about Umpqua Bank has been provided at the end of the chapter. • Video Case 18.1, “Chase Bank Helps Small Business Owners,” has been updated. • A new Case 18.2, “Bank of Hawaii Says ‘Aloha’ to Customers and Communities,” has been added. • The Building Skills for Career Success section contains a new Social Media Exercise. • The Exploring the Internet feature in Building Skills for Career Success has been deleted. 18.3 QUICK REFERENCE GUIDE Instructor Resource Location Transition Guide IM, pp. 694–695 Learning Objectives Textbook, p. 520; IM, p. 697 Brief Chapter Outline IM, pp. 697–698 Comprehensive Lecture Outline IM, pp. 698–715 At Issue: Should the United States become a cashless society? IM, p. 712 Entrepreneurial Success Kiva.org Connects Microloan Borrowers and Lenders Textbook, p. 535 Social Media Outsmart the Scam Artists Textbook, p. 536 Going for Success Vying to Run Your Digital Wallet Textbook, p. 537 Inside Business How Umpqua Bank Became “The World’s Greatest Bank” Textbook, p. 521 Return to Inside Business Textbook, p. 543 Questions and Suggested Answers, IM, p. 716 Marginal Key Terms List Textbook, p. 545 Review Questions Textbook, p. 545 Questions and Suggested Answers, IM, pp. 716–719 Discussion Questions Textbook, p. 546 Questions and Suggested Answers, IM, pp. 719–720 Video Case 18.1 (Chase Bank Helps Small Business Owners) and Questions Textbook, p. 546 Questions and Suggested Answers, IM, p. 721 Case 18.2 (Bank of Hawaii Says “Aloha” to Customers and Communities) and Questions Textbook, p. 547 Questions and Suggested Answers, IM, pp. 721–722 Building Skills for Career Success Textbook, pp. 547–549 Questions and Suggested Answers, IM, pp. 722–725 IM Quiz I & Quiz II IM, pp. 726–728 Answers, IM, p. 728 Classroom Exercises IM, pp. 729–730 18.4 LEARNING OBJECTIVES After studying this chapter, students should be able to: 1. Identify the functions and characteristics of money. 2. Summarize how the Federal Reserve System regulates the money supply to maintain a healthy economy. 3. Describe the organizations involved in the banking industry. 4. Identify the services provided by financial institutions. 5. Understand how financial institutions are changing to meet the needs of domestic and international customers. 6. Explain how deposit insurance protects customers. 7. Discuss the importance of credit and credit management. 18.5 BRIEF CHAPTER OUTLINE I. What Is Money? A. The Functions of Money 1. Money as a Medium of Exchange 2. Money as a Measure of Value 3. Money as a Store of Value B. Important Characteristics of Money 1. Divisibility 2. Portability 3. Stability 4. Durability 5. Difficulty of Counterfeiting C. The Supply of Money: M1 and M2 II. The Federal Reserve System A. Economic Crisis and the Fed’s Response B. Regulation of Reserve Requirements C. Regulation of the Discount Rate D. Open-Market Operations E. Other Fed Responsibilities 1. Serving as Government Bank 2. Clearing Checks and Electronic Transfers 3. Inspection of Currency 4. Selective Credit Controls III. The American Banking Industry A. Banking and Financial Reform: New Regulations B. Commercial Banks C. Other Financial Institutions 1. Savings and Loan Associations 2. Credit Unions 3. Organizations that Perform Banking Functions D. Careers in the Banking Industry IV. Traditional Services Provided by Financial Institutions A. Checking Accounts B. Savings Accounts C. Short- and Long-Term Loans D. Credit Card and Debit Card Transactions V. Innovative Banking Services A. Changes in the Banking Industry B. Online, Mobile, and International Banking 1. Electronic Funds Transfer (EFT) 2. International Banking Services VI. The FDIC and NCUA VII. Effective Credit Management A. Getting Money from a Bank or Lender after the Economic Crisis B. The Five C’s of Credit Management C. Checking Credit Information D. Protection for Consumers 18.6 COMPREHENSIVE LECTURE OUTLINE Most people regard a bank, savings and loan association, or similar financial institution as a place to deposit or borrow money. When you deposit money, you receive interest. When you borrow money, you must pay interest. The resource that will be transformed into money to repay the loan is the salary you receive for your labor. Businesses also transform resources into money. I. WHAT IS MONEY? The members of some societies still exchange goods and services through barter, without using money. A barter system is a system of exchange in which goods or services are traded directly for other goods or services. The trouble with the barter system is that the two parties in an exchange must need each other’s product at the same time, and the two products must be roughly equal in value. So even very isolated societies soon develop some sort of money to eliminate the inconvenience of trading by barter. Money is anything a society uses to purchase products, services, or resources. The most commonly used objects are metal coins and paper bills, which together are called “currency.” Teaching Tip: Remind students that early settlers and frontiersmen in America used beads and fur pelts as a form of exchange with the Native Americans. Ask them if they used any form of barter when they were kids—for example, exchanging sandwiches, baseball cards, etc. A. The Functions of Money. Money aids in the exchange of goods, services, and resources and serves three specific functions of money in any society. 1. Money as a Medium of Exchange. A medium of exchange is anything accepted as payment for products, services, and resources; the key word in this definition is “accepted.” As long as the owners of products, services, and resources accept money in an exchange, it is performing this function. 