Banking and Financial Services

Dhruv Bindhani · Jun 25, 2025

Manohj said:
1

P A R T O N E

Introduction to the

Business of Banking and

Financial-Services Management

Opening this book launches us on an adventure, exploring one of the oldest and most

important industries in the world. Banking and the financial-services industry encompasses

some of the largest business firms ever created—behemoths such as Citibank, J. P.

Morgan Chase, and Bank of America in the United States, Toronto-Dominion Bank in

Canada, Deutsche Bank in Germany, and Barclays PLC in Great Britain. And let’s not

forget banking’s huge nonbank competitors, including AXA, ING, Prudential, MetLife,

GE Capital, GMAC, Fannie Mae, Freddie Mac, and scores of other financial-service

giants that serve every major market around the globe. Yet, astonishingly, this industry

also contains some of the smallest businesses to ever open their doors, such as Heritage

Bank in Bozeman, Montana.

Whether big or small, however, banking and the financial-services industry has a profound

effect on our lives, influencing the availability of jobs, the cost of living, the adequacy

of our savings, and the quality of our existence.

However, banking and the financial-services industry as we know it today is rapidly

becoming a quite different industry than in the past. For example, bank and nonbank

financial firms are declining in numbers, consolidating into fewer but also much larger companies

that may be more efficient and failure resistant. At the same time banks, insurance

companies, security dealers, finance companies, and other financial firms are converging

toward each other, each proliferating the number of services they offer to capture new markets.

The result is that the boundaries between banking, insurance, security firms, finance

companies, and other financial-service providers are becoming hopelessly blurred—

customers, employees, and industry regulators often cannot tell the difference between

them. Financial-service providers are aggressively invading each other’s territories.

For example, if you are looking for a credit card today you can probably find what you

are looking for not only at the neighborhood bank, but also from retailers such as Target

and Wal-Mart, from leading security firms such as Fidelity and Merrill Lynch, and from

major insurance companies such as Prudential and State Farm. If you are seeking a personal

loan and your credit is good you likely have thousands of options, from credit card

companies and credit unions to finance companies and security brokers, not to mention

your friendly neighborhood bank. If you are computer oriented and want to access financial

services over the Internet, virtual banks and scores of other financial-service vendors

are waiting there for you, reflecting the fact that the entire financial-services sector is

undergoing a vast wave of technological change. Instead of focusing just on banking

today, as we used to do in the past, we must continually expand our focus to view banking

within a far broader financial-services industry. Instead of using only a microscope we

also need a telescope or we may miss something really important!

Hang on, then, because this rapidly changing industry is about to unfold before us. In

this opening part of the text we explore the origins of financial-service providers, examine

their range of services, tally up who the key competitors are, and see what career

opportunities may be waiting out there for you if you find enjoyment and satisfaction in

learning about the financial-services industry. We also explore the important roles played

by government in regulating and supervising financial firms and discover how these firms

are organized today and the service-delivery vehicles (such as branches, ATMs, cell

phones, the Internet, etc.) they employ to attract and hold their customers.

We welcome you on this important journey and hope you find it fascinating and

useful as you live for the present and plan for the future.

2 Part One Introduction to the Business of Banking and Financial-Services Management

C H A P T E R O N E

An Overview of Banks

and the Financial-

Services Sector

Key Topics in This Chapter

• Powerful Forces Reshaping the Industry

• What Is a Bank?

• The Financial System and Competing Financial-Service Institutions

• Old and New Services Offered to the Public

• Key Trends affecting All Financial-Service Firms

• Appendix: Career Opportunities in Financial Services

1–1 Introduction

There is an old joke attributed to comedian Bob Hope that says “a bank is a financial institution

where you can borrow money only if you can prove you don’t need it.” Although

many of a bank’s borrowing customers may get the impression that old joke is more truth

than fiction, the real story is that banks today readily provide hundreds of different services

to millions of people, businesses, and governments all over the world. And many of these

financial services are vital to our personal well-being and the well-being of the communities

and nations where we live.

Banks are the principal source of credit (loanable funds) for millions of individuals and

families and for many units of government (school districts, cities, counties, etc.). Moreover,

for small businesses ranging from grocery stores to automobile dealers, banks are

often the major source of credit to stock shelves with merchandise or to fill a dealer’s lot

with new cars. When businesses and consumers must make payments for purchases of

goods and services, more often than not they use bank-supplied checks, credit or debit

cards, or electronic accounts accessible through a Web site. And when they need financial

information and financial advice, it is the banker to whom they turn most frequently for

advice and counsel. More than any other financial-service firm, banks have a reputation

for public trust.

Worldwide, banks grant more installment loans to consumers (individuals and families)

than any other financial-service provider. In most years, they are among the leading buyers

of bonds and notes governments issue to finance public facilities, ranging from auditoriums

and football stadiums to airports and highways. Banks are among the most important

sources of short-term working capital for businesses and have become increasingly active

3

in recent years in making long-term business loans to fund the purchase of new plant and

equipment. The assets held by U.S. banks represent about one-fifth of the total assets and

an even larger proportion of the earnings of all U.S.-based financial-service institutions.

In other nations—for example, in Japan—banks hold half or more of all assets in the

financial system. The difference is because in the United States, many important nonbank

financial-service providers can and do compete to meet the needs of businesses,

consumers, and governments.

