Nondepository Institutions

The economy works best when there is money and credit available to finance business or
consumer purchases or investments. When money is limited, such as during the 2007 – 2009
credit crisis, businesses can't finance their operations nor invest in new projects, so
unemployment rises, causing people to curtail their spending, which contracts business even
more. Tax receipts fall, so governments cut back on their spending, adding to the recession.

Most of the money and credit readily available to the economy comes from financial
intermediaries. Depository institutions—banks that accept deposits—contribute to the economy
by lending much of the money saved by depositors. However, deposits do not provide all of an
economy's funding, since only the wealthy save a significant amount of money and most of it is
not in low-interest paying deposits which are taxable as ordinary income. The wealthy put most
of their money into assets such as stocks, real estate, and municipal bonds, which not only offer
greater returns, but the returns are often taxed less than ordinary income. People who are not
wealthy do not save very much, at least in the United States, because they need the money for
everyday wants and needs. Although wealthy individuals have a lot more money than lower-
income individuals, there are many more people in the lower-income classes; hence, the
aggregate of the money held by the lower-income classes is greater than the aggregate held by
the wealthy.

This greater aggregate wealth of the lower-income people is made available to the economy
through financial nondepository institutions, which are financial intermediaries that cannot
accept deposits but do pool the payments in the form of premiums or contributions of many
people and either invest it or provide credit to others. Hence, nondepository institutions form an
important part of the economy. These nondepository institutions are sometimes referred to as the
shadow banking system, because they resemble banks as financial intermediaries, but they
cannot legally accept deposits. Consequently, their regulation is less stringent, which allows
some nondepository institutions, such as hedge funds, to take greater risks for a chance to earn
higher returns. These institutions receive the public's money because they offer other services
than just the payment of interest. They can spread the financial risk of individuals over a large
group, or provide investment services for greater returns or for a future income.

Nondepository institutions include insurance companies, pension funds, securities firms,

government-sponsored enterprises, and finance companies. There are also smaller nondepository
institutions, such as pawnshops and venture capital firms, but they constitute a much smaller
portion of sources of funds for the economy.

Insurance Companies
Insurance companies protect their customers from the financial distress that can be caused by
unforeseen events, such as accidents or premature death. They pool the small premiums of the
insured to pay the larger claims to those who have losses. The premium payments are regular
while the losses are irregular, both in timing and amount. An insurance company can profit
because it can accurately estimate the payment of claims over a large group by using statistics
and it can invest its surplus for greater returns, which helps to lower premiums to be competitive.

Like banks, insurance companies are confronted with the informational asymmetry problems of
adverse selection and moral hazard. An insurance company solves the problem of adverse
selection by screening applicants—verifying information in the application, checking the
applicant's history, and by applying restrictive covenants in the insurance contract, such as not
covering a pre-existing condition. Adverse selection is also reduced by grouping—placing the
insurance applicant into specific classes where there is a difference in claims history for the
group, then charging the appropriate premium. One controversial example is the use of credit
scores for determining insurance premiums, since several studies have shown that people with
lower credit scores file more claims than those with higher scores.

The solution to moral hazard differs, depending on the type of insurance offered. There are 2
major types of insurance: property and casualty insurance and life insurance. How the premiums
are invested depends on what type of insurance the company offers, which determines the
amount of liquidity it needs.

Property and Casualty Insurance

Property and casualty insurance offers financial protection against damage or loss to property
or people caused by accidents, natural disasters, or from the action of others. The most common
type of this insurance is auto insurance, since it is legally required by every driver in every state.

Although losses can be estimated by using statistics over a large group, there is a larger standard
deviation of risk because property and casualty insurance covers many more types of events, so
claims can vary greatly in amount. Hence, these insurance companies must maintain liquidity by
investing the premiums in short-term securities, most of which are money market securities that
can be sold quickly at little cost and are very safe.

Although there are several methods to reducing moral hazard, property and casualty insurers use
the principle of indemnity, which is to pay for financial losses suffered by the insured—but no
more. After all, if people could profit from insurance, that would motivate them to cause losses
for profits. For this same reason, insurance companies will not pay for losses that are covered by
other insurance or other forms of compensation.