2. Money as a Measure of Value. A measure of value is a single standard or “yardstick” used to assign values to, and compare the values of products, services, and resources. a) Money serves as a measure of value because the prices of all products, services, and resources are stated in terms of money. b) It is thus the “common denominator” that we use to compare products and decide which ones we will buy. 3. Money as a Store of Value. Money received by an individual or a firm need not be used immediately. It may be held and spent later. Hence, money serves as a store of value, or a means of retaining and accumulating wealth. a) Value that is stored as money is affected by inflation—the general rise in the level of prices. b) One major problem caused by inflation is a loss of stored value. As prices go up in an inflationary period, money loses value because it can buy less. c) To determine the effect of inflation on the purchasing power of a dollar, economists often refer to a consumer price index such as the one illustrated in Figure 18.1). The consumer price index measures the changes in prices of a fixed basket of goods purchased by a typical consumer, including food, transportation, housing, clothing, medical care, recreation, education, communication, and other goods and services. B. Important Characteristics of Money. To be acceptable as a medium of exchange, money must be easy to use, trusted, and capable of performing the three functions. To meet these requirements, money must possess the following five characteristics: 1. Divisibility. The standard unit of money must be divisible into smaller units to accommodate small purchases as well as large ones. 2. Portability. Money must be small enough and light enough to be carried easily. 3. Stability. Money should retain its value over time. When it does not, people tend to lose faith in their money. When money becomes extremely unstable, people may turn to other means of storing value, such as gold, jewels, and real estate. 4. Durability. The objects that serve as money should be strong enough to last through reasonable usage. 5. Difficulty of Counterfeiting. If a nation’s currency were easy to counterfeit, its citizens would be uneasy about accepting it as payment. Teaching Tip: Consider using the “Money, Money, Money!” group exercise here. Groups of students are asked to decide what to use as currency when stranded on a desert island. This exercise takes about 20 minutes. C. The Supply of Money: M1 and M2. How much money is there in the United States? Before we can answer that question, we need to define a couple of concepts. 1. A demand deposit is an amount on deposit in a checking account. It is called a demand deposit because it can be claimed immediately by presenting a properly made out check, withdrawing cash from an ATM, or transferring money between accounts. 2. A time deposit is an amount on deposit in an interest-bearing savings account. a) Financial institutions generally permit immediate withdrawal of money from savings accounts. However, they can require written notice prior to withdrawal, and the customer may need to pay an early withdrawal penalty. b) The time between notice and withdrawal is what leads to the name time deposit. 3. There are two main measures of the supply of money: M1 and M2. a) The M1 supply of money is a narrow definition and consists only of currency, demand, and other checkable deposits. b) The M2 supply of money consists of M1 (currency and demand deposits) plus savings accounts, certain money-market securities, and certificates of deposit (CDs) of less than $100,000. The M2 definition of money is based on the assumption that time deposits can be converted to cash for spending. c) Figure 18.2 shows the elements of the M1 and M2 supplies. Teaching Tip: Consider showing the Fox Business video “John Stossel: Speaks to Ex-Federal Reserve Employee” that explores why people couldn’t create competing currencies. It also discusses the role of the Federal Reserve in creating money. The Web site for this video is http://www.youtube.com/watch?v=0qZszkWuADM. II. THE FEDERAL RESERVE SYSTEM. How do Federal Reserve actions affect me? What is the Federal Reserve System? Federal Reserve Board (often referred to as the “Fed”) activities have an impact on the interest rates you pay for loans and credit cards. The Fed lowers the interest rates that banks pay to borrow money from it in an effort to shore up a sagging economy. When the Fed lowers rates, banks pay less to borrow money from the Fed. In turn, they often lower the interest rates they charge for business loans, home mortgages, car loans, and even credit cards. Lower rates often provide an incentive for both business firms and individuals to buy goods and services. This helps to restore the economic health of the nation. On the other hand, rate increases are designed to sustain economic growth while controlling inflation. When the Fed raises rates, banks must pay more to borrow money from the Fed. And the banks, in turn, charge higher rates for both consumer and business loans. Now let’s answer the second question. The Federal Reserve System is the central bank of the United States and is responsible for regulating the banking industry. 1. Created by Congress on December 23, 1913, its mission is to maintain an economically healthy and financially sound business environment in which banks can operate. 2. The Federal Reserve System is controlled by the seven members of its board of governors who meet in Washington, D.C. a) Each governor is nominated by the president and confirmed by the Senate for a 14-year term. b) The president also selects the chairman and vice chairman of the board from among the board members for four-year terms. 3. The Federal Reserve System includes 12 district banks located in major cities throughout the United States, as well as 24 branch banks. (See Figure 18.3.) a) All national (federally chartered) banks must be members of the Fed. b) State banks may join if they choose to and if they meet membership requirements. A. Economic Crisis and the Fed’s Response. The Fed was responsible for maintaining the health of the U.S. economy during the recent economic crisis. To maintain a healthy economy, the Federal Reserve Board took a number of specific steps to minimize the effects of the crisis on both businesses and individuals. 