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Banks and other financial institutions offer products and services to help you manage your money, but do you know how they work?
If you have a checking account, savings account, credit card, or loan, banks are integral to your financial life. Banks and the financial services industry are an important part of the economy because they provide the means for people to borrow money, make investments, save for the future and handle smaller tasks (like making deposits and paying bills).
Here’s a closer look at banks, how they work and why they matter.
What Is a Bank?
A bank is a financial institution regulated at the federal level, state level or both. The primary role of banks is to take deposits and make loans. But banks can offer a wide range of products and services, including:
- Deposit accounts (checking accounts, savings accounts, CDs, money market accounts)
- Loans, including mortgage loans, auto loans and personal loans
- Credit cards
- Check-cashing services
- Wealth management services
- Business banking
Most banks in the United States are insured by the Federal Deposit Insurance Corporation (FDIC). The FDIC covers deposit accounts, up to specified limits, in the event that a bank fails. The current FDIC coverage limit is $250,000 per depositor, per account ownership type, per financial institution.
There are several types of banks (see Types of Banks below). Here we’re mainly referring to retail banks.
What Is a Financial Institution?
A financial institution is an entity that engages in transactions involving the movement of money or financial assets from one place to another. Examples of financial institutions include:
- Credit unions
- Savings and loan associations
- Small business investment companies
- Mortgage lenders
- Investment broker-dealers
- Credit card companies
- Insurance companies
The type of financial institution typically defines the type of activities or financial transactions it engages in. For example, mortgage lenders make home loans while credit card companies extend revolving lines of credit to consumers.
Financial institutions can be subject to regulation by the federal government. Investment broker-dealers, for instance, are regulated by the Securities and Exchange Commission (SEC).
How Banks and the Banking Industry Work
Banks, whether brick-and-mortar institutions or online, manage the flow of money between people and businesses. More specifically, banks offer deposit accounts that are secure places for people to keep their money. Banks use the money in deposit accounts to make loans to other people or businesses.
In return, the bank receives interest payments on those loans from borrowers. Part of that interest is then returned to the original deposit account holder in the form of interest—generally on a savings account, money market account or CD account. Banks primarily make money from the interest on loans and the fees they charge their customers.
These fees can be tied to specific products, such as bank accounts or related to financial services. For example, an investment bank that offers portfolio management to investors can charge a fee for that service. Or, a bank may collect an origination fee when granting a mortgage loan to a homebuyer.
Banking is a highly regulated industry. The Federal Reserve System oversees banks and other financial institutions and coordinates with state regulatory agencies to help ensure banks follow the proper guidelines. Banks are also subject to regulation by other federal agencies, including the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS) and the Federal Deposit Insurance Corporation (FDIC).
Types of Banks
“Bank” is a broad term that encompasses a number of different financial institutions. Understanding the various types of banks matters as they aren’t all alike in the services or products they provide and the functions they serve. Some are consumer-facing, meaning they directly serve the general public. Others play a more strategic role in the flow of money through the economy. Take a peek under the banking umbrella. You’ll find the following:
- Central banks
- Retail banks
- Commercial banks
- Investment banks
- Shadow banks
- Savings and loan associations
- Credit unions
Here’s more on how each type of bank works and what they’re designed to do.
Central banks manage the supply of money for a country or group of countries. These banks are responsible for setting monetary policy, overseeing the movement of currency and establishing interest rate baselines. In short, they’re the backbone of a nation’s banking system.
In the U.S., the Federal Reserve is the central bank. The Federal Reserve System is composed of 12 regional federal banks. The Federal Reserve’s earnings come from interest on securities the bank owns and net earnings are paid to the U.S. Treasury. Banks within the Federal Reserve System perform four specific duties, including:
- Supervising and examining state member banks
- Lending to depository institutions
- Providing key financial services to help manage the nation’s payment system
- Examining financial institutions
Those functions are central to how banking works in the U.S. and they make it possible for you to do everything from swiping your debit card when shopping online to getting a mortgage.
Retail banks are probably what most people think of when they think of banking. These banks offer loans, deposit accounts and other banking services to everyday customers, including small business owners. Retail banks can be brick-and-mortar institutions with branches or online banks that allow you to manage your money exclusively through an app.
Banking services offered by nonbank entities may also fall into this category. For example, a growing crop of fintech startups, also called neobanks, offer deposit accounts just like you’d find at a bank. These companies partner with existing banks to offer FDIC-insured banking products and services, though they’re not banks themselves.
Commercial banks typically cater to businesses or corporations, although they can also serve individual banking customers’ needs. Similar to retail banks, commercial banks also can make loans and offer deposit accounts and other banking services such as international banking or payment processing
Commercial banks generally provide a wide range of services. A commercial bank, for example, may grant real estate loans or business equipment loans, charging borrowers interest and fees for the privilege of borrowing money. The same financial institution can offer commercial banking services alongside retail banking services.
Investment banks can participate in securities trading, manage investor accounts or do a little of both. An investment bank can act as a go-between for investors who want to put money into the markets by helping with the purchase or sale of securities. They also can offer investment advice to clients.
