Money and banks are closely related. This is why courses are taught on “Money and Banking.” This is also why banks are highly regulated.

Money and Banks

Traditionally, money circulates through the banking system. This is one of the core services of retail banking. Most people in the U.S. have a bank account to manage their money. These customers of retail banking use ATMs as a way to deposit and withdraw cash. Rather than holding cash under a mattress or in a personal vault, most of us deposit our money in the bank. One way to consider the importance of this is to consider the cash management challenges of a homeless person without a bank account. Banks are a safe and secure place to store money. This was one of the earliest and most foundational services of a bank. This is also why bank buildings are architecturally designed to look like a physical fortress. Businesses, especially in retail, also use banks for cash management. This is why the coin shortage in 2020 was particularly problematic for businesses that use cash.

“Money” in a bank account is a form of electronic money. Money can be transferred from one account to another, such as in Zelle. Direct deposit can be used to deposit money directly from an employer and mobile deposit can be used to deposit checks using a smart phone. A routing number is a unique identifier for a bank and an account number is a unique identifier for an individual’s account. A checking account is an account designed to provide liquidity. Money can be withdrawn easily at any time and any number of checks can be written from the account. Some checking accounts have fees associated with them as a charge for this liquidity. However, the trend is toward “free checking.” A savings account is an account designed to save money and earn interest. Savings accounts pay a low interest rate to the depositor. Banks also offer certificates of deposit (CDs), which are savings products with a specific maturity. The depositor can put their money in a CD for a few months or a few years. CDs typically offer a higher interest rate than a savings account, but there is a penalty for withdrawing the money early.

Recall that banks deposit funds at the Federal Reserve in the form of reserves. The reserve requirement is a ratio of bank deposits that must be held at the Federal Reserve. In March 2020, the Federal Reserve reduced reserve requirement ratios to zero percent. Banks keep reserves at the Federal Reserve as a form of saving, just like individuals keep deposits at a bank. The FOMC changes the return on reserves by setting the federal funds rate. When the federal funds rate is low, banks have an incentive to lend their funds. This is how the federal funds rate influences the amount of reserves in the banking system. Low rates incentivize lending, which is the transformation of deposits into new credit.

The use of “cards” as a means of payment has changed the relationship between money and banks. A debit card is a card-based means of payment linked to a checking account. This is a safe way to manage personal funds, because a payment with a debit card is based on existing funds in a checking account. One of the main risks of a checking account is an overdraft fee, which is a fee that is charged if payments are made beyond funds in an account. A credit card is a card-based means of payment that is a form of borrowing. Payments are funded with credit each month and the borrower can either pay off the balance or carry a balance at a relatively high interest rate. Many credit cards now offer rewards (e.g., cash back) as an incentive for spending with the card. Card processing fees are paid by merchants and can be as large as 2-3% of a transaction.

Although debit cards and credit cards are not “cash,” they are still closely related to banks. Banks issue debit and credit cards. The card networks, Visa and Mastercard, are closely tied to the banking system. The connection between money and banking still exists even as the U.S. has moved further into mobile payments and e-commerce.

Not everyone has a bank account. The unbanked are individuals that do not have a bank account. A biennial survey of the unbanked in the U.S. by the FDIC tracks trends on this issue and the 2020 press release showed that about 5% of the U.S. population is unbanked. This is the lowest percentage since the FDIC began the survey in 2009. Some people still avoid banks due to distrust or high fees. The percentage of the unbanked in developing countries is much higher. This has been an area of concern among international policy makers for many years, but the rise of financial technology has begun to address this issue in new and interesting ways.

Bank deposits are insured by the Federal Deposit Insurance Corporation (FDIC). Since the financial crisis, individual depositors have been insured at a bank up to a deposit amount of $250,000. When a bank fails (enters bankruptcy), insured deposits will be returned to depositors and uninsured deposits will not be returned to depositors. The FDIC typically tries to find another bank to acquire the failed bank. If this is not possible, the bank goes into receivership and the FDIC will liquidate the bank’s assets. The FDIC was created in 1933 to protect U.S. depositors from bank failures. The FDIC has a Deposit Insurance Fund (DIF) that is funded by an assessment of bank insurance premiums. The DIF reserve ratio is about 2%, which means that it has funds that amount to about 2% of total insured deposits.

The Regulation of Money and Banking

Money is highly regulated due to the risks associated with any problems associated with money. Counterfeit is the production of cash and currency that is not true legal tender. What would happen to a country’s currency if its currency were not protected against counterfeit? The lack of trust would be disastrous. Similarly, the ability to deposit money in a bank must be checked against a number of safeguards to ensure legal activity. The series “Ozark” on Netflix highlights the efforts to convert illegal money into legal money. This process is referred to as money laundering (cleaning the money). To prevent money laundering, banks must implement compliance checks including Know Your Customer (KYC) and Bank Secrecy Act (BSA). These safeguards increase compliance costs for banks. They also result in slower transaction times involving U.S. banks. However, the U.S. has determined that these compliance costs are worth it. Some have argued for the discontinuation of the US $100 bill as a way to reduce criminal activity.

