Pride/Hughes/Kapoor Business, 10th Edition

Audio Review Transcript
Chapter 18 Understanding Money, Banking, and Credit

1. Identify the functions and characteristics of money

Businesses transform resources into money. If a firm has a good idea for a product or a service, a bank or other lender may lend it money to develop, produce, and market the good or service. The loan, with interest, will be repaid using future sales revenue. Both the firm and the lender earn a reasonable profit. And money helps make it happen.
In the past, people exchanged goods and services without using money. Instead they used a barter system, in which goods and services are traded directly for other goods and services. The problem with the barter system is that the two parties must need each other’s products at the same time and the two products must be of similar value. To eliminate these inconveniences, the concept of money was developed. Money is anything a society uses to purchase products, services, or resources. The most commonly used objects today are metal coins and paper bills, called currency.
Money has three primary functions. First and foremost, it is a medium of exchange. A medium of exchange is anything accepted as payment for products, services, and resources. If a business needs a certain raw material, it exchanges money for the product and transforms it into a product it can sell, in exchange for more money. Second, money is a measure of value. A measure of value is a single standard, or “yardstick” used to assign values to, and compare the values of, products, services, and resources. Money serves as a measure of value because the prices of all goods, services, and resources are stated in terms of money. The third function of money is as a store of value. A store of value is a means of retaining and accumulating wealth. Money received by an individual or a business may be held for now and spent later. It is important to remember, though, that the value of stored money is affected by inflation, the general rise in the level of prices. To determine the effect of inflation on buying power, economists refer to the consumer price index, which shows the price changes of typical consumer goods over a period of time.
To be acceptable as a medium of exchange, money must be easy to use, trusted, and capable of performing its three functions. It must possess five characteristics: divisibility, so it can to be divided into smaller units to accommodate large and small purchases; portability, so that it is light enough and small enough to be carried easily; stability, so that it retains its value over time; durability, so that it is strong enough to last through reasonable repeated usage; and difficulty of counterfeiting, so that people feel confident about accepting it as payment.
So how much money is there in the United States? Let’s start by defining a few money concepts. A demand deposit is an amount on deposit in a checking account. It is called a demand deposit because the owner can demand it immediately, by presenting a properly made out check, withdrawing from an ATM, or transferring money between accounts. A time deposit is an amount on deposit in an interest-bearing savings account. The time sometimes required between the notice and the withdrawal is why it is called a time deposit. But because they can be converted to cash easily, they are called near-monies.
Now let’s talk about how much money there is in the United States. There are two main measures of the supply of money: M1 and M2. The M1 supply of money consists of only currency and demand deposits. The M2 supply of money consists of M1 (currency and demand deposits), plus savings accounts, certain money-market securities and small denomination time deposits, or certificates of deposit (CDs), of less than $100,000. Generally, economists, politicians, and bankers tend to focus on M1, or a variation of M1. (LO 1 ends)