Life Insurance

While the death of a single individual is an uncertain event, the number of deaths in a large
group is very predictable. Furthermore, the amount of the claim for any single death is certain
since it is specified in the contract.

There isn't much of a moral hazard problem in life insurance because most people want to live
and would not be able to benefit directly from the proceeds unless it is a whole life policy that
also has a savings portion. However, this living benefit is limited by what the insured has paid in.
The only real moral hazard to life insurance is the possibility that the insurance applicant is
buying insurance to provide for his beneficiaries after he commits suicide. This moral hazard is
reduced by a suicide clause—not paying for suicides within the 1st 2 years of the policy, or 1
year in some policies. The reasoning behind this is that most people who commit suicide are
mentally ill, which is an affliction that should be covered, while the waiting period prevents
someone who is suicidal from taking out a policy just before committing suicide.

Because claim payments are more predictable, life insurance companies invest mostly in long-
term bonds, which pay a higher yield, and some stocks. Their portfolios have a smaller stock
portion because the reduction in liquidity caused by a stock market decline can last for years.

Pension Funds
Pension funds receive contributions from individuals and/or employers during their employment
to provide a retirement income for the individuals. Most pension funds are provided by
employers for employees. The employer may also pay part or all of the contribution, but an
employee must work a minimum number of years to be vested—qualified to receive the benefits
of the pension. Self-employed people can also set up a pension fund for themselves through
individual retirement accounts (IRAs) or other types of programs sanctioned by the federal
government.

While an individual has many options to save for retirement, the main benefit of government-
sanctioned pension plans is tax savings. Pension plans allow either contributions or withdrawals
that are tax-free. For instance, for regular IRAs, contributions are tax-free, but withdrawals are
taxed, while for Roth IRAs, contributions are taxed, but withdrawals are tax-free.

As a consequence of the regular contributions and the tax savings, pension funds have enormous
amounts of money to invest. And because their payments are predictable, pension funds invest in
long-term bonds and stocks, with more emphasis on stocks for greater profits.

Securities Firms
Securities firms are companies that provide institutional support for the buying and selling of
securities. Investment companies, brokerages, and investment banks are the major types of
securities firms. Investment companies pool the investments of many people into a single
portfolio that is managed by professional managers. Investment companies, such as mutual
funds, provide expertise and economies of scale that small individual investors would not be able
to afford otherwise. Brokerages provide an institutional framework that allows retail investors to
invest in stocks, bonds, options, futures, and other financial instruments directly. Brokers provide
trading software that allows traders to select their trades, and settlement and clearing services to
effect the transactions. Investment banks help businesses and other organizations to sell their
own stocks and bonds to the investing public. Investment banks offer advice to the issuer,
register the securities with the Securities and Exchange Commission, and sell the securities to
their customers.
Federal Government-Sponsored Enterprises (GSEs)
There are a number of government agencies or private corporations chartered by the federal
government that also act as financial intermediaries. These agencies were created ad hoc by
Congress to provide credit to specific constituencies that Congress has argued were not being
addressed adequately by the free market. The largest of these include the Government National
Mortgage Corporation (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae),
the Federal Home Loan Mortgage Corporation (Freddie Mac), the Student Loan Marketing
Association (Sallie Mae), and the Farm Credit System. These agencies are all involved in
providing credit to buy homes or farms, except for Sallie Mae, which provides student loans.

Most of these agencies buy loans from private lenders, then they securitize the loans into asset-
backed securities and sell them to the public. These agency securities are exempt from state and
local taxes, and they were considered very safe, at least before 2008, since most investors
believed that they had the implicit backing of the federal government, which has been
demonstrated in September, 2008, when the federal government placed Fannie Mae and Freddie
Mac under conservatorship, ousting its executives and turning over their loan portfolios to the
Federal Housing Finance Agency. Both GSE's became insolvent because they were
overleveraged and guaranteed securities based on subprime loans, which started defaulting in
large numbers in 2007.