Powerful Forces Are Reshaping Banking and Financial Services Today

As we begin our study of this important industry, we should keep in mind the great forces

reshaping the whole financial-services sector. For example, most banks today are profitable—

and, in fact, in several recent quarters they have posted record earnings—but their market

share of the financial-services marketplace is falling significantly. As the former chairman of

the Federal Deposit Insurance Corporation (FOIC) noted recently, in 1980 insured commercial

banks and other depository financial institutions held more than 90 percent of

Americans’ money—a share that had dropped to only about 45 percent as the 21st century

opened. Over the same time span, banks’ and other depositories’ share of U.S. credit market

liabilities fell from about 45 percent of the grand total to only about 25 percent (as reported

by Powell [6]).

The industry is also consolidating rapidly with substantially fewer, but much larger, banks

and other financial firms. For example, the number of U.S. commercial banks fell from

about 14,000 to fewer than 8,000 between 1980 and 2006. The number of separately

incorporated commercial banks in the United States has now reached the lowest level in

more than a century, and much the same pattern of industry consolidation appears around

the globe in most financial-service industries.

Moreover, banking and the financial-services industry are rapidly globalizing and experiencing

intense competition in marketplace after marketplace around the planet, not just

between banks, but also with security dealers, insurance companies, credit unions, finance

companies, and thousands of other financial-service competitors. These financial heavyweights

are all converging toward each other, offering parallel services and slugging it out

for the public’s attention. If consolidation, globalization, convergence, and competition

were not enough to keep an industry in turmoil, banking and its financial-service neighbors

are also undergoing a technological revolution as the management of information and

the production and distribution of financial services become increasingly electronic. For

example, thanks to the Check 21 Act passed in the United States in 2004, even the familiar

“paper check” is gradually being replaced with electronic images. People increasingly

are managing their deposit accounts through the use of personal computers, cell phones,

and debit cards, and there are virtual banks around the world that offer their services exclusively

through the Internet.

Clearly, if we are to understand bank’s and their financial-service competitors and see

where they all are headed, we have our work cut out for us. But, then, you always wanted

to tackle a big challenge, right?

1–2 What Is a Bank?

As important as banks are to the economy as a whole and to the local communities they

call home, there is still much confusion about what exactly a bank is. A bank can be

defined in terms of (1) the economic functions it serves, (2) the services it offers its customers,

or (3) the legal basis for its existence.

4 Part One Introduction to the Business of Banking and Financial-Services Management

Factoid

What nation has the

greatest number of

commercial banks?

Answer: The United

States with about 7,800

commercial banks,

followed by Germany

with close to 2,500.

Certainly banks can be identified by the functions they perform in the economy. They

are involved in transferring funds from savers to borrowers (financial intermediation) and

in paying for goods and services.

Historically, banks have been recognized for the great range of financial services they

offer—from checking accounts and savings plans to loans for businesses, consumers, and

governments. However, bank service menus are expanding rapidly today to include investment

banking (security underwriting), insurance protection, financial planning, advice for

merging companies the sale of risk-management services to businesses and consumers, and

numerous other innovative services. Banks no longer limit their service offerings to traditional

services but have increasingly become general financial-service providers.

Unfortunately in our quest to identify what a bank is, we will soon discover that not only

are the functions and services of banks changing within the global financial system, but

their principal competitors are going through great changes as well. Indeed, many financialservice

institutions—including leading security dealers, investment bankers, brokerage firms,

credit unions, thrift institutions, mutual funds, and insurance companies—are trying to be as

similar to banks as possible in the services they offer. Examples include Merrill Lynch, Dreyfus

Corporation, and Prudential Insurance—all of which own banks or banklike firms. Moreover,

if this were not confusing enough, several industrial companies have stepped forward in recent

decades in an effort to control a bank and offer loans, credit cards, savings plans, and other traditional

banking services. Examples of these giant banking-market invaders include General

Motors Acceptance Corporation (GMAC), GE Capital, and Ford Motor Credit, to name

only a few. Even Wal-Mart, the world’s largest retailer, recently has explored the possibility

of acquiring an industrial bank in Utah in an effort to expand its financial-service offerings!

American Express and Target already control bank-like institutions.

Bankers have not taken this invasion of their turf lying down. They are demanding

relief from traditional rules and lobbying for expanded authority to reach into new markets

all around the globe. For example, with large U.S. banks lobbying heavily, the United

States Congress passed the Financial Services Modernization Act of 1999 (known more

popularly as the Gramm-Leach-Bliley or GLB Act after its Congressional sponsors), allowing

U.S. banks to enter the securities and insurance industries and permitting nonbank

financial holding companies to acquire and control banking firms.

To add to the prevailing uncertainty about what a bank is, over the years literally

dozens of organizations have emerged from the competitive financial marketplace proudly

bearing the label of bank. As Exhibit 1–1 shows, for example, there are savings banks, investment

banks, mortgage banks, merchant banks, universal banks, and so on. In this text we

will spend most of our time focused upon the most important of all banking institutions—

the commercial bank—which serves both business and household customers all over the

world. However, the management principles and concepts we will explore in the chapters

that follow apply to many different kinds of “banks” as well as to other financial-service

institutions that provide similar services.