1. It provided liquidity. The Fed allowed banks in need of cash to borrow money from the Federal Reserve System. Without the ability to borrow needed funds from the Fed, some banks were in danger of failing. The Fed’s lending activities also helped encourage other banks to continue loaning money to their customers. 2. It supported troubled financial markets. During the first part of the crisis, investors feared that many commercial paper issues would become worthless, and they stopped investing in money-market funds that held commercial paper. Commercial paper is a short-term promissory note issued by a large corporation. In order to restore the commercial paper market and lower the cost of this type of short-term financing, the Federal Reserve provided secured loans to the financial institutions that sell this type of investment; as a result, the commercial paper market is now functioning well. 3. It supported financial institutions. The failure of investment bank Lehman Brothers and the commercial bank Washington Mutual fueled fears that other large financial institutions could fail. The resulting panic could have caused a full-scale “run” on banks and a breakdown of the entire financial system. To restore faith in the system, the Fed agreed to provide non-recourse loans to large banks which helped to calm investors and avoid an even larger financial meltdown. 4. It conducted stress tests of major banks. In the spring of 2009, the Federal Reserve, along with other federal agencies, conducted an unprecedented review of the financial condition of the 19 largest U.S. banks to determine if they could weather the financial crisis. Banks that failed the test were required to obtain new capital by selling stock or bonds or accept federal funds. 5. The Fed’s actions did help to restore confidence in the financial system, to encourage continued lending, to stabilize an unstable economy, and to provide additional time to create a financial rescue plan to restore the nation’s economy. At the time of publication, although the health of the banking and financial industry has improved, there are still concerns about the long-term effect of the Federal Reserve’s actions, what future actions may be needed to ensure continued economic growth, and the cost of the financial rescue plan. 6. The most important function of the Fed is to use monetary policy to regulate the nation’s supply of money in such a way as to maintain a healthy economy. The goals of monetary policy are continued economic growth, full employment, and stable prices. Three methods are used to implement the Fed’s monetary policy. a) Controlling bank reserve requirements b) Regulating the discount rate c) Running open-market operations B. Regulation of Reserve Requirements. The reserve requirement is the percentage of its deposits a bank must retain, either in its own vault or on deposit with its Federal Reserve district bank. The remainder is available to fund loans. 1. The present reserve requirements range from 0 to 10 percent. 2. Once reserve requirements are met, banks can use remaining funds to create more money and make more loans through a process called deposit expansion. a) Each time a loan is made and the borrower deposits the money in the lending bank, the deposit expansion process can be repeated. b) Of course, the bank’s lending potential becomes steadily smaller and smaller as it makes more loans. c) Since bankers are usually very conservative by nature, they will not use deposit expansion to maximize their lending activities; they will take a more middle-of-the-road approach. 3. The Fed’s board of governors sets the reserve requirements. a) When it increases the requirement, banks have less money available for lending. Fewer loans are made, and the economy tends to slow. b) When it decreases the requirement, the Fed can make additional money available for lending to stimulate a slow economy. C. Regulation of the Discount Rate. Member banks may borrow money from the Fed to satisfy the reserve requirement and to make additional loans to their customers. The interest rate the Fed charges for loans to member banks is called the discount rate. 1. It is set by the Fed’s board of governors. 2. In August 2007, in an attempt to stabilize the economy and encourage lending, the Federal Reserve began lowering the discount rate. By February 2010, the discount rate reached its lowest level and remains at 0.75 percent at the time of publication. 3. When the Fed lowers the discount rate, it is easier and cheaper for banks to obtain money. Member banks make more loans and charge lower interest rates. This increases the amount of money available to both consumers and businesses and generally stimulates the nation’s economy. 4. When the Fed raises the discount rate, banks begin to restrict loans. They increase the interest rates they charge and tighten their own loan requirements. The overall effect is to slow the economy—to check inflation. D. Open-Market Operations. The federal government finances its activities partly by buying and selling securities issued by the U.S. Treasury. These securities, which pay interest, may be purchased by any individual, firm, or organization—including the Fed. Open-market operations are the buying and selling of U.S. government securities by the Federal Reserve System for the purpose of controlling the supply of money. Teaching Tip: The Fed will raise interest rates when inflation levels begin rising to unacceptable levels. Consider, for example, if everybody’s money lost 10 percent of its value annually. Ask your students who the winners and losers are when inflation occurs. Most students will quickly identify retired people and others on fixed incomes as losers. All buyers and creditors are hurt, as producers raise prices to compensate. Most debtors will benefit. What students may not realize is how inflation redistributes wealth and income. The middle class can be hit the hardest, as the poor have little wealth to lose, while the rich are often able to transfer their wealth into forms not adversely affected by inflation (e.g., gold, precious metals, land, and foreign deposits). 