Finance Companies
Finance companies provide loans to people or businesses using the issuance of short-term
securities, especially commercial paper, as a source of funds. Consumer finance companies
provide consumer loans and sometimes mortgages. They also provide the instant credit offered
by so many retail stores, where the customer receives the item but doesn't have to pay for a
stipulated amount of time.

Business finance companies provide loans to businesses but are especially prominent in the
equipment leasing business, where the finance company will buy equipment that a particular
business wants, and lease it to the business. This saves the business the upfront purchase cost,
and allows it to treat the equipment as a current deduction for taxes rather than as a capital
expense that has to be depreciated over a number of years.

Business finance companies also provide businesses with short-term liquidity by financing
inventory until it is sold and with accounts receivable loans, which are short-term loans backed
by accounts receivable.

Sales finance companies finance specific types of major purchases or finance the purchases of a
specific retailer. For instance, most of the financing provided by automobile dealers is provided
by these companies, so that the potential buyer can buy right away.

◄ Previous Next ►
Types of Depository Institutions: Savings Institutions, Commercial Banks, Bank Bank Balance
and Financial Holding Companies Sheet

 Privacy Policy for thismatter.com

 Cookies are used to personalize content and ads, to provide social media features and to
analyze traffic. Information is also shared about your use of this site with our social
media, advertising and analytics partners. Details, including opt-out options, are
provided in the Privacy Policy.
 Send email to thismatter.com for suggestions and comments! Be sure to include the
words no spam in the subject. If you do not include the words, the email will be deleted
automatically.
 Information is provided 'as is' and solely for education, not for trading purposes or
professional advice.

Financial Institutions
Financial institutions are the businesses and organizations involved in the collection and
distribution of money. They develop the methods and procedures that allow them to collect
money from depositors and lend it out to borrowers. They develop the financial securities and
provide the financial markets where lenders, borrowers, investors, speculators, and hedgers can
exchange money for future payments in the form of interest, for ownership interests, such as
stocks, for the payment of future contingent claims, such as with options and derivatives, and for
sharing risk, such as the pooling of insurance premiums for financial protection. This pooled
money is then given as loans or as an investment to businesses and other organizations to finance
specific projects or to provide financing for other needs.

Businesses make money by supplying products and services that are desirable, and the more
desirable the product or service, the more money that the business can earn, and, thus, the greater
are the returns on the investments in the business. In their desire to earn greater returns, financial
institutions help to funnel money to the most successful businesses, which allows them to grow
faster and supply even more of the desirable goods and services. This is how financial
institutions greatly contribute to the efficient allocation of economic resources. Hence, financial
institutions are also financial intermediaries.

Financial intermediaries profit by earning higher returns on their investments than they pay for
their sources of money. The assets of a financial intermediary are the loans, stocks, bonds, and
real estate that are the company's investments and its liabilities are its obligations to its
customers, which includes deposits, insurance policies, and pension payouts.

Depository Institutions
Depository institutions, such as banks and credit unions, collect money from depositors and
lend the money out to borrowers. Lending has risks, because of information asymmetry
between the lender and the borrower. Borrowers know a lot more about their ability and willing
to pay than lenders do, which is why it is risky for people to lend out money directly to others.
Depository institutions mitigate this risk by assessing the creditworthiness of borrowers for
possible loans, monitoring the borrowers after the loan, and collecting on delinquent accounts.
They also convert the short-time deposits that most savers prefer to the long-term loans that
businesses desire.

Another major service offered by depository institutions is a convenient payment system. Money
can be transferred by check, electronic funds transfer, or by credit or debit card. This eliminates
the need for people to have a large amount of cash on hand, which is very risky, and it provides a
proof of payment.

International banks provide foreign exchange services, converting the currency of one country
for those of another. They also provide exporters and importers with services, such as letters of
credit, that facilitate international trade.

Nondepository Institutions
Nondepository institutions collect money as premiums, contributions, or by selling securities
for specific purposes, and then invest the money for higher returns. Nondepository institutions
include insurance companies, pension funds, securities firms, and finance companies.

