(From Encyclopedia Americana)

Banking in the United States

Banking in the United States, institutions and activities in the United States engaged in holding and lending money.

History of U.S. Banking

Colonial Period to 1863

Banking in the United States began in the 18th century, when individuals, merchants, and colonial governments loaned money to one another. In 1781 the new Continental Congress chartered the Bank of North America, primarily to aid in financing the Revolutionary War. Both chartered and private banks financed trade by extending credit to merchants to buy inventories, which, when sold, provided funds to repay the loan. Loans were ordinarily made in currency—notes issued by the lending bank; checks (demand deposits) were not yet an accepted medium of exchange.

In 1791 Congress established the First Bank of the United States with a 20-year charter. The First Bank served as the fiscal agent for the U.S. Treasury. It competed effectively with state banks, making them redeem their notes at full value. State bankers' objections led to the First Bank's termination in 1811, when Congress failed to renew its charter. Its dissolution complicated the financing of the War of 1812 and contributed to wartime inflation, since an important restraint on state banks' note issuance had been removed.

In 1816 Congress created the Second Bank of the United States. Under the aggressive direction of Nicholas Biddle, the Second Bank restored redemption values to banknotes and limited credit expansion. Biddle's success antagonized state bankers. Andrew Jackson vigorously opposed the bank and, as president, vetoed its charter extension in 1836.

Before 1837, when Michigan enacted free bank chartering, state bank charters could be obtained only by special acts of state legislatures. Under the free banking system anyone could open a bank who provided a minimum amount of capital and deposited a specified amount of bonds with a state agent to repay holders of the bank's notes. By 1860, 18 of the 32 states had passed such laws. States that allowed banks to issue notes in amounts greater than the market value of assets backing the notes experienced failures among the free banks; the other states did not. Losses suffered by the public from holding worthless or depreciated banknotes through 1860, however, were less than 2% of the money stock. (More than half were in Michigan, which allowed banks to back notes with unmarketable mortgages.) In any event, free bank financing contributed significantly to westward expansion.

National Bank System

The problem of financing the Civil War led Congress, in 1863, to pass the National Banking Act. The act created a system of federally chartered banks supervised by a federal agency, the Office of the Comptroller of the Currency. Civil War financing was enhanced by the act's requirement that all national banks' notes be backed by U.S. Treasury bonds. Because national bank charters required more capital than state charters, national banks tended to be established in larger communities. Unlike the First Bank of the United States and its successor, banks with national charters were not permitted to branch, even within states.

To expedite the development of the national banking system, Congress levied a 10% tax on all new state-banknote issues. By 1866 the number of nationally chartered banks had increased to more than 1,600 and accounted for 75% of all bank deposits. Circulation of state banks' notes declined, although the result was the rapid development of demand deposit banking (checking). Although local currency-redemption panics ended, the act made no allowance for seasonal currency needs, nor did it provide a flexible national or even regional lending mechanism. By supporting decentralized unit (nonbranch) banking, the act restricted the movement of excess bank funds in New England into the credit-starved South and West. Limits on real estate lending prevented national banks from effectively supporting migration to the West.

The total number of banks increased from 2,000 in 1866 to 13,000 in 1900, and to 27,000 in 1913. The typical new bank was state chartered. It was located in a small rural community and supplied credit to farmers. National banks grew more in size than in number. The largest of these banks, located in financial centers, supplied credit to an expanding industrial empire centered on railroads.

The initial stability imparted by the national banking system did not endure. Financial panics in 1893 and 1907 stimulated Congress to appoint a National Monetary Commission, the recommendations of which led to the Federal Reserve Act of 1913.

The Federal Reserve System

The Federal Reserve Act was initially designed as a system of bankers' banks that could avoid the state-imposed prohibition against interstate branching that constrained check clearance across state boundaries. The act required all national banks to become members and invited state banks to join, provided they met minimum capital requirements. Each member bank had to maintain reserves in cash or as noninterest-bearing deposits with its federal reserve bank. The reserve deposits facilitated a national check-clearing and fund-transfer arrangement. The member bank could also borrow (discount) at its federal reserve bank when it needed currency or loanable funds. President Woodrow Wilson turned the Federal Reserve into the nation's first true central bank.

The federal reserve banks helped finance World War I by purchasing government securities for federal reserve notes, thereby financing the war by printing money. Large state banks joined the system so that they could participate in wartime financing. The 1920s

By 1921 some 31,000 banks operated in the United States—more than at any other time in history. The trend toward small banks reversed somewhat thereafter, as banks formed holding companies as a means of avoiding states' prohibitions and limitations on branching. Holding companies and banking chains allowed banking companies to operate multiple units within and even across state lines. In 1927 Congress passed the McFadden Act, which allowed national banks to branch within the cities of their main offices, as permitted to state-chartered banks.

By the mid-1920s many commercial banks had become financial department stores. Banks in the larger cities underwrote and traded in securities, sometimes directly but more often through subsidiaries and holding-company affiliates. In 1927, commercial banks underwrote only 22% of bonds issued. By 1929 this percentage had increased to 61%. Banks also failed in the 1920s; 5,712 banks suspended operations during the decade. Most (76%) were unit banks in the agricultural regions of the western grain states and southwestern states, failing chiefly because of the agricultural depression. Improvements in roads and automobile transportation also reduced the demand for independent banks. Losses to depositors from failures during this period averaged only 0.15% of deposits.

The Stock Market Crash of 1929 and the Great Depression

The stock market crash in 1929 had only a small direct effect on the banking system. Indeed, the market recovered fairly quickly then, much as it did after the 1987 stock market crash. In 1929, however, unlike in 1987, the Federal Reserve Board reacted to the crash (and the prior inflation) by reducing or allowing a reduction in the growth of the money stock. From 1929 through 1933 the stock of money fell by over one-third; commercial bank deposits fell by over 42%, in large part because bank suspensions and fears about future failures led the public to convert deposits into currency and gold, resulting in a multiple contraction of the money supply that was not offset by the Federal Reserve. The consequence was a severe economic depression and the suspension of 9,096 banks between 1930 and 1933, as borrowers defaulted on their loans.

Some 90% of the banks that failed during the Great Depression were small banks (holding assets under $2 million), located in small, predominantly rural, towns. Almost all of these banks were unit banks. Banks that were involved in securities transactions (underwriting, sales, and investment) failed at considerably lower rates than similar-sized banks that were not so involved. Annual losses to depositors between 1930 and 1933 averaged 0.81% of deposits, 5.4 times the 1920s' rate.

The Banking Act of 1933 and the Recovery Among its principal provisions, the Banking Act of 1933 (also called the Glass-Steagall Act) separated commercial and investment banking, created federal insurance of deposits by establishing the Federal Deposit Insurance Corporation (FDIC), prohibited interest payments on demand deposits (checking accounts), allowed the Federal Reserve to limit interest on savings accounts (Regulation Q), and permitted national banks to branch to the extent permitted to state banks.

Deposit insurance dispelled customers' fears of losing deposits and ended currency "runs" on insured banks. The insurance premiums were levied on all deposits, insured or not. Consequently, larger banks that served customers with accounts well over the $5,000 insured amount paid for most of the deposit insurance. These banks, however, also had tended to pay interest on demand deposits, including the deposits of smaller banks (called correspondent bank deposits). It is estimated that the cost to larger banks of deposit insurance was almost exactly offset by their savings in deposit interest. Although the state-limited unit-banking system unique to the United States was responsible for most of the bank failures of the early 1930s (given the drastic decline in the money supply), interstate branching still was not permitted.

Recovery came slowly, and banks extended a minimum of credit during the Great Depression, in part because the FDIC and the other federal banking agencies closely monitored and closed weak banks. The recovery was reversed in 1937, when the Federal Reserve, incorrectly fearing inflation because banks held more reserves than were required, sharply increased reserve requirements. As banks, still fearing runs, rebuilt their "excess" reserves, money supply growth once more declined, and the economy contracted. During World War II commercial and Federal Reserve banks together purchased $100 billion in government securities—nearly half of all bonds sold—as the government paid for the war (much as governments have always done) by expanding the money supply. Banks' holdings of U.S. government bonds increased from 40% of total bank investments at year-end 1939 to 73% at year-end 1945.

Post-World War II through 1980

In the postwar period, existing banks prospered; demand for banking services expanded, and bank charters were very difficult to obtain, in large measure because of the (incorrect) perception that the bank failures of the 1930s were due to "over-banking." Banks supplied various types of credit to a diverse group of borrowers. Retail banking flourished, particularly consumer credit. Credit (charge) cards were first offered by banks in 1950, although large-scale operations did not start until 1966, when the Visa card was introduced, followed by MasterCard in 1967. Nonetheless, industrial credit dominated bank lending during the continuing prosperity of the mid-1960s. Mortgage lending, too, expanded after 1963, when Congress allowed national banks to offer terms similar to those offered by savings and loan associations.

Bank loans to foreigners increased from 0.9% of assets in 1945 to 17.4% in 1975, and to 24.5% in 1981. A large part of the increase was fueled by the deposits in sizable U.S. banks by oil producers following the upsurge in prices in 1973, which the receiving banks loaned to borrowers in developing countries. Regional banks followed the larger banks' lead in the mid-1970s. Total bank loans to less developed countries (LDCs) amounted to some $100 billion by 1980, setting the stage for large losses in the 1980s, when many of these debtors could not repay their obligations.

