Principles of Banking 9th Edition

PRINCIPLES OF BANKING
CONTENTS
CHAPTER 1 : BANKING AND YOU
LEARNING OBJECTIVES
INTRODUCTION
THE ROLE OF A BANK EMPLOYEE
• Service to customers
• A sense of responsibility
• Worthy of trust
• Professionalism
• Bank employee careers
• Bank employee training
THE BANK AS AN ORGANIZATION
• Typical bank structure

• Bank and financial holding companies
BANK PRODUCTS AND SERVICES
• Traditional products and services

• Nontraditional products and services
• Electronic services
• Marketing and cross-selling services
THE BANK AND THE COMMUNITY
• Financial services
• Customer service
• Contribution to the economy
• Community support
PARTNERSHIPS AND OUTSOURCING

MERGERS AND ACQUISITIONS
FUTURE TRENDS
• Deregulation
• Expansion of financial services
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• Intensity of competition
• Margin squeeze
• Technological advances
• Geographic expansion
SUMMARY
SELF-CHECK AND REVIEW
CHAPTER 2 THE U.S. BANKING SYSTEM
LEARNING OBJECTIVES
INTRODUCTION
BANKING AND THE ECONOMY
US BANKING SYSTEM 1700s-1913

• The early banking system
• Failed attempts to form a central bank
• Establishing the Federal Reserve system
BANKING IN THE 20th CENTURY
• The Great Depression and Bank Protections

• Social change and consumer protection
• Bank competition
• The savings and loan crisis
BANKING IN THE 21st CENTURY
• Opportunity : Gramm-Leach-Bliley Act

• Financial privacy&protecting the nation
• Accountability : The Sarbanes-Oxley Act
FEDERAL RESERVE SYSTEM
• The Fed’s Structure

• The Fed’s duties
• Federal Reserve services
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REGULATORS AND REGULATIONS
• Bank regulators
• Bank regulations
SUMMARY
CHAPTER 3 MONEY AND BANKING
LEARNING OBJECTIVES
INTRODUCTION
THE EVOLUTION OF MONEY
• Coin and currency

• Fiat money
THE FUNCTIONS AND PROPERTIES OF MONEY
• Functions of money
• Properties of money
• Alternatives to cash
THE MONEY SUPPLY AND THE ECONOMY
• How the money supply is measured

• The flow of economic activity
BANKS AND MONEY CREATION
• Money creation
THE FEDERAL RESERVE AND MONETARY POLICY
• Reserve requirements
• Discount operations
• Open market operations
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SUMMARY
CHAPTER 4 DEPOSIT ACCOUNTS
LEARNING OBJECTIVES
INTRODUCTION
THE DEPOSIT FUNCTION
• Safety
• Customer convenience
DEPOSIT ACCOUNT PRODUCTS
• Types of deposit accounts

• Common deposit account products
DEPOSIT-RELATED SERVICES
• Options for depositing funds

• Types of deposited items
• Accessing funds and account information
OWNERSHIP OF DEPOSIT ACCOUNTS
• Consumer account ownership

• Business account ownership
OPENING A DEPOSIT ACCOUNT
• Establishing identity
• Evaluating capacity and authority
DEPOSIT REGULATIONS
• Reserve requirements
• Electronic funds transfer
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• Expedited funds availability
• Truth in savings
• FDIC insurance protection
SUMMARY
CHAPTER 5 PAYMENTS : CASH AND CHECKS
LEARNING OBJECTIVES
INTRODUCTION
CASH AS A PAYMENT SYSTEM
• United States legal tender

• Damaged coin and currency
CHECKS AS A PAYMENT SYSTEM
• Elements of negotiable instruments

• Other types of checks
THE CHECK PAYMENT PROCESS
• The drawer
• The payee
• The depositary bank
• The drawee
ELECTRONIC CHECK PROCESSING
CHECK FRAUD
• Check counterfeiting
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• Bank efforts to combat check fraud
LAWS AND REGULATIONS
• Collection of checks and funds transfers

• Expedited Funds Availability Act
• Uniform Commercial Code (UCC)
SUMMARY
CHAPTER 6 ELECTRONIC BANKING
LEARNING OBJECTIVES
INTRODUCTION
ELECTRONING BANKING – WHAT AND WHO
• The roots of electronic banking