While we are discussing the many different kinds of banks, we should mention an important

distinction between banking types that will surface over and over again as we make our

way through this text—community banks versus money-center banks. Money-center banks

are giant industry leaders, spanning whole regions, nations, and continents, offering the

widest possible menu of financial services, gobbling up smaller businesses, and facing tough

competition from other giant financial firms around the globe. Community banks, on the

other hand, are usually much smaller and service local communities, towns, and cities,

offering a significantly narrower, but often more personalized, menu of financial services to

the public. As we will see, community banks are declining in numbers, but they also are

proving to be tough competitors in the local areas they choose to serve.

Chapter 1 An Overview of Banks and the Financial-Services Sector 5

One final note in our search for the definition of banks concerns the legal basis for their

existence. When the federal government of the United States decided that it would regulate

and supervise banks more than a century ago, it had to define what was and what was

not a bank for purposes of enforcing its rules. After all, if you plan to regulate banks you

have to write down a specific description of what they are—otherwise, the regulated firms

can easily escape their regulators, claiming they aren’t really banks at all!

The government finally settled on the definition still used by many nations today:

A bank is any business offering deposits subject to withdrawal on demand (such as by writing

a check or making an electronic transfer of funds) and making loans of a commercial

or business nature (such as granting credit to private businesses seeking to expand the

inventory of goods on their shelves or purchase new equipment). Over a century later,

during the 1980s, when hundreds of financial and nonfinancial institutions (such as J. C.

Penney and Sears) were offering either, but not both, of these two key services and, therefore,

were claiming exemption from being regulated as a bank, the U.S. Congress decided

to take another swing at the challenge of defining banking. Congress then defined a bank

as any institution that could qualify for deposit insurance administered by the Federal Deposit

Insurance Corporation (FDIC).

A clever move indeed! Under federal law in the United States a bank had come to be

defined, not so much by its array of service offerings, but by the government agency insuring

its deposits! Please stay tuned—this convoluted and complicated story undoubtedly

will develop even more bizarre twists as the 21st century unfolds.

6 Part One Introduction to the Business of Banking and Financial-Services Management

Name of Banking-Type Firm Definition or Description

Commercial banks: Sell deposits and make loans to businesses and individuals

Money center banks: Are large commercial banks based in leading financial centers

Community banks: Are smaller, locally focused commercial and savings banks

Savings banks: Attract savings deposits and make loans to individuals and families

Cooperative banks: Help farmers, ranchers, and consumers acquire goods and services

Mortgage banks: Provide mortgage loans on new homes but do not sell deposits

Investment banks: Underwrite issues of new securities by their corporate customers

Merchant banks: Supply both debt and equity capital to businesses

Industrial banks: State-chartered loan companies owned by financial or non financial

corporations

International banks: Are commercial banks present in more than one nation

Wholesale banks: Are larger commercial banks serving corporations and governments

Retail banks: Are smaller banks serving primarily households and small businesses

Limited-purpose banks: Offer a narrow menu of services, such as credit card companies and

subprime lenders

Bankers banks: Supply services (e.g., check clearing and security trading) to banks

Minority banks: Focus primarily on customers belonging to minority groups

National banks: Function under a federal charter through the Comptroller of the

Currency

State banks: Function under charters issued by banking commissions in the various

states

Insured banks: Maintain deposits backed by federal deposit insurance plans (e.g., the

FDIC)

Member banks: Belong to the Federal Reserve System

Affiliated banks: Are wholly or partially owned by a holding company

Virtual banks: Offer their services only over the Internet.

Fringe banks: Offer payday and title loans, cash checks, or operate as pawn shops

and rent-to own firms

Universal banks: Offer virtually all financial services available in today’s marketplace.

EXHIBIT 1–1

The Different Kinds

of Financial-Service

Firms Calling

Themselves Banks

Key URLs

The Federal Deposit

Insurance Corporation

not only insures

deposits, but provides

large amounts of data

on individual banks.

See especially

www.fdic.gov and

www.fdic.gov/bank/

index.html.

Insights and Issues

A BRIEF HISTORY OF BANKING AND OTHER

FINANCIAL-SERVICE FIRMS

As best we can tell from historical records, banking is the oldest of

all financial-service professions. Where did these powerful financial

institutions come from?

Linguistics (the science of language) and etymology (the study

of word origins) tell us that the French word banque and the Italian

banca were used centuries ago to refer to a “bench” or

“money changer’s table.” This describes quite well what historians

have observed about the first bankers offering their services

more than 2,000 years ago. They were money changers, situated

usually at a table in the commercial district, aiding travelers by

exchanging foreign coins for local money or discounting commercial

notes for a fee.

The earliest bankers pledged a lot of their own money to support

these early ventures, but it wasn’t long before the idea of

attracting deposits and loaning out those same funds emerged.

Loans were granted to shippers, landowners, and others at interest

rates as low as 6 percent to as high as 48 percent a month for

the riskiest ventures! Most of the early banks were Greek in origin.

The banking industry gradually spread from the classical civilizations

of Greece and Rome into Europe. It encountered religious

opposition during the Middle Ages primarily because loans to the

poor often carried high interest rates. However, as the Middle

Ages drew to a close and the Renaissance began in Europe, the

bulk of loans and deposits involved wealthy customers, which

helped to reduce religious objections.