2. Summarize how the Federal Reserve System regulates the money supply

A discussion of the money supply generally includes talk about the Federal Reserve System. The Federal Reserve System, also simply called the Fed, is the central bank of the United States. It's responsible for regulating the banking industry. Its mission is to maintain an economically healthy and financially sound business environment in which banks can operate. The Fed has tremendous power to regulate the money supply, control inflation, and regulate financial institutions. To regulate the money supply, it controls bank reserve requirements, regulates the discount rate, and runs open market operations.
When money is deposited in a bank, the bank must retain a portion of it to satisfy customers who may want to withdraw money from their accounts or to fund loans. The reserve requirement is the percentage of its deposits that a bank must retain, either in its own vault or in a Federal Reserve District Bank. Banks can use the remaining funds to create more money and make more loans by deposit expansion, a process that allows banks to continually reloan money that has been deposited in the bank. The Fed sets the reserve requirement. When it increases the requirement, banks have less money available for lending. When it decreases the requirement, the Fed can make additional money available to stimulate a slow economy.
The Fed also controls the money supply by regulating the discount rate. The discount rate is the interest rate the Federal Reserve System charges for loans to member banks. When the Fed lowers the discount rate, it is easier and cheaper for banks to obtain money, increasing the amount of money available to consumers and businesses and stimulating the economy. When the Fed raises the discount rate, banks begin to restrict loans, raise their lending rates, and tighten loan requirements, which slows the economy and checks inflation by making money more difficult and expensive to obtain.
The third way that the Fed controls the money supply is in open-market operations. The federal government finances its activities partly by selling US government securities. These securities pay interest, and are available to an individual or organization, including the Fed. Open-market operations is the buying and selling of US government securities by the Federal Reserve System for the purpose of controlling the money supply. To reduce the nation’s money supply, the Fed sells government securities on the open market. The money it receives from purchasers is taken out of circulation, making less money available for investment, purchases, or lending. To increase the money supply, the Fed buys government securities, which puts money back into circulation and makes it available to individuals and firms. The goal of buying and selling securities is to affect the federal funds rate, the interest rate at which a bank lends immediately available funds to another bank overnight in order to meet the borrowing bank’s reserve requirements. In addition to regulating the money supply, the Fed also serves as the government’s bank, clears checks and electronic transfers, inspects currency, and applies selective credit controls, including setting the margin requirements for stock transactions. The margin is the minimum amount of the purchase price that must be paid in cash or eligible securities. (LO 2 ends)

3. Describe the organizations involved in the banking industry

One of the major players in banking is the commercial bank, a profit-making organization that accepts deposits, makes loans, and provides related services to its customers. Its mission is to meet the needs of its customers while earning a profit. They earn a profit by accepting money from depositors, for which they pay interest, and then by lending it to qualified individuals and businesses that pay interest on the borrowed money. Commerical banks are chartered by the federal government or state governments. A national bank is a commercial bank chartered by the US Comptroller of the currency, and a state bank is a commercial bank chartered by the banking authorities in the state in which it operates. Both national and state banks are carefully regulated and subject to unannounced inspections by federal and/or state auditors.
In addition to commercial banks, there are at least 8 other types of financial institutions that perform either full or limited banking services. Let’s look briefly at each. (1) Savings and loan associations offer checking and savings accounts and CDs. They invest most of their assets in home mortgage and other consumer loans. (2) Credit unions accept deposits from and lend money to only those people who are their members. (3) Mutual savings banks are owned by their depositors and offer many of the same services offered by savings and loan associations. Mutual savings banks generally have state charters, and their profits are returned to the depositors, usually in the form of higher interest rates on savings. (4) Insurance companies provide long-term financing for commercial real estate projects. (5) Pension funds are set up by firms to guarantee their employees a regular monthly income on retirement, and may earn additional income from conservative investments. (6) Brokerage firms offer combination checking and savings accounts at higher-than-usual interest rates, called money-market rates. (7) Finance companies provide financing to individuals and firms that may be unable to get financing from other lenders. And (8) investment banking firms assist corporations in raising funds by selling new issues of stocks, bonds, or other securities. (LO 3 ends)

4. Identify the services provided by financial institutions

Financial institutions provide customers with a wide range of services. One of the most common is a checking account. A check is a written order for a bank or other financial institution to pay a stated dollar amount to the business or person indicated on the face of the check. Today most financial institutions offer interest-paying checking accounts, often called NOW accounts. NOW stands for negotiable order of withdrawal. In addition to checking accounts, savings accounts provide a safe place to store money until it is needed. A depositor who is willing to leave money on deposit with a bank for a set period of time can earn a higher rate of interest by buying a certificate of deposit, or CD, which is a document stating that the bank will pay the depositor a guaranteed interest rate for money left on deposit for a specified period of time. These rates change weekly.
Financial institutions also offer short-term and long-term loans. Short-term business loans must be repaid in one year or less. They are typically used to purchase inventory, finance promotional needs, and solve cash flow problems. To ensure that short-term money will be available when needed, many firms establish either a line of credit, a loan that is approved before the money is actually needed, or a revolving credit agreement, which is a guaranteed line of credit. Long-term business loans are repaid over a longer period, usually 3 to 7 years. They are most often used to finance expansion of facilities, replace equipment, or develop the firm’s product mix. Most lenders require collateral, real estate or property pledged as security for a loan, for long-term loans. If the borrower fails to repay the loan, the lender can repossess the collateral.
Finally, financial institutions offer credit card and debit card transactions. Credit is welcomed by businesses because credit transactions are easily convertible to cash. In return for this, the bank charges the merchant a fee. Individuals like credit cards because they allow purchasers to buy immediately and have almost a month to repay without any penalty. A debit card, on the other hand, electronically subtracts the amount of your purchase from your bank account at the moment the purchase is made. Other traditional services include financial advice, payroll services, certified checks, trust services, and safe-deposit boxes.  (LO 4 ends)

