BANKS AND BANKING

BANKS AND BANKING

Authorized financial institutions and the business in which they engage, which encompasses the receipt of money for deposit, to be payable according to the terms of the account; collection of checks presented for payment; issuance of loans to individuals who meet certain requirements; discount of COMMERCIAL PAPER; and other money-related functions.
Banks have existed since the founding of the United States, and their operation has been shaped and refined by major events in U.S. history. Banking was a rocky and fickle enterprise, with periods of economic fortune and peril, between the 1830s and the early twentieth cen-
tury. In the late nineteenth century, the restrained money policies of the U.S. TREASURY
DEPARTMENT, namely an unwillingness to issue more bank notes to eastern-based national banks, contributed to a scarcity of cash in many
Midwestern states. A few states went so far as to
charter local banks and authorize them to print
their own money. The collateral or capital that
backed these local banks was often of only
nominal value. By the 1890s, there was a full-
fledged bank panic. Depositors rushed to banks
to withdraw their money, only to find in many
cases that the banks did not have the money on
hand. This experience prompted insurance
reforms that developed during the next fifty
years. The lack of a regulated money supply led
to the passage of the Federal Reserve Act in
1913 (found in scattered sections of 12
U.S.C.A.), creating the Federal Reserve Bank
System.

Even as the banks sometimes suffered, there were stories of economic gain and wealth made through their operation. Industrial enterprises were sweeping the country, and their need for
financing was seized upon by men like J.P.Morgan (1837–1913). Morgan made his fortune as a banker and financier of various projects. His House of Morgan was one of the most powerful financial institutions in the world.Morgan’s
holdings and interests included railroads, coal, steel, and steamships. His involvement in what we now consider commercial banking and
SECURITIES would later raise concern over the
appropriateness of mixing these two industries,
especially after the STOCK MARKET crash of 1929
and the ensuing instability in banking. Between
1929 and 1933, thousands of banks failed. By
1933, President FRANKLIN D. ROOSEVELT tem-
porarily closed all U.S. banks because of a
widespread lack of confidence in the institu-
tions. These events played a major role in the
Great Depression and in the future reform of
banking.
In 1933, Congress held hearings on the
commingling of the banking and securities
industries. Out of these hearings, a reform act
that strictly separated commercial banking
from securities banking was created (12
U.S.C.A. §§ 347a, 347b, 412). The act became
known as the GLASS-STEAGALL ACT, after the two
senators who sponsored it, CARTER GLASS (D-
VA) and Henry B. Steagall (D-AL). The Glass-
Steagall Act also created the FEDERAL DEPOSIT
INSURANCE CORPORATION (FDIC), which insures
money deposited at member banks against loss.
Since its passage, Glass-Steagall has been the law
of the land, with minor fine-tuning on several
occasions.
Despite the Glass-Steagall reforms, periods
of instability have continued to reappear in the
banking industry. Between 1982 and 1987,
about 600 banks failed in the United States.Over
one-third of the closures occurred in Texas.
Many of the failed banks closed permanently,
with their customers’ deposits compensated by
the FDIC; others were taken over by the FDIC
and reorganized and eventually reopened.
In 1999, Congress addressed many concerns
on many involved in the financial industries
with the passage of the Financial Services Mod-
ernization Act, Pub. L. No. 106-102, 113 Stat.
1338, also known as the Gramm-Leach Act. The
act rewrote the banking laws from the 1930s and
1950s, including the Glass-Steagall Act, which
had prevented commercial banks, securities
firms, and insurance companies from merging
their businesses. Under the act, banks, brokers,
and insurance companies are able to combine
and share consumer transaction records as well
as other sensitive records. The act went into
effect on November 12, 2000, though several of
its provisions did not take effect until July 1,
2001. Seven federal agencies were responsible
for rewriting regulations that implemented the
new law.
Gramm-Leach goes beyond the repeal of the
Glass-Steagall Act and similar laws. One section
streamlines the supervision of banks. It directs
the FEDERAL RESERVE BOARD to accept existing
reports that a bank has filed with other federal
and state regulators, thus reducing time and
expenses for the bank. Moreover, the Federal
Reserve Board may examine the insurance and
brokerage subsidiaries of a bank only if reason-
able cause exists to believe the subsidiary is
engaged in activities posing a material risk to
bank depositors. The new law contains many
more similar provisions that restrict the ability
of the Federal Reserve Board to regulate the new
type of bank that the law contemplates. The
Gramm-Leach Act also breaks down barriers of
foreign banks wishing to operate in the United
States by allowing foreign banks to purchase
U.S. banks.
