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Understanding Depository Institutions: The Backbone of Modern Finance
Dive into the world of depository institutions and discover their crucial role in the financial system. Learn how banks and credit unions shape the economy and impact your daily life.

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  1. Definition & Types of Depository Institution
    • Commercial Banks
    • Thrift Institutions
    • Money market Mutual Funds
  2. Assets of Depository Institutions
    • Bank Reserves
    • Liquid Assets
    • Securities
    • Loans
Money definitions
Jump to:NotesConceptFAQsPrerequisites
Notes

Definition & Types of Depository Institutions

Depository Institution: a financial firm in the US that accepts deposits from households and businesses. These deposits can be components from M1 and M2.

There are three types of depository institutions:

  1. Commercial Banks: a firm that is licensed to take deposits and make loans.

    Deposits from commercial banks make 40% of M1 and 65% of M2.

  2. Thrift Institutions: consists of savings bank, savings and loan association, and as well as credit unions.

    1. Savings bank: is a depository institution that accepts savings deposit and make home-purchase loans.

    2. Savings and loan association: is a depository institution that takes deposits and make commercial, personal, and home-purchase loans.

    3. Credit Union: is a depository institution that takes savings deposits and personal loans.

    Deposits from thrift institutions make 9% of M1 and 16% of M2.

  3. Money Market Mutual Funds: A financial institution manages this fund, sells shares in the fund and hold assets like short-term commercial bills.

    Mutual funds shares act like a bank deposit, where shareholders can put money in or write checks. However, there are a lot of restrictions on these accounts.

    Money market mutual funds make 0% of M1 and 9% of M2.


Assets of Depository Institutions

Depository institutions make money from service fees of check clearing, account management, and credit cards. However, most of the income gained is from using the deposits to make loans and buy securities that earn higher interest rates than the ones paid to depositors.

To sustain the amount of depositor’s withdrawals, and loans and securities, the depository institution must perform a balancing act.

To see the balancing act clearly, we look at the assets of a commercial bank.

  1. Bank Reserves: are coins and notes in the bank’s vault or deposit account at the Federal Reserve. These funds are used to meet depositor’s withdrawals of currency, and payments of other banks.

    Normally, the bank keeps 0.5% of deposits as reserves.

  2. Liquid Assets: are cash, or assets that can be converted to cash easily and sold with little to no risk of loss. With liquid assets, banks can
    1. Meet reserve requirements (0.5% or higher)
    2. Use liquid assets to make overnight loans to other banks if their reserve requirements are not met. Since the risk is very low, overnight loan interest rates are very low as well.

    3. Note: The interest rate on overnight loans to other banks are also known as the federal funds rate.

  3. Securities: are government bonds and other types of bonds like mortgage-backed securities. These assets can be sold and converted to reserves like liquid assets. However, since the prices changes irregularly, the interest rate is high.

  4. Loans: Loans are the riskiest assets, but they are also the highest earning assets. This is because loans can’t be converted to reserves unless they are repaid, and some borrowers never pay back.


Benefits & Regulation of Depository Institutions

Depository institutions give 4 benefits:

  1. Create Liquidity: depository institutions take deposits and are ready to repay people with short notice, or if there is a high demand. In addition, they make loan commitments that run for many years (borrow short, lend long).

  2. Pool Risk: There is also a risk that a loan may not be repaid, which we call a default.

    Loaning to one person who defaults means you lose the entire loan amount. However, loaning to 1000 people and having one default means you lost almost nothing.

  3. Lowers the Cost of Borrowing: Suppose a firm needs a large sum of money, like 2 million. Without a depository institution, the firm would have to borrow from dozens of people to reach that amount. Depository institutions lowers the cost of searching by lending the entire 2 million to this firm.

  4. Lowers the Cost of Monitoring Borrowers: When a lender monitors a borrower, the lender can suggest good decisions for the borrower to prevent defaults. However, monitoring is very costly, especially if they monitor every individual that borrows money. Depository institutions can do this at a way lower cost.

Regulation of Depository Institutions: Since depository institutions are dealing with a risky business and have the potential to damage the economy, they must minimize this risk. They do so by meeting reserve requirements.

