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The Structure and Players of the U.S. Banking System
Business Essentials · Chapter 24: Banking Systems and International FinanceSection 24.1 · lesson 102 of 10512 min · free with a free account
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In this lesson
What banks do, how they earn, and what keeps them safe.
- Name the 4 functions of a banking system
- Compare the main types of institution
- Read a bank balance sheet and its income
- Explain bank runs, deposit insurance, and capital
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Banking Systems and International Finance
The U.S. Banking System: Structure and Players
Every business needs a bank. Few business owners understand how that bank actually works. This section opens the hood. It's educational content about how the U.S. banking system is structured, and how banks operate. It isn't financial, investment, tax, or legal advice, and it doesn't recommend any specific bank. We'll start with what a banking system does for an economy, and who the players are. Then we'll read a bank's balance sheet, and see how a bank earns its income. We'll look at the risks banks manage, and why bank runs happen. And we'll see the two safeguards, deposit insurance and capital, that keep the system steady.
What Banks Do
4 Functions for an Economy
A banking system performs four functions for an economy. First, it accepts deposits, giving people and businesses a safe place to hold their funds. Second, it makes loans, channeling those funds to borrowers who can use them productively. That's the deposit creation mechanism from the multiplier section. Third, it runs the payment system, so funds can move between parties to settle transactions. Fourth, and most interesting, it performs maturity transformation. Depositors can usually withdraw on short notice. Yet the bank turns those deposits into longer-term loans. That function is the source of both the system's usefulness, and its fragility. It's useful, because few depositors want to lend directly to a business for years. The bank bridges that gap. And it's fragile, because a bank can't quickly turn its long-term loans back into cash. If withdrawals surge, that becomes a serious problem. We'll come back to it.
The Players
Institution Types
The U.S. financial system includes several types of institution. Commercial banks are the most familiar. They're for-profit, accepting deposits and lending to individuals and businesses. Savings institutions serve a similar depositor base. Historically, they've had a more specialized lending focus, on residential mortgages. Credit unions are different in a basic way. They're member-owned cooperatives. Instead of outside shareholders, a credit union is owned by its own depositors, called members. Members typically share a common bond, like an employer, a community, or an association. And profits go back to the members, not to external shareholders. Finally, non-depository institutions provide financial services without accepting deposits. They include finance companies, which lend money they've borrowed, rather than deposits. They also include insurance companies and investment firms, which earlier chapters covered.
Table 24.1.1
Who Owns, Serves, and Oversees Each
Here's how the types compare on ownership, customers, and regulation. Commercial banks are owned by shareholders, public or private, and serve individuals and businesses of all sizes. Their regulator varies with their charter, and includes both federal and state banking regulators. Savings institutions may be shareholder-owned, or mutually owned by their depositors. They serve mainly individual depositors and homebuyers, under federal or state regulators, depending on charter. Credit unions are member-owned, serving members who share a defined common bond. They answer to a dedicated federal or state credit union regulator. Non-depository institutions vary in ownership, in customers, and in regulator, depending on what they do. So why should a business care about ownership? Because a member-owned credit union and a shareholder-owned bank can have different incentives, even when they offer similar services.
Charters And Regulators
The Dual Banking System
The United States runs what's called a dual banking system. A bank may be chartered, meaning legally established and authorized to operate, at either the federal or the state level. A federal charter brings federal regulatory oversight. A state charter brings oversight by that state's own banking regulator. And state law can be more protective than federal law. As we've seen before, federal law sets a floor. The result is that multiple regulators operate across the banking system. Those regulators carry out supervision, the ongoing oversight of a bank's condition and practices. They also conduct examinations, periodic, detailed reviews of a specific bank's loans, records, and practices. Examinations check whether a bank is operating safely, and in compliance with the law. Which regulator does this depends on the bank's charter. There's no single, uniform answer. So to confirm who oversees a particular bank, check its own disclosures, or ask the regulatory agency directly.
Figure 24.1.1
Your Deposit Is the Bank's Liability
Now a point that many people find counter-intuitive at first. Your deposit is the bank's liability, not its asset. That cuts against everyday intuition. Money in the bank feels like it's yours, sitting safely inside. And it is yours. But from the bank's accounting perspective, that deposit is an amount it owes you. Owing money to someone is, by the definition from our accounting chapter, a liability. Flip it around for loans. A loan is an amount owed to the bank, which it expects to collect over time. So the bank's loans are its assets. On a simplified balance sheet, the assets are loans, reserves, and securities. On the other side sit customer deposits, borrowed funds, and owners' capital. The two sides are equal in total. This explains why a bank's stability depends on collecting its loans reliably. Those loans are the assets that ultimately back everything the bank owes its depositors.