1. The Federal Open Market Committee (FOMC) is charged with carrying out the Federal Reserve’s open-market operations by buying and selling government securities—usually U.S. Treasury bills—through the trading desk of the Federal Reserve Bank of New York. 2. To reduce the nation’s money supply, the FOMC sells government securities on the open market. The money it receives from purchasers is taken out of circulation. Thus, less money is available for investment, purchases, or lending. 3. To increase the money supply, the FOMC buys government securities. The money it pays for the securities goes back into circulation, making more money available to individuals and firms. 4. Because the major purchasers of government securities are financial institutions, open-market operations tend to have an immediate effect on lending and investment. 5. Of the three tools used to influence monetary policy, the use of open-market operations is the most important. 6. When the Federal Reserve buys and sells securities, the goal is to affect the federal funds rate; the interest rate at which a bank lends funds to another bank in order to meet the borrowing bank’s reserve requirements. 7. There is a difference between the federal funds rate and the discount rate. The federal funds rate is the interest rate paid by a bank to borrow funds from another bank. The discount rate is the interest rate paid by a bank to borrow funds from the Federal Reserve. 8. Table 18.1 summarizes the effects of open-market operations and the other tools used by the Fed to regulate the money supply and control the economy. E. Other Fed Responsibilities. The Fed is responsible for serving as the government’s bank, clearing checks and electronic transfers, inspecting currency, and applying selective credit controls. 1. Serving as Government Bank. As the government’s bank, it processes a variety of financial transactions involving trillions of dollars each year. 2. Clearing Checks and Electronic Transfers. A check written by a customer of one bank and presented for payment to another bank in the same town may be processed through a local clearinghouse, but the procedure becomes more complicated when the banks are not in the same town. a) At one point, the Fed is responsible for the prompt and accurate collection of 15 to 17 billion checks each year. b) Today, the number of paper checks cleared through the Fed is decreasing because of improved automation and electronic equipment. c) Banks that use the Fed to clear checks are charged a fee for this service. d) Through the use of automation and electronic equipment, most checks can be cleared within two or three days. Teaching Tip: Go to one of the Federal Reserve Web sites (http://www.federalreserve.gov/consumer info/bankaccountservices.htm) for details regarding EFT safety and monitoring. Students will probably be fascinated by the mechanics of electronic banking. You can also use one of these sites to discuss why the three- to four-day “float” between the writing of a check and its presentation for payment to your account is gone, or you can follow up on the new credit card protections. 3. Inspection of Currency. When member banks deposit their surplus cash in a Federal Reserve Bank, the currency is inspected. Bills unfit for further use are separated and destroyed. 4. Selective Credit Controls. The Fed is responsible for enforcing the Truth-in-Lending Act, which Congress passed in 1968. This act requires lenders to state clearly the annual percentage rate and total finance charge for a consumer loan. The Federal Reserve System also sets the margin requirements for stock transactions. a) The margin is the minimum amount (expressed as a percentage) of the purchase price that must be paid in cash. The current margin requirement is 50 percent. III. THE AMERICAN BANKING INDUSTRY. Banks, savings and loan associations, credit unions, and other financial institutions were at the center of the nation’s economic problems. Aggressive lending practices that led to record numbers of home foreclosures and nonperforming loans caused a financial meltdown. As the economic problems within the banking industry became larger, the ability to borrow money became more difficult for both individuals and business firms—a very serious problem for both borrowers and lenders. In fact, the nation’s economic problems (and the world’s) became so severe that the government needed to take action. Both the Bush and the Obama administrations developed financial plans to rescue the economy. In addition, both the Federal Reserve Board and the U.S. Treasury took action. Eventually, the rescue plans did help relieve at least some of the financial problems associated with the economic crisis. Still, there was need for more changes in the way that banks and financial institutions operate. A. Banking and Financial Reform: New Regulations 1. Although there are many critics of increased regulation, it was apparent something needed to be done to prevent the type of economic problems the nation experienced during the economic crisis. 