If a depository institution fails, then each depository is guaranteed up to $250,000 per bank by the Federal Deposit Insurance Corporation (FDIC).
Concept

Introduction to Depository Institutions

Depository institutions play a crucial role in the financial system, serving as the backbone of modern economies. These institutions, including banks, credit unions, and savings associations, accept deposits from individuals and businesses, providing a safe place to store money while offering various financial services. In our introduction video, we explore the fundamental concepts of depository institutions and their significance in the broader economic landscape. This article delves deeper into the world of depository institutions, covering their types, functions, and regulatory framework. We'll examine how these institutions facilitate the flow of money, extend credit, and contribute to economic growth. Additionally, we'll discuss the challenges and opportunities facing depository institutions in today's rapidly evolving financial environment. By understanding the intricacies of these vital financial intermediaries, readers will gain valuable insights into the inner workings of the financial system and its impact on everyday life.

FAQs

  1. What are the main types of depository institutions?

    The main types of depository institutions are commercial banks, thrift institutions (including savings banks, savings and loan associations, and credit unions), and money market mutual funds. Commercial banks offer a wide range of services and hold the largest share of deposits. Thrift institutions focus on savings and mortgages, while money market mutual funds provide liquid, savings-like instruments.

  2. How do depository institutions make money?

    Depository institutions generate income through various channels, including service fees, account management fees, credit card fees, and interest from loans and securities. They use customer deposits to make loans and invest in securities, earning a profit from the difference between the interest they pay on deposits and the interest they receive from loans and investments.

  3. What is the role of the Federal Deposit Insurance Corporation (FDIC)?

    The FDIC plays a crucial role in regulating depository institutions in the United States. It supervises and examines banks for safety and soundness, resolves failed institutions, and provides deposit insurance. The FDIC currently guarantees deposits up to $250,000 per depositor, per insured bank, for each account ownership category, protecting depositors from losing their savings in the event of a bank failure.

  4. Why are reserve requirements important for depository institutions?

    Reserve requirements mandate that banks hold a certain percentage of their deposits in reserve, either as cash on hand or as deposits with the central bank. These requirements ensure that banks have sufficient liquidity to meet customer withdrawals, help control the money supply, and act as a buffer against potential losses. They are a key tool in maintaining the stability and integrity of the financial system.

  5. What are the main benefits of depository institutions to the economy?

    Depository institutions offer four main benefits to the economy: creating liquidity, pooling risk, lowering the cost of borrowing, and lowering the cost of monitoring borrowers. They transform illiquid assets into liquid ones, spread risk across a large pool of loans, achieve economies of scale to reduce transaction costs, and use specialized systems to evaluate and monitor borrowers efficiently. These benefits enhance the overall efficiency of the financial system and support economic growth.

Prerequisites

Understanding depository institutions is a crucial aspect of financial literacy and economic knowledge. While there are no specific prerequisite topics listed for this subject, it's important to recognize that a solid foundation in basic financial concepts can greatly enhance your comprehension of depository institutions and their role in the economy.

Depository institutions, such as banks, credit unions, and savings associations, play a vital role in our financial system. These organizations accept deposits from individuals and businesses, providing a safe place to store money while often offering interest on savings. They also use these deposits to make loans, facilitating economic growth and helping individuals and businesses achieve their financial goals.

To fully grasp the concept of depository institutions, it's beneficial to have a basic understanding of how money works in an economy. This includes concepts like the functions of money, the role of central banks, and the basics of monetary policy. While not strictly prerequisites, familiarity with these topics can provide valuable context for understanding depository institutions.

Additionally, knowledge of basic banking operations can be helpful. This might include understanding different types of accounts, such as checking and savings accounts, as well as the concept of interest rates and how they affect both savers and borrowers. Familiarity with these concepts can help you better appreciate the services offered by depository institutions and how they operate within the broader financial system.

Another area that can enhance your understanding of depository institutions is a basic grasp of financial regulations. While you don't need to be an expert in financial law, knowing that there are rules and oversight bodies governing these institutions can help you understand their operations and the protections in place for consumers.

Furthermore, a general understanding of economic principles can provide valuable context. Concepts such as supply and demand, inflation, and economic cycles all play a role in how depository institutions function and make decisions. While not prerequisites in the strictest sense, having a foundation in these areas can deepen your understanding of depository institutions and their importance in the economy.

In conclusion, while there are no specific prerequisite topics listed for understanding depository institutions, a broad foundation in basic financial and economic concepts can significantly enhance your comprehension of this subject. By building your knowledge in these related areas, you'll be better equipped to understand the complexities of depository institutions and their crucial role in our financial system.