What is a Bank?

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Definition:

A bank is an institution that accepts deposits, protects customers’ money, extends loans, and provides other financial services.

🤔 Understanding banks

A bank is a financial institution that accepts deposits and aims to protect its customers’ money. Many banks have large vaults on site where physical cash is held, though these days a lot of money exists electronically — Meaning in banking computer systems. Banks typically use some of the deposits made by customers to extend loans and charge interest to generate profits. They may also provide other services, such as wealth management, currency exchange, issuing credit cards, and more. While many banks have physical locations, banking activities are now frequently conducted through apps and websites.

Example

Suppose your neighbor, Jane, turned 16 and started her first job. She sets up a bank account to deposit her paycheck. Each time she receives a paycheck, she deposits it into her savings account, and she earns 1% interest annually. A few years later, Jane needs to purchase a car so she can go to college. Her bank extends her a loan for $10,000 and charges her 5% interest annually.

Takeaway

A bank is like a large community safe where everyone can deposit their money…

However, only a few people have the key to the safe. Those with the keys accept deposits into the safe and also allow people to withdraw money when needed.

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What is a bank?

A bank is an institution that provides a variety of financial services, including accepting deposits and extending loans. Banks often facilitate electronic payments, automatic teller machine (ATM) withdrawals, and other activities. Some banks also issue credit cards and Certificates of Deposit.

Banks can’t loan all of their money out; they’re required to set aside cash reserves to ensure that customers can withdraw money. They also play an important role in creating money. When banks lend money to borrowers, they actually increase the money supply. If you borrow $500, the bank will put the money in your account so your balance increases by $500. This money didn’t exist until the bank credited it to your account.

Banks help businesses secure money to maintain and expand business operations. This might mean offering business loans. An investment bank could help a company launch an Initial Public Offering (IPO) — The first time a company sells shares to the public.

What are the different types of banks?

Many banks specialize in serving different clients. Some large banks have multiple divisions, such as retail and investment banking. Let's take a look at some of the most common types:

Retail banks: They typically serve individuals and small businesses. Retail banks typically offer savings accounts, checking accounts, loans, and other services.

Commercial banks: They tend to serve large companies and support commercial activities. Commercial banks may provide organizations with staff credit cards, help them secure financing, extend lines of credit, and facilitate domestic and overseas financial transactions.

Investment banks: An investment bank helps companies access and utilize financial markets. For example, a startup could work with an investment bank to launch an initial public offering (IPO). The investment bank may help the company get listed on a stock exchange and determine the initial share price. A company may raise funds by selling shares.

Central banks: A central bank is a public institution that oversees a country's monetary policy by controlling the money supply. Some, including the U.S. Federal Reserve, are also tasked with supporting full employment — They must use monetary policies to encourage a low unemployment rate. Central banks play a significant role in managing economies. Cutting interest rates, for example, may spur investments but it may also increase inflation — Which may make goods more expensive and reduce the value of your savings.

Savings and loan associations: These associations operate somewhat like banks: They accept deposits, provide loans, and may offer other financial services or products. Some associations are "mutual" — Meaning when you make a deposit you may receive some ownership of the association. Some are corporations owned by investors who buy stock in the company. Depending on the association, they may specialize in real estate investments by providing mortgages and other services.

What are the functions of banks?

Banks primarily accept their customers’ deposits and extend loans. They may also allow people to overdraft their accounts or secure cash advances — Which may be considered forms of lending. Many banks provide a variety of other services, including:

  • Safe deposit boxes: Some banks offer secured boxes that customers can rent. These boxes are often placed in secure rooms, such as vaults.
  • Fund transfers: You can usually pay bills and make other payments through banks. Bank transfers may be less expensive and faster than transfers offered by wire companies and other providers (like PayPal).
  • Money exchange: You can often exchange currencies at a bank. For example, if you return from Europe and have euros left over, your bank can convert them into U.S. dollars.

Many banks partner with other organizations to provide specialized services, such as payroll management.

What is the banking industry?

The banking industry is the network of financial institutions that provide financial services around the world. While local retail banks may be the first to come to mind, the banking industry is much larger and includes other financial institutions, such as central banks and commercial banks.