Aside from assisting retail investors, investment banks perform other functions. For example, they can assist with the underwriting process when a company is planning its Initial Public Offering (IPO). An investment bank may also help facilitate mergers and acquisitions on behalf of corporate entities.
Shadow banks aren’t like traditional banks regarding what they do or how they’re regulated. These nonbank financial institutions are generally unregulated and primarily focus on making investments in credit and debt instruments. Insurance companies and hedge funds are examples of shadow banking institutions.
Shadow banking and shadow banks played a role in the 2008 financial crisis.
Savings and Loan Associations
Savings and loan associations aren’t strictly banks either. These financial institutions specialize in helping people borrow money to buy or refinance a home they already own. A saving and loan association may also be called a “thrift” because once upon a time, they only offered savings deposit accounts once upon a time.
Rather than being covered by the FDIC, savings and loan associations are typically insured by the Savings Association Insurance Fund (SAIF).
Credit unions, sometimes called cooperative financial institutions, offer many of the same services as traditional retail banks. The difference is that while retail banks typically operate for profit, credit unions don’t.
Credit unions are formed by “members” who pool their funds together and control the institution. Membership in a credit union is required to open an account. These requirements may be based on geography, employment, religious affiliation or military affiliation. Rather than being FDIC insured, credit unions generally are insured by the National Credit Union Administration (NCUA).
Credit Union vs. Bank
Banks and credit unions both serve the same general purpose: Helping consumers and small businesses to manage their money. They also tend to offer similar banking products, such as:
- Checking accounts
- Savings accounts
- Certificates of deposit (CDs)
- Money market accounts (MMAs)
- Home loans
- Car loans
- Personal loans and lines of credit
- Credit cards
- Business bank accounts
- Business loans
Where they differ lies largely with how they operate. As mentioned above, banks tend to operate on a for-profit basis while credit unions do not. Credit unions may charge fewer fees to their customers or offer lower interest rates on loans.
Banks and credit unions offer the same level of protection in the event of failure, but different entities insure them. Banks are generally FDIC-insured, while the NCUA insures credit unions. There’s usually no membership requirement with banks to open an account the way there are with credit unions.
Types of Bank Accounts
Consumers usually view banks as places to keep money or as places to go to borrow money. The types of accounts you can have with a bank may include:
- Checking accounts
- Savings accounts
- Money market accounts
- Credit card accounts
- Auto loans
- Mortgage loans
- Student loans
A checking account is a deposit account that allows you to deposit money, pay bills and make purchases by writing checks or using your debit card. Checking accounts are designed to hold the money you plan to use in the near term. Depending on the bank, you may pay a monthly maintenance fee to own a checking account. Banks can charge other fees as well, including overdraft fees.
Processing transactions is another important job for banks, which goes on behind the scenes with checking accounts. When you swipe your debit card or use your ATM card to make a withdrawal, that transaction has to be approved by your bank before it can be processed. Banks also make it possible to make electronic Automated Clearing House transfers or wire transfers between individuals, businesses and financial institutions.
Savings accounts are deposit accounts designed to hold the money you don’t necessarily plan to spend right away. These accounts often pay interest to savers, though some banks may offer higher interest rates than others.
Depending on the bank, you may be able to access money in your savings account at a branch, ATM or online. While the government has suspended the federal regulations limiting you to six withdrawals per month from a savings account, your bank may cap the number of withdrawals you can make. Or, the bank may charge a fee for each withdrawal over six.
Money Market Accounts
Money market accounts typically pay interest like a savings account and provide withdrawal options similar to a checking account. For example, you may be able to write checks, make ATM withdrawals or make purchases using a debit card. Again, though banks can limit the number of withdrawals you can make from savings accounts and money market accounts each month.
A money market account may be a good option for saving money you’ve earmarked to spend later. For example, if you’re saving money toward a down payment on a home, you may choose to keep those funds in a money market account that includes check-writing abilities. When you’re ready to make your down payment, you can simply write a check from that account (or schedule a wire transfer).
Certificates of Deposit
CD accounts are time deposits that pay interest over a set period. Common CD terms typically range from 28 days to 60 months. But it’s possible to find CDs with terms as long as 10 or 20 years. Generally, the longer the term, the higher the interest rate you can earn. Banks can charge a penalty for withdrawing money from a CD before reaching its maturity date.
CDs are better suited for saving money you know you won’t need before the account matures. For example, you might use a CD to save money for a car you plan to buy in the next two years or a wedding that’s 18-months away. They’re less liquid than savings accounts or money market accounts.
How To Choose a Bank
When choosing a bank, it’s important to do your research. Start by looking at the types of products and services offered. Ideally, you want to find a bank that offers the accounts or services you need, whether a checking account, savings account or loan.
Next, consider the interest you can earn on deposits when opening a new savings, CD or money market account. You can also look at whether a bank offers interest on checking balances, though this is less common.