The development of overland trade routes and improvements

in navigation in the 15th, 16th, and 17th centuries gradually shifted

the center of world commerce from the Mediterranean toward

Europe and the British Isles. During this period, the seeds of the

Industrial Revolution, which demanded a welldeveloped financial

system, were planted. The adoption of mass production required

an expansion in global trade to absorb industrial output, which in

turn required new methods for making payments and obtaining

credit. Banks that could deliver on these needs grew rapidly, led

by such institutions as the Medici Bank in Italy and the Hochstetter

Bank in Germany.

The early banks in Europe were places for the safekeeping of

wealth (such as gold and silver) for a fee as people came to fear

loss of their assets due to war, theft, or expropriation by government.

Merchants shipping goods found it safer to place their

payments of gold and silver in the nearest bank rather than risking

loss to pirates or storms at sea. In England government

efforts to seize private holdings resulted in people depositing

their valuables in goldsmiths’ shops, which issued tokens or certificates

indicating the customer had made a deposit. Soon,

goldsmith certificates began to circulate as money because they

were more convenient and less risky to carry around than gold

or other valuables. The goldsmiths also offered certification of

value services—what we today call property appraisal. Customers

would bring in their valuables to have an expert certify

these items were real and not fakes.

When colonies were established in North and South America,

Old World banking practices entered the New World. At first the

colonists dealt primarily with established banks in the countries

from which they had come. Later, state governments in the United

States began chartering banking companies. The U.S. federal

government became a major force in banking during the Civil

War. The Office of the Comptroller of the Currency (OCC) was

established in 1864, created by the U.S. Congress to charter

national banks. This divided bank regulatory system, in which

both the federal government and the states play key roles in the

supervision of banking activity, has persisted in the United States

to the present day.

Despite banking’s long history and success, tough financialservice

competitors have emerged over the past century or two,

mostly from Europe, to challenge bankers at every turn. Among the

oldest were life insurance companies—the first American company

was chartered in Philadelphia in 1759. Property-casualty

insurers emerged at roughly the same time, led by Lloyds of London

in 1688, underwriting a wide range of risks to persons and

property.

The 19th century ushered in a rash of new financial competitors,

led by savings banks in Scotland in 1810. These institutions

offered small savings deposits to individuals at a time when most

commercial banks largely ignored this market segment. A similar

firm, the savings and loan association, appeared in the midwestern

United States during the 1830s, encouraging household saving

and financing the construction of new homes. Credit unions were

first chartered in Germany during the same era, providing savings

accounts and low-cost credit to industrial workers.

Mutual funds—one of banking’s most successful competitors—

appeared in Belgium in 1822. These investment firms entered

the United States in significant numbers during the 1920s, were

devastated by the Great Depression of the 1930s, and rose again

to grow rapidly. A closely related institution—the money market

fund—surfaced in the 1970s to offer professional cash management

services to households and institutions. These aggressive

competitors attracted a huge volume of deposits away from

banks and ultimately helped to bring about government deregulation

of the banking industry. Finally, hedge funds appeared to

offer investors a less regulated, more risky alternative to mutual

funds. They grew explosively into the new century.

1–3 The Financial System and Competing Financial-Service Institutions

Roles of the Financial System

As we noted at the opening of this chapter, bankers face challenges from all sides today as

they reach out to their financial-service customers. Banks are only one part of a vast financial

system of markets and institutions that circles the globe. The primary purpose of this

ever-changing financial system is to encourage individuals and institutions to save and to transfer

those savings to those individuals and institutions planning to invest in new projects. This

process of encouraging savings and transforming savings into investment spending causes

the economy to grow, new jobs to be created, and living standards to rise.

But the financial system does more than simply transform savings into investment. It

also provides a variety of supporting services essential to modern living. These include payment

services that make commerce and markets possible (such as checks, credit cards, and

interactive Web sites), risk protection services for those who save and venture to invest

(including insurance policies and derivative contracts), liquidity services (making it possible

to convert property into immediately available spending power), and credit services for

those who need loans to supplement their income.

The Competitive Challenge for Banks

For many centuries banks were way out in front of other financial-service institutions in

supplying savings and investment services, payment and risk protection services, liquidity,

and loans. They dominated the financial system of decades past. But this is no longer as

true today. Banking’s financial market share generally has fallen as other financial institutions

have moved in to fight for the same turf. In the United States of a century ago, for

example, banks accounted for more than two-thirds of the assets of all financial-service

providers. However, as Exhibit 1–2 illustrates, that share has fallen to only about one-fifth

of the assets of the U.S. financial marketplace.

Some authorities in the financial-services field suggest this apparent loss of market

share may imply that traditional banking is dying. (See, for example, Beim [2] and the

counterargument by Kaufman and Mote [3].) Certainly as financial markets become more

efficient and the largest customers find ways around banks to obtain the funds they need

(such as by borrowing in the open market), traditional banks may become less necessary.

Some experts argue that the reason we still have thousands of banks scattered around the

globe—perhaps many more than we need—is that governments often subsidize the industry

through cheap deposit insurance and low-cost loans. Still others argue that banking’s

market share is falling due to excessive government regulation, restricting the industry’s

ability to compete. Perhaps banking is being “regulated to death,” which may hurt those

customers who most heavily depend on banks for critical services—individuals and small

businesses. Other experts counter that banking is not dying, but only changing—offering

new services and changing its form—to reflect what today’s market demands. Perhaps the

traditional measures of the industry’s importance (like total assets) no longer reflect how

truly diverse and competitive bankers have become in the modern world.

