Chapter Eighteen

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Chapter EighteenUnderstanding Money, Banking,

and Credit

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PRIDE HUGHES KAPOOR

INTRODUCTION TOBUSINESS

ELEVENTH EDITION


Learning Objectives

1. Identify the functions and characteristics of money.

2. Summarize how the Federal Reserve System regulates the money supply in order to maintain a healthy economy.

3. Describe the organizations involved in the banking industry.

4. Identify the services provided by financial institutions.

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Learning Objectives (cont’d)

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.

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Introduction

The economic crisis• Described by many experts as the worst since the

Great Depression- Many people lost their homes because they couldn’t

pay their loans- Many people and businesses filed for bankruptcy

because they couldn’t pay their loans- Many people and businesses found it harder or

impossible to borrow money

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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

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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

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The Consumer Price Index and the Purchasing Power of the Consumer Dollar (Base Period 1982–1984 = 100)

Source: The U.S. Bureau of Labor Statistics website, www.bls.gov, June 16, 2010.

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Figure 18.1


The Consumer Price Index and the Purchasing Power of the Consumer Dollar (Base Period 1982–1984 = 100)

Source: The U.S. Bureau of Labor Statistics website, www.bls.gov, June 16, 2010.

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Figure 18.1


Important Characteristics of Money

Divisibility Portability Stability Durability Difficulty of

counterfeiting

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The Supply of Money: M1 and M2

Demand deposit• An amount on deposit in a checking account

Time deposit• An amount on deposit in an interest-bearing

savings account Two main measures of the supply of money

• M1- Currency, demand deposits, and travelers checks

• M2- M1 plus savings accounts, certain money-market

securities and small-denomination time deposits or certificates of deposit (CDs) of less than $100,000

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The Supply of Money

Source: The Federal Reserve website, www.federalreserve.gov, accessed June 15, 2010.

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Figure 18.2


The Federal Reserve System

The central bank of the United States responsible for regulating the banking industry• Controlled by a seven-member board of governors

who are appointed by the president and confirmed by the Senate to serve a fourteen-year term

• Composed of twelve district banks and twenty-four branch banks

• District banks are owned by commercial banks that are members of the Federal Reserve system

• Main function is to regulate the banking system and maintain a healthy economy

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The Federal Reserve System (cont’d)

Source: “91st Annual Report, 2004,” The Federal Reserve Board website, www.federalreserve.gov, accessed June 18, 2010.

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Figure 18.3



Economic crisis and the Fed’s response• Provided liquidity• Supported troubled financial markets• Supported important financial institution• Conducted stress tests of major banks

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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

• More required reserves = less money in circulation• Less required reserves = more money in circulation

to stimulate the economy

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Regulation of the discount rate• Discount rate—the interest rate the Federal Reserve

System charges for loans to member banks• Lower loan rates allow banks to lend more and

stimulate the economy• Higher rates slow the economy

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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

• To reduce the money supply, the Fed sells government securities to take money out of circulation

• To increase the money supply, the Fed buys government securities

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Controlling the Money Supply and the Economy

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Table 18.1



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

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The American Banking Industry

Banking and financial reform: New regulations• Goals are

- Protection from unfair, abusive financial and banking practices

- Close gaps that allowed large banks and financial firms to avoid strong, comprehensive federal oversight

- Curb high-risk investment strategies- Require banks and financial firms to pay back

bailout funds- Provide a foundation for stable economic growth

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The American Banking Industry (cont’d)

Commercial bank• A profit-making organization that accepts deposits,

makes loans, and provides related services to its customers

- National bank: chartered by the U.S. Comptroller of the Currency

- State bank: chartered by the banking authorities in the state in which it operates

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The Seven Largest U.S. Banks,Ranked by Total Revenues

Source: The Fortune website, www.fortune.com, accessed June 20, 2010.

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Table 18.2



Other financial institutions• Savings and loan associations (S&L)

- 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

• Credit unions- 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 local credit union

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Other financial institutions (cont’d)• Organizations that perform banking functions

- Mutual savings banks- Insurance companies- Pension funds- Brokerage firms- Finance companies- Investment banking firms

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Careers in Banking

The seven largest banks in the U.S. employ approximately 1,200,000 people

The U.S. Department of Labor expects the number of people employed in banking to grow more slowly than other jobs in the economy between now and the year 2018

Traits of successful bankers• Honesty• Ability to interact with people• Strong background in accounting• Appreciation for the banking-finance relationship• Basic computer skills

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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 the 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 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

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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

• 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

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Typical Services Provided by Banks

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Figure 18.4


Innovative Banking Services

Changes in the banking industry• Anticipated changes

- More emphasis on evaluating the creditworthiness of loan applicants as a result of the recent economic crisis

- An increase in government regulation of the industry- A reduction in the number of banks, S&Ls, credit

unions, and financial institutions because of consolidation and mergers

- Globalization of the banking industry

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Innovative Banking Services (cont’d)

Changes in the banking industry (cont’d)• Anticipated changes (cont’d)

- The importance of customer service as a way to keep customers from switching to competitors

- Increased use of credit and debit cards and a decrease in the number of written checks

- Increased competition from nonbank competitors that provide many of the same services as banks (S&Ls, credit unions)

- Continued growth in online banking

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Online Banking

Advantages• Easy access to account regardless of time or location• 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

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Online Banking (cont’d)

Electronic funds 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 (POS) terminals - Electronic check conversion (ECC)

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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

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The FDIC and NCUA

Federal Deposit Insurance Corporation (FDIC)• Created as a result of the Depression, to restore

public confidence in the banking industry to insure deposits against bank failures

FDIC provides deposit insurance of $250,000 per account

National Credit Union Association (NCUA)• Insures the deposits of credit union members for up to

$250,000 per account

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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

Borrower• Person or business wishing to make a purchase

Lender• Bank or firm selling merchandise or service on credit• Interest charged for the loan is profit

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Getting Money from a Bank or Lender After a Credit Crisis

For individuals• 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

• Update your business plan• Prepare a convincing cover

letter

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The Five C’s of Credit Management

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 a loan• Conditions—general economic conditions that can affect

a borrower’s ability to repay the loan

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Credit Application Form

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Figure 18.5


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 • 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

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New Protection for Consumers: The Credit Card Act of 2009

Designed to level the playing field between credit card customers and financial institutions that issue credit cards• Disclosures regarding due dates, late fees, time required to pay

off balances written in plain language• Protection against arbitrary rate increases, requires 45-day

notice• Increased protection for students and people under 21• Standardized billing dates • Requires fees to be reasonable in relation to a credit agreement

violation• New measures of accountability such as posting contract on the

Internet review by Federal Reserve Board• Increases penalties for companies that violate the Truth in

Lending Act for credit card customers

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Sound Collection Procedures

Techniques• Subtle reminders• Telephone calls• Personal visits• Legal action

Sound collection procedures• Firm• Fair, allowing for compromise• Not harassing

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Documents

Chapter Eighteen