Demand deposits declined from 75% of total bank assets in 1945 to 26% in 1980, despite the fact that individual checking accounts increased during this period from 34% to almost all households. This change occurred as banks increasingly funded their loans with negotiable certificates of deposit (first introduced in 1961) and businesses and consumers shifted their funds to interest-bearing accounts. This change was due largely to increases in market interest rates in the late 1960s and 1970s, combined with banks' inability to pay interest on demand deposits, owing to the prohibition enacted in 1933. As inflation-driven market rates of interest increased in the late 1970s above the legal ceiling permitted on savings and time deposits (Regulation Q), consumers transferred funds to money-market mutual funds, which grew from holdings of $4 billion in 1977 to $220 billion in 1982, and businesses managed their deposit accounts carefully. Banks were permitted to pay interest on savings accounts that could be transferred by check (negotiable order of withdrawal, or NOW, accounts) held by individuals, but not on ordinary demand deposits. Deregulation of interest on savings and time deposits began at year-end 1980 with the passage of the Depository Institutions Deregulation and Monetary Control Act. This law also made demand deposits at all banks and thrifts subject to Federal Reserve reserve requirements and increased deposit insurance from $40,000 to $100,000 per account.

Since expansion of banks across state lines was limited by the Bank Holding Company Act of 1956, banks attempted to offer additional products through affiliates of holding companies. These activities were restrained by a 1966 amendment limiting bank holding-company affiliates essentially to financial services.

Only about five banks a year failed from 1960 through 1981; most were small. Depositors (even those with more than the insured maximum) did not lose their funds, since the failed banks were taken over by other banks, often with FDIC assistance.

The 1980s and 1990s

The very high inflation-driven interest rates of the late 1970s declined in 1982. The prices of oil, farmland, and commercial real estate increased and then plummeted. The result was the greatest number of commercial bank and thrift failures since the 1930s. In 1982, 46 banks failed; the number climbed each year, and more than 200 banks a year failed from 1987 through 1990. Many were very large, beginning with the giant Continental Illinois Bank in Chicago, which collapsed in 1984. During this decade some 1,200 savings and loan associations failed, at a cost of perhaps $200 billion.

The primary cause of the failures was under-capitalization combined with federal deposit insurance. When oil producers, farmers, real estate developers, and foreign governments could not repay their loans, the losses were too great to be absorbed fully, and depositors, since they were insured, did not close banks by withdrawing funds. Large banks' losses were made worse when the authorities were slow to close insolvent banks. The prohibition of interstate branching, too, was important, since losses from one area could not be offset by gains from another.

After 1984 U.S. banks were displaced by Japanese and other foreign institutions as the world's largest banks, largely because of losses on LDC loans and restrictions on mergers and products not faced by foreign banks. The size rankings, though, do not reflect U.S. banks' development of sophisticated financial products and off-balance sheet obligations not reflected in the usual measures of size.

In 1991 legislation established a system of structured early resolution that requires banks to maintain their capital. By 1992 most states permitted any holding company to have banks (but not branches) anywhere. The biggest changes, however, came in 1999, with passage of the Financial Modernization Act. This law repealed the portions of the Glass-Steagall Act of 1933 that prevented investment companies and insurance interests from affiliating with commercial banks. The result was a spate of megamergers in which financial conglomerates could offer complete portfolios of services. The change was not without its problems, however. By 2001 regulators had identified serious abuses, such as stock analysts "hyping" the value of a stock in order to win banking contracts from the companies being promoted.

George J. Benston, Emory University Commercial Banks

Commercial banks, which exist in every country, are the oldest and most important financial institutions in the world. They originated in the Middle Ages to collect savings from individuals and put them to use to finance commerce. The oldest operating bank in the world is the Monte dei Paschi di Siena in Italy, which dates back to 1472. The first commercial bank in the United States was the Bank of North America, established in Philadelphia in 1782. It operates today as the First Pennsylvania Bank. In the United States, there are approximately 12,500 commercial banks, and their assets represent about one-third of the dollar assets of all U.S. financial institutions.

Commercial banks are financial intermediaries that channel funds from savers to borrowers in ways that are more attractive than those available to savers and borrowers who deal with each other directly. Banks thus increase the total amount of funds saved and invested. They encourage savings by providing deposit accounts that are available in almost any size and maturity, and with low credit and interest-rate risks. They encourage investment by making loans, similarly of almost any size and maturity, and accepting a variety of risk. To lessen the possibility of losses, banks charge more interest on loans than they pay out in deposit interest. This difference is often referred to as the interest rate spread.

Banks provide many deposit and lending services. Lending services appear on the asset side of a bank's balance sheet, while deposit activities appear on the liability side.

Assets are broken down into the following categories: loans, investments, and cash reserves.

Loans are funds lent to borrowers for specified periods of time. They are generally repayable at a scheduled maturity date and at a certain interest rate. A loan is usually tailored by a bank to meet the needs of an individual borrower. Thus, most loans are unique and not very marketable.

In 1990, loans accounted for 62% of bank assets, and revenues from interest payments on loans were the major source of bank earnings. The major types of loans were business loans (which accounted for 27% of total loans), mortgage loans on residential and commercial real estate (37%), consumer loans (18%), and loans to other financial institutions (9%). While the percentages tend to vary according to bank size and location, large city banks tend to make more business loans, while smaller, rural banks lean toward consumer and agricultural loans.

Investments on bank balance sheets are loans made in large, standard amounts to large, well-known borrowers, such as the U.S. Treasury and sizable corporations. In return, the bank receives bonds issued by the borrower. Unlike loans, investments or bonds tend to be marketable and hence provide banks with greater liquidity. Like loans, bonds yield interest income; although, because the risks are generally lower than for loans, they yield less. In 1990, investments accounted for 18% of bank assets. Most bonds are bought from the federal government or from state and local governments.

Banks hold cash reserves to meet demands for deposit outflows quickly and to satisfy the cash reserve requirements imposed by law by the Federal Reserve. The cash may be held in the banks' own vaults or on deposit at other banks or at Federal Reserve banks. Because cash reserves do not yield interest or other income, banks try to minimize the amount they hold. As of 1991 the Federal Reserve applied its reserve requirements only against demand deposits.

Liabilities on a bank's balance sheet fall into the following categories: deposits, borrowed funds, and capital.

Deposits are funds lent to the bank, for varying lengths of time, by households, businesses, and government units. The bank pays for the funds by offering interest, rendering certain services, or both. Services rendered include processing checks, maintaining records, and providing periodic statements to depositors on the status of their accounts. Deposits are generally classified as those that can be withdrawn and transferred to a third party by check ("transaction deposits"), and those that cannot.

Traditionally, checks could be written only on demand deposits (deposits payable on demand), on which the payment of interest was prohibited. More recently, consumer deposit holders have been permitted to write checks on interest-bearing accounts called negotiable order of withdrawal (NOW) accounts, and in limited numbers on money-market deposit (MMD) accounts. Noncheckable deposits generally have a specific maturity date or carry a provision (rarely imposed) for a waiting period before repayment. These accounts are referred to as time deposits, and they yield a higher interest rate. For individuals, time deposits generally come in the form of either savings accounts or consumer certificates of deposits (CDs). For businesses, time deposits are usually negotiable certificates of deposit in amounts of a million dollars or more. In 1990 27% of all bank deposits were in the form of transaction deposits, and 73% in the form of time deposits.

Banks borrow funds primarily from other banks (called "Fed" funds because the funds are reserves on deposit with the Federal Reserve) or from the Federal Reserve itself through its own lending operation (which is known as the discount window). These Fed fund loans generally come in large denominations and for short periods of time, frequently only overnight.

Capital represents funds invested by the owners of the bank. Generally, it is in the form of equity or stock and is issued in shares. Shareowners do not receive a fixed interest rate. Rather, they participate in the earnings and losses of the bank. If the bank generates earnings, shareholders benefit from increases in the value of their shares. Sometimes they also receive dividends. If the bank suffers losses, shareholders lose some of their investment. If the losses are large enough to wipe out the total value of the capital, the bank becomes insolvent, and shareholders lose both their total investment and control of the bank. Capital is a buffer that protects depositors from losses, and the bank from failure. In 1990, U.S. banks had capital equivalent to 7% of their assets.

Bank Management

Banking is a risky business. Banks assume credit risk in the form of possible default by borrowers, and interest rate risk in the form of unfavorable changes in interest rates that reduce revenues more than the cost of deposits. Banks also assume operating risk from inefficient management, liquidity risk from losses due to hurried sales of assets to meet deposit outflows, fraud risk from dishonest activities, and foreign currency risk from making loans or accepting deposits in other currencies.

Because banks make much of their income by assuming a certain degree of risk, they do not want to eliminate it. Rather, they try to manage the risk by charging a sufficiently high interest rate to cover expected losses.

Bank Risk Management
Frequently referred to as asset and liability management, bank risk management may be divided into four major categories: credit risk management, liquidity risk management, interest-rate risk management, and capital management.

Credit risk management involves screening applications for loans and purchases of bonds for creditworthiness, pricing the degree of risk assumed correctly, and diversifying the bank's total loan and investment portfolio to reduce its aggregate risk exposure.

Liquidity management applies to both a bank's assets and its liabilities. On the asset side, it involves determining the proper mix of cash, liquid investments, and loans (which are less liquid) needed to meet all demands for deposit outflows, on time and in full, thus avoiding the large, so-called fire losses that come from having to sell assets too hastily. On the liability side, liquidity management involves maintaining the ability to raise funds quickly by selling new large CDs and borrowing on the Fed funds market to meet deposit outflows. All banks practice asset liquidity management. Only larger, solvent banks, however, can practice liability liquidity management, because borrowing on the national money markets occurs only in large denominations.