Cryptocurrency is sometimes viewed as an attractive alternative to sovereign currency. This is partly due to the reduced compliance issues. The history of cryptocurrency includes many stories of criminal activity, such as the Silk Road exchange. It will be interesting to see how cryptocurrency evolves as it becomes more mainstream and potentially more regulated.

The banking sector is among the highest regulated sectors in the economy. Because banks handle money and provide a foundation to the financial system, it is imperative that they remain safe and secure. One of the primary goals of federal bank regulation is to prevent bank failures. Prior to the creation of the Federal Reserve in 1913 and the FDIC in 1933, the U.S. had a number of banking crises. Bank regulation is the first line of defense against banking crises.

The most important form of bank regulation is capital regulation. Capital regulation is a requirement that banks have sufficiently levels of capital to absorb unexpected losses. A required capital ratio is a minimum capital ratio that a bank must maintain. This prevents excess leverage in the bank’s capital structure.

To be “well capitalized” as of 2020, an FDIC-insured bank must have a

• total risk-based capital ratio of 10% or greater
• tier-1 risk-based capital ratio of 8% or greater
• common equity tier 1 risk-based capital ratio of 6.5% or greater
• a leverage ratio of 5% or greater
• and not be subject to any written orders for infractions

“Risk-based capital” means that more capital must be held if assets are risky. Tier 1 means high-quality capital (loss absorbing). Common equity is the highest quality form of capital. Leverage ratio is a capital ratio that is not based on any risk measurement for assets.

Here is the full list of regulatory requirements for capital regulation.

There are three primary federal regulators for banks: the FDIC, the Federal Reserve, and the Office of the Comptroller of the Currency (OCC). The OCC is a an office of the U.S. Treasury. A bank has one of the three as a primary federal regulator, which depends on the bank’s charter. A state-chartered bank that is not a member of the Federal Reserve system is regulated by the FDIC; a state-chartered bank that is a member of the Federal Reserve system is regulated by the Federal Reserve; and a bank with a national charter is regulated by the OCC. All three regulators have similar regulations (rules), but one of the differences is in bank supervision. Bank supervision is the process in which bank examiners from the regulator visit the bank and do on-site exams to review individual loans and compliance details. Bankers would say that supervision can differ from one regulator to another. State-chartered banks are also regulated at the state level by the state banking agency. In Illinois, that is the Illinois Department of Financial and Professional Regulation (IDFPR).

As financial institutions that serve the public, banks must also comply with regulations that require ethical business practices. The Consumer Financial Protection Bureau (CFPB) was created in 2010 after the financial crisis by the Dodd-Frank Act. The creation of the CFPB was a response to the predatory lending practices in subprime mortgage lending. Today, it covers a wide range of issues including the Truth in Lending Act (TILA), debt collection practices, and racial discrimination. Red lining is a term that dates back to the 1960s and 1970s and describes how banks would not offer mortgages in certain numbers and to certain racial/ethnic groups. One effort to fight red-lining is the Community Reinvestment Act (CRA) of the 1970s, which requires banks to lend equitably across their entire branch network. There is still ongoing debate about how to effectively encourage and enforce these types of practices.

Some lending practices outside of the banking system have drawn even greater scrutiny. Payday lending is a short-term personal loan that is secured by a pay-check that is about to be received. The idea is that an individual can get an “advance” on their paycheck and then payback the loan when they get paid. Some people have argued that this provides a service to those who are living “paycheck-to-paycheck” and may need funds to cover an emergency expense like a medical bill. Other people have pointed out that payday loans can have an interest rate of around 400%. This starts to relate to the term “loan shark,” which is a form of price gouging (like selling water when it is not available).

What Makes a Bank a Bank?

Deposits are the defining feature of a bank. There are many types of financial institutions that make loans, but only banks have insured deposits. Protecting depositors is key rationale for bank regulation.

Quicken is an example of a firm that makes loans but does not take insured deposits. Quicken is not a bank. However, Quicken is the largest mortgage lender in the U.S.. You have likely seen advertising for their Rocket Mortgage product. It is interesting to think that mortgage lending is no longer dominated by traditional deposit-taking banks. Guaranteed Rate is a Chicago-based mortgage lender that is similar to Quicken. Some banks complain that these types of firms have a competitive advantage because they are less regulated than banks.

A shadow bank is a financial institution that provides services similar to a bank but is not a bank. The growth of shadow banking has pros and cons for the stability of the financial system.

Government Safety Net

Deposit insurance is the classic form of the government safety net. If a bank fails, its insured depositors will be made whole. This is good for depositors and prevents bank runs. A bank run is when depositors rush to withdraw deposits from a bank before it fails. Bank runs were common in the United States before the creation of the FDIC in 1933.

