BANKS AND BANKING



A bank is an institution that provides financial services to consumers, businesses, and governments. One major type of bank is the commercial bank, which has fewer restrictions on its services than other types of banks. Commercial banks profit by taking deposits from customers, for which the banks typically pay a relatively low rate of interest, and lending the deposits at a higher rate of interest to borrowers. These borrowers may be individuals purchasing homes, cars, and other items or they may be businesses financing working capital needs, equipment purchases, etc. Banks may also generate revenue from services such as asset management, investment sales, and mortgage loan maintenance.

According to the Federal Deposit Insurance Corporation, which monitors all federally insured banks, in 1998 there were 8,774 U.S. commercial banks with more than 60,000 branches. An additional 1,687 savings institutions were in operation that year. The number of separate banks has dwindled considerably in the wake of mergers and consolidation in the U.S. banking sector; in 1998 alone the number of banks fell by 4 percent. Such consolidation has made banking in the United States more profitable, with industrywide profits setting new records throughout the 1990s. In 1998 bank profits totaled nearly $62 billion, up 4.5 percent from 1997. Within the commercial banks, some 6,100 bank holding companies, which often own multiple banks, controlled 94 percent of all federally insured commercial bank assets. As of 1998 the U.S. banking sector reported $6.5 trillion in assets and $4.4 trillion in deposits. Accounting for inflation, this level represented a 26 percent increase in assets since 1992.

In addition to commercial banks, major types of banks include savings banks, trust companies, and central banks, which are described below.

Most commercial banks operate under corporate holding companies, which may own one or several banks. Because of regulatory constraints, banks that are not associated with holding companies must operate under restrictions that often put them at a disadvantage compared with other financial institutions. Holding companies are often used as vehicles to circumvent legal restrictions and to raise capital by otherwise unavailable means. For instance, many banks can indirectly operate branches in other states by organizing their entity as a holding company. Banks are also able to enter, and often effectively compete in, related industries through holding-company subsidiaries. In addition, holding companies are able to raise capital using methods from which banks are restricted, such as issuing commercial paper. Multibank holding companies may also create various economies of scale related to advertising, bookkeeping, and reporting, among other business functions.

BACKGROUND

Financial intermediaries to safeguard funds, lend money, and guarantee the exchange of currency have existed since ancient times. The modern banking industry, however, is rooted in European institutions established in the 1700s. Early in that century, English goldsmiths discovered that they were consistently storing large amounts of gold owned by their customers. They found that they could temporarily lend some of the gold to other people in exchange for a promissory note for interest. Importantly, these early bankers found that the value of their promissory notes could exceed the value of their stored gold—in effect, they were creating money that could be used to expand the economy. That pivotal banking approach, known as fractional-reserve banking, is credited with making Western industrialization possible. Among the first major modern banks to use fractional-reserve banking were the Riksbank, founded in Sweden in 1656, and the Bank of England, created in 1694.

Similar banking industries sprang up throughout the world during the 1700s and 1800s. For example, one of the first banks in the United States—the Bank of the United States—was formed in 1791. Despite their important social and economic function, depositors considered banks a relatively risky investment until the mid-19th century. In fact, bank failures, such as those occurring throughout the late 1800s and during the Great Depression of the 1930s, effectively wiped out millions of dollars of depositors' savings. Following those disasters, most countries developed a system of government insurance for bank deposits. In the United States, that insurance resulted from the Banking Acts of 1933 and 1935, which created the Federal Deposit Insurance Corporation (FDIC). Those and similar efforts resulted in greater bank stability and increased bank use, particularly by individuals.

BANKING TODAY

Commercial banking in the United States during the 1970s and through the early 1990s was characterized by (1) a proliferation of competition from other financial service industries, such as mutual funds and leasing companies; (2) the growth of multibank holding companies; and (3) new technology that has changed the way banks conduct business.

The first two developments are closely related. Indeed, as new types of financial institutions have emerged to meet specialized needs, banks have turned to the holding company structure to increase their competitiveness. In addition, a number of laws passed since the 1960s have favored the multibank holding company format. As a result, the U.S. banking industry grew increasingly concentrated in the hands of bank holding companies during the 1990s. The number of independent commercial banks declined by almost a third between 1985 and 1995, dropping below 10,000 for the first time in many decades. The number of banks in operation had peaked in 1984 at 14,496. By 1997, nearly 70 percent of all commercial assets were held by the top 100 banks, well above the 50-60 percent typical between 1970 and 1990.

The trend toward large holding companies provided incentive for commercial banks to offer comprehensive financial service packages, including financial planning, investment brokering, and insurance. Nonbanking activities by banks have been tightly regulated since the Depression, but in the 1980s and, especially, the 1990s, lawmakers and regulators alike proved increasingly sympathetic to banks that wished to offer integrated services. The biggest challenge to the historical separation of these activities came with the 1998 merger between Citicorp, then the second-largest U.S. bank, and the Travelers Group, a major insurance carrier and parent of the Salomon Smith Barney brokerage. Under the law at the time, the merged entity, named Citigroup, would have needed to divest its insurance business at minimum, and the size of the brokerage might also have posed a hurdle. But the companies entered the agreement fully expecting the laws would be changed in coming years. One such piece of legislation had already been in the works in the House of Representatives and was passed barely a month after the Citigroup merger; however, the Senate failed to approve a version during that session.

Electronic information technology, the third major factor in the recent evolution of banking, is evidenced most visibly by the proliferation of electronic transactions. Electronic fund transfer systems, automated teller machines (ATMs), and computerized home-banking services all combined to transform the way banks conduct business. By 1998, there were upwards of 190,000 ATMs operating in the United States, and that figure represented a 13 percent increase from the previous year. Such technological developments have reduced labor demands and intensified the trend toward larger and more centralized banking organizations. They have also diminished the role that banks have traditionally played as personal financial service organizations. Finally, electronic systems have made possible, on a national and even global scale, banking systems with nearly instant information access.

SEE ALSO : Investment Banking ; Savings and Loan Associations

FURTHER READING:

Benoit, Ellen. "Breaking the Bounds." CFO, July 1998.

Board of Governors of the Federal Reserve System. 84th Annual Report, 1997. Washington, May 1998. Available from www.federalreserve.gov .

Pilloff, Steven J., and Robin A. Prager. "Thrift Involvement in Commercial and Industrial Lending." Federal Reserve Bulletin, December 1998. Available from www.federalreserve.gov .

"Top 25 Bank Holding Companies in Number of ATMs." American Banker, 3 December 1998.



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