Interest-rate risk management involves managing the maturity structure of the two sides of a bank's balance sheet (assets and liabilities) to control the effects of interest rate changes on income and capital.

Because a bank's capital assets act as a buffer to absorb losses before they must be charged against deposits, capital costs more than deposits as a source of funds. Capital management involves maintaining the minimum amount of capital needed to retain solvency, consistent with the degree of risk the bank wishes to assume. The greater the amount of credit, liquidity, or interest-rate risk, the more capital is needed. Conversely, the more capital a bank has, the more risks it can assume.

Bank Structure

Banks vary according to size, number of branches, and organizational format. The United States has both more banks, as well as more banks per capita, than any other country. In 1990, U.S. banks operated more than 50,000 branch offices, and the total number of bank offices exceeded 60,000. The number of banks has declined after peaking at more than 30,000 in the 1920s. At the same time, the number of branches has increased.

Most banks are relatively small. Nearly 90% have assets smaller than those of the average bank—$270 million—and 80% hold less than 15% of the banking system's total dollar assets. By contrast, the 150 largest banks, which make up less than 2% of all banks, have more than one-half the total assets. The largest U.S. bank is Citibank in New York; in 1990 its assets were about $155 billion, making it, however, only the 26th-largest bank in the world. A small but increasing number of banks and banking offices in the United States are foreign-owned.

The ability of banks to establish branch offices is restricted by law. States limit intrastate branching, and both state and federal law prohibit interstate branching. Until recently, one-third of the states, mostly in the Midwest, were "unit-banking" states: they prohibited any bank branches at all. Another third, mostly on the East Coast, were limited-branching states, allowing banks to form branches within city or county boundaries. The rest of the states, mostly on the West Coast, were statewide-branching states. In recent years, most states have liberalized their branching laws, and in 1991 Colorado became the last state to abandon unit banking.

Banks may be owned independently or by a holding company that owns one or more banks. Banks often prefer the holding company format for a number of reasons. First, they may wish to keep different banks or other affiliates as separate entities rather than branches for organizational purposes. Second, they may want to circumvent restrictions on branching within states and, more recently, across state boundaries. Beginning in the early 1980s most states began to permit acquisition of domestic banks by out-of-state holding companies.

A bank may also join a holding company in order to engage in certain financial activities not permitted to the bank itself and to operate nonbank financial services offices across state lines. In 1990 there were some 6,500 bank holding companies, operating 8,700 banks. Holding companies own most large banks.

The Bank Holding Company Act of 1956 gave the Federal Reserve the right to regulate the powers of bank holding companies, and the Douglas Amendment to the act gave states the right to permit interstate banking acquisitions, which they began to do in the early 1980s. By the early 1990s almost all states permitted some form of interstate acquisitions.

Bank Regulation

Banking has always been a relatively regulated industry, mostly to increase the safety of deposits and to reduce bank failures. Banks and bank holding companies are regulated in the types of products they may offer (primarily financial products); the number and locations of their offices; the minimum cash reserves they must maintain; the minimum capital they must maintain; the interest rate they may pay on deposits; the amount of lending to any single borrower; and the ability to merge with other banks.

Some of the regulations date back to the earliest days of the United States, when there was widespread public fear of allowing banks to have excessive or monopolistic power. Many of the country's earliest settlers remembered having poor experiences with banks in their native countries and welcomed regulations that would prevent U.S. banks from establishing branch offices or entering into other lines of business.

Additional regulations were imposed in the mid-1930s, during the Great Depression, when the number of commercial banks dropped from 25,000 to 14,000, mostly because of bank failures. Bank safety soon became the major public-policy concern of the day. Among other things, restrictions were placed on the interest rates payable on bank deposits, the entry of new banks, bank involvement in securities activities, and on loans collateralized by securities. Federal deposit insurance was also adopted.

Bank Regulators

Commercial banks are regulated and supervised at both the federal and state levels. Unlike other types of business firms, banks require special charters from either the federal or state governments. Federally chartered banks are required to include the term "national" in their name. They are supervised by the Office of the Comptroller of the Currency, an agency established by the National Bank Act of 1863 and housed in the U.S. Treasury Department. Federally chartered banks are required to belong to the Federal Reserve System, which, as the nation's central bank, sets its monetary policy. They are also required to be members of the Federal Deposit Insurance Corporation (FDIC), which provides deposit insurance through the Bank Insurance Fund (BIF).

State-chartered banks are subject to their state's banking laws and are regulated by their state's banking agency. Because state-chartered banks may join the Federal Reserve, and almost all choose to be insured by the FDIC, they are also subject to federal regulations and supervision. In other activities banks, like other businesses, may come under both the jurisdiction of the antitrust laws, administered by the Department of Justice, and the securities regulations, administered by the Securities and Exchange Commission.

Deposit Insurance

To remain solvent, banks must meet all demands for deposit outflows in full and on time. Because bank deposits make up most of the country's money supply, and banks operate the country's payments system through their check-clearing network, bank failures may reduce a nation's money supply and interfere with the efficient operation of the payment system. That in turn can affect trade and income within a community. In addition, the fear that a bank may be insolvent and thus not able to reimburse depositors in full may cause depositors at neighboring banks to doubt the financial solvency of their institutions and start withdrawing deposits in massive bank runs. The loss of deposits not only reduces the money supply but also forces banks to sell assets quickly to meet the demands, which further increases the likelihood of failure. Thus, failures may spill over from one bank to another.

The United States has suffered periodic bouts of bank failures throughout its history, culminating in the major banking crisis of the early 1930s, when nearly 40% of the nation's banks failed. In his first official act in office in March 1933, President Franklin D. Roosevelt closed all the nation's banks for at least one week until the banks could prove they were economically viable. To prevent more bank failures, as well as discourage depositors from running on banks to withdraw funds, Congress in 1933 established a system of federal deposit insurance for ensuring depositors in an amount of up to $2,500 per account. Accounts are now covered up to $100,000.

Deposit insurance has been highly successful at preventing bank runs and collapses of the money supply. But by reducing the concern of depositors, it has added an element of risk by indirectly encouraging banks to invest in riskier assets and operate with lower capital. During the 1980s such "moral hazard" behavior within the banking industry created major financial problems for the industry, as well as for the nation.

Recent Banking Problems

From 1933, when federal deposit insurance was introduced, through the early 1980s, the commercial banking system functioned well. After the extensive bank failures of the early 1930s, fewer than 10 banks failed a year, on average, through 1981. Thereafter, the number of bank failures increased sharply, to nearly 200 a year by the late 1980s. Between 1985 and 1990 more banks failed than in the previous 50-year history of the FDIC.

A number of factors contributed to the industry's downhill slide. For one thing, the low rate of bank failures at the time, as well as the relative degree of protection that deposit insurance offered, encouraged banks to increase their credit risk exposure by making more loans to less developed countries, commercial-real-estate companies, and highly leveraged business operations, and to lower their capital-to-asset ratios. While private financial institutions not covered by deposit insurance had capital ratios in the range of 10% to 20%, commercial banks developed ratios in the range of 6%. (The ratio was 15% before the FDIC was formed.) Advances in computer and telecommunication technology made matters worse by allowing depositors and banks to transfer funds rapidly and cheaply, evading existing regulations.

Massive changes in the U.S. economy accelerated the problem. During the late 1970s and early 1980s, inflation rose rapidly to double digit levels, then slowed considerably in the mid-1980s. This, in turn, slowed increases in consumer prices and income. During the years of double-digit inflation, commercial banks made loans on the assumption that income would increase rapidly enough to finance the repayment of the debt, along with interest. When the economy slowed, however, the low rate of inflation caused many borrowers to default. The result was to make collateral values drop below the value of the loans.

The bust was especially severe in energy-producing states such as Texas, Louisiana, and Oklahoma. Owing in part to the Iranian revolution of 1979, oil prices jumped from $12 a barrel to more than $35 a barrel, and some experts foresaw prices of nearly $100 a barrel. The jump generated great interest in U.S. oil reserves, stimulated economic activity in the oil-producing regions, and encouraged local banks to increase their loans. Instead of rising, though, oil prices collapsed back to near $12 a barrel by 1986, and the resulting economic bust devastated local banks. By the late 1980s 9 of the 10 largest banks in Texas had failed, and nearly 500 banks had failed in the entire Texas-Louisiana-Oklahoma region. These failures accounted for more than one-half of the total bank failures in the country during that period. A similar cycle, though triggered by other factors, hit New England and the Middle Atlantic states in the late 1980s and early 1990s, with only slightly less disastrous results for banks.

Federal tax-law changes in 1981 and 1986, too, caused problems for the industry. The 1981 law encouraged commercial-real-estate development, which is traditionally heavily leveraged. These benefits were reversed by the Tax Reform Act of 1986, however, and this in turn caused many real estate developments to become unprofitable and generated sharp losses for banks throughout the country.

In response to these problems, Congress and federal regulators began to implement major changes in the banking industry during the early 1990s, imposing higher capital requirements, increasing supervision, and reducing the potential for deposit insurance to encourage excessive risk taking by both banks and regulators. Earlier intervention by regulators in the affairs of troubled banks and mandatory recapitalization before a bank's capital was fully depleted was required by the FDIC Improvement Act of 1991.

