Banking Fundamentals

What are Banking Fundamentals?

Banking fundamentals includes the essential ideas and guidelines governing the operations of banks. Within banking, various activities such as extending credit, safeguarding cash, managing investments, and facilitating financial transactions are conducted.

The banking business is one of the essential drivers of most economies since it provides cash to borrowers in exchange for productive investments. The concepts and principles that govern banking practices are known as banking fundamentals.

Banking is a business sector that manages cash, credit, and other financial activities for individuals and corporations.

Banks typically must maintain a minimum reserve, often around 10% of each deposit, but they can lend out the remainder. The Federal Reserve Board of Governors determines the reserve requirement according to market conditions.

A reduction in the Fed's reserve requirement is one measure of expansionary monetary policy, as it increases the lending capacity of member banks.

Banking Fundamentals – How the Banking Industry Works

Banks, whether physical or virtual, move money between individuals and corporations. They receive deposits and issue loans, earning from the difference between the interest rates given on deposits and the interest rates charged on loans.

Banks exist because we trust them. We give a bank our money to keep it secure, and the bank then loans it to someone else to make money.

The Federal Reserve regulates banks in the United States. Banks must keep at least 10% of each deposit on hand but can lend out the remaining 90% as loans.

When it cuts the reserve requirement for member banks, the Fed is adopting an economic loosening. The Fed supervises banks and other financial institutions.

Other government authorities, such as the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC), regulate banks. However, banks generate most of their money through lending interest and fees.

Banks generally profit through the interest earned on loans and fees charged to their clients. A banking system is a collection or network of entities offering financial services. These organizations run a payment system, make loans, accept deposits, and assist with investments.

Banks complete two primary functions:

1. Primary duties

2. Secondary Purposes

Banking Fundamentals – Accepting Deposits

Commercial banks' fundamental yet critical duties are uniting public money, guaranteeing secure custody of savings, and paying interest to depositors. The bank takes many sorts of public deposits, including:

• Fixed deposits: Term deposits are a type of bank deposit where money is placed for a set time, and no money can be withdrawn. Banks charge a penalty if depositors withdraw before maturity, but the interest rate changes with the length of the deposit.
• Saving Deposits: The account can be opened in a single or joint name. Depositors need to maintain a minimum balance, which varies per institution. The interest rate is shallow. While there may be no restrictions on the number of withdrawals, saving deposit accounts often have limits on the amount that can be withdrawn without penalties or fees.
• Current deposits: Business individuals and functions open current deposits as short-term loans to meet immediate requirements. Current deposit accounts often provide access to an overdraft facility, which incurs interest charges and additional fees on the overdraft amount.
• Recurring Deposits: A recurring deposit account is a bank account used by individuals on a salary and small businesses. These deposits may offer a competitive interest rate and accrue interest through compounding over time. In addition, these accounts allow depositors to save a significant sum of money for some time.

Banking Fundamentals – Making Loans And Advances

The following Loans and Advances are available from the bank:

• Cash Credits are a short-term borrowing arrangement with a predetermined maximum. Banks allow customers to borrow against a mortgage on a specific property (physical assets and guarantees). Cash credit is extended to all types of account holders and people who do not have a bank account. The amount removed that is more than the limit is subject to interest charges. Cash credit allows for a higher loan amount than overdrafts, particularly for longer durations.
• Bank Overdraft: This service is available to current account holders. It permits holders to withdraw funds at any moment that exceeds the amount accessible in their bank account, but only up to the specified maximum. Depending on the bank's policies and the customer's creditworthiness, an overdraft facility may be provided with or without collateral security. As a result, overdraft interest is only charged on the borrowed amount when the loan is taken.
• Discounting the Bill of Exchange: A short-term loan in which the seller discounts the bill from the bank in exchange for a fee. The bank lends money by ignoring or buying bills of exchange. After subtracting the standard discount costs, it pays the bill to the drawer (seller) on the buyer's behalf. When the bill matures, the bank hands it to the drawee or acceptor to receive the bill amount.
• Loans: Banks lend customers for various purposes and durations, ranging from short-term to long-term, with collateral requirements varying depending on the loan type and borrower's creditworthiness. In addition, banks can now lend money on a long-term basis. The borrower repays the money in a single sum or installments over a certain period. The bank charges interest on the borrowed amount, whether it is withdrawn or not. The interest rate is lower than that of overdrafts and cash credits.