• EFT and ACH
• The Internet
• Users of electronic banking
• Electronic banking security
CONSUMER BANKING
• Card access to funds

• Internet banking services
BUSINESS BANKING
• Electronic Bill Presentment and Payment (EBPP)

• Imaging and remote deposit capture
• Fedwire, CHIPS and SWIFT
• Other federal reserve services
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DEVELOPMENT AND TRENDS
• Virtual banks
• Wireless banking
• Electronic funds transfers

• Funds availability
• Check collection and funds transfers
• Check conversion
• Electronic signatures
SUMMARY
CHAPTER 7 - LENDING
LEARNING OBJECTIVES
INTRODUCTION
THE LENDING FUNCTION
• Sources of credit
• Banks as lenders
LOAN CATEGORIES
• Consumer loans
• Real estate loans
• Business loans
• Government as borrower and loan supporter
THE LENDING PROCESS
• The application and the interview

• The investigation
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• Loan documentation
• Loan decision
• Loan administration
• Loan review and asset recovery
LOAN POLICY
• Equal Opportunity Act

• Truth In Lending Act
• Community Reinvestment Act
• Loans to bank insiders
• Home Mortgage Disclosure Act
• Real Estate Settlement Procedures Act
• Fair Credit Reporting Act
• Fair Debt Collection Practices Act
• Bank lending limits
SUMMARY
CHAPTER 8 - PERSONAL FINANCING PLANNING
LEARNING OBJECTIVES
INTRODUCTION
FINANCIAL HEALTH EQUALS PERSONAL WEALTH
• Banks and financial planning

• Financial planning goals
• Time value of money
• Risk management considerations
• The role of the planner
• Ethical standards
• Minimizing tax liability
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FINANCIAL PLANNING PROCESS
• Customer life stages

• Financial planning goals
• Financial services products
• Net worth statement
• Cash flow strategy
INSURANCE PROTECTION
• Life insurance
• Health, disability, long-term care insurance
• Property, title, and vehicle insurance
• Liability insurance
INVESTMENT SERVICES
• Investment strategies
• Portfolio management
RETIREMENT PLANNING
• Social security and pensions

• Individual retirement accounts
• Estate planning
BANK TRUST SERVICES
• Estate settlement
• Trust administration
• Guardianship
• Personal agency services
• Retail sales of nondeposit investment products

• Uniform Laws
• Consumer protection in sales of insurance
• Hero earned retirement opportunities
SUMMARY
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CHAPTER 9 - BUSINESS AND INTERNATIONAL BANKING SERVICES
LEARNING OBJECTIVES
INTRODUCTION
BUSINESS BANKING SERVICES
• Cash management
• Business banking products & services
• Capital markets
BUSINESS TRUST SERVICES
• Corporate agency services

• Employee benefit services
INTERNATIONAL BANKING
• International payments
• Foreign exchange services
• Fiduciary activities of National Banks, Regulation 9

• Gramm-Leach-Bliley Act
• Uniform Commercial Code Article 5
SUMMARY
CHAPTER 10 - BANK INVESTMENTS AND PERFORMANCE
LEARNING OBJECTIVES
INTRODUCTION
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THE ANNUAL REPORT
• Statement of Condition
• Profit and Loss Statement
• Statement of Cash Flows
IMPORTANCE OF FINANCIAL INFORMATION
• Shareholders and investors

• Regulators
• Other banks
• Customers
• Employees
MANAGEMENT OF BANK FUNDS
• Business risks in banking

• Asset and liability management
FUNDS MANAGEMENT OBJECTIVES
• Liquidity
• Safety
• Income
MAXIMIZING ASSET RETURN
• Loans versus investments

• Credit risk versus market risk
• Loan interest
• Market interest rates and lending
• Investment diversification
• Investment requirements
• Types of bank investments
• Fee income
PERFORMANCE MEASURES
• Financial ratios
• Other performance measures
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BUDGETING AND PLANNING
• The budgeting process