Leading Competitors with Banks

Among the leading competitors with banks in wrestling for the loyalty of financial-service

customers are such nonbank financial-service institutions as:

Savings associations: Specialize in selling savings deposits and granting home

mortgage loans and other forms of credit to individuals and families, illustrated by

such financial firms as Atlas Savings and Loan Association (www.atlasbank.com),

8 Part One Introduction to the Business of Banking and Financial-Services Management

Factoid

Did you know that the

number of banks

operating in the U.S.

today represents less

than a third of the

number operating 100

years ago? Why do you

think this is so?

Key URLs

Want to know more

about savings

associations? See

especially the Office of

Thrift Supervision at

www.ots.treas.gov and

the Federal Deposit

Insurance Corporation

at www.fdic.gov.

Flatbush Savings and Loan Association (www.flatbush.com) of Brooklyn, New York,

Washington Mutual (www.wamu.com), and American Federal Savings Bank

(www.americanfsb.com).

Credit unions: Collect deposits from and make loans to their members as nonprofit

associations of individuals sharing a common bond (such as the same employer),

including such firms as American Credit Union of Milwaukee (www.americancu.org)

and Chicago Post Office Employees Credit Union (www.my-creditunion.com).

Money market funds: Collect short-term, liquid funds from individuals and

institutions and invest these monies in quality securities of short duration, including

such firms as Franklin Templeton Tax-Free Money Fund (www.franklintempleton.

com) and Scudder Tax-Free Money Fund (www.scudder.com).

Mutual funds (investment companies): Sell shares to the public representing an

interest in a professionally managed pool of stocks, bonds, and other securities,

including such financial firms as Fidelity (www.fidelity.com) and The Vanguard

Group (www.vanguard.com).

Hedge funds: Sell shares mainly to upscale investors in a broad group of different

kinds of assets (including nontraditional investments in commodities, real estate,

loans to ailines companies, and other risky assets); for additional information see such

firms as Magnum Group (www.magnum.com) and Turn Key Hedge Funds

(www.turnkeyhedgefunds.com).

Security brokers and dealers: Buy and sell securities on behalf of their customers and

for their own accounts, such as Merrill Lynch (www.ml.com) and Charles Schwab

(www.Schwab.com).

Chapter 1 An Overview of Banks and the Financial-Services Sector 9

Total Financial Assets Percent of All Financial

Financial-Service Institutions Held in 2005 (bill.)* Assets Held in 2005

Depository Institutions:

Commercial banks** 8,713 20.1%

Savings institutions*** 1,693 3.9

Credit unions 670 1.5

Nondeposit Financial Institutions:

Life insurance companies 4,166 9.6

Property/casualty and other insurers 1,197 2.8

Private pension funds 4,286 9.9

State and local government

retirement funds 2,040 4.7

Federal government retirement funds 71 0.2

Money market funds 1,841 4.2

Investment companies (mutual funds) 5,443 12.5

Finance companies 1,424 3.3

Mortgage companies 32 ****

Real estate investment trusts 259 0.6

Security brokers and dealers 1,941 4.5

Other financial service providers

(including government-sponsored

enterprises, mortgage pools, payday

lenders, etc.) 9,670 22.3

Totals 43,446 100.0%

EXHIBIT 1–2

Comparative Size by

Industry of

Commercial Banks

and Their Principal

Financial-Service

Competitors

Source: Board of Governors of

the Federal Reserve System,

Flow of Funds Accounts of the

United States. First Quarter

2005, June 2005.

Notes: Columns may not add to totals due to rounding error.

*Figures are for the first quarter of 2005.

**Commercial banking as recorded here includes U.S. chartered commercial banks, foreign banking offices in the United States, bank

holding companies, and banks operating in United States affiliated areas.

***Savings institutions include savings and loan associations, mutual and federal savings banks, and cooperative banks.

****Figure is less than one-tenth of one percent.

Key URLs

The nature and

characteristics of money

market funds and other

mutual funds are

explained at length in

such sources as

www.smartmoney.com,

www.ici.org,

www.morningstar.com,

and market watch.com.

Key URLs

To explore the

character of the credit

union industry see

www.cuna.org and

woccu.org.

Key URLs

To learn more about

security brokers and

dealers see www.sec.gov

or www.investorguide.

com.

Investment banks: Provide professional advice to corporations and governments

raising funds in the financial marketplace or seeking to make business acquisitions,

including such prominent investment banking houses as Bear Sterns

(www.bearsterns.com) and Morgan Stanley (www.morganstanley.com).

Finance companies: Offer loans to commercial enterprises (such as auto and

appliance dealers) and to individuals and families using funds borrowed in the open

market or from other financial institutions, including such well-known financial firms

as Household Finance (www.household.com) and GMAC Financial Services

(www.gmacfs.com).

Financial holding companies: (FHCs) Often include credit card companies,

insurance and finance companies, and security broker/dealer firms under one

corporate umbrella as highly diversified financial-service providers, including such

leading financial conglomerates as GE Capital (www.gecapital.com) and UBS

Warburg AG (www.ubswarburg.com).

Life and property/casualty insurance companies: Protect against risks to persons or

property and manage the pension plans of businesses and the retirement funds of

individuals, including such industry leaders as Prudential Insurance (www.prudential.

com) and State Farm Insurance Companies (www.statefarm.com).

