Financial Institutions: Chapter Seven

Economics: Theory & Practice 9
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Edition Welch & Welch
John Wiley & Sons, Inc. 2010 All Rights Reserved
Chapter Seven:
Financial I nstitutions
Chapter Objectives
7-2
To define money and explain the functions of money.

To identify the various measures and components of the U.S. money supply and different
monetary standards.

To introduce the financial institutions that are important for the maintenance and control of
the U.S. money supply, and to highlight commercial banks and commercial bank regulation.

To explain the role of the Federal Reserve system, its organization, and the functions that
Federal Reserve banks perform.

To discuss recent legislative and structural changes in the financial institutions system.
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Chapter Seven Overview
Chapter Seven
7-3
Money
Monetary Standards
Financial Institutions
Federal Reserve System
Money Supply
Recent Trends in Financial Institutions
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Money
7-4
Money:
Anything that is generally accepted as a medium of exchange.

Medium of Exchange:
Something that is generally accepted as payment for goods, services, and
resources; the primary function of money.

Value of Money:
Measured by the goods, services, and resources that money can purchase.

Barter System:
System in which goods and services are exchanged for each other rather
than for money.
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Money
7-5
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Money
7-6
Measure of Value:

A function of money; the value of every good, service,
and resource can be expressed in terms of an economys
base unit of money.

Method for Storing Wealth and Delaying Payments:

A function of money; allows for saving, or storing wealth
for future use, and permits credit, or delayed payments.
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Money Supply
7-7
M1:
Is a narrower definition of the U.S. money supply that includes
coins, and paper money in circulation, some travelers checks,
most demand deposits, and other checkable deposits.
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Money Supply
7-8
Currency:
Coins and paper money.

Token Money:
Money with a face value greater than the value of the commodity from which it is made.

Federal Reserve Notes:
Paper money issued by the Federal Reserve Banks.

Demand Deposits:
Checking account balances kept primarily at commercial banks.

Other Checkable Deposits:
Interest-bearing accounts similar to demand deposits offered by financial institutions.
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Money Supply
7-9
Currency, Travelers Checks, Demand Deposits, and Other
Checkable Deposits (Billions of Dollars)
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Money Supply
7-10
Velocity:
Average number of times the money supply is turned
over in a year in relationship to GDP.
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Money Supply
7-11
M2:
Includes M1 and:
Savings, small denomination time deposit accounts, money
market deposit accounts, and other financial instruments.
M3:
Includes M2 and:
Eurodollar holdings by U.S. residents, $100,000+ time deposit
accounts, and other financial instruments.
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Money Supply
7-12
Liquidity:
Ease of converting an asset to its value in cash or spendable funds.

Commodity Monetary Standard:
Economys money is backed by something of tangible value such as gold or silver.
Prior to 1933 the U.S. had a gold-coin standard.
Gold not only backed the money supply but also freely circulated in the hands of the public.
From 1934 through 1971 the U.S. had a gold-bullion standard.
Gold backed the money supply but was no longer available to the general public.

Paper Monetary Standard:
Economys money is not backed by anything of tangible value such as gold or silver.
Since 1971 the U.S. economy has been on a paper monetary standard.
Occurred after foreign debts were paid off in gold bullion and the U.S. gold reserves
were nearly exhausted, no longer allowing the U.S. to back its money with gold.
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7-13
Financial Depository Institutions (FDI):
Institutions that accept and maintain deposits, and make loans.
Have the ability to create and destroy money.
Come in many forms:
Commercial banks
Savings and loan associations
Savings banks
Credit unions
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7-14
Commercial Banks:
Primary financial depository institutions.
Institutions that hold and maintain checking accounts for their
customers, make commercial and other loans, and perform
other functions.
Must be incorporated or have a corporate charter.
Dual Banking System:
National banks
Incorporated under a federal charter.
State banks
Incorporated under a state charter.
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Banking Agencies:
Charter Authority:
National banks are regulated by a federal agency, and state
banks by a state banking agency.