• Budget variances
GAAP
Regulatory reporting
SUMMARY
CHAPTER 11 - BUILDING RELATIONSHIPS : SALES, MARKETING AND

CONSUMER SERVICE
LEARNING OBJECTIVES
INTRODUCTION
SELLING TODAY
• Sales, marketing and customer service

• The market-driven strategy
MEETING CUSTOMER EXPECTATIONS
• Responsive service
• Competent staff
• Customer perspective
• Courteous treatment
• Reliable services
• Viable products and services
• Professional appearance
• Access to funds and staff
• Financial privacy
CROSS-SELLING AND REFERRALS
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THE PURCHASING PROCESS
• Needs identification
• Prepurchase searching
• Purchase decision
• Postpurchase assessment
PRODUCT DEVELOPMENT
• Unfair or deceptive acts or practices

• Do not call, do not fax
CAN-SPAM Act
SUMMARY
CHAPTER 12 - SAFEGUARDING CUSTOMER INFORMATION
LEARNING OBJECTIVES
INTRODUCTION
PROTECTING CUSTOMER INFORMATION
• Data security
• General security features
• Emergency preparedness
CUSTOMER IDENTIFICATION
• New account identification requirements

• Account access identification methods
• Biometric identification methods
FRAUD AND PREVENTION METHODS
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• Caller-ID manipulation
• Online fraud schemes
• Computer attacks
• Bank card fraud
• Elder financial abuse
• Identity theft
WHAT CUSTOMERS CAN DO
• Communication devices
• Computers
• Personal data
• Privacy of consumer financial information

• Interagency guidelines on information security
• Guidance on Internet Authentication
• Protecting children online
• Right to financial privacy
SUMMARY
CHAPTER 13 - SAFEGUARDING THE BANK, THE ECONOMY & THE NATION
LEARNING OBJECTIVES
INTRODUCTION
MANAGING RISK
• Ratings systems
• Technology and risk management
SAFEGUARDING BANK ASSETS
• Corporate governance & ethical behavior

• Employee hiring & vendor management
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• Crimes against banks
SAFEGUARDING THE ECONOMY AND THE NATION
• Terrorism
• Emergency preparedness
SUMMARY
Answers to self-check and review

Chapter 1 Chapter 8
Chapter 2 Chapter 9
Chapter 3 Chapter 10
Chapter 7
EXHIBIT LIST
CHAPTER 1
Exhibit 1.1 Sample careers in banking and education qualifications

Exhibit 1.2 Sample certifications through the Institute of Certified Bankers
Exhibit 1.3 Typical commercial bank organization
Exhibit 1.4 Sample bank holding company activities
Exhibit 1.5 Sample financial holding company activities
Exhibit 1.6 A hypothetical financial holding company organizational chart
CHAPTER 2
Exhibit 2.1 Milestones in the evolution of U.S banking

Exhibit 2.2 Timeline of banking legislation in the 20th century
Exhibit 2.3 Innovations in banking in the 20th and 21st centuries
Exhibit 2.4 Consumer protection laws
Exhibit 2.5 Number of bank failures 1934 – 2006
Exhibit 2.6 Chronology of major banking legislation and events
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Exhibit 2.7 Structure of the Federal Reserve System
Exhibit 2.8 Categories of Federal Reserve Regulations
CHAPTER 3
Exhibit 3.1 Components of the money supply

Exhibit 3.2 The circular flow of economic activity
Exhibit 3.3 Banks and multiple deposit creation
Exhibit 3.4 Fed tools and their effects
CHAPTER 4
Exhibit 4.1 A bank’s relationship with depositor and borrower

Exhibit 4.2 Characteristics of deposited items
Exhibit 4.3 Account ownership
CHAPTER 5
Exhibit 5.1 U.S. cash distribution system

Exhibit 5.2 Parties to a check
Exhibit 5.3 Elements of a negotiable check
Exhibit 5.4 Check payment process
Exhibit 5.5 Visual and nonvisual tests for inspecting a check
Exhibit 5.6 Presenting checks for payment and posting
Exhibit 5.7 Magnetic Ink Character Recognition (MICR) Line
Exhibit 5.8 Check sorting and bundling
Exhibit 5.9 Recognizing substitute checks
Exhibit 5.10 Check 21 expedited Re-credit
CHAPTER 6
Exhibit 6.1 Process flow for preauthorization payment