2. According to President Obama, the goals of new government banking and financial regulations are more than justified in the wake of the crisis and include the following: • Protect American families from unfair and abusive financial and banking practices. • Close the gaps in our financial system that allowed large banks and financial firms to avoid strong, comprehensive federal oversight. To accomplish these goals, the Dodd–Frank Wall Street Reform and Consumer Protection Act was passed in 2010. The act: ○ Creates a new Consumer Financial Protection Bureau. ○ Gives the government the power to seize and close down large failing financial firms in an orderly fashion. ○ Increases government regulation of firms in the financial and banking industry. ○ Curbs the high-risk investment strategies that led to the financial problems at some major financial institutions and the nation’s economic crisis. ○ Creates a Financial Stability Oversight Council that serves as an early warning system of potential risks and problems in the financial system. 3. To provide this type of comprehensive reform, it will be necessary to make sure banks and financial institutions are complying with the new regulations. a) As a result, future regulations will subject banks and financial institutions to more in-depth evaluation to determine their financial health and to spot signs of trouble before they affect individuals, the American economy, and the world economy. 4. In addition to the nation’s economic problems, competition among banks, savings and loan associations, credit unions, and other business firms that want to perform banking activities has never been greater. Many are now using social media sites to attract new customers and retain old ones. B. Commercial Banks. A commercial bank is a profit-making organization that accepts deposits, makes loans, and provides related services to its customers. 1. The bank’s primary goal—its mission—is to meet the needs of its customers while earning a profit. 2. Because banks deal with money belonging to individuals and other business firms, banks must meet certain requirements before they receive a charter (or permission to operate) from either federal or state banking authorities. 3. A national bank is a commercial bank chartered by the U.S. Comptroller of the Currency. a) These banks must conform to federal banking regulations and are subject to unannounced inspections by federal auditors. 4. A state bank is a commercial bank chartered by the banking authorities in the state in which it operates. a) State banks outnumber national banks by about four to one, but they tend to be smaller than national banks. b) They are subject to unannounced inspections by both state and federal auditors. 5. Table 18.2 lists the seven largest U.S. banks; these are classified as national banks. C. Other Financial Institutions. In addition to commercial banks, at least eight other types of financial institutions perform either full or limited banking services. 1. Savings and Loan Associations. A savings and loan association (S&L) is 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. a) Originally, S&Ls were permitted to offer their depositors only savings accounts. But since Congress passed legislation regarding S&Ls in the 1980s, they have been able to offer other services to attract depositors. b) Federal associations are supervised by the U.S. Comptroller of the Currency, a branch of the U.S. Treasury. c) State-chartered S&Ls are subjected to unannounced audits by state authorities. 2. Credit Unions. A credit union is a financial institution that accepts deposits from, and lends money to, only those people who are its members. a) Usually, the membership consists of employees of a particular firm, people in a particular profession, or those who live in a community served by a local credit union. b) Credit unions may pay higher interest on deposits than commercial banks and S&Ls, and they may provide loans at lower cost. c) The National Credit Union Administration regulates federally chartered credit unions. State authorities regulate credit unions with state charters. 3. Organizations that Perform Banking Functions. Six other types of financial institutions are involved in limited banking activities. a) Mutual savings banks are financial institutions that are owned by their depositors and offer many of the same services offered by banks, S&Ls, and credit unions. Unlike the profits of other types of financial institutions, the profits of a mutual savings bank go to the depositors, usually in the form of slightly higher interest rates on savings. b) Insurance companies provide long-term financing for office buildings, shopping centers, and other commercial real estate projects. The funds used for this type of financing are obtained from policyholders’ insurance premiums. c) Pension funds are established by employers to guarantee their employees a regular monthly income on retirement. Contributions may come from the employer, the employee, or both. Pension funds earn additional income through generally conservative investments in stocks, bonds, and government securities, as well as through financial real estate developments. d) Brokerage firms offer combination savings and checking accounts that pay higher-than-usual interest rates. e) Finance companies provide financing to individuals and businesses that may not be able to get financing from banks, savings and loan associations, or credit unions. The interest rates charged by these lenders may be higher than the interest rates charged by other financial institutions. f) Investment banking firms are organizations that assist corporations in raising funds, usually by helping sell new issues of stocks, bonds, or other financial securities. Although these firms do not accept deposits or make loans like traditional banking firms, they do help companies raise millions of dollars. D. Careers in the Banking Industry. As indicated in Table 18.2, the seven largest banks in the United States employ approximately 1,200,000 people. If you add to this amount the people employed by smaller banks and those employed by S&Ls, credit unions, and other financial institutions, the number of employees grows dramatically. According to the Career Guide to Industries, published by the U.S. Department of Labor, banking employment is projected to have average growth between now and the year 2020. 