Chapter 5 Banking and Interest Rates Chapter Objectives

Chapter 5 Banking and Interest Rates

Chapter Objectives • Describe the types and functions of financial institutions • Describe the banking services offered by financial institutions • Identify the components of interest rates • Explain why interest rates change over time Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -2

Types of Financial Institutions • Depository institutions: Financial institutions that accept deposits from individuals and provide loans – Commercial banks: financial institutions that accept deposits and use the funds to provide commercial and personal loans • Deposits insured by Federal Deposit Insurance Corporation (FDIC) up to $250, 000 per depositor Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -3

Types of Financial Institutions (cont’d) – Savings institutions (or thrift institutions): financial institutions that accept deposits and provide mortgage and personal loans to individuals – Credit unions: nonprofit depository institutions that serve members who have a common affiliation Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -4

Types of Financial Institutions (cont’d) • Nondepository institutions: financial institutions that do not offer federally insured deposit accounts, but provide various other financial services – Finance companies: nondepository institutions that specialize in providing personal loans to individuals Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -5

Types of Financial Institutions (cont’d) – Securities firms: nondepository institutions that facilitate the purchase or sale of securities by providing investment banking and brokerage services – Insurance companies: nondepository institutions that provide insurance to protect individuals or firms against possible adverse events Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -6

Types of Financial Institutions (cont’d) – Investment companies: nondepository institutions that sell shares to individuals and use the proceeds to invest in securities to create mutual funds • Financial conglomerates: financial institutions that offer a diverse set of financial services to individuals or firms – Examples include Bank of America and Citigroup Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -7

Types of Financial Institutions (cont’d) Copyright © 2014 Pearson Education, Inc. All rights reserved.

Banking Services Offered by Financial Institutions • Checking services – Checking accounts allow you to draw on funds by writing checks – Paying Bills on Time • Fees are charged for – Paying bills after the deadline – Making loan payments after the deadline – Ignoring the rules of a car lease contract, such as maximum mileage allowed Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -9

Banking Services Offered by Financial Institutions (cont’d) – Monitoring Your Account Balance • Record checks in your checkbook as you write them – Reconciling Your Account Balance • Make sure the bank statement agrees with your check register Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -10

Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -11

Banking Services Offered by Financial Institutions (cont’d) • Check float—the time from when you write a check until your checking account balance is reduced – Check Clearing for the 21 st Century Act (Oct. 2004) allows banks to transmit electronic images of checks, virtually eliminating float – Electronic checking deters fraud Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -12

Banking Services Offered by Financial Institutions (cont’d) • Credit card financing such as Visa and Mastercard • Debit card: a card that is used to make purchases that are charged against a checking account – Debit cards for Teenagers • Convenient way for parents to transfer funds to children, but may encourage overspending Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -13

Additional Services Financial Institutions Offer • Safety deposit box: a box at a financial institution where a customer can store documents, jewelry, or other valuables • Automated teller machines (ATMs): a machine where individuals can deposit and withdraw funds any time of the day – Fees can be charged for using another financial institution’s ATM Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -14

Additional Services Financial Institutions Offer (cont’d) • Cashier’s check: a check that is written on behalf of a person to a specific payee and will be charged against a financial institution’s account • Money order: a check that is written on behalf of a person for a fixed amount that is paid in advance Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -15

Additional Services Financial Institutions Offer (cont’d) • Traveler’s check: a check that is written on behalf of an individual and will be charged against a large well-known financial institution or credit card sponsor’s account Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -16

Selecting a Financial Institution • Criteria Used to Select a Financial Institution – Convenience • Close to where you live or work, convenient ATM locations, online banking – Paying bills online – Deposit rates and insurance • Comparison shop for best interest rates – Fees • Some consumers using Wal-Mart to avoid fees Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -17

Financial Planning Online • Go to www. fdic. gov/bank/individual/online/%0 Dsa fe. html safe. html • This Web site provides tips for safe banking over the Internet Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -18

Interest Rates on Deposits and Loans • Interest rates on deposits and loans affect your cash inflows and outflows • Certificate of deposit: an instrument that is issued by a depository institution and specifies a minimum investment, an interest rate, and a maturity • Risk-free rate: a return on an investment that is guaranteed for a specified period Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -19

Interest Rates on Deposits and Loans (cont’d) • Risk premium: an additional return beyond the risk-free rate that can be earned from a deposit guaranteed by the government • Loan rate—financial institutions loan money at a rate higher than they pay depositors – Individuals with a poor credit history pay higher rates Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -20

Interest Rates on Deposits and Loans (cont’d) • Impact of the economy of the risk premium – When economic conditions weaken, firms issuing securities must pay a higher risk premium to sell their securities, resulting in investors reluctance to purchase the securities for fear the firm might go bankrupt and not repay their debt – Investors more willing to invest in a favorable economic climate Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -21

Financial Planning Online • Go to dir. yahoo. com/business_and_economy/ finance_and_investment/banking • This Web site provides information about individual financial institutions such as the services they offer and the interest rates they pay on deposits or charge on loans. Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -22

Interest Rates on Deposits and Loans (cont’d) • Twisted perception of the risk premium – Some investors attracted to investments for the wrong reasons – They pursue risky investments to make up for limited income – This is faulty reasoning as those with limited incomes can less afford losses Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -23

Interest Rates on Deposits and Loans (cont’d) • Comparing interest rates and risks – Choice depends on risk tolerance • If you will need your money within a year, you should take no risk • If you will need a portion of your money when your investment matures, you can afford to take some risk • No choice is right for all investors Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -24

Financial Planning Online • Go to www. bloomberg. com/markets/rates/%0 Din dex. html index. html • This Web site provides updated quotations on key interest rates and charts showing recent movements in these rates Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -25

Interest Rates on Deposits and Loans (cont’d) • Term structure of interest rates: the relationship between the maturities of riskfree debt securities and the annualized yields offered on those securities – Often based on rates of return offered by U. S. Treasury securities with different maturities Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -26

Interest Rates on Deposits and Loans (cont’d) • Shifts in the yield curve - Graphs such as the on the previous slide can be found in financial publications such as the Wall Street Journal and illustrate how returns change over time • Loan Rates - Financial institutions obtain funds by accepting deposits and providing loans to individuals and firms Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -27

Financial Planning Online • Go to www. bankrate. com/finance/federalreserve • This Web site provides updated information about the Fed’s recent actions and upcoming meetings, as well as forecasts of future policy decisions and the potential impact of these decisions. Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -28

Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -29

Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -30

Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -31

Why Interest Rates Change • Monetary policy: the actions taken by the Federal Reserve to control the money supply – Money supply: demand deposits (checking accounts) and currency held by the public – Open market operations: the Fed’s buying and selling of Treasury securities Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -32

Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -33

Why Interest Rates Change • Shift in the government demand for funds – Any change in the government’s borrowing behavior can affect the demand for funds and affect interest rates • Shift in the business demand for funds – When firms adjust their borrowing and spending plans, this affects demand interest rates Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -34

Financial Planning Online • Go to http: //www. bloomberg. com/markets/rates/ index. html • This Web site provides updated information about the Fed’s recent actions and upcoming meetings, as well as forecasts of future policy decisions and the potential impact of these decisions Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -35

How Banking Services Fit within Your Financial Plan • The key banking decisions for your financial plan are: – What banking service characteristics are most important to you? – What financial institution provides the best banking service characteristic for you? Copyright © 2014 Pearson Education, Inc. All rights reserved. 5 -36