Secondary Purposes

Secondary functions, like primary functions, are divided into two categories:

1. Bank Agency Functions

Because banks act as agents for their customers, they must execute the following agency functions:

• Transfer of Funds: The transfer of funds from one branch or location to another
• Recurring Collections: Collecting dividends, salaries, pensions, and other comparable periodic payments on behalf of clients
• Periodic Payments: Making recurring payments on behalf of the customer for rent, utility bills, and so on
• Collection of Cheques: Like collecting money from bills of exchange, the bank contains money from cheques through its clients' clearing sections
• Portfolio Management: Banks manage their clients' portfolios. It purchases and sells the customers' shares and debentures and debits or credits the account
• Other Agency Functions: This bank acts as a client representative for other institutions. It serves as the client's executor, trustee, administrator, advisor, and so on

2. Functions of Utility

Some of the utility functions are:

• Issuing letters of credit, traveler's checks, and other financial instruments for facilitating transactions
• Banks provide safe deposit vaults or lockers to safeguard customers' valuables, important documents, and securities
• Offering foreign exchange trading services to customers for currency exchange and international transactions
• Underwriting shares and debentures for corporate clients
• Dealing

Banking Fundamentals – Types of Banks

Let's understand the different types of banks below:

1. Commercial banks

A commercial bank is the most common type of bank in the US. It provides a wide range of services to both individuals and businesses. Commercial banks make money by offering business loans to people and organizations, earning interest, and charging service fees.

Their products encompass a variety of services, including deposit acceptance, primary investment products, lending services, international trade services, and more.

2. Investment banks

Investment banks facilitate access to capital markets for corporate clients, helping them raise funds for various purposes, including expansion. They help companies raise funds in the stock and bond markets to fund development, acquisitions, and other financial endeavors.

Investment banks also assist mergers and acquisitions by identifying companies suitable for purchase and meeting the buyer's criteria. These banks generate revenue through advisory services to corporations, trading in financial markets, and acting as intermediaries in mergers and acquisitions.

3. Insurance companies

This word refers to a single entity that writes insurance policies, pays claims, and bears all of the risks connected with such policies. As a result, the government strictly regulates these businesses (also known as insurers) to guarantee they have the financial wherewithal to cover their risk.

4. Brokerage firms

A brokerage business or company acts as a go-between for buyers and sellers of stock shares, bonds, options, and other financial instruments.

Brokers are rewarded through commissions or fees levied after the transaction is finished. Many budget brokerages now provide zero-commission stock trading to their consumers for certain trades.

To compensate for this loss of income, companies may rely on revenue from sources like exchange compensation for executing high-order volumes and charging trading fees for other financial products, such as mutual funds and bonds.

5. Credit Union

A credit union is a member-owned organization based on individuals helping others.

Credit unions' ownership structure enables them to deliver more personalized and lower-cost banking services. While credit unions may offer competitive interest rates, their rates are not necessarily higher solely due to their operating scale.

Banking Fundamentals – Types of Bank Accounts

Some of the types are:

1. Current Account

A current account is a deposit account for traders, company owners, and entrepreneurs who must make and receive payments more often than other accounts.

These accounts store more liquid deposits and have no daily transaction restrictions. Current accounts allow for overdrafts or withdrawals above what is currently available in the statement.

Furthermore, unlike some savings accounts, current accounts typically do not pay interest. You must maintain a minimum balance to maintain a current account.

2. Savings Account

A savings bank account is a regular deposit account that pays a low interest rate. The number of transactions you may do per month is limited.

Banks provide a range of savings accounts based on depositor type, product characteristics, age or purpose of holding the bill, and so on.

Savings accounts are tailored to different demographics and purposes, including accounts for children, seniors, women, institutions, families, and more.

You can choose from a variety of savings programs. Zero-balance and sophisticated savings accounts have features such as auto sweep, debit cards, bill payments, and cross-product perks.

3. Salary Account

Among the several types of bank accounts, your salary account is the one you created due to the partnership between your employer and the bank. Per the employer and bank agreement, many employees' wages are typically credited to this account at the start of the pay cycle.

Employees can select the sort of pay account that best suits their needs. For example, the bank with a salary account also has reimbursement accounts where your allowances and reimbursements are credited.

4. Fixed Deposits

Fixed and recurring deposits are two types of accounts in which you can deposit money and receive a respectable interest rate.

A fixed deposit (FD) account allows you to receive a fixed interest rate for locking up a specified amount for a set period until the FD matures. FDs have maturities ranging from seven days to ten years.

The interest rate you earn on FDs varies based on the term of the FD. In most cases, you cannot remove funds from an FD before it matures. While some banks permit early withdrawals from fixed deposits, they often result in a lower interest rate than if the deposit were held until maturity.

5. Recurring Account

A recurrent deposit (RD) has a set duration. To earn interest, you must spend a set amount of money regularly (every month or once a quarter). Unlike fixed deposits (FDs), which require a lump sum deposit, recurring deposits (RDs) typically require smaller, regular investments.

You cannot adjust the RD's term or amount invested monthly or quarterly. Early withdrawal from RDs typically incurs a penalty, often resulting in a reduced interest rate on the withdrawn amount.

Core banking system

A core banking system is a backend system that conducts daily banking transactions and posts updates to accounts and other financial records. Deposit, loan, and credit processing capabilities, as well as connections to general ledger systems and reporting tools, are often included.