Categories of Banks
There are two main categories of banks: fed-
erally chartered national banks and state-char-
tered banks.
A national bank is incorporated and oper-
ates under the laws of the United States, subject
to the approval and oversight of the comptroller
of the currency, an office established as a part of
the Treasury Department in 1863 by the
National Bank Act (12 U.S.C.A. §§ 21, 24, 38,
105, 121, 141 note).
All national banks are required to become
members of the Federal Reserve System. The
Federal Reserve, established in 1913, is a central
bank with 12 regional district banks in the
United States. The Federal Reserve creates and
implements national fiscal policies affecting
nearly every facet of banking. The system assists in the transfer of funds, handles government deposits and debt issues, and regulates member
banks to achieve uniform commercial procedure.
The Federal Reserve regulates the availability
and cost of credit, through the buying
and selling of securities, mainly government
bonds. It also issues Federal Reserve notes,
which account for almost all the paper money in
the United States.
A board of governors oversees the work of
the Federal Reserve. This board was approved in
1935 and replaced the Federal Reserve Board.
The seven-member board of governors is
appointed to 14-year terms by the President of
the United States with Senate approval.
Each district reserve bank has a board of
directors with nine members. Three nonbankers
and three bankers are elected to each board of
directors by the member bank, and three directors
are named by the Federal Reserve Board of
Governors.
A member bank must keep a reserve (a specific
amount of funds) deposited with one of the
district reserve banks. The reserve bank then
issues Federal Reserve notes to the member bank
or credits its account. Both methods provide stability
in meeting customers’ needs in the member
bank. One major benefit of belonging to the
Federal Reserve System is that deposits in member
banks are automatically insured by the
FDIC. The FDIC protects each account in a
member bank for up to $100,000 should the
bank become insolvent.
A state-chartered bank is granted authority
by the state in which it operates and is under
the regulation of an appropriate state agency.
Many state-chartered banks also choose to
belong to the Federal Reserve System, thus
ensuring coverage by the FDIC. Banks that are
not members of the Federal Reserve System can
still be protected by the FDIC if they can meet
certain requirements and if they submit an
application.
The Interstate Banking and Branching Efficiency
Act of 1994 (scattered sections of 12
U.S.C.A.) elevated banking from a regional
enterprise to a more national pursuit. Previously,
a nationally chartered bank had to obtain
a charter and set up a separate institution in
each state where it wished to do business; the
1994 legislation removed this requirement. Also,
throughout the 1980s and the early 1990s, a
number of states passed laws that allowed for
reciprocal interstate banking. This trend
resulted in a patchwork of regional compacts
between various states, most heavily concentrated
in the New England states.
Types of Banks
The term bank is generally used to refer to
commercial banks; however, it can also be used
to refer to savings institutions, savings and loan
associations, and building and loan associations.
A commercial bank is authorized to receive
demand deposits (payable on order) and time
deposits (payable on a specific date), lend
money, provide services for fiduciary funds,
issue letters of credit, and accept and pay drafts.
A commercial bank not only serves its depositors
but also can offer installment loans, commercial
long-term loans, and credit cards.
A savings bank does not offer as wide a
range of services. Its primary goal is to serve its
depositors through providing loans for purposes
such as home improvement, mortgages, and
education. By law, a savings bank can offer a
higher interest rate to its depositors than can a
commercial bank.
A SAVINGS AND LOAN ASSOCIATION (S&L) is
similar to a savings bank in offering savings
accounts. It traditionally restricts the loans it
makes to housing-related purposes including
mortgages, home improvement, and construction,
although, some S&Ls have entered into
educational loans for their customers. An S&L
can be granted its charter by either a state or
the federal government; in the case of a federal
charter, the organization is known as a federal
savings and loan. Federally chartered S&Ls have
their own system, which functions in a manner
similar to that of the Federal Reserve System,
called the Federal Home Loan Banks System.
Like the Federal Reserve System, the Federal
Home Loan Banks System provides an insurance
program of up to $100,000 for each
account; this program is called the Federal Savings
and Loan Insurance Corporation (FSLIC).
The Federal Home Loan Banks System also provides
membership options for state-chartered
S&Ls and an option for just FSLIC coverage for
S&Ls that can satisfy certain requirements.
A building and loan association is a special
type of S&L that restricts its lending to home
mortgages.
The distinctions between these financial
organizations has become narrower as federal
legislation has expanded the range of services
that can be offered by each type of institution.
Bank Financial Structure
Banks are usually incorporated, and like any
corporation must be backed by a certain
amount of capital (money or other assets).
Banking laws specify that banks must maintain a
minimum amount of capital. Banks acquire
capital by selling capital stock to shareholders.
