1. Chapter Nineteen Understanding Money, Banking, and Credit

2. Copyright © Houghton Mifflin Company. All rights reserved.19 - 2 Learning Objectives 1.Identify the functions and characteristics of money. 2.Summarize how the Federal Reserve System regulates the money supply. 3.Describe the differences between commercial banks and other financial institutions 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.

3. Copyright © Houghton Mifflin Company. All rights reserved.19 - 3 Learning Objectives (cont’d) 6.Explain why banks, savings and loan associations, and credit unions provide insurance for their customers. 7.Discuss the importance of credit management.

4. Copyright © Houghton Mifflin Company. All rights reserved.19 - 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

5. Copyright © Houghton Mifflin Company. All rights reserved.19 - 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

6. Copyright © Houghton Mifflin Company. All rights reserved.19 - 6 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.

7. Copyright © Houghton Mifflin Company. All rights reserved.19 - 7 Important Characteristics of Money Divisibility- divided into smaller units Portability-small enough to carry Stability-retain its value over time Durability-strong enough to last Difficulty of counterfeiting

8. Copyright © Houghton Mifflin Company. All rights reserved.19 - 8 The Supply of Money: M 1, M 2, and M 3 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–M1 Currency, demand deposits, and travelers checks –M2–M2 M 1 plus certain money-market securities and small- denomination time deposits or certificates of deposit of less than $100,000 –M3–M3 M 1 and M 2 supplies of money plus time deposits or certificates of deposit of $100,000 or more

9. Copyright © Houghton Mifflin Company. All rights reserved.19 - 9 The Supply of Money Source: The Federal Reserve website, www.federalreserve.gov, January 8, 2003.

10. Copyright © Houghton Mifflin Company. All rights reserved.19 - 10 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

11. Copyright © Houghton Mifflin Company. All rights reserved.19 - 11 Federal Reserve System Source: Federal Reserve Bulletin, May 2002, pp. A84-86.

12. Copyright © Houghton Mifflin Company. All rights reserved.19 - 12 The Federal Reserve System (cont’d)Federal Reserve System 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 –Deposit Expansion ($20 million, 10% RR) –More required reserves = less money in circulation –Less required reserves = more money in circulation to stimulate the economy

13. Copyright © Houghton Mifflin Company. All rights reserved.19 - 13 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 banksDiscount rate –Lower loan rates allow banks to lend more and stimulate the economy –Higher rates slow the economy and check inflation

14. Copyright © Houghton Mifflin Company. All rights reserved.19 - 14 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 (immediate effect) –To increase the money supply, the Fed BUYS government securities –To reduce the money supply, the Fed SELLS government securities on the open market to take money out of circulation

15. Copyright © Houghton Mifflin Company. All rights reserved.19 - 15 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

16. Copyright © Houghton Mifflin Company. All rights reserved.19 - 16 Clearing a Check Through the Federal Reserve System Source: Federal Reserve Bank of New York, The Story of Checks, 7 th ed. New York, 1995, p. 11.

17. Copyright © Houghton Mifflin Company. All rights reserved.19 - 17 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

18. Copyright © Houghton Mifflin Company. All rights reserved.19 - 18

19. Copyright © Houghton Mifflin Company. All rights reserved.19 - 19 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

20. Copyright © Houghton Mifflin Company. All rights reserved.19 - 20 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

21. Copyright © Houghton Mifflin Company. All rights reserved.19 - 21 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

22. Copyright © Houghton Mifflin Company. All rights reserved.19 - 22 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

23. Copyright © Houghton Mifflin Company. All rights reserved.19 - 23 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

24. Copyright © Houghton Mifflin Company. All rights reserved.19 - 24 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

25. Copyright © Houghton Mifflin Company. All rights reserved.19 - 25 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

26. Copyright © Houghton Mifflin Company. All rights reserved.19 - 26 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

27. Copyright © Houghton Mifflin Company. All rights reserved.19 - 27 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

28. Copyright © Houghton Mifflin Company. All rights reserved.19 - 28 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

29. Copyright © Houghton Mifflin Company. All rights reserved.19 - 29 How Do You Get Money From a Bank or Lender? 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

30. Copyright © Houghton Mifflin Company. All rights reserved.19 - 30 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

31. Copyright © Houghton Mifflin Company. All rights reserved.19 - 31 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

32. Copyright © Houghton Mifflin Company. All rights reserved.19 - 32 Effective Credit Management (cont’d) Sound collection procedures –Firm –Fair, allowing for compromise –Not harassing Techniques –Subtle reminders –Telephone calls –Personal visits –Legal action