Banks are authorized financial institutions and banking is 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 century. 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 fullfledged 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 (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 such as 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. In 1933 President FRANKLIN D. ROOSEVELT temporarily closed all U.S. banks because of a widespread lack of confidence in the institutions. 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 revision on several occasions.
Despite the Glass-Steagall reforms, periods of instability have continued to recur in the banking industry. Between 1982 and 1987, about 600 banks failed in the United States. More than 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 concerns of many involved in the financial industries with the passage of the Financial Services Modernization 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 reasonable cause exists to believe the subsidiary is engaged in activities posing a material risk to bank depositors. The new law contains many other 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.
Since the mid-1980s, periods of instability have recurred in the banking industry. Beginning in 2006, the decline in U.S. housing prices and corresponding subprime MORTGAGE crisis were believed by many to be the cause of banks suffering major adverse consequences, including many bank failures. Government-issued bailout funds were provided to banks in conjunction with other measures designed to stimulate the weak economy and restore liquidity to the financial markets. As of May 2009, many referred to the period of economic instability as the worst financial crisis since the Great Depression.
Categories of Banks
There are two main categories of banks: federally chartered national banks and state chartered banks.
A national bank is incorporated and operates 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 (in 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 New England.
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.
ASAVINGS 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 certain minimum amount of capital. Banks acquire capital by selling CAPITAL STOCK to shareholders. The money that 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.
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 of 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.
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 enact reasonable rules and regulations for the efficient operation of its business through its governing board.
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 One 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, because 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.
Many banks are replacing traditional checks and deposit slips with electronic fund transfer (EFT) systems, which use 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-by-phone 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 activates 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 goes into effect.
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 online. Several computer software companies produce technology that can complete many routine banking services, such as 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 such as 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 is 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 caused a considerable 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 where 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 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 were expected to see savings of millions of dollars resulting from streamlining.
Adler, Joseph. 1995. ''Banking without Glass-Steagall? Look Overseas.'' American Banking Association Journal (May).
Bunditz, Mark. 2006. Consumer Banking and Payments Law. Boston: National Computer Law Center.
Carnell, Richard Scott, Jonathan R. Macey, and Geoffrey P. Miller. 2006. The Law of Banking and Financial Institutions. New York: Aspen.
Farrell, Cathlyn. 2008. Law and Banking. Washington, D.C.: American Bankers Association.
Lovett, William A. 2005. Banking and Financial Institutions Law in a Nutshell. St. Paul: West.
Timberlake, Richard H., Jr. 1993. Monetary Policy in the United States: An Intellectual and Institutional History. Chicago: University of Chicago Press.
Bank of the United States; Federal Deposit Insurance Corporation; Federal Reserve Board; Glass-Steagall Act; Securities.