1. To be successful in the banking industry, you need a number of different skills. a) You must be honest. b) You must be able to interact with people. c) You need a strong background in accounting. d) You need to appreciate the relationship between banking and finance. e) You should possess basic computer skills. 2. Depending on qualifications, work experience, and education, starting salaries are generally between $18,000 and $30,000 a year, but it is not uncommon for college graduates to earn $35,000 a year or more. IV. TRADITIONAL SERVICES PROVIDED BY FINANCIAL INSTITUTIONS. Typical services provided by a bank or other financial institutions are shown in Figure 18.4. A. Checking Accounts. Firms and individuals deposit money in checking accounts (demand deposits) so that they can write checks to pay for purchases. 1. A check is a written order for a bank or other financial institution to pay a stated dollar amount to the business or person indicated on the face of the check. a) Many financial institutions offer free checking; others charge activity fees (or service charges) for checking accounts, which generally range between $5 and $20 per month for individuals. b) For businesses, monthly charges are based on the average daily balance in the checking account and/or on the number of checks written. Typically, charges for business checking accounts are higher than those for individual accounts. 2. Today, most financial institutions offer NOW (negotiable order of withdrawal) accounts. A NOW account is an interest-bearing checking account. a) The usual interest rate is between 0.05 and 0.25 percent. Online Internet banks pay slightly higher interest rates. b) Although banks and other financial institutions may pay low interest rates on checking accounts, even small earnings are better than no earnings. c) In addition to interest rates, compare monthly fees before opening a checking account. B. Savings Accounts 1. Savings accounts (time deposits) provide a safe place to store money and a very conservative means of investing. 2. A depositor who is willing to leave money on deposit with a bank for a set period of time can earn a higher rate of interest. a) A certificate of deposit (CD) is 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. b) The rate always depends on how much is invested and for how long. Generally, the longer the period of time until maturity, the higher the rate. c) Depositors are penalized for early withdrawal of funds. C. Short- and Long-Term Loans. Banks, savings and loan associations, credit unions, and other financial institutions provide short- and long-term loans to both individuals and businesses. 1. Short-term business loans must be repaid within one year or less. Typical uses for the money include solving cash-flow problems, purchasing inventory, financing promotional needs, and meeting unexpected emergencies. a) To ensure that short-term money will be available when needed, many firms establish a line of credit. A line of credit is a loan that is approved before the money is actually needed. b) Even with a line of credit, a firm may not be able to borrow money if the bank does not have sufficient funds available. For this reason, some firms prefer a revolving credit agreement, which is a guaranteed line of credit. 2. Long-term business loans are repaid over a period of years. a) The average length of a long-term business loan is generally three to seven years but sometimes as long as 15 years. b) Long-term loans are used most often to finance the expansion of buildings and retail facilities, mergers and acquisitions, replacement of equipment, or product development. c) Most lenders require some type of collateral for long-term loans. Collateral is real estate or property (stocks, bonds, land, equipment, or any other asset of value) pledged as security for a loan. 3. Repayment terms and interest rates for both short- and long-term loans are arranged between the lender and the borrower. Borrowers should always “shop” for a loan. D. Credit Card and Debit Card Transactions. By the end of 2012, 160 million Americans will use credit cards to pay for goods and services. Why have credit cards become so popular? 1. By depositing charge slips in a bank or other financial institution, the merchant can instantly convert credit card sales into cash. 2. In return for processing the merchant’s credit card transactions, the bank charges a fee that ranges between 1.5 and 4 percent. 3. There are differences between credit cards and debit cards. a) A debit card electronically subtracts the amount of your purchase from your bank account at the moment the purchase is made. b) By contrast, when you use your credit card, the credit card company extends short-term financing, and you do not make payment until you receive your next statement. c) Debit cards are used most commonly to obtain cash at ATMs and to purchase products and services from retailers. V. INNOVATIVE BANKING SERVICES A. Changes in the Banking Industry. Experts all agree that banking will change. The most obvious changes are as follows: 1. More emphasis on evaluating the creditworthiness of loan applicants as a result of the recent financial crisis 2. An increase in government regulation of the banking industry 3. A reduction in the number of banks, S&Ls, credit unions, and financial institutions because of consolidation and mergers 4. Globalization of the banking industry as the economies of individual nations become more interrelated 5. The importance of customer service as a way to keep customers from switching to competitors 6. Increased use of credit and debit cards and a decrease in the number of written checks 7. Continued growth in online banking B. Online, Mobile, and International Banking. Online banking allows you to access your bank’s computer