The downside of the government safety net is that it can affect banks’ incentive to manage risk. The government safety net creates a moral hazard problem for banks. Banks have an incentive to take on excessive risk because of the safety net beneath them. A famous phrase related to this is “Heads I win, tails you lose.”

Another form of government safety net is the “Too Big to Fail” problem. When banks are extremely large, there is a concern that their failure could have negative spillover effects on the economy and the rest of the financial system. Too Big to Fail describes the implicit government guarantee that a large bank will be bailed out before it reaches the point of failure.

Financial Crises

Financial crises are usually tied to the banking sector. Banks are the “plumbing” of the financial system, so problems in the banking sector have implications for every other aspect of finance.

Contagion is the spread of a negative shock beyond its initial impact. This term can be applied to the transmission of a virus across a population of people, as we’ve seen with COVID-19. It can also apply to financial shocks in the financial sector. If a single financial institution enters financial distress and fails as an isolated incident, this is not a financial crisis. But if the failure of the institution places other institutions under distress, then the impact of the shock can spread. Financial institutions are extremely interconnected, which means that their financial performance is closely linked.

Systemic risk is risk that is can pose a threat to the entire financial system. This is different than idiosyncratic or systematic risk, like in CAPM. Systemic risk is more about tail risk, which is the worst outcomes in the distribution of possible scenarios. Large financial institutions are systemically important when their failure can cause problems for the rest of the financial system.

Government Intervention

Banks are often at the nexus of the economy and government intervention. One phrase for government intervention is “bail out,” which is like rescuing a sinking ship. There is heated debate about the appropriate role of the government in a financial crisis. Some people would argue that bail outs are a bad idea, because it rescues the bad actors and incentivizes further bad behavior. Other people would argue that bail outs are necessary, because it prevents contagion and minimizes spillover effects throughout the system. There does not seem to be a right answer to this issue.

The global financial crisis of 2008-2009 is often remembered for “bail outs.” Bear Stearns was an investment bank that was bailed out in March 2008. At the brink of bankruptcy, Bear Stearns was acquired by J.P. Morgan with the assistance of government funds and guarantees. This is what we mean when we say that Bear Stearns was “bailed out.” In contrast, Lehman Brothers was an investment bank that was allowed to fail in September 2008. The decision to let Lehman fail illustrates the tension in government about whether to bail out or not. The Lehman decision reflects the hands off approach to market discipline. However, the failure of Lehman was the event that marks the epicenter (depth) of the financial crisis. When Lehman failed, other financial institutions connected to Lehman suffered losses, and soon the global financial system was spiraling downward. This led to a call for government intervention.

The response of governments around the world was to expand the government safety net. Banks received additional funds in the form of equity and debt. This helped banks to shore up their balance sheets and survive the crisis.

One of the key U.S. interventions in the global financial crisis of 2008-2009 was the Troubled Asset Relief Program (TARP). TARP was an injection of equity capital into banks by the U.S. Department of the Treasury. This capital injection was in the form of warrants that were owned by the government. In this way, TARP was a partial nationalization of the U.S. banks. Similar programs were put in place across Europe and Asia as well. These programs were effective in stopping the free fall of the banking sector. However, these programs also raised significant policy questions about the potential downsides of government ownership of private institutions.

The COVID-19 Intervention

COVID-19 posed a different type of problem to the economy. Rather than a banking shock, COVID-19 was a health shock that destabilized non-financial businesses and the labor market. The government response was to use the banking sector to provide support to the economy.

One of the largest government interventions during the COVID pandemic was the Paycheck Protection Program (PPP). This program was administered by the Small Business Administration (SBA) and involved government funding of loans originated by banks. The spike in Commercial and Industrial Loans (loans to businesses) in the spring of 2020 (March, April, and May) can be seen in the following chart. Business lending grew by 167% (annual growth rate, year-over-year) in April 2020 due to the PPP program.

In contrast, consumer lending (e.g., credit cards) declined dramatically in the spring of 2020. This is depicted in the chart below. Consumer lending fell by 74.5% (annual growth rate, year-over-year) in April 2020. This is a good indicator of bank lending without government intervention.

This decline in consumer lending is the combined effect of a decline in loan demand and a decline in loan supply. Consumers are less willing to borrow in a recession and banks are less willing to lend in a recession.

Forward-Looking Government Policy

One area of agreement that has emerged since the financial crisis is the need to have forward-looking government policy. Governments cannot simply react when things get bad. Governments need to have plans in place to prepare as best as they can for these bad scenarios.

There are two schools of thought on this as it relates to the Too Big to Fail problem. Some people have argued that we should “break up the big banks.” In other words, make them smaller so that their failure would not pose such a large threat. The banks often counter that their large scale is necessary to compete internationally. The current approach is to apply stricter regulation and higher capital requirements on larger banks. For instance, banks like J.P. Morgan Chase must hold an additional amount of capital as a way to prevent failure.

In some regard, the future of bank regulation in the U.S. will reflect our society’s views on the appropriate balance between free markets and the role of the government.