George G. Kaufman, Loyola University

Trust Services

Fewer than 50 trust companies operating in the United States concentrate exclusively on trust and agency activities. All other "trust companies" are either commercial banks—national banks or state-chartered commercial banks—that have been authorized to operate trust departments, or state-chartered trust companies that have been authorized to engage in commercial (and savings) banking. Although almost all state-chartered trust companies have commercial banking departments, a large majority of the nation's commercial banks, especially those in smaller cities and towns, do not have trust departments.

The trust institution plays a vital role in the American economic and social order. Serving both users and suppliers of capital, it has three broad economic functions: (1) it conserves wealth and private property by safekeeping accumulated capital and preventing its wasteful use; (2) it encourages the collective ownership of industry both by its handling of estates and by its services to corporations in connection with their securities issues; and (3) it helps stabilize investment and therefore stimulates enterprise by putting funds into productive uses.

Service to Individuals

Personal trust business includes performance of trust and agency functions for individuals. The trust functions include the settling of estates of deceased persons and the care and management of trusts created by either deceased or living persons.

An executor acts under the last will and testament of a deceased person; an administrator serves by appointment of the courts if the individual dies without leaving a will or naming an executor in his or her will. The duties of the two are similar: to collect the assets of the estate; pay debts, taxes, and other charges; and distribute the balance. The duties of an executor are usually temporary; otherwise, if the will sets up a trust, it also names a testamentary trustee. Similar duties are performed by a guardian of the estate of a minor, whether appointed in the will or by the courts, and by a conservator of the estate of a legally incompetent person.

The most important voluntary or living trusts are retirement trusts, life insurance trusts, and pension trusts. Although the source of funds in each of these trusts differs, they share the common purpose of providing beneficiaries with relief from problems of property management while at the same time sustaining the flow of income.

Other types of personal trusts include sheltering trusts, set up, for example, by parents to ensure the support of their children; spendthrift trusts, to protect improvident beneficiaries from the consequences of their incompetence in money matters; and charitable trusts, for religious, educational, literary, or scientific purposes.

Most personal trusts call for active investment management by the trustee. Legal trusts restrict investments to those designated by state law, but discretionary trusts leave the manner in which the trust estate is to be invested to the trustee. In any event, diligence and prudence are required of a trustee, who may be surcharged by the courts for losses stemming from poor management of the entrusted assets.

Traditionally each trust was a separate unit with a separate portfolio; now, however, common trust funds are permitted. A number of small trusts may participate in both assets and income according to their relative sizes. The purpose of common trust funds is to achieve asset diversification, to facilitate efficiency in management, and to secure a higher yield on the investment of trust assets. Use of the device by the trust departments of national banks is regulated by Federal Reserve Regulation F, which recognizes three kinds of funds—for investment of small amounts, for general investment, and for mortgage investment. Common trust funds have become much more popular in recent years, and many commercial-bank trust departments now use them to attract trust investment accounts that were formerly considered too small to handle economically.

Trust institutions offer various agency services to individuals. They act as agents for trustees and executors in handling the mechanical phases of their duties, as custodians in the physical care and handling of securities, and as escrow agents. The latter function involves safekeeping something of value that is to be delivered to another party upon the occurrence of some specified happening.

Services to Corporations

Trust departments, especially in larger financial centers, perform important trust and agency services for corporations. The principal corporate function is to serve as trustee under an indenture or mortgage securing a bond issue. The trust department cooperates in drafting the indenture, the contract between the bond-issuing corporation and the bondholders. During the life of the bonds, acting on behalf of the bondholders, the trust department monitors the issuer's performance, serves notice on the issuer of any breach of the indenture, and, if the defect in performance is not remedied, may institute legal or other action to protect the bondholders.

The agency functions that corporate trustees perform for business takes several principal forms. A transfer agent arranges and keeps records of ownership transfers of corporate stock. When stock is transferred through a sale between individuals, the agent issues new certificates and cancels the old ones. A registrar prevents overissue of shares by keeping a record of the issued and outstanding shares. The registrar's duty is primarily to the public; the transfer agent serves the corporation. For bonds, the trustee usually acts also as registrar, noting the holder's name and transfer date on the existing bond instead of countersigning a new certificate issued by the transfer agent.

A fiscal agent relieves a corporation of clerical work in keeping records and drawing checks. For example, trust companies and departments may act as agents for paying bond interest and the principal amounts of maturing obligations. They may also handle sinking funds when these exist behind bond and preferred-stock issues. They may act as dividend-paying agents, as depositaries, and as exchange agents, issuing new securities for old.

In some cases a trust institution has been appointed receiver of a bankrupt business by the courts. In an such event, the institution may operate the business on a temporary basis, pending either reorganization or appointment of a trustee or liquidator.

Clifton H. Kreps, Jr. , University of North Carolina

Payment Services

One of the most important functions of banks is to provide the means of making payments within the economy. Most small payments are made with currency, but on a volume basis, most payments are made by transferring a deposit in a financial institution from one party to another. These transferable deposits are called demand deposits, or checkable deposits, and they form the bulk of the money supply by the most common definition of the term. (Currency makes up the rest.)

A bank check is simply an instruction to the bank by its customer to transfer funds from the customer's (payer's) account to that of a third party (the payee). If the payment system is efficient, those orders will be implemented swiftly, cheaply, and with certainty. About 70 billion checks are written annually in the United States, requiring a massive system for collecting and clearing checks. Operating this system is a substantial task for banks.

The simplest procedure for collecting checks takes place when the payer and the payee of the check have accounts at the same bank. The bank collects the check simply by reducing (debiting) the account of the payer by the amount of the check and then crediting the same amount to the payee's account.

When the check writer and the payee use different banks, the payee first deposits the check in his or her bank, which in turn collects the funds from the payer's bank. If both banks belong to the same clearinghouse (check-clearing organization), the banks may deal with one another directly. If not, the bank may send the check either to another bank that provides check collection services (a "correspondent bank") or to its own Federal Reserve bank. All banks must maintain deposit accounts (called reserves) with their regional Federal Reserve bank. These banks in turn collect the checks sent to them by crediting the reserve account of the bank depositing the check and debiting the account of the bank on which it was written. The Federal Reserve bank also returns the check to the payor's bank, which usually returns it to the payor with his or her next monthly statement.

One of the chief reasons for the establishment of the Federal Reserve System in 1913 was to create a more effective check collection system. Before the system was created, the collection of out-of-town checks was slow and costly, although clearinghouses handled local checks efficiently.

Until 1980 the Federal Reserve provided its check collection services without charge to banks that agreed to maintain reserve accounts with the reserve. The Monetary Control Act of 1980 changed this system, however. It required all banks to maintain these reserves, made Federal Reserve services available to all depository institutions, and required the Federal Reserve to charge full costs for all services provided.


A clearinghouse is a meeting place where representatives of participating banks come at specified times each day with all the checks they have received that are drawn on other member banks. Some banks will have more checks drawn on other banks than those banks will have drawn on them, and vice versa. Rather than have each bank settle its accounts with other banks on a bilateral basis, the clearinghouse arrangement allows the bank to settle only its net surplus or deficit. Generally, the clearinghouse notifies the Federal Reserve to credit the accounts of those of its banks that have a surplus in the clearinghouse, and to debit the accounts of those with a deficit. In a clearinghouse with ten members, for example, only ten adjustments to reserve accounts would have to be made on the banks' books. By contrast, if each of the ten banks had to settle with each of the other nine members, a total of 45 adjustments would be needed.

Electronic Funds Transfers

While most consumers still make their payments by checks, electronic wire transfer systems for household use are gaining popularity.

The largest wire transfer system is the so-called Fed Wire, which links the nation's Federal Reserve banks with participating commercial banks. This system lets a bank transfer funds virtually instantaneously from its reserve account to the reserve account of another bank. All transactions on the Fed Wire are final, which means they cannot be reversed in the event a participating bank does not have adequate funds. By contrast, a bank receiving a paper check cannot be sure that the check is good. There are several private wire transfer systems, the largest of which is the New York Clearing House Interbank Payments System (CHIPS).

The automated clearinghouse (ACH) provides a way to reduce the cost of handling paper checks by putting check information into a form that is machine readable. A typical ACH transaction might involve a large employer putting payroll information on magnetic tape that is then delivered to the ACH. The ACH combines the information on that tape with the information on tapes from other employers and sorts it by payee bank. Each bank then receives a tape with information on the amounts to be credited to the accounts of its depositors. The actual transfer of funds would be made by the bank of the employer. The ACH should lead to sizable economies of scale as volume grows and may reduce the cost of a payment transaction to less than that of a paper check. Point-of-sale (POS) systems have still greater potential to reduce the costs of making payments. These systems use a plastic card (a "debit" card) and a terminal at the merchant's checkout counter. The customer can electronically transfer funds from his or her bank account to the merchant's account. The technology is identical to that used in the automated teller machine (ATM), which allows a customer to use a card to withdraw funds or perform other banking transactions. The federal government uses POS technology to make certain welfare payments. Instead of receiving a monthly check, welfare recipients receive debit cards that allow them to draw on a specified amount of funds.

Some bank customers can make payments electronically using devices such as telephones, home computers, or interactive cable-television systems. The success of these various electronic payment systems will ultimately depend on their cost and convenience to the consumer.

Paul M. Horvitz, University of Houston

Thrift Institutions

Thrift institutions in the United States are generally considered to comprise savings banks and savings and loan associations. These institutions are the nation's oldest type of specialized depository institution.