Exhibit 6.2 Users of electronic banking
Exhibit 6.3 Debit card Point-of-Sale transactions
Exhibit 6.4 CHIPS members’ countries
CHAPTER 7
Exhibit 7.1 Consumer loan pricing methods

Exhibit 7.2 The lending process
Exhibit 7.3 Sample loan interview questions
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Exhibit 7.4 The Five Cs of Credit
CHAPTER 8
Exhibit 8.1 The risk pyramid

Exhibit 8.2 Net Worth Worksheet
Exhibit 8.3 Monthly cash flow plan for a single working person
CHAPTER 9
Exhibit 9.1 Cash concentration

Exhibit 9.2 Corporate trust chain of events for a bond offering
Exhibit 9.3 Qualified plan requirements
CHAPTER 10
Exhibit 10.1 Consolidated Statement of Condition

Exhibit 10.2 Consolidated Profit and Loss Statement
Exhibit 10.3 Banking Industry Statement of Cash Flows (billions of dollars)
Exhibit 10.4 Risk areas in banking
Exhibit 10.5 Interest rate comparison
Exhibit 10.6 Sources of fee income
Exhibit 10.7 Financial ratios for the banking industry, comparison of two years
CHAPTER 11
Exhibit 11.1 The purchasing process

Exhibit 11.2 New product development
CHAPTER 12
Exhibit 12.1 Famous malicious software programs

Exhibit 12.2 Sample bank privacy notice
CHAPTER 13
Exhibit 13.1 Contents of a typical bank code of conduct

Exhibit 13.2 Outsourcing services – Vendor management
Exhibit 13.3 The $20 Bill
Exhibit 13.4 Know your money – Raised banknote
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CHAPTER 1 BANKING AND YOU
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
- discuss the roles of bank employees

- describe a bank’s organizational structure
- explain bank products and services
- identify trends in banking
- describe the role of banks in their communities
- discuss the benefits of banking partner and outsourcing relationships
- explain the reasons for acquiring or merging with another bank
- define the bolded key terms that appear in the text
INTRODUCTION
25 years ago, former New York Federal Reserve Bank President Gerald Corrigan
wrote in an influential essay : “Are banks special ?” that “a strong case can be made
that banks continue to be special ......But banks must also compete in the marketplace.
Consequently we can expect over time to see adjustments in both the direct activities
of banks, and in the line separating banking and commerce”.
Quoting Corrigan, Federal Reserve Governor Olson observed that adjustments are
being made. Banks do much more than accept deposits or make loans. They provide a
variety of financial services to meet the diverse requirements of their customers.
The link between the customer and the bank is the banker. To serve customers well
and fulfill their responsibilities, bankers must have a thorough working knowledge of
bank products, services. policies, and practices.
Banks also contribute to the community, the economy, and the welfare of the nation.
As businesses that operate for the benefit of their shareholders, banks seek ways to
operate efficiently and profitably. To achieve all these goals, banks form business
alliances, merge with or acquire other financial institutions, and support technological
innovations to deliver services and streamline operations.
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SITUATION
Customers Matthew and Verna, who came to the USA several years
ago from the Caribbean, have always wanted a home of their own.
Although they have found the house they want, they now need a mortgage
to buy it. Another customer, Tamara, has her own successful interior
decorating business. She has never worked for a company that offered a
pension plan. She would like to set aside a portion of her income for
retirement security, but is unsure what plans are available for a person in
her situation.
THE ROLE OF A BANK EMPLOYEE
The banker’s primary responsibility is to professionally represent the bank’s interest

in every interaction with customers, other bank employees, vendors, and other
community members. Bankers must have good judgment, address requests promptly,
follow procedures, and establish a banking relationship that meets the customers’
needs and the bank’s goals.
SERVICE TO CUSTOMERS
Customer-focused banks give customers exceptional personal service, maintain complete