Core banking refers to the centralized backend system that enables banking transactions across all networked branches. It allows consumers to access their accounts and conduct various transactions from any branch location within the network.

Deposit, loan, and credit processing are all part of the system. Core banking services include opening new accounts, servicing loans, calculating interest, processing deposits and withdrawals, and managing customer relationships.

CORE stands for Centralized Online Real-time Exchange. It emphasizes the ability for consumers to interact with the bank seamlessly across locations, providing them with flexibility in accessing their accounts and conducting transactions globally.

Sources of income for banks

The bank's primary revenue source is interest on loans and advances made to industries, corporations, and individuals.

Diversified banks generate revenue in several ways; nonetheless, they are considered lenders.

Banks normally borrow money from depositors and repay it with interest. Then, banks will lend the money to borrowers, charging higher interest rates and benefitting from the interest rate spread.

Furthermore, banks often diversify their business portfolios and create revenue from financial services such as investment banking and wealth management. However, the money-making business of banks may be divided into the following categories:

• Interest earnings
• Profits from capital markets
• Fee-based earnings
• Interest Earnings

Commercial banks make most of their money by charging interest. This is achieved by using funds deposited by individuals who do not need immediate access to their cash.

Depositors receive a certain interest rate and funds protection in return for depositing their money. Banks then lend the deposited funds to borrowers who require financing while ensuring liquidity to meet depositor withdrawals.

Profits from capital markets

Capital markets connect firms needing capital to investors to support development or initiatives. Banks will assist in the execution of deals using their in-house brokerage services.

The investment banking teams will also assist with corporate mergers and acquisitions (M&A). Capital market income is a highly volatile source of revenue for banks.

Fee-based earnings

Banks charge a variety of fees for services provided, as well as fees for certain investment products such as mutual funds.

Banks also charge fees for various other services and products they provide. Fee-based income sources are attractive because they are stable over time and do not fluctuate.

It is beneficial, especially during economic downturns when interest rates may be artificially low and capital market activity slows down.

Challenges a bank faces

Some of the challenges are:

1. Growing Competition

FinTechs represent a serious threat since they often target some of the most profitable financial services sectors. According to Goldman Sachs, these startups will account for up to $4.7 trillion in yearly income siphoned from established financial services corporations.

As a result of these new sector entrants, several financial institutions are looking for partnerships and/or acquisition prospects as a stopgap solution; for instance, Goldman Sachs recently made news for aggressively investing in FinTech.

Traditional banks and credit unions must learn from FinTechs to preserve a competitive advantage. FinTechs have achieved success by delivering a streamlined and intuitive client experience.

2. A Cultural Change

Technology has grown ingrained in our society—from artificial intelligence (AI)- enabled wearables that monitor the wearer's health to smart thermostats that allow you to modify heating settings from internet-connected devices—and this applies to the banking business.

Manual procedures and systems have no place in the digital era. Banks and credit unions must consider technological solutions to banking sector difficulties.

As a result, financial institutions must foster an innovative culture using technology to enhance current processes and procedures for optimal efficiency. This cultural change toward a technology-first mindset mirrors the broader industry adoption of digital transformation.

3. Regulatory Accountability

After the 2008 financial crisis, regulatory costs increased enormously compared to revenues and credit losses, making regulatory compliance one of the most critical banking sector concerns.

From Basel's risk-weighted capital requirements to the Dodd-Frank Act and from the Financial Account Standards Board's Current Expected Credit Loss (CECL) to the Allowance for Loan and Lease Losses (ALLL), banks and credit unions must comply with an increasing number of regulations.

4. Modifications to Business Models

The expense of compliance management is only one of multiple banking sector concerns compelling financial firms to adjust their business practices.

Traditional sources of banking profitability are under strain due to rising capital costs, low interest rates, declining return on equity, and diminished proprietary trading. Regardless, shareholder expectations remain intact.

To retain profitability, several institutions have created new competitive service offerings, rationalized business lines, and sought long-term improvements in operating efficiencies.

Failure to adapt to shifting needs is not an option, so financial institutions must be designed for agility and be ready to pivot when necessary.

5. Increasing Expectations

The modern customer is sharper, savvier, and more educated than ever, and they demand a high level of personalization and ease from their banking experience.

Changing consumer demographics play a significant part in these heightened expectations: with each new generation of banking customers comes a deeper awareness of technology and, as a result, a higher expectation of digital experiences.

Millennials have led the march toward digitalization, with five out of six saying they prefer to communicate with companies through social media.

Banks may anticipate that future generations, including Generation Z, will exhibit even greater engagement in omnichannel banking and possess higher technological proficiency.

Baby Boomers and senior members of Generation X value human connection highly and prefer to visit physical branch sites.

Bank Vs. Banking

Let's understand the difference between the two below:

Free Resources

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