As suggested by Exhibit 1–3, all of these financial-service providers are converging in

terms of the services they offer—rushing toward each other like colliding trains—and

embracing each other’s innovations. Moreover, recent changes in government rules, such

as the U.S. Financial Services Modernization (Gramm-Leach-Bliley) Act of 1999, have

allowed many of the financial firms listed above to offer the public one-stop shopping for

financial services. To bankers the financial-services marketplace appears to be closing in

from all sides as the list of aggressive competitors grows.

Thanks to more liberal government regulations, banks with quality management and

adequate capital can now truly become conglomerate financial-service providers. The

same is true for security firms, insurers, and other financially oriented companies that wish

to acquire bank affiliates.

Thus, the historic legal barriers in the United States separating banking from other financialservice

businesses have, like the walls of ancient Jericho, “come tumbling down.” The challenge

of differentiating banks from other financial-service providers is greater than ever before. However,

inside the United States, Congress (like the governments of many other nations around

the globe) has chosen to limit severely banks’ association with industrial and manufacturing

firms, fearing that allowing banking–industrial combinations of companies might snuff out competition,

threaten bankers with new risks, and possibly weaken the safety net that protects

depositors from loss when the banking system gets into trouble.

10 Part One Introduction to the Business of Banking and Financial-Services Management

Key URLs

You can explore the

world of investment

banking more fully at

www.wallstreetprep.

com.

Key URLs

To discover more about

hedge funds see the

Security and Exchange

Commission’s Web site

at www.sec.gov/

answers/hedge.htm.

Key URLs

To explore the life

insurance and

property/casualty

insurance industries see

especially www.acli.com

and www.iii.org.

Key URLs

To learn more about

finance companies see

www.nacm.org,

www.hsbcusa.com, and

www.capitalone.com.

Concept Check

1-1. What is a bank? How does a bank differ from most

other financial-service providers?

1-2. Under U.S. law what must a corporation do to qualify

and be regulated as a commercial bank?

1-3. Why are some banks reaching out to become

onestop financial-service conglomerates? Is this a

good idea, in your opinion?

1-4. Which businesses are banking’s closest and toughest

competitors? What services do they offer that

compete directly with banks’ services?

1-5. What is happening to banking’s share of the financial

marketplace and why? What kind of banking

and financial system do you foresee for the future if

present trends continue?

Chapter 1 An Overview of Banks and the Financial-Services Sector 11

Offering customers credit,

payments, and savings deposit

services often fully

comparable to what banks

offer

Providing customers

with long-term savings

plans, risk protection,

and credit

Credit Unions and

Other Thrift

Institutions

Security Brokers

and Dealers

Insurance

Companies

and Pension Plans

Providing investment and savings

planning, executing security

purchases and sales, and providing

credit cards to their customers

Supplying customers with

access to cash (liquidity) and

short- to medium-term loans

for everything from daily

household and operating

expenses to the purchase of

appliances and equipment

Finance

Companies

Supplying professional

cash management and

investing services for

longer-term savers

Mutual Funds

Highly

diversified

financial-service

providers

that control

multiple

financial

firms

offering

many

different

services

Financial

Conglomerates

Modern

Bank

Bankers feel the impact of their fiercest nonbank

competitors coming in from all directions

Investment

Banks

Advising corporations and

Governments on raising funds,

entering new markets, and planning

acquisitions and mergers

EXHIBIT 1–3 The Most Important Nonbank Competitors for Banks

The result of all these recent legal maneuverings is a state of confusion in the public’s

mind today over what is or is not a bank. The safest approach is probably to view these historic

financial institutions in terms of the many key services—especially credit, savings,

payments, financial advising, and risk protection services—they offer to the public. This

multiplicity of services and functions has led to banks and their nearest competitors being

labeled “financial department stores” and to such familiar advertising slogans as “Your

Bank—a Full-Service Financial Institution”.

1–4 Services Banks and Many of Their Closest Competitors Offer the Public

Banks, like their neighboring competitors, are financial-service providers. As such, they

play a number of important roles in the economy. (See Table 1–1.) Their success hinges on

their ability to identify the financial services the public demands, produce those services

efficiently, and sell them at a competitive price. What services does the public demand

from banks and their financial-service competitors today? In this section, we present an

overview of both banking’s traditional and its modern service menu.

Services Banks Have Offered Throughout History

Carrying Out Currency Exchanges

History reveals that one of the first services banks offered was currency exchange. A banker

stood ready to trade one form of coin or currency (such as dollars) for another (such as

francs or pesos) in return for a service fee. Such exchanges have been important to travelers

over the centuries, because the traveler’s survival and comfort may depend on gaining access

to local funds. In today’s financial marketplace, trading in foreign currency is conducted

primarily by the largest financial-service firms due to the risks involved and the expense

required to carry out these transactions.

Discounting Commercial Notes and Making Business Loans

Early in history, bankers began discounting commercial notes—in effect, making loans to

local merchants who sold the debts (accounts receivable) they held against their customers

to a bank to raise cash quickly. It was a short step from discounting commercial

notes to making direct loans for purchasing inventories of goods or for constructing new

facilities—a service that today is provided by banks, finance companies, insurance firms,

and other financial-service competitors.