confidentiality, and conduct business in a professional manner. However, customers are not
just depositors and borrowers. Bank employees can be customers to each other as well,
depending on one another to fulfill their own job responsibilities.
A helpful pleasant attitude combined with job knowledge leaves a positive impression
with both customers and fellow employees.
A SENSE OF RESPONSIBILITY
In addition to specific job duties, bank employees are responsible for observing the
bank’s policies and procedures. They are also responsible to those they report to, and for
those reporting to them. Most importantly, they are responsible to the bank’s shareholders
and customers.
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Did you know ...... ?
In 1897, the ABA Bureau of Education distributed a pamphlet to educate the

public on the role of banks and bankers. What is a Bank ? was so popular that
over a million copies were distributed the first year.
WORTHY OF TRUST
The strength of the financial services industry depends on how much customers trust its
institutions and employees. Because they handle and safeguard the funds and assets of
others, banks must uphold the highest standards of business ethics. By law, banks must
report even minor deviations from established policies to regulatory authorities. These
policies usually are explained in the bank’s code of conduct.
Ethics
Principles of conduct and judgment that affect business practices.
Code of conduct
Typically, a code of conduct establishes bank policies about such matters as employees
receiving gifts from customers, serving on public boards, taking outside jobs, and reporting
suspicious activities.
Code of conduct
A formal set of guidelines approved by the board of directors that represents a

company’s policies for corporate governance and individual conduct.
Because of corporate governance scandals and the passage of the Sarbanes-Oxley Act in
2001, it is important for employees to adhere to the ethical values expressed in the bank’s
code of conduct. Employees are required to read the code of conduct, and periodically
certify they are in compliance. Codes of conduct address the following :
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Sarbanes-Oxley Act
A federal law intended to improve the governance of public corporations

by holding boards of directors, management, and auditors to high standards
of conduct and accountability.
- Personal conduct : As protectors of other people’s money, bankers are held to high
standards of employee conduct. In fact, banks are prohibited from employing persons
who have committed dishonest acts, or been convicted of certain crimes. Dishonest
and fraudulent activity of any kind is not tolerated.
- Conflict of interest : The Sarbanes-Oxley Act has made avoiding conflicts of interest
especially important. As a representative of the bank, every employee is obligated to
act in the best interest of the bank, its shareholders and its customers. Bank employees
should avoid situations, where personal or financial interests or relationships might
influence, or appear to influence professional judgment.
Conflict of interest
A situation in which an action taken by an individual in an official

capacity may benefit that individual personally to the detriment of the
employer.
- Compliance : Employees have a personal responsibility to adhere to the many laws

and regulations that affect banks. With equal employment opportunity regulations, for
example, an employee must not cooperate in any form of job bias, and employees
must report acts that suggest discrimination.
- Accepting gifts : Employees may not accept money or gifts of significant value from
customers or anyone else, if acceptance of the gift may cause suspicion of influence,
or compromise the employee’s performance.
- Outside activities : Employee conduct, both at work and away, reflects on the bank’s
reputation and its image in the community. Participating in civic, social, educational,
and charitable activities is encouraged. If a question should arise about the activities
of an outside organization that an employee supports, the employee should put the
bank’s interests first.
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- Confidentiality : Bankers are obligated to avoid unauthorized use, or release of a
customer’s confidential information. State and federal privacy laws, such as the
Gramm-Leach-Bliley Act, limit how banks may share personal financial information
with affiliates and third parties.
Indeed, customers expect their personal information will be kept strictly confidential.
Never should a customer’s financial information be the subject of discussion or gossip
with other employees, family members, friends or acquaintances.
Gramm-Leach-Bliley Act
The financial modernization law that permits banking organizations to

engage in a broad range of financial activities, including incidental and
complementary activities. The law created the financial holding company,
which can own companies engaged in nonbanking activities. It also
includes provisions on financial privacy and security and ATM disclosures.
- Purchasing defaulted property : Employees should not purchase property that has
been repossessed or foreclosed by their bank or an affiliate. Such purchases suggest a
conflict of interest, and bring the bank’s reputation into question.
- Notification of violations : Bank employees are obligated to report if they suspect