5. Understand how financial institutions are changing to meet the needs of domestic and international customers

Banking is undergoing enormous changes, particularly as a result of technology. Among the laws enacted during the last thirty years to deregulate the banking industry, probably the most important is the Financial Services Modernization Banking Act. This act allowed banks to establish one-stop financial supermarkets where customers can bank, buy and sell securities, and purchase insurance coverage. Because of this act, competition among banks, brokerage firms, and insurance companies has increased. More and more Americans visit ATMs for cash and do some or all of their banking electronically. In the next decades, increased technology and the need to help American businesses compete in the global marketplace will mean that financial institutions will offer an even wider array of services. Online banking includes such activities as electronic funds transfer (EFT), which is a means of performing financial transactions through a computer terminal or telephone hookup. EFT activities are expected to grow substantially, and include the use of ATMs, automated clearinghouses or ACHs (used by large companies to transfer wages and salaries directly to employees’ bank accounts), and point-of-sale (or POS) terminals, which are computerized cash registers located in retail stores and connected to a bank’s computer. A similar process happens when a store uses electronic check conversion to process a paper check. Electronic check conversion (ECC) is used to convert information from a paper check into an electronic payment for merchandise, services, or bills.
International banking services are extremely important. A bank can help a firm in two ways, by providing (1) a letter of credit, which is a legal document issued by a financial institution guaranteeing to pay a seller a stated amount for a specified period of time, if certain conditions are met, or (2) a banker’s acceptance, which is a written order for a bank to pay a third party a stated amount of money on a specified date. Both a letter of credit and a banker’s acceptance are popular methods of paying for import and export transactions. Banks also provide for international currency exchange.
(LO 5 ends)
6. Explain how deposit insurance protects customers

The Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Association (NCUA) insure accounts in member financial institutions for up to $100,000 for nonretirement accounts and $250,000 for some types of retirement accounts. Note: The Emergency Economic stabilization Act of 2008 increased FDIC and NCUA coverage from $100,000 to $250,000 per depositor through December 31, 2009. Deposits maintained in different categories of legal ownership are insured separately. The most common ownership categories are single ownership and joint ownership. It is also possible to obtain additional coverage by opening separate accounts in different banks, S&Ls, or credit unions. The FDIC and NCUA have improved banking in the United States. When either of these organizations insures a financial institution’s deposits, they reserve the right to examine that institution’s operations periodically. If a bank, S&L, or credit union is found to be poorly managed, it is reported to the proper banking authority.  (LO 6 ends)

7. Discuss the importance of credit and credit managementHow do banks and other lenders decide to whom they are going to lend money or extend credit? They evaluate all applicants by looking at several factors. Credit is immediate purchasing power that is exchanged for a promise to repay borrowed money, with or without interest, at a later date. Lenders generally look at the five Cs of credit management. The first is character, which is the borrower’s attitude toward credit obligations. The second is capacity, the borrower’s financial ability to meet the credit obligations. The third is capital, which refers to the borrower’s assets or net worth. The fourth is collateral, which you may recall is real estate or property pledged as security; and the fifth is conditions, which refers to the general economic conditions.
The lender then verifies the accuracy of the borrower’s claim by consulting global or local credit-reporting agencies, checking industry associations or other firms that have extended the applicant credit. (LO 7 ends)