The money shareholders pay for the capital
stock becomes the working capital of the bank.
The working capital is put in a trust fund to protect
the bank’s depositors. In turn, shareholders
receive certificates that prove their ownership of
stock in the bank. The working capital of a bank
cannot be diminished. Dividends to shareholders
must be paid only from the profits or surplus
of the bank.
Shareholders have their legal relationship
with a bank defined by the terms outlined in the
contract to purchase capital stock. With the
investment in a bank comes certain rights, such
as the right to inspect the bank’s books and
records and the right to vote at shareholders’
meetings. Shareholders may not personally sue a
bank, but they can, under appropriate circumstances,
bring a stockholder’s derivative suit on
behalf of the bank (sue a third party for injury
done to the bank when the bank fails to sue on
its own). Shareholders also are not usually personally
liable for the debts and acts of a bank,
because the corporate form limits their liability.
However, if shareholders have consented to or
accepted benefits of unauthorized banking practices
or illegal acts of the board of directors, they
are not immune from liability.
Bank Officials
The election and term of office of a bank’s
board of directors are governed by statute or by
the charter of the bank. The liabilities and duties
of bank officials are prescribed by statute, charter,
bylaws, customary banking practices, and
employment contracts. Directors and bank officers
are both responsible for the conduct and
honorable management of a bank’s affairs,
although their duties and liabilities are not the
same.
Officers and directors are liable to a bank for
losses it incurs as a result of their illegal, fraudulent,
or wrongful conduct. Liability is imposed
for EMBEZZLEMENT, illegal use of funds or other
assets, false representation about the bank’s condition
made to deceive others, or fraudulent
purchases or loans. The failure to exercise reasonable
care in the execution of their duties also
renders officials liable if such failure brings
about bank losses. If such losses result from an
error in judgment, liability will not be imposed
so long as the officials acted in GOOD FAITH with
reasonable skill and care. Officers and directors
will not be held liable for the acts of their
employees if they exercise caution in hiring
qualified personnel and supervise them carefully.
Civil actions against bank officials are
maintained in the form of stockholders’ derivative
suits. Criminal statutes determine the liability
of officers and directors for illegal acts
against their bank.
Bank Duties
The powers and duties of a bank are determined
by the terms of its charter and the legislation
under which it was created (either federal
or state regulations). A bank can, through its
governing board, enact reasonable rules and regulations
for the efficient operation of its business.
Deposits A deposit is a sum of money
placed in an account to be held by a bank for the
depositor. A customer can deposit money by
cash or by a check or other document that represents
cash. Deposits are how banks survive.
The deposited money establishes a debtor and
creditor relationship between the bank and the
depositor.Most often, the bank pays the depositing
customer interest for its use of the money
until the customer withdraws the funds. The
bank has the right to impose rules and regulations
managing the deposit, such as restrictions
governing the rate of interest the deposited
money will earn and guidelines for its withdrawal.
Collections A primary function of a bank is
to make collections of items such as checks and
drafts deposited by customers. The bank acts as
an agent for the customer. Collection occurs
when the drawee bank (the bank ordered by the
check to make payment) takes funds from the
account of the drawer (its customer who has
written the check) and presents it to the collecting
bank.
Checks A check is a written order made by
a drawer to her or his bank to pay a designated
person or organization (the payee) the amount
specified on the check. Payment pursuant to the
check must be made in strict compliance with its
terms. The drawer’s account must be reduced by
the amount specified on the check. A check is a
demand instrument, which means it must be paid by the drawee bank on the demand of, or
when presented by, the payee or the agent of the
payee, the collecting bank.
A payee usually receives payment of a check
upon endorsing it and presenting it to a bank in
which the payee has an account. The bank can
require the payee to present identification to
prove a relationship with the bank, before cashing
the check. It has no obligation to cash a
check for a person who is not a depositor, since
it can refuse payment to a stranger. However, it
must honor (pay) a check if the payee has sufficient
funds on deposit with the bank to cover
the amount paid if the drawer of the check does
not have adequate funds in his or her account to
pay it.
A certified check is guaranteed by a bank, at
the request of its drawer or endorser, to be cashable
by the payee or succeeding holder. A bank is
not obligated to certify a check, but it usually
will do so for a customer who has sufficient
funds to pay it, in exchange for a nominal fee. A
certified check is considered the same as cash
because any bank must honor it when the payee
presents it for payment.
A drawer can revoke a check unless it has
been certified or has been paid to the payee. The
notice of revocation is often called a stop payment
order. A check is automatically revoked if
the drawer dies before it is paid or certified,
since the drawer’s bank has no authority to complete
the transaction under that circumstance.