system from home, from the office, or even while you are traveling. The advantages include the following: (1) the ability to obtain current account balances, (2) the capability to deposit checks without leaving your home or office, (3) the convenience of transferring funds from one account to another, (4) the ability to pay bills, (5) the convenience of seeing which checks have cleared, (6) simplified loan application procedures. Online banking also provides a number of advantages for the financial institution, including lower cost of processing large numbers of transactions. Financial institutions believe that online banking offers increased security because fewer people handle fewer paper documents. Many banks now offer mobile banking via text messages or apps (software applications) downloaded to cell phones and other electronic devices. This is especially convenient for busy businesspeople who don’t live or work next door to a bank branch and can’t always get to a computer to use online banking. 1. Electronic Funds Transfer (EFT). An electronic funds transfer (EFT) system is a means of performing financial transactions through a computer terminal or telephone hookup. The following EFT applications are changing how banks do business. a) Automated teller machines (ATMs). An ATM is an electronic bank teller—a machine that provides almost any service a human teller can provide. Once the customer is properly identified, the machine dispenses cash from the customer’s checking or savings account or makes a cash advance charged to a credit card. Customers have access to them at all times of the day or night, although there may be a fee for each transaction. b) Automated clearinghouses (ACHs). Designed to reduce the number of paper checks, ACHs process checks, recurring bill payments, Social Security benefits, and employee salaries, thus saving time and effort and adding a measure of security. c) Point-of-sale (POS) terminals. A POS terminal is a computerized cash register located in a retail store and connected to a bank’s computer. d) Electronic check conversion (ECC) is a process used to convert information from a paper check into an electronic payment for merchandise, services, or bills. When you give your completed check to a store cashier, the check is processed through an electronic system that captures your banking information and the dollar amount of the check. The funds to pay for your transaction are transferred into the business firm’s account. Bankers and business owners are generally pleased with online banking and EFT systems. EFT and online banking are fast, and they eliminate the costly processing of checks. a) However, many bank customers are reluctant to use online banking or EFT systems. Some customers simply don’t like “the technology;” others fear the computer will garble their accounts. 2. International Banking Services. For international businesses, banking services are extremely important. Depending on the needs of an international firm, a bank can help by providing a letter of credit or a banker’s acceptance. a) A letter of credit is 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—usually 30 to 60 days. Certain conditions like delivery of the merchandise may be specified before payment is made. b) A banker’s acceptance is a written order for the bank to pay a third party a stated amount of money on a specific date. With a banker’s acceptance, no conditions are specified. c) Both a letter of credit and a banker’s acceptance are popular methods of paying for import and export transactions. d) One other international banking service should be noted. Banks and other financial institutions provide for currency exchange. Teaching Tip: Ask students how many of them have studied or plan to study overseas before they graduate. What might they need to do to have credit and be liquid while they travel? One of the things they may consider is taking a letter of introduction from their U.S. bank. VI. THE FDIC AND NCUA. During the Great Depression that began in 1929, a number of banks failed, and their depositors lost all their savings. To make sure this did not happen again and to restore public confidence in the banking industry, Congress enacted legislation that created the Federal Deposit Insurance Corporation (FDIC) in 1933. The primary purpose of the FDIC is to insure deposits against bank failures. Today, the FDIC provides basic deposit insurance of $250,000 per depositor. Deposits maintained in different categories of legal ownership are insured separately. Thus, you can have coverage for different categories of ownership in a single institution. The most common categories of ownership are single (or individual) ownership and joint ownership. A depositor also may obtain additional coverage by opening separate accounts in different financial institutions. To determine if your deposits are insured or if your bank or S&L is insured, visit the FDIC Web site at www.fdic.gov. To obtain coverage, banks and S&Ls must pay insurance premiums to the FDIC. In a similar manner, the National Credit Union Association (NCUA) insures deposits in member credit unions for up to $250,000 per depositor. Like FDIC coverage, increased coverage is provided for accounts with different categories. The FDIC and NCUA have improved banking in the United States. When either of these organizations insures a financial institution’s deposits, they reserve the right to periodically examine that institution’s operations. If a bank, S&L, savings bank, or credit union is found to be poorly managed, it is reported to the proper banking authority. VII. EFFECTIVE CREDIT MANAGEMENT. Credit is immediate purchasing power that is exchanged for a promise to repay borrowed money, with or without interest, at a later date. Banks and other financial institutions lend money because they are in business for that purpose. The interest they charge is what