Insurance companies pool the premiums of many people and businesses to protect each from
financial disaster resulting from rare events.

Pension funds collect contributions from workers and businesses to invest so that workers can
retire with an income provided from the invested funds. Pension funds are set up by businesses,
labor unions, or governments for their employees. Employers and employees make contributions
from payrolls into the fund. The fund manager then invests the money to earn a return that will
allow it to pay out benefits according to a prescribed schedule based actuarial estimates.
Contributions to the fund and the returns earned by the fund are usually tax deferred.

Securities firms, such as stock brokers or future merchant commissions, provide the institutional
foundation that allows investors to invest their money in the various financial markets by
providing current market information, and allowing the investors to select market or limit orders
to buy or sell securities through their computer system. Securities firms also provide clearing and
settlement systems so that investors can easily clear and settle trades.
Finance companies get money by selling securities, mostly commercial paper, in the money
market to other businesses, including banks, and then lend the money out to individuals or
businesses at a higher interest rate than what they pay on their securities. There are 3 basic types
of finance companies. Small loan companies (aka direct loan companies) lend money to
individuals. Sales finance companies (aka acceptance companies) buy retail and wholesale
commercial paper of consumer and capital goods dealers. Commercial finance companies (aka
commercial credit companies) loan money to manufacturers and wholesalers that is secured by
the borrowers' account receivables, inventory, or equipment.

Some financial institutions, such as financial supermarkets, offer several types of products and
services that traditionally have been served by separate financial institutions.

Financial Institution Regulation

A characteristic of all financial institutions that accept public funds is that they are heavily
regulated, not only because of their central importance to modern economies, but because most
people would be unwilling to put their money in a financial institution if they did not believe it
was safe to do so. If people kept their money instead of saving or investing it, then the allocation
of economic resources would be much less efficient.

In the United States, financial institutions are regulated by government agencies that promulgate
rules and regulations for the industry, and who also monitor those institutions for compliance.
The Federal Reserve regulates depository institutions and the Federal Deposit Insurance
Corporation (FDIC) insures the savings of depositors for up to a certain amount, depending on
the type of account. The Securities and Exchange Commission (SEC) regulates the securities
industry and the Securities Investor Protection Corporation (SIPC) insures both securities and
cash in customers' accounts of securities firms within an overall limit of $500,000 and a limit of
$100,000 for cash. The Pension Benefit Guaranty Corporation (PBGC) guarantees basic
pension funds of companies that become insolvent and takes steps to correct serious
underfunding of pension liabilities. Insurance companies are mostly regulated by state law and
guarantees by the states vary widely. All states have solvency laws to maintain the solvency of
its insurers by requiring minimum amounts of capital and guaranty funds to help failing
insurers, or, to at least maintain coverage and pay the claims of customers of insolvent insurers.

Central Banks
Central banks are financial institutions that have the most influence over their economies, since
they determine the money supply and key interest rates, and they regulate and monitor other
financial institutions, especially depository institutions.

As regulators and overseers of the financial institutions, central banks issue and implement many
banking regulations and require institutions to have a minimum amount of capital compared to
their liabilities. They may audit financial institutions to ensure that the proper procedures are
being followed and that they are not taking excessive risk. Central banks also provide services to
financial institutions, such as clearing and settlement services, especially for checks and
electronic money transfers.

However, the main function of central banks is to regulate the money supply. The money supply
must grow proportionately with the economy.

The quantity of money in an economy must be stable. If it grows too rapidly, then the resulting
inflation causes people to lose faith in the currency, causing them to save less and to buy more.
People on fixed incomes are hurt. Businesses can't plan effectively because of the uncertainty
about the future value of money.

If the money supply decreases relative to the size of the economy, then the resulting deflation
causes people to hold onto their money, since it will be more valuable in the future. Decreased
spending causes businesses to lose income, which then results in unemployment. Increases in
unemployment causes demand to fall even more, causing a spiral of deflation.