However, if the drawer’s bank does not receive
notice of the drawer’s death, it is not held liable
for the payment or certification of that drawer’s
checks.
Upon request, a bank must return to the
drawer all the checks it has paid, so that the
drawer can inspect the canceled checks to ensure
that no forgeries or errors have occurred, in
adjusting the balance of her or his checking
account. This review of checks is usually completed
through the monthly statement. If the
drawer finds an error or forgery, it is her or his
obligation to notify the bank promptly or to
accept full responsibility for whatever loss has
been incurred.
Bank liabilities A bank has a duty to know
a customer’s signature and therefore is generally
liable for charging the customer’s account with
a forged check. A bank can recover the loss from
the forger but not from the person who in good
faith and without knowledge of the crime gave
something in exchange for the forged check. If
the depositor’s NEGLIGENCE was a factor in the
forgery, the bank can be excused from the
liability.
A bank is also responsible for determining
the genuineness of the endorsement when a
depositor presents a check for payment. A bank
is liable if it pays a check that has been materially
altered, unless the alteration was due to the
drawer’s fault or negligence. If a bank pays a
check that has a forged endorsement, it is liable
for the loss if it is promptly notified by the customer.
In both cases, the bank is entitled to
recover the amount of its loss from the thief or
forger.
A drawee bank that is ordered to pay a check
drawn on it is usually not entitled to recover
payment it has made on a forged check. If, however,
the drawee bank can demonstrate that the
collecting bank was negligent in its collection
duties, the drawee bank may be able to establish
a right of recovery.
A bank can also be liable for the wrongful
dishonor or refusal to pay of a check that it has
certified, since by definition of certification it
has agreed to become absolutely liable to the
payee or holder of the check.
If a bank has paid a check that has been
properly revoked by its drawer, it must reimburse
the drawer for the loss.
Drawer liabilities A drawer who writes a
check for an amount greater than the funds on
deposit in his or her checking account is liable to
the bank. Such a check, called an overdraft,
sometimes results in a loan from the bank to the
drawer’s account for the amount by which the
account is deficient, depending on the terms of
the account. In this case, the drawer must repay
the bank the amount lent plus interest. The bank
can also decide not to provide the deficient
funds and can refuse to pay the check, in which
case the check is considered “bounced.” The
drawer then becomes liable to the bank for a
handling fee for the check, as well as remaining
liable to the payee or subsequent holder of the
check for the amount due. Many times, the
holder of a returned, or bounced, check will
impose another fee on the drawer.
Loans and Discounts A major function of a
bank is the issuance of loans to applicants who
meet certain qualifications. In a loan transaction,
the bank and the debtor execute a promissory
note and a separate agreement in which the
terms and conditions of the loan are detailed.
The interest charged on the amount lent can differ based on many variables. One variable is a
benchmark interest rate established by the Federal
Reserve Bank Board of Governors, also
known as the prime rate, at the time the loan is
made. Another variable is the length of repayment.
The collateral provided to secure the
loan, in case the borrower defaults, can also
affect the interest rate. In any case, the interest
rate must not exceed that permitted by law. The
loan must be repaid according to the terms
specified in the loan agreement. In case of
default, the agreement determines the procedures
to be followed.
Banks also purchase commercial papers,
which are commercial loans, at a discount from
creditors who have entered into long-term contracts
with debtors. A creditor sells a commercial
paper to a bank for less than its face value
because it seeks immediate payment. The bank
profits from the difference between the discount
price it paid and the face value of the bond,
which it will receive when the debtor has finished
repaying the loan. Types of commercial
paper are educational loans and home mortgages.
Electronic Banking
Many banks are replacing traditional checks
and deposit slips with electronic fund transfer
(EFT) systems, which utilize sophisticated computer
technology to facilitate banking and payment
needs. Routine banking by means of EFT
is considered safer, easier, and more convenient
for customers.
Many types of EFT systems are available,
including automated teller machines; pay-byphone
systems; automatic deposits of regularly
received checks, such as paychecks; automated
payment of recurring bills; point-of-sale transfers
or debit cards, where a customer gives a
merchant a card and the amount is automatically
transferred from the customer’s account;
and transfer and payment by customers’ home
computers.
When an EFT service is arranged, the customer
receives an EFT card that will activate the
system and the bank is legally required to disclose
the terms and conditions of the account.
These terms and conditions include the customer’s
liability and the notification process to
follow if an EFT card is lost or stolen; the type of
transactions in which a customer can take part;
the procedure for correction of errors; and the
extent of information that can be disclosed to a
third party without improper infringement on
the customer’s privacy. If a bank is planning to
change the terms of an account—for example,
by imposing a fee for transactions previously
conducted free of charge—the customer must
receive written notice before the change will be
effective.