Savings banks and savings and loans originated as different types of institutions to serve different needs of low- and moderate-income individuals and families: savings banks to encourage and provide a safe haven for savings, and savings and loans to provide the means to achieve home ownership. Over time, however, the two kinds of thrifts evolved into roughly similar institutions, with balance sheets consisting primarily of savings deposits on the liabilities side and home mortgages on the assets side. In the early 1990s there were some 3,000 thrift institutions in the United States.

v Economic as well as legislative and regulatory changes have altered the competitive balance between thrifts and other types of financial institutions, causing the thrift industry to decline in importance. In 1980, for example, thrifts held about 20% of the financial assets of all financial institutions. By the end of the decade, however, this percentage had dwindled to less than 15%. Moreover, the thrift industry's traditional role is changing. Although thrifts still hold about 26% of U.S. home mortgages, they prefer to sell or swap many of the loans they originate in secondary markets and hold the more liquid mortgage-backed securities. Thrift portfolios also include a growing percentage of consumer and commercial loans.

The composition of deposits at thrift institutions shifted markedly during the 1980s. Traditionally dependent on savings deposits and small time deposits gathered from individuals, thrifts took advantage of regulatory changes to offer larger time deposits and demand deposits. They also made more use of wholesale sources of funds from federal agencies and private institutions. Thrift institutions thus have become more like commercial banks, albeit with a definite community emphasis.

Savings Banks

Savings banks are the oldest specialized savings institutions in the United States, and among the oldest in the world. Though the first modern savings bank was founded in 1810 by the Reverend Henry Duncan in Dumfrieshire, Scotland, the concept can be traced back two centuries earlier. The idea was to encourage thrift among the poor and working class by providing a safe haven for their savings.

The Provident Institution for Savings in the Town of Boston and the Philadelphia Savings Fund Society, both of which began operations in 1816, were the first two U.S. savings banks. Savings banking spread rapidly in the northeastern United States during the 19th century, reaching a peak of 666 banks around 1875. Savings banks generally failed to follow the frontier westward, largely because settlers were more in need of business credit from commercial banks and home mortgage credit from savings and loans. Savings banks remained concentrated in the northeast, with the largest number in Massachusetts, Connecticut, and New York.

Traditionally, savings banks operated as mutual institutions with no stockholders. They received operating charters from their states and were created as permanent rather than self-liquidating entities. Except for adding to their protective reserves, the banks distributed all net earnings to depositors. Competitive pressures among banks in the late 1970s and early 1980s led to regulations permitting first the conversion from state to federal charter and then de novo chartering of federal savings banks. At the same time, the banks' need for more capital paved the way for conversion from the mutual form of ownership to the stock form.

Historically, the savings deposits of individuals have been the main source of savings bank funds, and home mortgages have been a major investment outlet. Traditional savings accounts still form over 25% of their liabilities, but savings banks now offer a wider variety of savings vehicles as well as checking accounts. Deposits at state-chartered savings banks are insured by the Bank Insurance Fund of the Federal Deposit Insurance Corporation (FDIC).

State and federal regulations still restrict the powers of savings banks. Like other thrifts, however, savings banks in most states now have powers similar to those of commercial banks. Moreover, savings banks in New York, Massachusetts, and Connecticut also sell low-cost savings-bank life insurance.

Savings and Loan Associations

The first savings and loan in America was the Oxford Provident Building Association, established in Frankford, Pa., in 1831. The early institutions were modeled on the English building societies of the late 1700s. They were self-liquidating, mutual entities owned by member shareholders. Their goal was to provide the member shareholders with home financing, and they were dissolved once this was accomplished. Eventually, the associations began admitting new shareholders periodically, even those who did not intend to borrow. Finally, savers were admitted on a day-to-day basis, and the savings function was separated completely from the borrowing function.

Until the 1930s all savings and loan associations operated under a state charter. With the onset of the Great Depression and subsequent failure of a considerable number of associations, Congress created a federal savings and loan system in 1933 to reestablish confidence in these institutions. The new federal chartering agency—the Federal Home Loan Bank Board—existed until 1989, when a new chartering and supervisory agency, the Office of Thrift Supervision, was established under the U.S. Treasury Department.

Like savings banks, savings and loans have historically relied chiefly on individual savings accounts for their funds. As the industry has evolved, however, the institutions have made use of alternative types of deposits as well as wholesale sources of funds. The deposits of savings and loan associations are all insured by the Savings Association Insurance Fund of the FDIC.

Savings and loan associations have traditionally operated under fairly narrow lending restrictions, and their portfolios have been dominated by home mortgages. Only recently have they been allowed to expand into other forms of community lending.

Saul B. Klaman, BEI Golembe, Inc.
Martin Regalia , National Council of Community Bankers

Federal Reserve System

The U.S. Federal Reserve System began operations in 1914 as the nation's central bank. Through its influence on money and credit, it has become a major instrument of national economic policy. It plays a large role in the regulation of financial institutions and in international financial relations. The Federal Reserve System is composed of the Board of Governors in Washington, the 12 regional Federal Reserve banks, and the roughly 6,000 commercial banks that are "members" of the system.

The board consists of seven persons nominated by the president of the United States, subject to Senate confirmation. Each member serves a 14-year term; one member's term expires every 2 years. Twice a year the board must report to Congress on its activities.

The 12 Federal Reserve banks are located in major financial centers. While technically private institutions that are "owned" by member banks, they act as public service institutions. All deposit institutions must hold reserves (as a proportion of their checking deposits) either on deposit with Federal Reserve banks or in currency. Reserve deposits with Federal Reserve banks serve as a medium for a national check-clearing system. The Federal Reserve banks can make loans to deposit institutions. They manage financial transactions for the U.S. Treasury and for foreign and international financial institutions. They put new currency into circulation, chiefly to replace worn-out specimens; Federal Reserve notes constitute the nation's paper currency. Each reserve bank has a staff of bank examiners who conduct on-the-spot inspections of the institutions under their jurisdiction.

The most important activities of the Federal Reserve are those that determine the speed with which the nation's money supply (currency and deposits) increases. Each deposit institution's loans and deposits are limited by its reserves, and the volume of reserves is determined by Federal Reserve actions, chiefly through open-market operations. In these operations the Federal Reserve Bank of New York buys or sells U.S. securities, foreign currencies, or other assets in transactions with banks and the public. When the Federal Reserve buys assets, it pays with a check drawn on itself and can create the funds to pay the check. If the purchases are insufficient, the economy may suffer from a lack of cash or credit. If the purchases are excessive, the money supply grows too rapidly, driving up inflation and interest rates.

The Federal Reserve has wide regulatory duties. It supervises state-chartered member banks, U.S. branches of foreign banks, and bank holding companies. The board regulates the establishment of bank branches, trust operations, and bank mergers. It sets minimum margin requirements for stock market lending, can determine the required ratio of reserves to deposits, and can vary the interest rates charged on loans to deposit institutions. The Federal Reserve also regulates consumer protection activities. Reserve authorities cooperate closely with foreign central banks and international organizations such as the International Monetary Fund and the World Bank.

Paul B. Trescott, Southern Illinois University

Consumer Lending

Although U.S. consumers actually lend more in financial markets than they borrow (usually in the form of holding deposits, life insurance, and pension fund reserves in financial institutions), consumers still borrow substantial amounts of money for housing, durable goods, and other purposes. Of the total household credit outstanding, the largest portion is associated with the purchases of homes. Such real-estate-related credit is typically referred to as mortgage credit because of the lien, or mortgage, placed on the property, making it collateral for the loan. Most of the rest of household credit is installment credit, so-named because it is repayable in more than one payment, or installment, usually scheduled monthly. The remainder of household debt is noninstallment credit, sometimes referred to as single-payment credit. It includes single-payment bank loans (sometimes with bonds or stocks as collateral), charge cards without an extended payments feature, and service credit, such as deferred payments to doctors, dentists, lawyers, or auto or home repair specialists.

Installment Lending

The origins of installment lending in the United States can be traced to the period after the Civil War, when massive industrial growth spurred a rise in the number of urban wage earners. Many of these wage earners came from rural areas or from Europe, where extended families could help them in difficult times. In the new industrial cities of the United States, however, these new workers had to face financial emergencies on their own, and they increasingly turned to installment lenders. The earliest lenders were simply loan sharks, who often charged extreme interest rates and took advantage of the borrowers. Recognition of the loan-shark problem led to changes in lending laws after 1900, permitting formation of legitimate finance companies, credit unions, and pawnshops.

It was the development of the automobile, however, that gave real impetus to the growth of installment lending. In the period after World War I, almost anyone with a steady job could purchase an automobile on the installment plan. The depression of the 1930s, as well as wartime controls on automobile and home appliance production and on consumer credit, dampened the growth of installment credit until after World War II. After the war suburban development and the accompanying spread of home and automobile ownership, as well as lenders' new enthusiasm for consumer installment credit, made installment credit so pervasive that almost all Americans have used it at one time or another.

Kinds of Consumer Installment Credit

There are many ways to categorize consumer installment credit, including the purpose of the credit, the type of lender, or, most commonly, the method of credit extension and repayment. Traditional forms of consumer installment credit are known as closed-end credit. The consumer and the lender agree at the outset on a fixed amount of credit to be repaid in a set number of payments, for example, over 48 or 60 months. Most of the credit extended for furniture, automobile, and appliance purchases, as well as for home repairs, education, and medical emergencies, is closed-end credit.