Central banks control the money supply either by setting key interest rates or by the creation and
destruction of money, usually in the form of buying or selling government securities.

Central banks are also the fiscal agents of their countries, providing banking services for the
government. They collect tax receipts and provide payment services for the government. They
also issue and retire government securities.

Economic Importance of Financial Institutions

The credit crisis of 2008 and 2009 underscores the importance of financial institutions to the
economy. Businesses, for instance, depend on financial institutions for money. When they can't
get it, unemployment rises, mortgage and other credit defaults increase, people and businesses
stop spending money, which reduces income for other people and businesses, and reduces tax
revenue for governments, which causes them to cut spending, which causes more
unemployment, and so on. This is why governments around the world injected trillions of dollars
into their financial institutions during the credit crisis to prevent their collapse and the
subsequent collapse of the economy.

Depository Institutions (Banks)

Depository institutions (aka banks), which includes commercial banks, savings and loans, and
credit unions, receive money from depositors to lend out to borrowers. Nondepository
institutions, such as finance companies, rely on other sources of funding, such as the
commercial paper market. Because depository institutions receive funds from the public for
safekeeping and are major sources of credit and the main providers of a payment system, these
institutions are more heavily regulated than nondepository institutions.

Depository institutions provide 4 important services to the economy:

1. they provide safekeeping services and liquidity;

2. they provide a payment system consisting of checks and electronic funds transfers;
3. they pool the money of many savers and lend it out to people and businesses; and
4. they invest in securities.

The 1st 3 services are so important in any economy that when banks fail, the economy suffers.
The credit crisis of 2008 and 2009 underscored the primary importance of banks and why
governments all over the world propped up their banks with trillions of dollars.

Balance Sheet of Banks

A bank receives money from the deposits of its customers and from the fees that it charges for its
services, and from borrowing either from other banks or by selling securities in the financial
markets. It uses the money to make loans and to buy securities. A bank profits from the interest
rate spread of what it earns on its assets and what it pays in liabilities, and from banking fees.

The net worth of a bank is equal to its bank capital which is equal to total assets minus its total
liabilities.

Net Worth ≡ Owners Equity ≡ Bank Capital = Total Assets – Total Liabilities

Bank Assets—Uses of Funds

Most of the assets of banks can be grouped into 4 categories:

1. cash,
2. securities,
3. loans,
4. other assets, which includes real property, such as equipment, buildings, land, and repossessed
collateral from borrowers who have defaulted.

Most of a bank's assets are in the form of loans with a large portion in securities, since these are
the main sources of income for a bank.

Cash is obviously an asset to a bank, but it's an expensive asset in terms of opportunity cost
because it earns no interest—therefore, banks try to minimize the amount of cash that they hold.
They have to keep some cash to conduct business which includes being able to meet withdrawal
requests and to meet reserve requirements that are set by the Federal Reserve to help prevent
insolvency.

Before there were ATM machines or the Federal Reserve, banks kept almost all of their cash in
their vaults, and, for this reason, it is called vault cash. Nowadays, vault cash also includes cash
kept at the bank's account at the Federal Reserve and in the bank's ATM machines. Cash kept in
vaults and ATM machines allows banks to give customers cash in the form of coin and currency.
Cash kept in its account at the Federal Reserve is used to clear and settle checks and electronic
funds transfers. Required reserves is the amount of cash that must be held by law and includes
vault cash and cash held in the bank's account at the Federal Reserve and is equal to a percentage
of a bank's liabilities.

Banks also hold securities to earn additional returns. While banks in other countries can own
stocks, banks in the United States are restricted to bonds, most of which are Treasuries or
municipal bonds, although they also held a good portion in mortgage-backed securities which
contributed to the 2008 - 2009 credit crisis. Banks could also own corporate bonds, but since
corporate bonds increase their reserve requirements just as loans, banks would earn more money
lending to corporations rather than buying their bonds. Because government bonds can be
quickly sold in the secondary financial markets to raise cash, securities are also referred to as
secondary reserves.