provides their profit. Other businesses extend credit to their customers for at least three reasons: (1) some customers cannot afford to pay the entire amount of their purchases immediately, but they can repay credit in a number of smaller payments; (2) some firms are forced to sell goods or services on credit to compete effectively when other firms offer credit to their customers; and (3) firms can realize a profit from interest charges. Teaching Tip: Use the “Who’s Got the Interest?” exercise here. This is a five-minute exercise during which students brainstorm transactions that result in interest paid to them and transactions that cause them to pay interest to others. It demonstrates the need to manage credit carefully. A. Getting Money from a Bank or Lender after the Economic Crisis. While lenders need interest from loans to help pay their business expenses and earn a profit, they also want to make sure that the loans they make will be repaid. After the recent economic crisis, bankers, lenders and suppliers, and credit card companies are much more careful when evaluating credit applications. 1. For individuals, the following suggestions may be helpful when applying for a loan: a) Obtain a loan application and complete it at home. Answer all the questions on the loan application. b) Be prepared to describe how you will use the money and how the loan will be repaid. c) For most loans, an interview with a loan officer is required. Here again, preparation is the key. d) If your loan is rejected, try to analyze what went wrong. 2. Business owners in need of financing may find the following additional tips helpful: a) It is usually best to develop a relationship with your banker before you need financing. b) Help the banker understand what your business is and how you may need future financing for expansion, cash-flow problems, or unexpected emergencies. c) Apply for a preapproved line of credit or revolving credit agreement even if you don’t need the money. d) In addition to the application, supply CPA-prepared financial statements and business tax returns for the last three years and your own personal financial statements and tax returns for the same period. e) Update your business plan in case the lender wants to review your plan. Be sure the sales estimates and other projections are realistic. f) Write a cover letter describing how much experience you have, whether you are operating in an expanding market, or any other information that would help convince the banker to provide financing. B. The Five C’s of Credit Management. When a business extends credit to its customers, it must face the fact that some customers will be unable or unwilling to pay for their credit purchases. Most lenders build their credit policies around the five C’s of credit. (See Table 18.3.) 1. Character—the borrower’s attitude toward credit obligations 2. Capacity—the financial ability to meet credit obligations (to make regular loan payments) 3. Capital—the term “capital” as used here refers to the borrower’s assets or net worth 4. Collateral—real estate or property including stocks, bonds, equipment, or any other asset pledged as security for a loan 5. Conditions—general economic conditions that can affect a borrower’s ability to repay a loan or other credit obligation Teaching Tip: Ask students about their “loaning” practices. How often do they lend a fellow student money? How soon do they expect to be repaid? What would they do if they were not repaid? C. Checking Credit Information. The five C’s of credit are concerned mainly with information supplied by the applicant. How can the lender determine whether this information is accurate? 1. Credit information concerning businesses can be obtained from four sources. a) Global credit-reporting agencies. D&B (formerly Dun & Bradstreet) is the world’s leading credit-reporting agency. Its reports present detailed credit information about specific companies. b) Local credit-reporting agencies. These agencies may require a monthly or yearly fee for providing information on a continual basis. c) Industry associations. These associations may charge a service fee. d) Other firms. This refers to other firms that have given the applicant credit. 2. Various credit bureaus provide credit information concerning individuals. The three major consumer credit bureaus are Experian, TransUnion, and Equifax Credit Information Services. D. Protection for Consumers. Consumer credit bureaus are subject to the provisions of the Fair Credit Reporting Act. This act safeguards consumers’ rights in two ways: 1. You have the right to know what information is contained in your credit bureau file. 2. If you feel that some information in the file is inaccurate, misleading, or vague, you have the right to request that the credit bureau verify it. a) If the disputed information is found to be correct, you can provide a brief explanation, giving your side of the dispute. b) If the disputed information is found to be inaccurate, it must be deleted or corrected. c) You may request that any lender or prospective employer that has been supplied an inaccurate credit report in the last six months be sent a corrected credit report. 3. The Fair and Accurate Credit Transactions Act requires each of the nationwide credit-reporting companies to provide you with a free copy of your credit report (at your request) once every 12 months. 4. The Credit Card Act of 2009 also provides additional protection for credit card customers. It encourages disclosures written in plain language that include more information about due dates, late fees, and the amount of time required to pay off card balances if only minimum monthly payments are made. Instructor Manual for Business William M. Pride, Robert J. Hughes, Jack R. Kapoor 9781133595854, 9780538478083, 9781285095158, 9781285555485, 9781133936671, 9781305037083
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