another employee of wrongdoing. Again, the employee’s overriding responsibility is
to act in the best interests of the bank, its shareholders and its customers.
PROFESSIONALISM
In their working relationships with customers, other employees and managers, the
professional attitude and appearance of bank employees set the tone for the entire
bank. Skilled bank professionals are :
Organized : They keep work areas neat, answer messages, answer customer inquiries
promptly, and get to work on time.
Positive : They recognize the importance of customer-focused banking service,

maintain a positive attitude, and are honorable and sincere.
Confident : They dress appropriately, maintain eye contact, treat customers and others
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with courtesy, respect, and empathy; have a business-like posture, know
the bank’s products; and act decisively.
Attentive : They listen, solve problems, keep promises, and pay attention to details.
Did you know ....... ?
Bank employees who have access to inside knowledge about the

business of corporations, whether or not they are bank customers, are
prohibited by the Securities Exchange Act of 1934 from using that
knowledge for their personal gain.
BANK EMPLOYEE CAREERS
As banking products, services, and applications expand; so do career opportunities in

banking. There will always be a need for employees who enjoy working with
customers on a daily basis, such as customer service representatives, tellers and other
front-office staff, but there are many other career opportunities available, ranging
from accounting, auditing. and compliance to lending, sales, trust services, human
resources, and corporate support. Banks also employ many technology and operations
specialists.
As they enter new lines of business permitted by the financial modernization laws, banks are
also employing more people with specialized skills in areas like insurance and securities sales.
The following are among the areas where bankers enjoy career growth.
Exhibit 1.1 : Sample careers in banking and education qualifications
HIGH SCHOOL DIPLOMA COLLEGE DEGREE
Preferred courses : A degree in business administration or liberal arts

with these courses
Accounting Bookkeeping Accounting Business law
Business writing Computers Business management Communications
Economics Math Computer programming Economics
Public speaking Finance Marketing
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Positions to consider Positions to consider
Accounting clerk Accountant
Administrative assistant Antifraud investigator
Courier Commercial or consumer loan officer
Computer service representative Compliance risk management officer
Data processor Computer programmer / systems analyst
Loan assistant Credit analyst
Operations processor Division or branch manager
Proof operator Human resources administrator
Receptionist Market researcher
Sales representative Public relations specialist
Security guard Trust / investment officer
Teller
Sales and business development
To reach potential customers, and keep current customers informed, banks promote the
benefits of financial products and services. Though it is, to some degree, every banker’s job to
sell, certain bank employees are dedicated to this task full time.
Sales and business development are critical in today’s highly competitive financial services
environment. Sales teams specialize by product. Retail banking, business banking, insurance,
investment products, and trust services, for example, are sales career avenues open to today’s
bankers.
Operations
Employees in operations departments work behind the scenes. By servicing deposits

and loans and processing transactions, these departments provide support to the
customer-contact staff. Operations personnel are among the first to use new
technology and software applications to efficiently accomplish their increasingly
challenging tasks.
E-business
E-business, or e-commerce, is a major growth area for banks. For their employees, opportunities
abound in Web design, hosting, and maintenance; business-to-business links, and Internet-based
transaction services.
Technology
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With technology, traditional labor-intensive jobs have been transformed, and new
opportunities opened up for bank employees. Technology careers include servicing and
supporting mainframes, personal computers, networks; computer programming software training,
information security, transaction processing, automated teller machine support, and customer call
center support.
Did you know ........ ?
The American Bankers Association recommends that graduating students interested in

careers in banking
- get to know a local banker
- develop a career path
- - take advantage of training opportunities
BANK EMPLOYEE TRAINING
Banks have a long history of training employees for current and new positions within the bank.
In addition to job-specific onsite training, many banks offer full or partial reimbursement for
education & training, as part of their benefits packages. Employees can receive college degrees
and American Institute of Banking (AIB) credit and diplomas. They can also earn specialty
certifications and designations. Exhibit 1.2 lists certifications available through the Institute of
Certified Bankers.
Exhibit 1.2 Sample certifications through the Institute of Certified Bankers
Certified Financial For financial services professionals whose primary function

Services Security and expertise are in the management, or execution of
Professional (CFSSP) physical safety and security, for a financial services
organization’s facilities, staff, systems, or customers.
Certified Financial For financial services professionals whose primary