How Banks Earn
The Spread, and Fees
So how does a bank make money? Chiefly through the spread. The spread is the difference between what a bank pays on deposits, and what it earns on loans. A bank pays depositors a relatively modest return for the use of their funds. Then it charges borrowers a higher rate for the use of those same funds. Across the whole balance sheet, that difference is a central source of its earnings. We won't state any specific rates here. The spread available in the market changes continuously, with the broader interest rate conditions we studied earlier. Banks also earn fee income. That means charges for specific services, like account maintenance, or payment processing. Fee income doesn't depend on the spread at all, which makes it a different kind of revenue.
Built Into The Model
4 Risks a Bank Manages
Four categories of risk arise directly from the banking business model. Each has a reason. Credit risk comes first. A bank's income depends on borrowers repaying, and some borrowers won't. Liquidity risk comes straight from maturity transformation. A bank's loans can't quickly be turned into cash. Its deposits can often be withdrawn on short notice. So a bank can be unable to meet withdrawals, even while it remains fundamentally solvent. Interest rate risk arises because loans and deposits don't always reprice together. When market rates move, they may change at different times, or by different amounts. That can squeeze or widen the spread, in ways the bank doesn't fully control. And operational risk is the risk that the bank's own processes, systems, or people fail to perform as intended. We'll see that one again when we look at banking technology.
The Maturity Mismatch
Why Bank Runs Happen
Now let's put liquidity risk under a microscope. The maturity mismatch is the gap between how quickly a bank's liabilities can be called, and how quickly its assets become cash. Suppose every depositor demanded their money at once. The bank would need to turn its loans into cash immediately. Multi-year loans generally can't do that. That's the setting for a bank run. A bank run happens when many depositors, fearing the bank will fail, rush to withdraw at the same time. And the mechanism feeds itself. The fear of failure, even if it starts out unfounded, can cause the very failure it fears. Facing mass withdrawal, a bank can't meet the demand, however sound its loans really are. That's why confidence matters more in banking than in most other businesses. It's also why deposit insurance exists. If an insured deposit is protected whether you withdraw first or last, there's no reason to race.
Two Different Safeguards
Deposit Insurance and Capital
Two safeguards address two different problems. Deposit insurance protects depositors against losing insured funds if their bank fails. In the United States, it's provided by the Federal Deposit Insurance Corporation, a federal agency. By guaranteeing depositors are made whole up to the insured limit, it removes the rational incentive to rush. That makes bank runs far less likely than they were before such insurance existed. The specific coverage limit, and which accounts it applies to, should be confirmed with the agency, or the bank's own disclosures. The limit has been adjusted over time, and coverage depends on account structure and ownership. A business, especially, shouldn't assume all its funds are covered. Its balances can exceed typical limits more easily. Capital requirements work differently. They're a solvency buffer. Owners' capital is the cushion that absorbs loan losses, before those losses could threaten depositors' funds. A thicker buffer absorbs larger losses. A thin one leaves less room. So capital answers whether the assets ultimately cover what's owed. Reserves and insurance answer whether cash is there today.
The Business View
What a Banking Relationship Provides
For a business, a banking relationship is more than a place to hold funds. It shapes what credit, payment services, and other support the business can draw on. When a bank considers lending to a business, it assesses the categories we met in the financing chapter. Character, capacity, capital, collateral, and conditions. Here, they're applied by the specific bank making the lending decision. It pays to understand those categories from the bank's side of the table. Because a bank's lending decisions rest on the same fundamentals every time. That's true whether the business is applying for its first loan, or its tenth. A business that knows what the bank is weighing can build that relationship deliberately.
Case Vignette
The Deposit That Wasn't an Asset
Odessa owns a boutique catering business. This is a composite case, constructed for instruction. She keeps her operating funds in a business checking account. Reading a basic explanation of banking for the first time, she's startled. Her deposit appears on the bank's balance sheet as a liability, not an asset. Does that mean the bank doesn't really consider the money hers? No. The classification doesn't change her ownership, or her right to withdraw. It describes the bank's obligation. Her deposit is an amount the bank owes her. Meanwhile, the bank has lent much of its total pool of deposits to other borrowers, recorded as its own assets. So her trade-off is convenience and a modest return, while her funds are put to work through lending. They aren't sitting untouched in a vault. That's maturity transformation in action. Her conclusion is that this is exactly why deposit insurance and capital requirements exist. Her ability to get her money back shouldn't depend on every borrower repaying on schedule. And she'll confirm her own account's coverage directly with her bank, rather than trust a figure she heard elsewhere.
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