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How Do Banks Work In The U.S.?

The U.S. boasts over 5,000 commercial banks and savings institutions.

You’re probably familiar with banks in your home country, and are wondering if banks in the U.S. work differently.

The short answer is yes. Read on for a more in-depth explanation.

How Do Banks in the USA Work?

The U.S. banking system is structured on the same principles as all other banks in the world.

You deposit your money into your bank account for safekeeping, which you can earn interest from and transact with anytime. They loan out a portion of your funds to partner banks and institutions. As deposit volumes multiply and the lending cycles continue, money from banks boosts economic growth.

But, how do they generate money? The revenue pours in from interest and fees on credit cards and loans.

Interest rates charged are higher than what is doled out. For instance, the interest rate received on your savings is 0.5%, and the rate you pay on a mortgage is 3%. The bank pockets the 2.5% difference.

Don’t get confused if you see banks mentioning annual percentage rate (APR) and annual percentage yield (APY) instead of interest rates. APR is what you pay on loans. APY is what accrues annually on your deposits.

Depending on the bank, APY can be the same or separate from the savings interest rate. Interest might be paid out short-term, whereas APY can be left to compound.

Over time, interest grows on the deposit plus yearly interest. It’s known in financial circles as “the power of compounding.” The $1,000 in your account today will become $13,725.50 in 10 years when you deposit $100 monthly and get an APY of 1%.

Interest rates are wide-ranging, and depend on the nature of the bank and account. The Federal Deposit Insurance Corporation (FDIC) fixes a national rate cap on the third Monday of every month.

Types of Banks in the USA

Banks offer a huge number of services. There are dedicated entities for some, while others are departments within the establishment. The U.S. is home to eight major categories of banks. 

1.       Central bank

The central bank is the governing authority, which is the Federal Reserve System in the U.S. It was formed in 1913 following the passing of the Federal Reserve Act. 

The Federal Reserve is headquartered in Washington D.C. and supported by 12 branches of Federal Reserve Banks. The national network is managed by the Federal Reserve Board.

Besides supervision, the Fed is responsible for the banking system’s stability, increasing employment, and sponsoring other U.S. organizations.     

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2.       Retail banks

The bank that you use for your everyday needs is most likely a retail bank. They cater to the layperson and small businesses, making them stalwarts of the U.S. banking industry.

Retail banks provide savings options, personal loans, and several consumer-centric services. These can be accessed in-person, via the phone, or online.

3.       Commercial banks

These banks assist industrial operations. Their offerings were initially tailored to medium and large enterprises, but now also include individuals. They deal with deposits and loans on a larger scale.

Commercial banking is responsible for over 71,000 businesses and 1.8 million employees. The industry is answerable to the Office of the Comptroller of the Currency (OCC).

4.       Investment banks

As the name suggests, investment banks are the middlemen for investors buying and selling securities. They counsel clients on investment strategy.

They also help conglomerates with the financial aspects of mergers and acquisitions, and in entering the stock market via initial public offerings.

5.       Online banks

These are banks that exist exclusively on the internet. They have no brick-and-mortar locations. Their services mirror retail banks.

Without the overheads of maintaining physical outlets, online banks offer higher interest rates on savings than their peers. Customers should be somewhat tech-savvy to maximize benefits, but it’s nothing that new generations can’t handle.

6.       Credit unions

Credit unions are nonprofit organizations that are owned and run by their members. They provide similar services to banks in terms of deposits and loans for private needs.

Membership is mandatory for becoming a customer. A community with common denominators like an area of residence or workplace constitutes a credit union. 

Since credit unions are hyperlocal, they promise individual attention and competitive interest rates.

7.       Savings and loan associations

Otherwise called a thrift institution, this type of association focuses on handing out loans, particularly for home and property purchases.

They too function on membership, and each participant owns a stake in the group. Apart from proprietors, companies and government bodies borrow from savings and loan associations as well. 

8.       Shadow banks

Shadow banks are alternative organizations like hedge funds and insurance companies. Though they dabble in finances, they are ungoverned.

According to the International Monetary Fund, shadow banks obtain “short-term funds in the money markets and use those funds to buy assets with longer-term maturities.” It’s along the lines of what commercial banks do, minus the safety net of the Fed.

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Dual Banking System

American banks are modeled after the dual banking system, which is divided into national banks and state banks. The former operates under federal rules, while the latter is directed by both federal and state charters.

Both can operate out of any state in the country. National banks must be incorporated with the word “national” or N.A. in the title. State banks are prohibited from using these or “federal” in their name. 

Remember how banks lend to others? The amount they can give out isn’t flexible. It is overseen by the Fed, and enforced by the FDIC and OCC.

Banks need to maintain a 10% reserve. For every $100 received, they must retain $10 and can loan $90. The next bank needs to hold on to $9 before lending $81. This way, the money moves on in the economy. 

Types of Bank Accounts

Within national and state banks, various accounts serve different purposes.

1.       Checking account

This is the average American’s bank account. It is also referred to as a transaction account, or current account. 

It comes with a debit card that can be used for ATM cash withdrawals, a checkbook for issuing checks, and internet banking features that enable linking to digital, third-party wallets.  

Checking accounts are designed to contain enough money for day-to-day expenses. They are not fitting for long-term reserves. Some require a minimum balance in the account, and charge fees in case of overdrawing. 

2.       Savings account

People build their nest of wealth over the years in a savings account.

These accounts are not intended for as much liquidity as checking accounts, but they facilitate regular transactions. A debit card, face-to-face aid, and online services are provided. However, withdrawals are limited.

Savings, or share accounts, are advantageous not only because of decent interest rates, but also because they are secured by federal insurance. That’s risk-free interest for the taking.

3.       Money market account

Many aspects of money market accounts (MMA) are akin to savings accounts: gathering bank balances, amassing interest, and teller services. MMA interest rates usually beat those of savings accounts.

They are also comparable to checking accounts in terms of sustaining a minimum amount. Debit cards, ATM transactions, and the ability to write checks are part of the package as well.

In that sense, MMAs are the best of both accounts.

4.       Certificate of deposit account

If coins collected in a savings account become a fund pool, the same will grow to be a lake with a certificate of deposit (CD) account. 

CD accounts work on the motto of “set it and forget it.” You could start a deposit for as little as 30 days, but you reap the most benefits in the long haul. When the set period ends, you’ll receive the initial amount deposited plus interest.

The catch is that you cannot withdraw as you please before maturity. If you must, you will incur a penalty and near-nullify any gains. Cash in CD accounts resembles investments.

Overall, these interest-yielding accounts are considered tiered-rate accounts. The tier indicates the typical sum of funds held in the account; the higher the tier, the higher the interest rate.

The FDIC national rate cap correlates to this. Checking and savings accounts are deemed $2,500 tiers. They have slightly lower caps than the $10,000 tier money market account and $100,000 CD account.

These account types are insured up to $250,000 under the FDIC. If a person holds more than one of these accounts, a combined balance of $250,000 will be covered. Someone with $100,000 each in three accounts means $50,000 will remain uninsured.

Having had an overview of how banks function in the U.S., you are ready to narrow down which bank and account category suit you best. Look closer at the options within your selection before making a decision.

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