Marketing function and expertise are in financial services marketing.
Professional (CFMP)
Certified Lender For financial services professionals whose primary

Business Banker function and expertise are in the provision of credit and
(CLBB) financial transaction services to business.
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Certified Regulatory For financial services professionals whose primary
Compliance Manager function and expertise are in the application,
(CRCM) implementation, and maintenance of federal and state
regulatory requirements.
Certified Trust and For financial services professionals whose primary function
Financial Advisor and expertise are in the provision of fiduciary services
(CTFA) related to trusts, estates, guardianships, and individual
asset management accounts.
THE BANK AS AN ORGANIZATION
Most banks in the USA are commercial banks. Originally, commercial banks concentrated on
meeting the deposit and credit needs of businesses. Today, they serve both consumers and
businesses. Savings banks, savings & loan (S&L) associations, cooperative banks primarily
serve the saving and mortgage needs of middle-and-lower income consumers.
TYPICAL BANK STRUCTURE
A bank’s charter is granted either by the state in which it is organized, or by the federal
government through the Office of the Comptroller of the Currency for national commercial
banks, or the Office of Thrift Supervision for savings banks. A bank may be publicly owned or
closely held. A publicly owned company, a corporation, sells stock to the public; buyers
become shareholders. A closely held or privately held bank is owned by a limited number of
individuals or a family. Exhibit 1.3 illustrates how a typical commercial bank is organized.
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Exhibit 1.3 Typical Commercial Bank Organization
Board of Directors
Board Level Position Chief Executive Officer

(CEO)
General Counsel Chief Information

Officer (CIO)
Regulatory E-Commerce Information

Compliance Systems
Chief Operating Officer Chief Financial Officer

(COO) (CFO)
Branch Loans & Personal Trust Treasury Human

Operations Leases Banking Services Resources
Accounting Employee
Business Consumer Marketing
Benefits
Lending Lending
Charter
A document issued by a federal or state supervisory agency granting a bank the right to
do business.
Corporation
A business organization treated as a legal entity and owned by a group of shareholders
( (stockholders). The shareholders elect the directors, who serve as the governing body
amanaging the corporation’s affairs.
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If the bank is a corporation, shareholders elect a board of directors to be the governing body of the
corporation. Directors ultimately are responsible for the bank’s operations, compliance with the
law, and performance, including profitability; they can be held liable for their actions. Directors
appoint the bank’s executive officers. The board of directors usually functions through committees
such as audit, compliance, risk, credit, trusts, corporate governance and compensation committees.
Board of directors
The governing body of a corporation ultimately responsible for its financial

performance, consisting of individual directors elected by the shareholders.
The chairman of the board, often the bank’s chief executive officer, is responsible for the
policies that guide the bank. The bank’s president, typically the chief operating officer, is
responsible for applying those policies and supervising operations. Depending on the size and
scope of the bank, various departments or divisions may be created, and specific individuals made
responsible for certain functional areas.
While specific titles may vary, a typical bank has the following division of functions :
Departments Function
Accounting and Finance Organizes, records and reports all transactions that
represent the financial condition of the bank, including how
efficiently and profitably the bank is operated.
Audit and Loan Review Makes sure the bank is safe from risks, such as internal and
external fraud, and under performing loans.
Commercial or Business Delivers loans, deposit, and payment services to businesses

Banking
Compliance Ensures that all bank staff and departments are in

compliance with banking laws and the associated
regulations.
Consumer Banking Delivers loan, deposit, and payment services to individuals.
Funds Management Balances the bank’s needs for liquidity, safety and income.
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Human Resources Recruits, trains, and compensates bank staff.
Information Systems Delivers information to the bank and its customers;