Offering Savings Deposits

Making loans proved so profitable that banks began searching for ways to raise additional

loanable funds. One of the earliest sources of these funds consisted of offering

12 Part One Introduction to the Business of Banking and Financial-Services Management

The modern bank has had to adopt many roles to remain competitive and responsive to public needs.

Banking’s principal roles (and the roles performed by many of its competitors) today include:

The intermediation role Transforming savings received primarily from households into credit

(loans) for business firms and others in order to make investments in

new buildings, equipment, and other goods.

The payments role Carrying out payments for goods and services on behalf of customers

(such as by issuing and clearing checks and providing a conduit for

electronic payments.

The guarantor role Standing behind their customers to pay off customer debts when those

customers are unable to pay (such as by issuing letters of credit).

The risk management role Assisting customers in preparing financially for the risk of loss to

property, persons, and financial assets.

The investment banking role Assisting corporations and governments in marketing securities and

raising new funds.

The savings/investment Aiding customers in fulfilling their long-range goals for a better life by

advisor role building and investing savings.

The safekeeping/certification Safeguarding a customer’s valuables and certifying their true value.

of value role

The agency role Acting on behalf of customers to manage and protect their property.

The policy role Serving as a conduit for government policy in attempting to regulate

the growth of the economy and pursue social goals.

TABLE 1–1

The Many Different

Roles Banks and

Their Closest

Competitors Play

in the Economy

Insights and Issues

THE ROLE OF BANKS AND OTHER FINANCIAL

INTERMEDIARIES IN THEORY

Banks, along with insurance companies, mutual funds, finance

companies, and similar financial-service providers, are financial

intermediaries. The term financial intermediary simply means a

business that interacts with two types of individuals and institutions

in the economy: (1) deficit-spending individuals and institutions,

whose current expenditures for consumption and investment

exceed their current receipts of income and who, therefore, need

to raise funds externally through borrowing or issuing stock; and (2)

surplus-spending individuals and institutions whose current

receipts of income exceed their current expenditures on goods and

services so they have surplus funds that can be saved and

invested. Intermediaries perform the indispensable task of acting

as a bridge between these two groups, offering convenient financial

services to surplus-spending units in order to attract funds and

then allocating those funds to deficit spenders. In so doing, intermediaries

accelerate economic growth by expanding the available

pool of savings, lowering the risk of investments through diversification,

and increasing the productivity of savings and investment.

Intermediation activities will take place (1) if there is a positive

spread between the expected yields on loans that financial intermediaries

make to deficit spenders and the expected cost of the

funds intermediaries attract from surplus spenders; and (2) if there

is a positive correlation between the yields on loans and other

assets and the attracting funds. If an Intermediary’s asset yields

and its fund-raising costs are positively correlated, this will reduce

uncertainty about its expected profits and allow it to expand.

An ongoing debate in finance concerns why financial intermediaries

exist at all. What services do they provide that other businesses

and individuals cannot provide for themselves?

This question has proven difficult to answer. Research evidence

showing that our financial markets are reasonably efficient

has accumulated in recent years. Funds and information flow

readily to market participants, and the prices of assets seem to be

determined in highly competitive markets. In a perfectly competitive

and efficient financial system, in which all participants have

equal and open access to the financial marketplace, no one participant

can exercise control over prices, all pertinent information

affecting the value of various assets is available to all, transactions

costs are not significant impediments to trading, and all

assets are available in denominations anyone can afford, why

would banks and other financial-service firms be needed at all?

Most current theories explain the existence of financial intermediaries

by pointing to imperfections in our financial system. For

example, all assets are not perfectly divisible into small denominations

that everyone can afford. To illustrate, marketable U.S. Treasury

bonds—one of the most popular securities in the world—have

minimum denominations of $1,000, which is beyond the reach of

many small savers and investors. Financial intermediaries provide

a valuable service in dividing up such instruments into smaller units

that are readily affordable for millions of people.

Another contribution that intermediaries make is their willingness

to accept risky loans from borrowers, while issuing low-risk

securities to their depositors and other funds providers. These

service providers engage in risky arbitrage across the financial

markets and sell risk-management services as well.

Financial intermediaries satisfy the need for liquidity. Financial

instruments are liquid if they can be sold quickly in a ready market

with little risk of loss to the seller. Many households and businesses,

for example, demand large precautionary balances of liquid

funds to cover future cash needs. Intermediaries satisfy this

customer need by offering high liquidity in the financial assets

they provide, giving customers access to liquid funds precisely

when they are needed.

Still another reason intermediaries have prospered is their

superior ability to evaluate information. Pertinent data on financial

investments is limited and costly. Some institutions know more

than others or possess inside information that allows them to

choose profitable investments while avoiding the losers. This

uneven distribution of information and the talent to analyze it is

known as informational asymmetry. Asymmetries reduce the efficiency

of markets, but provide a profitable role for intermediaries

that have the expertise to evaluate potential investments.

Yet another view of why financial institutions exist in modern

society is called delegated monitoring. Most borrowers prefer to

keep their financial records confidential. Lending institutions are

able to attract borrowing customers because they pledge confidentiality.

For example, a bank’s depositors are not privileged to

review the records of its borrowing customers. Depositors often

have neither the time nor the skill to choose good loans over bad.

They turn the monitoring process over to a financial intermediary.

Thus a depository institution serves as an agent on behalf of its

depositors, monitoring the financial condition of those customers

who do receive loans to ensure that depositors will recover their

funds. In return for monitoring, depositors pay a fee to the lender

that is probably less than the cost they would incur if they monitored

borrowers themselves.