By contrast, open-end installment credit, which includes credit card credit and checking-account overdraft credit, allows consumers more flexibility. Instead of fixed amounts of credit and an inflexible repayment schedule agreed to in advance, open-end installment credit (also called revolving credit) gives a consumer a maximum amount of credit—a credit line—from the outset. Credit extensions are up to the consumer, who also decides the size of the monthly payments needed to repay the loan, as long as the payments exceed some minimum. Payment sizes can vary from one month to the next.

Such flexibility has made open-end installment credit increasingly popular with consumers since its early days in the 1950s. Nevertheless, it has taken the use of high-speed electronic computer systems by creditors to make open-end credit programs truly feasible. Banks, retail stores, and other creditors can now easily keep track of the transactions in millions of revolving accounts. This has encouraged the growth of open-end credit, and even allowed its use in mortgage credit through home-equity loans.


Commercial banks are the largest and best-known consumer installment creditors. Banks are leaders in automobile lending, as well as in open- and closed-end credit for other purposes. Commercial banks founded and operate the sizable, joint-effort credit card systems that operate under names such as Visa and MasterCard. Finance companies, which include the financial arms of manufacturers, are also large consumer lenders, primarily for closed-end credit. Savings banks and savings and loan associations offer both closed- and open-end installment credit.

Credit unions, too, are important sources of consumer loans. Credit unions operate as financial cooperatives, taking deposits from and lending funds to their members. While credit unions traditionally have focused on closed-end consumer credit, including automobile loans, larger credit unions now handle revolving credit as well.

Savings banks and savings and loan associations make both closed- and open-end installment loans. Retail stores, both local stores and nationwide chains, also offer credit plans. These may be closed-end plans for major purchases but are more typically revolving credit plans. Gasoline companies, too, maintain revolving credit operations.

Consumer Protection

Both states and the federal government have long accepted the principle that consumers deserve some governmental protection when engaging in complex transactions with their creditors.

Before the late 1960s most consumer-protection efforts were at the state level, but much of the focus shifted to Washington with the passage of the Truth in Lending Act in 1968. The 1970s saw the passage of the Fair Credit Reporting Act, the Equal Credit Opportunity Act, the Consumer Leasing Act, and the Fair Debt Collection Practices Act, as well as several consumer-protection laws in the area of mortgage credit. Each of these laws has led to the development of substantial bodies of case law, and many consumer-protection laws have been amended over time. While creditors often grumble about the administrative burden imposed by these laws, most would agree that they have helped minimize unethical practices in the installment-credit industry.

Thomas A. Durkin , Board of Governors, Federal Reserve System

Real Estate Financing

Debt created to finance real-estate purchases represents the largest component of outstanding debt in U.S. capital markets. Of the total debt outstanding in all domestic nonfinancial sectors at the beginning of 1990, real-estate mortgage debt accounted for more than 45%. Almost 70% of this amount represented home mortgages, which in turn constituted two-thirds of the total liabilities of all U.S. households. Thus real-estate finance clearly ranks among the most important economic activities in the United States.

Mortgage Instruments

A mortgage loan is evidence of debt secured by real property. It may be granted to finance land development, new construction, the purchase of new or existing property, to refinance an existing mortgage, or for other purposes. Mortgage debt is secured by a wide variety of properties, including homes, apartment houses, office buildings, shopping centers, industrial structures, and farms. Each loan contract carries a package of credit terms that vary according to the type of loan, the mortgage market and general economic conditions, the borrower's creditworthiness, the type and location of property used as collateral, and the legal requirements.

Since the Great Depression of the 1930s, the traditional mortgage loan has been the fixed-rate, long-term, amortized, level-payment loan. The terms include the interest rate, down payment requirements, maturity, and prepayment options. Payments are made monthly or biweekly for the life of the loan (which generally has been 25 to 30 years, although 15-year mortgage schedules have become more common). The payment is fixed, with a portion representing interest on the outstanding balance and the remainder reducing the principal. Thus the loan is fully reduced or amortized at maturity.

During the 1970s and 1980s alternative kinds of mortgages were developed. The most successful of these has been the adjustable-rate mortgage (ARM). An ARM differs from a fixed-rate mortgage in that the payment varies over the life of the loan. An ARM contract specifies the index used to adjust the interest rate, the repricing schedule, and the highest interest rate permitted over the life of the loan. The interest rate, and therefore the payment, is adjusted periodically, based on the repricing schedule and movement in the index. Some ARMs have limits, called caps, on the magnitude of the adjustment. If these caps prevent a full adjustment to the new interest rate, some loans allow the difference to be added to the principal. This is called negative amortization.

Other mortgage types include "graduated payment mortgages," for which the payment escalates during the early years on a prearranged basis, and "reverse-annuity mortgages," which specify periodic payments to be made to the homeowner; title to the property reverts to the lender on maturity. The latter mortgage type provides homeowners (typically elderly people) with a way to access the equity in their homes without having to sell them.

Mortgage Markets

Mortgage markets may be categorized as primary or secondary markets. The primary market includes the originators and holders of mortgages. The secondary market, which is dominated by government or government-sponsored agencies, consists of institutions that purchase existing mortgages and repackage or otherwise reconfigure them for resale. Many institutions operate in both markets.

Historically, thrift institutions—savings and loan associations and savings banks—were the largest originators and holders of home mortgages. But innovations in mortgage finance and growth in the secondary markets—along with the thrift industry's financial problems—forced a realignment in the mortgage market in the 1980s.

Mortgage companies originate almost 36% of all home loans, while commercial banks originate 33%. Thrift institutions originate about 30%. In the early 1990s the thrift industry held about 26% of the outstanding home mortgage debt in the country, while commercial banks held only about 16%. Mortgage companies, which mostly originate loans, themselves hold virtually no outstanding mortgage debt.

Many originators of home loans choose not to hold the loans in their portfolios. Rather, they sell the mortgages to other institutions or to the secondary market. In the secondary market, mortgages are pooled together, and shares of the pool are sold to investors. These shares, called mortgage-backed securities (MBSs), are more liquid and have both more stable payment streams and higher credit ratings than the original mortgages. Thus, they appeal to a broader range of investors.

While mortgage pools do not actually provide the funds for mortgage lending, their development has tapped new sources of funding. By the early 1990s more than one-third of all home mortgages had been pooled. Many traditional mortgage lenders, such as thrift institutions, commercial banks, and insurance companies, are significant purchasers of MBSs.

Some mortgage-backed securities are structured to pass all principal and interest payments, as well as any prepayments, through to the investors on a prorated basis as the payments come into the pool. This kind of MBS is called a "passthrough" security. Another approach groups the shareholders of the pool into various classes, with certain classes receiving all the principal payments coming into the pool until their share is completely paid off. Payments are then directed to the next class of investors, and the process continues until all shares are paid off. Interest payments are shared on a prorated basis. This kind of security is called a collateralized mortgage obligation (CMO).

The Role of Government

The secondary markets are dominated by three government or government-sponsored agencies: the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC). Each agency focuses on a different segment of the market, with GNMA buying and pooling mortgages guaranteed by the Veterans Administration or the Federal Housing Administration, and FNMA and FHLMC dealing in conventional mortgages.

Because real estate financing has such great social ramifications, federal and state governments try to influence this activity both directly and indirectly. The supply and terms of mortgage credit are set by the Federal Reserve System, the Treasury Department, and financial services regulators as they set monetary and debt management policy. More directly, federal tax policy fosters home ownership by making mortgage interest payments deductible on federal income tax returns.

The federal government administers various mortgage guarantee and mortgage insurance programs through the Veterans Administration, which fosters homeownership among armed services personnel and veterans, and the Federal Housing Administration, which directs its activities toward low- and moderate-income groups. Congress established the Federal Home Loan Bank System in 1933 to provide a reserve system for thrifts analogous to the Federal Reserve System for commercial banks. It also set up a system of federal deposit insurance to provide depository institutions with steady funding, part of it for home mortgage lending.

Saul B. Klaman , BEI Golembe, Inc.
Martin Regalia, National Council of Community Bankers

Investment Banking

Investment banking is the provision of services to businesses and governments in obtaining money, usually through the sale of marketable securities. These securities are usually stocks or bonds. Common or preferred stocks, or shares, sometimes called equities, are sold to investors, who become owners of a part, or share, of the business. Bonds are borrowings and are sold to investors, who then become creditors of the business or government. Many varieties of bonds and stocks are issued to obtain money, called capital.

When new securities are sold by an issuer, the transaction is a primary sale, and the money goes to the issuer. When a security holder sells a stock or bond, the transaction is a secondary sale. In a secondary sale, the money goes to the former security owner, not to the business or government issuer. Investment bankers may be asked to manage large secondary as well as primary transactions.

Investment banking is as old as the corporate form of business. When profit-seeking companies need capital, they turn to agents, who obtain it for them from savers. Traditionally, those savers were individuals, but they are now more likely to be financial institutions, such as insurance companies, private or government pension funds, or mutual funds.

Instead of obtaining money through a public sale of securities, investment-banking agents sometimes obtain it directly through a private sale to one or several institutions. Such private placements may be more flexible or faster than a public offering. For a private placement, the Securities and Exchange Commission (SEC), which oversees U.S. securities markets, does not require a lengthy registration document and prospectus describing the issuer and the security. Development of the "shelf registration" process has made it possible for qualified issuers to get advance clearance from the SEC to permit a quick public sale when market conditions become favorable.