The Federal Reserve:
Regulates its own members and imposes some uniform
regulations on all commercial banks regardless of
membership.

Federal Deposit Insurance Corporation (FDIC):
Administers regulations and insures deposits in commercial
banks that choose to affiliate with the FDIC.
7-15
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7-16
Bank Failure:
Occurs when a banks assets are no longer sufficient to cover
liabilities that must be paid.
Usually the result of heavy loan losses and deposit withdrawals.

FDIC will guarantee depositors with accounts of less than a specified
amount in this situation.
Asset:
Something that an individual or business owns; can be used to cover liabilities.
Liability:
A claim on assets; an obligation or a debt of an individual or a business.
Net Worth:
Assets minus liabilities; the monetary value of a business.
Key Terms
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7-17
Federal Reserve System:
Created in 1913.
Charged with:
Overseeing the money supply and adjusting its size to meet the
needs of the economy.
Coordinating commercial banking operations, and
Regulating some aspects of all depository institutions.
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7-18
Organization of the Federal Reserve System:
Board of Governors:
Seven-member board heading the Federal Reserve System;
develops policies concerning money, banking, and other
financial institution practices.

Open Market Committee:
Oversees the buying and selling of government securities by the
Federal Reserve System.

Federal Reserve Bank:
Twelve banks that deal with commercial banks and other
financial institutions.
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7-19
The Twelve Banks
Functions of the Federal
Reserve Banks:
Supervise & examine
member banks
Maintain reserve
accounts
Currency circulation
Check clearing
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7-20
Functions of the Federal Reserve Banks
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7-21
Reserve Account:
Deposit in the name of a financial institution held at a Federal Reserve bank
or other designated place.

Check 21:
Law that allows electronic substitute checks for check clearing purposes.

Automated Clearing House (ACH) Network:
A large electronic payments network that facilitates a reliable, secure, and
efficient payments system.

Correspondent Banking:
Interbank relationship involving deposits and various services.
Functions of the Federal Reserve Banks
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7-22
Interstate Banking:
Performance of services in more than one state by a single banking
organization.

Legislative Changes:
Depository Institutions Deregulation & Monetary Control Act (1980):
Increased the similarity among many financial institutions and increased
the control of the Federal Reserve System.
Other legislation strengthened this trend.
Riegle-Neal Interstate Banking & Branching Efficiency Act (1994):
Allows banking organizations from one state to open or acquire banks,
and to open branches, in other states.
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7-23
Legislative Changes (cont.):

Bank Holding Company:
Corporation formed for the purpose of owning, or holding, the
controlling shares of stock in a bank or banks.
New legislation allows certain bank holding companies to
become financial holding companies.
No Federal Reserve approval necessary.
Can engage in wide range of nonbanking activities.
Securities.
Mutual funds.
Insurance.
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7-24
Legislative Changes (cont.):

Gramm-Leach-Bliley Act:
Passed in 1999 to allow bank holding companies to become financial holding
companies and engage in securities and insurance activities.

Financial Holding Company:
A holding company that can own the controlling shares of stock of
corporations in banking, securities, insurance, and other financial activities.

Emergency Economic Stabilization Act:
Passed in 2008 to provide $700 billion to the U.S. Treasury for assistance in
keeping financial companies from failing.
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7-25
Structural Changes:
Branch Banking:
Operation of more than one facility by a bank to perform its functions.
Trend toward large banking organizations.
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7-26
Mutual Fund Growth:
Banks have begun providing mutual fund services in response to
the growing interest by customers.

Savings & Loan Crisis:
Many savings and loan institutions became insolvent in the late
1980s and early 1990s due to relaxed regulations.
Resolution Trust Corporation (RTC)
Federal agency created to reorganize troubled savings and
loans or to deal with their affairs if they failed and closed.
Went out of existence in 1995 after having closed or merged
747 Savings and Loans and paid out $480.9 billion.

Financial Institutions: Chapter Seven

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