By making a large volume of loans, lending institutions acting

as delegated monitors can diversify and reduce their risk exposure,

resulting in increased safety for savers’ funds. Moreover,

when a borrowing customer has received the stamp of approval

of a lending institution it is easier and less costly for that customer

to raise funds elsewhere. This signals the financial marketplace

that the borrower is likely to repay his or her loans. This

signaling effect seems to be strongest, not when a lending institution

makes the first loan to a borrower, but when it renews a

maturing loan.

savings deposits—interest-bearing funds left with depository institutions for a period of

time. According to some historical records, banks in ancient Greece paid as high as 16 percent

in annual interest to attract savings deposits from wealthy patrons and then made

loans to ship owners sailing the Mediterranean Sea at loan rates double or triple the rate

bankers were paying to their savings deposit customers. How’s that for a nice profit spread?

Safekeeping of Valuables and Certification of Value

During the Middle Ages, banks and other merchants (often called “goldsmiths”) began the

practice of holding gold and other valuables owned by their customers inside secure vaults,

thus reassuring customers of their safekeeping. These financial firms would assay the market

value of their customer’s valuables, especially gold and jewelry, and certify whether or

not these “valuables” were worth what others had claimed.

Supporting Government Activities with Credit

During the Middle Ages and the early years of the Industrial Revolution, governments in

Europe noted bankers’ ability to mobilize large amounts of funds. Frequently banks were

chartered under the proviso that they would purchase government bonds with a portion of

the deposits they received. This lesson was not lost on the fledgling American government

during the Revolutionary War. The Bank of North America, chartered by the Continental

Congress in 1781, was set up to help fund the struggle to throw off British rule and

make the United States a sovereign nation. Similarly, during the Civil War the U.S. Congress

created a whole new federal banking system, agreeing to charter national banks provided

these institutions purchased government bonds to help fund the war.

Offering Checking Accounts (Demand Deposits)

The Industrial Revolution ushered in new financial services, and new service providers.

Probably the most important of the new services developed during this period was the

demand deposit—a checking account that permitted the depositor to write drafts in payment

for goods and services that the bank or other service provider had to honor immediately.

Demand deposit services proved to be one of the financial-service industry’s most

important offerings because it significantly improved the efficiency of the payments

process, making transactions easier, faster, and safer. Today the checking account concept

has been extended to the Internet, to the use of plastic debit cards that tap your checking

account electronically, and to “smart cards” that electronically store spending power.

Today payment-on-demand accounts are offered not only by banks, but also by savings

associations, credit unions, securities firms, and other financial-service providers.

Offering Trust Services

For many years banks and a few of their competitors (such as insurance and trust companies)

have managed the financial affairs and property of individuals and business firms in

return for a fee. This property management function is known as trust services. Providers

of this service typically act as trustees for wills, managing a deceased customer’s estate by

paying claims against that estate, keeping valuable assets safe, and seeing to it that legal

heirs receive their rightful inheritance. In commercial trust departments, trust-service

providers manage security portfolios and pension plans for businesses and act as agents for

corporations issuing stocks and bonds.

Services Banks and Many of Their Financial-Service Competitors

Have Offered More Recently

Granting Consumer Loans

Historically, banks did not actively pursue loan accounts from individuals and families,

believing that the relatively small size of most consumer loans and their relatively high

14 Part One Introduction to the Business of Banking and Financial-Services Management

Factoid

What region of the

United States contains

the largest number of

banks? The Midwest.

The smallest number of

banks? The Northeast.

Why do you think this

is so?

default rate would make such lending unprofitable. Accordingly, other financial-service

providers—especially credit unions, savings and loans, and finance companies—soon

moved in to focus on the consumer. Early in this century, however, bankers began to rely

more heavily on consumers for deposits to help fund their large corporate loans. In addition,

heavy competition for business deposits and loans caused bankers increasingly to turn

to the consumer as a potentially more loyal customer. By the 1920s and 1930s several

major banks, led by one of the forerunners of New York’s Citibank and by the Bank of

America, had established strong consumer loan departments. Following World War II,

consumer loans were among the fastest-growing forms of bank credit. Their rate of growth

has slowed recently, though, as bankers have run into stiff competition for consumer credit

accounts from nonbank service providers.

Financial Advising

Customers have long asked financial institutions for advice, particularly when it comes to

the use of credit and the saving or investing of funds. Many service providers today offer a

wide range of financial advisory services, from helping to prepare tax returns and financial

plans for individuals to consulting about marketing opportunities at home and abroad

for business customers.

Managing Cash

Over the years, financial institutions have found that some of the services they provide

for themselves are also valuable for their customers. One of the most prominent is cash

management services, in which a financial intermediary agrees to handle cash collections

and disbursements for a business firm and to invest any temporary cash surpluses in interestbearing

assets until cash is needed to pay bills. Although banks tend to specialize mainly in

business cash management services, many financial institutions are offering similar services

to consumers.

Offering Equipment Leasing

Many banks and finance companies have moved

The writer's distinctive writing style shines through, making this piece a pleasure to read. Its expertly chosen structure guides you seamlessly from one point to the next, while the exceptional clarity ensures every idea is not just presented, but truly understood.

Banking and Financial Services

Dhruv Bindhani

Active member