Banks allow consumers to access credit and payment methods to make purchases. Investment banks also allow companies to access capital through loans and by selling stock, and help investors manage their wealth. At the international level, banks play a role in facilitating trade and commercial activities. For these reasons, the banking industry is an important component of economies around the world.

How has the banking industry changed?

The earliest known banks appeared in temples across ancient Mesopotamia. Even back then, banks accepted deposits and extended loans. They also traded in more than just currency. For example, banks lent seeds to farmers who then repaid the loans with harvested crops. Merchant banks emerged in the medieval period, financing commercial activities, like trade on the Silk Road.

In 1408, the first public bank, Banco di San Giorgio, was established in Genoa, Italy. The Bank of England was set up in 1694 and would go on to offer checking, overdrafts, and other financial services — Paving the way for the modern banking industry. Many subsequent central and private banks were modeled on the Bank of England.

In the 20th century, the banking industry diversified even more to meet the needs of customers and the overall economy. Commercial banks, for example, now focus on serving businesses. Investment banks specialize in financial markets and help companies go public. As online banking becomes more popular, some banks avoid physical locations altogether, instead exclusively offering their services online and through mobile apps. Banks remain vital for supporting cashless payments, including debit cards and direct transfers.

How are banks regulated?

In the United States, banks are licensed and regulated by various government authorities, including Congress, the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), local and state authorities, and others. During the Great Depression, many banks collapsed. Countless people lost their savings, so the U.S. government created the FDIC. This way, if an insured bank collapsed, the FDIC would step in and refund depositors up to a certain amount (in 1934 it was $5,000. In 2021, it is $250,000). The government also separated investment banking from retail banking with the Glass Steagall Act — It saw investment banking as a potential risk and threat to other banking activities. If a bank engaged in risky investments and suffered substantial losses, it could go bankrupt, wiping out customer deposits.

In the decades after the Great Depression, federal authorities loosened banking regulations; in 1999, Congress repealed the Glass-Steagall Act. Some retail and investment banks then consolidated as financial holding companies (a company that has ownership over another company). Some economists argue that this deregulation later contributed to the 2008 Great Recession — A financial crisis which nearly caused the collapse of the global financial sector. The U.S. federal government and other authorities bailed out large banks in an effort to protect the financial system.

Following the 2008 Great Recession, the Dodd-Frank Wall Street Reform and Consumer Protection Act placed new regulations on the banking industry, like forbidding banks from operating hedge funds for their own profit. In recent years, however, some parts of the act have been rolled back. Originally, banks with assets in excess of $10 billion had to undergo stress tests — Through which banks must prove that they have the capital to absorb losses during stressful situations (like a severe recession). Now, only banks with $250 billion or more in assets must perform these tests.

What is the difference between a bank and a credit union?

A credit union is similar to a retail bank. Both credit unions and retail banks accept deposits and extend loans. However, credit unions are nonprofit organizations, while retail banks are for-profit companies.

Credit unions are owned by their members, who are also their customers. A board of directors oversees the credit union, with directors selected by and from the members. In a bank, things work a bit differently — Many banks also have a board of directors, but those directors are selected by shareholders who have ownership in the bank.

Joining a credit union typically requires meeting a set of specific criteria. For example, some universities set up credit unions to serve their students, employees, and other people connected to the institution. Retail banks accept most customers and don’t require a special association.

What is the relationship between banks and the economy?

Banks are an essential component in many economies. Generally speaking, banks make it easier for consumers to secure their wealth, manage investments, make purchases, and engage other financial activities. They also help people secure loans, like mortgages, which helps people pay for homes in increments over time.

Banks also help keep major industries, like construction, stay in operation. Think of a local real estate development company that may want to build rental apartments. Without a loan from the bank, it may not have the capital to do so.

What is the banking industry's outlook for 2021?

It’s impossible to know what the future holds. Some experts predict that geopolitical, technological, environmental, demographic, and economic factors will have a major impact on the banking industry in 2021. For example, technologies like machine learning, blockchain, and quantum computing may change how banks process payments. Experts have also expressed concerns about slow economic growth and low-interest rates, particularly in highly-developed countries. The Covid-19 pandemic may also continue to have a major impact on the banking industry in 2021 and beyond.

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Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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