Loans are the biggest assets of banks. In fact, the different types of banks can be categorized by
the type of loans that they make. Commercial banks specialize in loans to businesses, saving and
loans specialize in mortgages, and credit unions specialize in consumer loans. However, since
the commercial paper market offers many large businesses with a lower cost of funds,
commercial banks have started to enlarge their portfolios with other kinds of loans, such as
mortgages and consumer loans. The securitization of these loans into asset-backed securities has
eliminated their credit default risk to the bank and can easily be sold in the financial markets,
making them more liquid than the underlying loans.

Loans can be categorized as:

 commercial and industrial loans (C&I), which are business loans

 real estate loans
o residential
o commercial
o home equity
 consumer loans
o auto loans
o credit card loans
 interbank loans
 other types

Liabilities—Sources of Funds
Besides owners' equity, the major source of funds for a bank is deposits and borrowings, with
deposits being the larger percentage of a bank's liabilities. Deposits are considered a liability
because it is money that is owed to its customers.

Deposits are money that the banks customers place in the bank for safekeeping, to provide
payment services, and to earn interest. Deposits can be classified as either checkable deposits or
nontransaction deposits.

Checkable Deposits and Nontransaction Deposits

Checkable deposits (aka transaction deposits) are deposits placed in checking accounts that
allow the depositors to withdraw money at will, write checks, and transfer funds electronically to
and from the account. Thus, checkable deposits provide safekeeping, accounting, and payment
services, but pay little or no interest. Because depositors can earn more interest elsewhere and
can easily transfer money to their checking accounts when necessary, they generally keep only
enough in their checking accounts to maintain the amount of liquidity they need to pay bills or to
have as a source of cash. Because technology has made transferring funds faster and easier,
checkable deposits have declined as a percentage of the bank's liability, from an average above
40% in the early 1970s to less than 10% today.

Nontransaction deposits are deposits in savings and time deposit accounts, where withdrawals
are limited. However, since nontransaction deposits do not provide payment services, the main
benefit to depositors is the interest that they pay. Banks can pay a lower rate of interest on
deposits because the funds that they hold are guaranteed by the Federal Deposit Insurance
Corporation (FDIC) up to a certain limit.

Years ago, most savings accounts were passbook savings accounts, where each transaction was
recorded in the customer's passbook. Nowadays, transactions are recorded electronically. Most
savings accounts pay a low interest rate, but allow the depositor to withdraw funds at will.
However, if a depositor makes too many withdrawals within a month, the bank will charge a fee
for withdrawals above the limit.

Banks also offer time deposits in the form of certificates of deposit (CDs) that has a specified
term and face value, which is equal to the amount deposited. The withdrawal of funds is
restricted until the CD matures. The interest rate on a CD is commensurate with its term length.
A small CD has a principal of $100,000 or less and is not generally negotiable. The bank will
charge the CD holder fees for withdrawing the money before the maturity date.

Large certificates of deposit have a face value greater than $100,000 and can easily be sold in
money markets. Banks can obtain quick funds by selling large CDs in the money markets, in
addition to selling commercial paper and bonds.

Borrowings

The borrowings of most banks is in the interbank market known as the federal funds market, so
called because the money that is both lent and borrowed involves the money held in the banks'
accounts at the Federal Reserve, which is referred to as federal funds. Banks with excess
reserves lend money to banks with a deficit in reserves. These loans are unsecured so banks only
lend to banks that they can trust. In most cases, smaller banks have the excess reserves to lend
while large banks in major metropolitan areas need to borrow.

Banks can also borrow directly from the Federal Reserve through its discount window if it
cannot obtain a loan from other banks. However, this is used as a last resort, since it indicates to
the Federal Reserve that the bank is under financial stress.

Another major means of short-term borrowing is through repurchase agreements. A repurchase

agreement (aka repo) is an agreement to exchange securities, usually in the form of Treasury
bills, for funds, usually for a term of 1 day, after which the borrower buys back, or repurchases
the securities with interest. Most repos are with corporations or financial intermediaries, such as
pension funds or insurance companies, that have a temporary surplus of cash.