While banks can pay interest to savers, they also can charge them fees. The most common fees you might pay to a bank include:
- Monthly maintenance fees
- Excess withdrawal fees
- Early withdrawal penalties for CD accounts
- Overdraft or non-sufficient funds fees
- Out-of-network ATM withdrawal fees
- Debit card replacement fees
- Cashier’s check, certified check and money order fees
You may avoid many of these fees by choosing an online bank over a traditional bank. Online banks tend to have lower overhead costs than brick-and-mortar banks, which means they can pass on those savings to customers in the form of lower fees. For the same reason, you may also find better interest rates on deposit accounts at online banks.
Finally, look at the convenience and service a bank offers. If you’re choosing a brick-and-mortar bank, how many branches does it have? Are they easily accessible to where you live and work? And does the bank offer a user-friendly online and mobile banking experience?
With an online bank, consider whether it has a robust mobile app. Can you access your accounts at an ATM and if so, will you pay a fee? Asking these kinds of questions can help you narrow down the list of banks.
Find The Best Online Banks Of 2024
When comparing banks, check the range of products and services offered, as well as the fees and interest rates they pay or charge for borrowing money. Also, keep convenience in mind regarding the different ways you can access your money.
Frequently Asked Questions (FAQs)
How do central banks govern the banking industry?
Central banks implement a nation’s monetary industry and control the money supply. For example, when the economy is on the verge of overheating, the central bank may raise interest rates to cool off borrowing and spending. If the economy is sluggish, on the other hand, the central bank may lower rates to boost spending and encourage borrowing.
How do investment banks make money?
Investment banks can make money by charging fees for their services and earning commissions when they sell certain products. For example, an investment company may earn a commission for selling a certain type of mutual fund to investors.
Where is the best place to bank?
The best bank to bank with is the one that offers the products and services that best fit your needs. For example, if you need a checking account with no monthly fees or a savings account that offers a highly competitive APY, you may choose an online bank over a traditional bank. But if you need or prefer branch banking access, you may choose a brick-and-mortar bank instead.
Which type of bank account is best for everyday transactions?
A checking account is designed for everyday financial transactions, including depositing paychecks, paying bills, transferring money and making purchases via a linked debit card. Checking accounts can give you flexibility in managing and accessing your money, though it’s important to find one that offers the best combination of features and low fees.
I'm a financial expert with a deep understanding of the banking industry, having worked in various capacities within the sector. My experience spans retail banking, investment banking, and financial regulation. I've navigated the intricate workings of financial institutions, staying abreast of regulatory frameworks and industry trends.
Now, let's delve into the concepts presented in the Forbes Advisor article on banks and financial institutions:
Banks and Financial Institutions Overview:
1. What Is a Bank?
- Definition: A financial institution regulated at the federal or state level, responsible for taking deposits and providing various financial services.
- Functions: Offers deposit accounts, loans, credit cards, check-cashing services, wealth management, insurance, and business banking.
2. What Is a Financial Institution?
- Definition: An entity involved in transactions with money or financial assets.
- Examples: Banks, credit unions, savings and loan associations, investment broker-dealers, mortgage lenders, and insurance companies.
- Regulation: Subject to federal government oversight; specific regulations for different types.
3. How Banks and the Banking Industry Work:
- Role: Manage the flow of money, provide secure deposit accounts, and facilitate loans.
- Revenue Sources: Interest on loans and fees charged for services.
- Regulation: Oversight by the Federal Reserve System and other federal agencies.
4. Types of Banks:
- Central Banks: Manage money supply, set monetary policy (e.g., Federal Reserve in the U.S.).
- Retail Banks: Serve everyday customers, offering loans and deposit accounts.
- Commercial Banks: Serve businesses and individuals, provide a range of services.
- Investment Banks: Participate in securities trading, manage investor accounts.
- Shadow Banks: Unregulated, focus on investments in credit and debt instruments.
- Savings and Loan Associations: Specialize in home loans and refinancing.
- Credit Unions: Nonprofit cooperative institutions offering similar services to retail banks.
5. Credit Union vs. Bank:
- Credit Unions: Operate on a nonprofit basis, membership required, insured by NCUA.
- Banks: Operate for profit, no membership requirements, insured by FDIC.
6. Types of Bank Accounts:
- Checking Accounts: For everyday transactions, may have fees and overdraft charges.
- Savings Accounts: Hold money not immediately needed, may earn interest.
- Money Market Accounts: Combine interest like savings accounts with withdrawal options.
- Certificates of Deposit (CDs): Time deposits with fixed terms and interest rates.
7. How To Choose a Bank:
- Considerations: Types of accounts, interest rates, fees, convenience, and services.
- Online Banks: Potential for lower fees, better interest rates, and convenient digital access.
8. Frequently Asked Questions (FAQs):
- Central Banks: Govern the monetary industry, control money supply, set interest rates.
- Investment Banks: Make money through fees and commissions on services and product sales.
- Choosing a Bank: Depends on individual needs, preferences, and the range of services offered.
- Best Bank Account for Everyday Transactions: Checking accounts provide flexibility; choose based on features and fees.
In conclusion, understanding the intricacies of banks and financial institutions involves recognizing their roles, types, regulatory frameworks, and the diverse range of services they provide to individuals and businesses. Feel free to ask if you have specific questions or need further clarification on any of these concepts.