Banks must send account statements for
EFT transactions on a monthly basis. The statements
must have the amount, date, and type of
transaction; the customer’s account number; the
account’s opening and closing balances; charges
for the transfers or for continuation of the service;
and an address and telephone number for
referral of account questions or mistakes.
EFT transactions have become a highly competitive
area of banking, with banks offering
various bonuses such as no fee for the use of a
card when the account holder meets certain provisions
such as maintaining a minimum balance.
Also, the rapid growth of personal and
home office computing has increased pressure
on banks to provide services on-line. Several
computer software companies produce technology
that can complete many routine banking
services, like automatic bill paying, at a customer’s
home.
Banks have a wide range of options available
for notifying a customer that a check has been
directly deposited into her or his account.
If a customer has arranged for automatic
payment of regularly recurring bills, like mortgage
or utility bills, the customer has a limited
period of time, usually up to three days before
the payment is made, in which to order the bank
to stop payment. When the amounts of such
bills vary, as with utility bills, the bank must
notify the customer of the payment date in sufficient
time so that there will be enough funds in
the account to cover the debt.
If the customer discovers a mistake in an
account, the bank must be notified orally or in
writing after the erroneous statement is
received. The bank must investigate the claim.
Often, after several days, the customer’s account
will be temporarily recredited with the disputed
amount. After the investigation is complete, the
bank is required to notify the customer in writing
if it concludes that no error occurred. It
must provide copies of its decision and explain
how it reached its findings. Then the customer
must return the amount of the error if it was
recredited to his or her account.
A customer is liable if an unauthorized
transfer is made because an EFT card or other
device is stolen, lost, or used without permission.
This liability can be limited if the customer
notifies the bank within two business days of the
discovery of the misdeed; it is extended to $500
if the customer fails to comply with the notice
requirement. A customer can assume unlimited
liability if she or he fails to report any unauthorized
charges to an account within a specified
period after receiving the monthly statement.
A customer is entitled to sue a bank for COMPENSATORY
DAMAGES caused by the bank’s
wrongful failure to perform the terms and conditions
of an EFT account, such as refusing to
pay a charge if the customer’s account has more
than adequate funds to do so. The customer can
also recover a maximum penalty of $1,000,
attorneys’ fees, and costs in an action based
upon violation of this law.
The expansion of the INTERNET in the mid
1990s allowed banks to offer many more electronic
services to their customers. Although this
form of business with banks is certainly convenient,
it has also caused a considerable amount of
concern regarding the security of transactions
conducted in this manner. Although laws
designed to prevent FRAUD in traditional banking
also apply to electronic banking, identifying
individuals engaged in fraud can be more difficult
when electronic transactions are concerned.
On the federal level, the Electronic Funds Transfers
Act, 15 U.S.C.A. §§ 1693a et seq., provides
protection to consumers who are the subject of
an unauthorized electronic funds transfer.
The Gramm-Leach-Bliley Financial Modernization
Act, PL 106-102 (S 900) November
12, 1999. also modified federal statutory provisions
related to electronic banking. Under this
act, banks must now disclose the fees they
charge for use of their automated teller
machines. If the consumer is not provided with
proper fee disclosure, an ATM operator cannot
impose a service fee concerning any electronic
fund transfer initiated by the consumer. Furthermore, the act requires that possible fees be
disclosed to a consumer when an ATM card is
issued.
Interstate Banking and Branching
In late 1994, the 103d Congress authorized
significant reforms to interstate banking and
branching law. The Interstate Banking Law
(Pub. L. No. 103-328), also referred to as the
Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994, provided the banking
industry with major legislative changes. The
Interstate Banking Act was expected to accelerate
the trend of bank mergers. These mergers are
a benefit to the nation’s largest banks, which will
likely see savings of millions of dollars resulting
from streamlining.
FURTHER READINGS
Adler, Joseph. 1995. “Banking without Glass-Steagall? Look
Overseas.” American Banking Association Journal (May).
Bunditz, Mark. 2002. Consumer Banking and Payments Law.
Boston: National Computer Law Center.
Lovett, William A. 2001. Banking and Financial Institutions
in a Nutshell. St. Paul,Minn.:West.
Timberlake, Richard H., Jr. 1993. Monetary Policy in the
United States: An Intellectual and Institutional History.
Chicago: Univ. of Chicago Press.
CROSS-REFERENCES
Bank of the United States; Federal Deposit Insurance Corporation;
Federal Reserve Board; Glass-Steagall Act; Securities.