The Federal Reserve also uses repurchase agreements to control the money supply. When the
Fed wants to increase the money supply, it buys Treasuries, and when it wants to decrease it, it
sells Treasuries.

◄ Previous Next ►
Financial Types of Depository Institutions: Savings Institutions, Commercial Banks, Bank and
Intermediation Financial Holding Companies

 Privacy Policy for thismatter.com

 Cookies are used to personalize content and ads, to provide social media features and to
analyze traffic. Information is also shared about your use of this site with our social media,
advertising and analytics partners. Details, including opt-out options, are provided in the Privacy
Policy.
 Send email to thismatter.com for suggestions and comments! Be sure to include the words no
spam in the subject. If you do not include the words, the email will be deleted automatically.
 Information is provided 'as is' and solely for education, not for trading purposes or professional
advice.

Types of Depository Institutions

Depository institutions, which are usually just called banks, are categorized as such because their
primary source of funding is the deposits of savers. Their savings accounts are insured by the
Federal Deposit Insurance Corporation (FDIC) up to certain limits. Banks are further
subcategorized depending on the markets they serve, their primary sources of funding, type of
ownership, how they are regulated, and the geographic extent of their market.

These categories of banks arose because they were established to serve different markets at
different times. What state and federal regulations governed a particular bank also depended on
its type, and whether it had a state or federal charter. States, especially, restricted the banks'
ability to compete and to expand geographically. However, modern technology and deregulation
are blurring these traditional distinctions, with categories overlapping even more than in the past.

Savings Institutions
Savings institutions, sometimes called thrift institutions, are banks that serve a local
community. They take the deposits of local residents and lend the money back in the form of
consumer loans, mortgages, and small business loans. Savings institutions include savings and
loan institutions, savings banks, and credit unions. Most savings institutions are regulated by the
Office of Thrift Supervision (OTS), which was created by the Financial Institutions Reform,
Recovery and Enforcement Act of 1989 (FIRREA). The FIRREA empowered the OTS to
enact rules and regulations for savings institutions, manage the Savings Association Insurance
Fund (SAIF), which insures the deposits of savings institutions, and to charter federal savings
banks and savings and loans associations.

Prior to 1980, savings institutions were mostly limited to the residential mortgage market, but the
Depository Institutions Deregulation and Monetary Control Act of 1980 deregulated banking
by removing interest rate ceilings and allowing savings institutions to offer more services,
including commercial and consumer lending. The Act also eliminated dollar limits on mortgages,
allowed second mortgages, and eliminated the territorial restrictions on mortgage lending and
permitted savings institutions to offer interest-paying Negotiable Order of Withdrawal (NOW)
accounts—basically, checking accounts paying interest.

Savings and Loan Associations (SLAs, S&Ls) first appeared in the 1800s so that factory
workers could save money to buy a home. They were loosely regulated until the Great
Depression, when Congress passed several major laws to shore up the banking industry and to
restore the public's trust in them. Before 1980, SLAs were restricted to mortgages and savings
and time deposits, but the Monetary Control Act extended their permitted activities to
commercial loans, non-mortgage consumer lending, and trust services.

Many S&Ls have been owned by depositors, which was their main source of funding—thus they
were called Mutual Savings and Loans Associations or just Mutual Associations. Mutual
S&Ls, like credit unions, used their earnings to lower future loan rates, raise deposit rates, or to
reinvest while corporate S&Ls either reinvested profits or returned profits to their owners by
paying dividends. Nowadays, most S&Ls are corporations, giving them access to additional
capital funding to compete more successfully and to facilitate mergers and acquisitions.
Savings banks (aka mutual savings banks, MSBs) began as mutual companies first chartered
in 16 states, with most in New York and New Jersey, that were owned by the depositors and
were restricted to mortgages. They were governed by a local board of trustees. When interest
rates were limited by law, mutual savings banks distributed their earnings back to the depositors.
The Garn-St. Germain Depository Institutions Act of 1982 gave savings banks the option of a
federal charter and allowed them to convert to corporations, which many of them did since it
extended their funding options and facilitated mergers and acquisitions.