Investment banks meet their expenses and earn a profit by charging a commission, called the underwriters' spread, on the funds they raise. The commission may be as low as 1% on a good-sized bond issue for a state, or as high as 15% for a new business selling common shares in an initial public offering.

Investment banks usually guarantee, or underwrite, that they will raise the needed capital whether or not the securities are sold to savers at the initial price. Underwriting is sometimes called buying, because the investment banks buy the securities for resale. In the case of highly speculative issues, investment bankers may agree only to make their best efforts to raise the capital. Such "best efforts" transactions are not underwritten.

A managing investment bank, frequently called the managing underwriter, oversees the security issuance process. This firm offers advice to the issuer about the amount of money to be raised, the nature of the securities to be issued, and the timing of the issue in view of market conditions. The managing underwriter selects the firms that will share the risk of underwriting the issue. It also selects the firms-some of which may be in the underwriting syndicate-that will distribute or sell the securities.

The managing underwriter receives a share of the commission that is earned on an entire securities offering, whereas members of the underwriting or selling syndicates are compensated only on the securities that they underwrite or sell. Because of the revenues and power that are associated with the managing underwriter role, investment bankers often compete intensely for the position.

Instead of negotiating with a managing underwriter, an issuer will occassionally invite bids from prospective underwriters, who form syndicates to compete for a particular security issue. The issuer sells the securities to the syndicate that offers the best terms. Security offerings by states, municipalities, and regulated public utilities are often handled in this manner.

Pricing a security is a challenging task. If a security is priced too high, it will not sell, causing the underwriters to suffer a loss. If a security is priced too low, it may rise quickly in price within a secondary market, denying the issuer just compensation for the security. Most investment banking firms have allied brokerage and market-making businesses that provide insight into appropriate security prices. As brokers, they constantly buy and sell securities on behalf of clients. As market makers, they establish prices by buying and selling securities for their own accounts.

In order to facilitate the selling of a large new issue, a managing underwriter will attempt to stabilize the price by announcing its willingness to buy at the offering price on the secondary market any of the new securities that recent buyers have decided they would rather not hold. Initially, underwriters may sell more than the allocated number of securities in order to ensure that they have some buying power to repurchase these shares.

Investment bankers offer many services to their clients. They often help clients find companies to buy in friendly or unfriendly acquisitions. They counsel companies that have been targeted for unfriendly takeovers. They may sell novel securities, such as "high-risk, high-interest-rate" bonds (called junk bonds). They also make investments with their own capital, acting in the manner of European merchant bankers.

The trend toward merchant banking and more complex business operations has led the majority of investment-banking houses to obtain additional capital by going public and selling shares to outsiders. As the financial strength of these firms has grown, some have even been able to underwrite and sell large issues without the help of other firms.

Investment bankers have also created new securities to help their clients better manage investment risks and returns. These include securities derived from collections of mortgages and from stock market indexes. Investment bankers help their clients exchange obligations through complex swap arrangements that affect the maturities, costs, and sometimes even the currencies of these obligations. Following the globalization of the securities market, investment bankers have opened offices worldwide.

Wesley W. Marple, Jr. Northeastern University

Life Insurance Companies and Pension Funds

The main purpose of life insurance companies and pension funds is to assist clients in managing financial risks associated with premature death and retirement. The institutions compete with banks for savings and investment funds.

Life Insurance

Life insurers offer several types of savings plans. Annuity contracts provide the opportunity to tax-defer savings before retirement and then use those accumulated funds (usually paid out periodically) for income. The contracts protect against the risk that contract holders will outlive their financial resources. Fixed-dollar annuities guarantee a minimum return; the return from variable annuities depends on the performance of an underlying investment portfolio. Many life insurance companies also participate in the retirement savings market by selling Guaranteed Investment Contracts (GICs) to employer-sponsored pension funds. These contracts guarantee a high return. A GIC is similar to a Bank Investment Contract (BIC), but federal deposit insurance does not cover GIC investments.

Savings are also possible through contracts designed to pay benefits at the time of the insured's death. Many policies have savings elements called cash values. In traditional forms of life insurance (for example, whole life insurance), cash value is a by-product of the way premiums are paid. Premiums in the early years of a policy often exceed the cost of the death benefits. Excess premiums accumulate and are used by the insurer to offset the higher costs of death protection during a policyholder's later years.

An insured person who terminates a policy prior to death is entitled to a refund equal to the cash value. The insured, however, then owes income taxes on the difference between the cash value received and the total premiums paid out during the life of the contract. No taxes are levied on cash values before a policy is terminated if the size of the savings relative to the death protection falls within guidelines specified by the Internal Revenue Code.

Some life insurance policies have cash values designed to vary directly with the insurer's experience in the areas of investments, policyholder mortality, and operating expenses. The most notable example of this type of policy is universal life insurance, which was introduced in the United States in 1979. Such policies often provide for flexible premium payments and periodic adjustment of the policy's death benefit, as well as an emphasis on accumulating savings through cash values. Similar policies include variable life insurance, interest-sensitive whole life, and variable universal life policies. All these products, by way of their cash values, offer consumers a chance to minimize the taxes owed on savings.

Rather than terminating their contracts, insurance policyowners can get access to their cash values-without losing their death benefits-through the life insurance policy loan provision. Interest charged for such loans under older policies is often at a low, fixed rate, while interest rates for newer policies generally vary with the rates charged by other lenders at the time. While these policies carry no contractual obligation to repay either the policy loan or the interest charged, if an insured person dies with a policy loan outstanding, the death benefit is reduced by the sum of the loan and any unpaid interest. Policy loans are not taxable as income as long as they meet the requirements of the Internal Revenue Code. Demand for these loans tends to increase when interest rates within the economy are high and other kinds of loans are difficult to obtain.

Life insurers help individuals and businesses save money indirectly through products other than cash value policies. Term life insurance, for example, is coverage that has no cash value and that pays out death benefits only if the insured dies within a certain period. It now accounts for about one-third of all life insurance coverage purchased annually. Younger people pay lower premiums for this kind of policy than for cash value coverage. As a result, many buy whatever death protection they need through term life and put the money saved into other investments.

As part of their operations, life insurers concentrate their investments in long-term corporate bonds, mortgages, and government securities. While life insurers tend to be conservative in their investments and are subject to various state regulations, their investments may run into financial difficulties. Weak real estate loans and investment in high-risk bonds led to concern over the solvency of many insurers during the early 1990s. Although there is no federal program that guarantees the payment of benefits by life insurers, most states provide for assessments from insurers to pay off benefits owed by a failed insurer.

Pension Funds

Many people hold a significant portion of their savings in employer-sponsored pension plans. Employers with defined-benefit pension plans promise to provide a specific amount of monthly income at retirement, with individual amounts based on factors such as a person's salary history and years of employment. Employers who sponsor defined-contribution pensions promise only to contribute a specified amount to the plan each year during an employee's working career; benefits depend on the amount that accumulates by retirement. Both pension plans can be either contributory (employees fund part of the cost during their working years) or noncontributory (employers pay the full cost).

The Employee Retirement Income Security Act (ERISA), passed in 1974, specifies the rules that pension plans must follow to qualify for favorable tax status. The rules include provisions that prohibit discrimination in favor of highly compensated employees, set requirements for advance pension funding, and specify the speed with which promised benefits must become vested, or nonforfeitable. ERISA also established the Pension Benefit Guarantee Corporation (PBGC), which insures benefits that were promised as part of defined-benefit pension plans terminated by employers. ERISA amendments passed during the 1980s limit PBGC benefit payments only to underfunded pensions terminated by employers experiencing severe financial distress. Such PBGC coverage is mandatory for defined-benefit plans and is funded with premiums based on each plan's funding status and number of participants.

Sandra G. Gustavson, University of Georgia

Government-Sponsored Enterprises and Loan Guarantees

Though the public sector has for decades exerted influence on implementation of public policies in ways going far beyond the direct actions of governmental bodies, relatively little attention has been given to the systematic comparison of the various means of public action. A number of potential tools may be chosen to implement a given policy. More efficient and effective programs may be achieved through selection of the proper tool. Such tools include, for example, grants and subsidies, tax expenditures, social and economic regulation (including a variety of direct and indirect incentives), government corporations, and manipulation of credit by means of loan guarantees and financial market intervention. The latter method can involve both government and government-sponsored enterprises (GSEs), depending on the particular policy area and market context.

Thus there are loan guarantee programs administered entirely within government, such as loan guarantees to small-business contractors administered by the Small Business Administration; private-sector programs (perhaps with some governmental supervision), such as the Federal National Mortgage Association, or "Fannie Mae"; and programs with mixed public-private administration, such as the Federal Home Loan Mortgage Association ("Freddie Mac"), which has on its board both federal and private-sector officials.

States as well as the federal government make use of these different program designs. This article will focus entirely, however, on programs with federal origin or oversight.

In December 1990 the House Committee on Banking, Finance and Urban Affairs' Subcommittee on Economic Stabilization identified about 72 loan guarantee programs within the federal government. These include such programs as rural development loan guarantees, mortgage insurance, economic development loan guarantees for Native Americans, small-business loan guarantees, veterans' housing loan guarantees, ship-financing guarantees, and student-loan guarantees. The major GSEs include the Federal Home Loan Bank (FHLB) System (1932), the Farm Credit System (1933), the Federal National Mortgage Association (1938), the Federal Home Loan Mortgage Corporation (1970), the Student Loan Marketing Association ("Sallie Mae," 1972), and the Federal Agricultural Mortgage Corporation ("Farmer Mac," 1987).

Government-Sponsored Enterprises

A major vehicle for these programs is the government-sponsored enterprise, which is formally external to the government, though the loan guarantees it employs are also widely used in certain program areas within government. Scholars disagree as to the precise definition of a GSE, but in essence, a GSE exists when an enterprise is chartered by Congress to achieve some specific public end, yet is privately owned. In general, GSEs are involved in lending or in guaranteeing loans; hence they may be considered financial institutions. Broad conceptions of the GSE allow for other activities.

Typically, GSEs purchase loans from the banks that originated them. (Some GSEs, such as the Farm Credit Administration, also issue loans directly.) They hold some of the purchased loans for their own account but resell many of them, often grouped or packaged in some way, to investors. Investors generally assume that there is an implicit governmental guarantee placed on these loans should the borrowers default. Banks can be quite interested in such programs, given their ability to dispose of the loans profitably in the secondary market created by the GSEs, though the complexity of such programs and the amount of paperwork they require evidently discourage many banks from participating. Enjoying special privileges as well as an apparent governmental guarantee, GSEs produce profits for the private investors in the securities issued by the GSEs themselves, as well as for those investors who puchase the GSEs' repackaged loan products.

The Implicit Guarantee

That the loans and loan guarantees GSEs provide are thought to be backed by the full credit and budget authority of the U.S. government is critically important to their success. Yet GSE charters, with few exceptions, do not mandate that the government provide this safety net. In fact, the securities issued by GSEs often state that they are not guaranteed by the federal government.

Nevertheless, the statutes governing GSEs often grant their securities a status similar to that of U.S. Treasury obligations. Hence the securities need not be registered by the Securities and Exchange Commission (those of the Federal Agricultural Mortgage Corporation excepted); they may not be subject to state and local taxes; and they may possess other privileges of governmentlike status. GSEs may be exempt in varying degrees from federal regulations applying to private businesses yet may also sometimes evade those applying to federal agencies, such as Civil Service and personnel regulations.

Besides the special exemptions or privileges they may enjoy, GSEs are considered to be backed by the federal government for several other reasons. The enormous scale of their obligations—estimates ranged up to $3 trillion in the early 1990s—means that their collective failure would have serious consequences for the U.S. economy. Failure to back any one of these essentially similar entities would create an implicit threat to all of the others, with the increased risk being reflected adversely in their borrowing costs and in the value of the securities they issue.

Once the federal government demonstrated recognition of an unwritten obligation by intervening to rescue one GSE—as it did in the $4 billion rescue of the Farm Credit System in 1987—it could thereafter be expected to make good elsewhere as well. In fact, the federal government has even provided bailouts in certain cases in which no guarantee, explicit or implicit, existed at all. In 1980 it extended government-secured loans to the Chrysler Corporation; these loans were fully repaid by the end of 1983.

That GSEs need not meet the standards required of other securities-issuing entities, such as private firms, in itself implies a guarantee. By regulating securities issuance, trade, ownership, investor protections, and so on, the Securities and Exchange Commission and other regulatory agencies provide the trust and security essential to create a market; markets in GSE securities would not function appropriately without the implicit U.S. guarantee.

Moreover, the obligations of the GSEs are not only huge but also widely distributed. Since both providers and recipients can be found in most congressional districts, continued congressional support for these programs, and for bailouts should they become necessary, seems assured.

Advantages and Disadvantages

As a policy tool, loan guarantees address situations in which the private market provides too little credit, given the aims of public policy. Lenders perceive too much risk or too little potential return. The government then steps in to absorb some of the risk or create market conditions assuring adequate returns. Private lenders may misjudge risk because the relevant markets are unfamiliar, or they may be discouraged by poor economic conditions in other markets or in general. During the Great Depression, the National Housing Act of 1934 (which created the Federal Housing Administration) and the Housing Act of 1938 (which created the Federal National Mortgage Association) were passed to address these concerns by guaranteeing loans and providing a secondary market for them.

In some cases lawmakers expect initial losses but establish a program anyway in order to create a market that will prove sustainable. This logic may apply, for example, to federal programs intended to stimulate rural development or urban redevelopment. In general, however, loan guarantee programs are attractive because they appear costless. They are not in the federal budget; they require no tax increase. They do not—on the surface—appear to worsen the federal deficit. They have low governmental administrative costs. Moreover, the costs of default on loans are all in the future.

Loan guarantees are a good way to jumpstart a federal initiative. They often work through existing private-sector organizations and individuals (such as banks and those entrepreneurs to whom the banks lend). Hence there is no need to build a public bureau with in-house expertise; the private-sector organizations already exist and have already moved up the learning curve. Creation of a hard-to-reduce federal bureaucracy is avoided. In principle, loan guarantee programs should not adversely interfere with existing credit, since the purpose of the programs is to create credit in areas where it is insufficient. In principle, the loans will be repaid; thus there is no handout or bailout intended.

Critics of loan guarantees argue that they are equivalent to hidden subsidies. They reduce the costs of borrowing in markets that would properly be evaluated as risky. Inevitably, there are defaults, and the government pays; hence they are not costless at all. They give special benefits to selected industries, such as housing and ship-building, and they therefore can be inequitable. Some critics argue that GSEs do not always provide credit where it would not otherwise be provided; private secondary markets could accomplish the same goals as GSEs. It has even been proposed that at least some GSEs be privatized. Further, GSEs can distort, not merely supplement, capital markets, favoring some participants.

Loan guarantee programs are complex in design and hard to implement, and they do not target needy recipients well. Loan guarantees may misdefine social problems as credit problems alone, when a more complex set of interventions may be called for. The guarantees are often not well coordinated with other federal programs. Paperwork and processing delays have discouraged many lenders from participating.

Loan guarantees also can be difficult to monitor, and the relative lack of oversight of GSEs by government agencies has been much criticized. Since they are narrowly focused under their federal charters, GSEs find it hard to diversify to protect themselves against risk. As problems snowball, few may be watching. The government's guarantee creates an incentive against meticulous review of loan applications, increasing the chance of defaults. Without adequate supervision, government liabilities may increase.

Given these factors, it is not surprising that GSEs have shown mixed results.

Barry M. Mitnick, University of Pittsburgh

Further Reading

Aspinwall, Richard C., and Robert A. Eisenbeis, eds., Handbook for Banking Strategy (Wiley 1985).

Baughn, William, et al., The Banker's Handbook, 3d ed. (Dow Jones-Irwin 1988).

Benston, George J., ed., Financial Services: The Changing Institutions and Government Policy (Prentice-Hall 1983).

Benston, George J., et al., Safe and Sound Banking (MIT Press 1986).

Congressional Budget Office, Controlling the Risks of Government-Sponsored Enterprise (USGPO 1991). England, Catherine, Governing Banking's Future (Kluwer Academic Publishers 1991).

Fabozzi, Frank J., and Frank G. Zarb, Handbook of Financial Markets, 2d ed. (Dow Jones-Irwin 1986).

Federal Deposit Insurance Corporation, Deposit Insurance in a Changing Environment (USGPO 1983).

Federal Home Loan Bank Board, Agenda for Reform (USGPO 1983).

Friedman, Milton, and Anna Schwartz, A Monetary History of the United States, 1867-1960 (Princeton Univ. Press 1963).

Gardner, Mona, and Dixie L. Mills, Managing Financial Institutions, 2d ed. (Dryden 1991).

Golembe, Carter H., and David S. Holland, Federal Regulation of Banking 1983-84 (Golembe Associates 1983).

Hammond, Bray, Banks and Politics in America from the Revolution to the Civil War (Princeton Univ. Press 1957).

Haraf, William, ed., Restructuring Banking and Financial Services in America (American Enterprise Institute 1988).

Horvitz, Paul M., and Richard A. Ward, Monetary Policy and the Financial System, 6th ed. (Prentice-Hall 1987).

Kane, Edward J., The S&L Insurance Mess: How Did It Happen? (Urban Institute 1990).

Kaufman, George G., The U.S. Financial System, 5th ed. (Prentice-Hall 1992).

Klebaner, Benjamin J., Commercial Banking in the United States: A History (Dryden 1974).

Krooss, Herman E., A Documentary History of Banking and Currency in the United States (Chelsea House 1969).

Lowy, Martin, High Rollers: Inside the Savings and Loan Debacle (Praeger 1991).

Lund, M. S., "Between Welfare and the Market: Loan Guarantees as a Policy Tool," in L. M. Salamon, ed., Beyond Privatization: The Tools of Government Action (Urban Institute Press 1989).

Pierce, James L., The Future of Banking (Yale Univ. Press 1991).

Polakoff, Murray E., et al., Financial Institutions and Markets, 2d ed. (Houghton Mifflin 1981).

Rose, Peter S., The Changing Structure of American Banking (Columbia Univ. Press 1987).

Rose, Peter S., The Interstate Banking Revolution: Benefits, Risks, and Tradeoffs for Bankers and Consumers (Greenwood 1989).

Schweikart, Larry E., ed., Banking and Finance to 1913 (Facts on File 1990).

Stigum, Marcia, The Money Market, 3d ed. (Dow Jones-Irwin 1990). Temin, Peter, Did Monetary Forces Cause the Great Depression? (Norton 1976).

Timberlake, Richard H., The Origins of Central Banking in the United States (Harvard Univ. Press 1978).

White, Lawrence J., The S & L Debacle: Public Policy Lessons for Bank and Thrift Regulation (Oxford Univ. Press 1991).