Credit unions are nonprofit depository institutions that are financial cooperatives owned by
people belonging to a particular group, such as the employees of a particular company, a union,
or a religious group, or who live in a specific area such as a county, and they are governed by a
board of volunteers. Because they are nonprofits and owned by their customers, they charge
lower loan rates and pay higher interest rates on savings, and they offer a wide variety of
financial services for their owners. All credit unions with federal charters and most with state
charters are regulated and insured by the National Credit Union Administration. Deposit
insurance is provided by the National Credit Union Share Insurance Fund.

Commercial Banks
The primary business of commercial banks is to serve businesses, although with banking
deregulation they have entered into the consumer business as well. Commercial banks provide
the widest variety of banking services. In addition to savings accounts, checking services,
consumer loans, commercial and industrial (C&I) loans, and credit cards, commercial banks may
also offer trust services, trade financing, investment banking and management for corporations,
governments and their agencies, and treasury services.

Before 2005, deposits were insured by the Bank Insurance Fund (BIF), but it was merged with
the SAIF, the fund used to insure thrifts, into a single fund—the Deposit Insurance Fund (DIF).

Commercial banks are the largest banks, both in assets and in geographic extent. Community
banks, however, are smaller commercial banks with assets of less than $1 billion that generally
serve their immediate community of consumers and small businesses. Community banks are also
the most numerous by a large margin.

Some commercial banks, often called regional and super-regional banks, cover a much wider
geographic area and usually have assets in the hundreds of billions of dollars. They have many
branches that extend into several states and many ATM machines at convenient locations
throughout their area. Global banks also offer international services, such as letters of credit,
and currency exchange. These larger banks use short-term borrowing in the money markets to
supplement their deposits and often require loans from the smaller community banks. These
correspondent banks have accounts at the larger banks, which facilitates the frequent transfers
of funds with the big banks. Some banks—money center banks—borrow for their funding
instead of relying on deposits. However, the recent credit crisis has forced money center banks to
become depository institutions because they could not sell their commercial paper or bonds in
financial markets that have been greatly diminished by investors' fear of defaults.
Bank and Financial Holding Companies
Many of the largest banks are actually bank holding companies, which is a company that
controls 2 or more banks. A holding company is a company whose only purpose is to own a
controlling interest in other companies. A bank holding company can more easily expand its
market through acquisitions than a bank can. The Bank Holding Company Act of 1956 requires
that bank holding companies register with the Board of Governors of the Federal Reserve
System. A 1966 amendment to the Act set standards for acquisitions and a 1970 amendment
restricted bank holding companies to banking.

Another benefit enjoyed by bank holding companies is the removal of the geographic restriction
imposed by most state laws on banks that required all branches of a bank to be within a certain
geographic location. The advantages of bank holding companies are evidenced by the fact that,
in 2000, 76% of banks were owned by bank holding companies.

The Financial Services Modernization Act of 1999 deregulated the financial industry even
more by creating the legal entity known as the financial holding company that can control banks,
securities firms, and insurance companies. Previous to this Act, banks were restricted to banking
by the Glass-Steagall Act of 1933 and the Bank Holding Company Act. The primary purpose of
restricting banks to banking is to limit their risk because the federal government insures their
customers' deposits and because solvent banks are essential to any modern economy as best
evidenced by the 2007-2009 credit crises. Consequently, for a bank holding company to qualify
as a financial holding company, its subsidiaries must be well managed and well capitalized. All
of its depository institutions must have satisfactory Community Reinvestment Act (CRA)
ratings, which requires banks to lend back to the community of its depositors. The bank holding
company must register with the Federal Reserve, declaring and certifying that it is qualified as a
financial holding company under the Act.

The largest financial holding company is J.P. Morgan Chase & Co., with assets totaling $2.1
trillion in 2009. According to the Federal Reserve, at the end of 2007, the top 10 banks held 53%
of all assets held by banks, while the top 100 banks held 80%.