Operations processes transactions by using mainframes, personal
computers, the Internet and other electronic media; and
keeps the necessary equipment functioning.
Insurance Provides insurance services for consumers and businesses.
International Banking Services the bank’s international consumer and business

needs, such as letters of credit and foreign exchange
services.
Internet Banking Provides banking services over the Internet or other

electronic channels.
Marketing and Sales Identifies potential customers, learns what they want, and
devises strategies for promoting and delivering the bank’s
products and services to its market area.
Trust Administers trusts and trust-related activities for individuals

and businesses.
Wealth Management Provides personalized service to high-net worth customers.
BANK AND FINANCIAL HOLDING COMPANIES
A bank may be organized as a bank holding company (BHC), which is a company that has control
over one or more banks or other BHCs. It does not have to be large to choose a BHC structure. Bank
holding companies may engage in financial activities through nonbank subsidiaries that banks
themselves are not allowed to engage in, such as securities brokerage and underwriting stocks and
bonds (See Exhibit 1.4)
Exhibit 1.4 Sample Bank Holding Company Activities
- Issue credit cards

- Provide trust services
- Sell general and portfolio investment advice, general economic information, and
bookkeeping and data processing services
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- Provide courier services
- Provide management consulting services
- Issue traveler’s checks and money orders
- Deal in bankers’ acceptances and broker gold bullion
- Provide services associated with mortgage banking, finance companies, factoring
companies, trust companies, collection agencies, and credit bureaus
- Service loans
- Act as insurance agents or brokers for credit extensions, and underwriting credit-
related life, accident, and health insurance
- Lease personal and real property and provide land escrow services
- Sponsor, organize, or control a closed-end investment company
- Act as a general insurance agent in towns with populations less than 5 000
- Provide investment services that promote the welfare of the community
- Sell property insurance through finance company subsidiaries
- Advise those seeking to buy commodities or foreign exchange

- Act as futures commission merchants
- Sell financial counseling, tax planning, and tax preparation services to consumers
- Underwrite and deal in revenue bonds, commercial paper, mortgage-backed
securities, and consumer-related receivables
- Underwrite and deal in corporate bonds and corporate stock, provided the revenue
from these activities does not exceed 25% of the subsidiary’s total revenue
- Provide financial advice to institutions and high-net worth individuals
- Offer combined investment advisory and securities brokerage services.
Banker Profile
Gloria Fuentes came from Mexico to the USA as a child with her family and settled
in Chicago, Illinois. There she eventually earned her M.B.A while working at a local
bank that served the Hispanic community. Starting out as a part-time teller, she
moved up through the ranks, boosting her career as a business banking officer by
earning her AIB Commercial Lending Banker diploma, and her Commercial
Lending Banker (CLB) certificate from the Institute of Certified Bankers. Gloria
stayed very connected to, and active in her community. A well-known Midwest
regional bank took notice of her skills as a businesswoman, banker, and community
leader and hired her. All her education and work experience paid off. Gloria
Fluentes, CLB, is now a senior vice president and manager of the Community
Relations division, and is active in bringing financial resources, and promoting
financial literacy, in conjunction with the American Bankers and Illinois Bankers
associations. in her city and state.
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BHCs are under the jurisdiction of the Federal Reserve for commercial banks and the Office
of Thrift Supervision for savings banks.
The Gramm-Leach-Bliley Act authorized financial holding companies (FHCs) so that banks
and other businesses could engage in a broad array of finance-related activities.
FHCs allow banks, insurance companies, brokerage firms, and securities dealers to affiliate
under common ownership, and offer customers a complete range of financial services.
BHCs and FHCs can own banks in more than one state, which facilitates interstate banking. A
BHC that meets certain eligibility requirements may apply for FHC status.
Situation
Jane started at the bank as a bank teller. She retires this year as senior vice president
in charge of human resources. In the interim, she received an AIB General Banking
diploma, and a bachelor’s degree from a local college, paid for by the bank’s
education reimbursement program. She regularly reads ABA’s Human Resources
Solutions on www.aba.com and attends conferences sponsored by ABA and her state
association, to stay current professionally.
Exhibit 1.5 Sample financial Holding Company Activities
All activities allowed for bank holding companies (See Exhibit 1.4), plus :
- Provide administrative and other services to mutual funds

- Own shares of a securities exchange
- Act as a certification authority for digital signatures
- Provide employment histories to third parties for use in making credit decisions, and
to depository institutions and affiliates for general business use
- Provide check-cashing and wire transmission services
- Offer notary public services, sell postage stamps, provide vehicle registration
services, and sell public transportation tickets and tokens, in connection with other bank services
- Offer real estate title abstracting
- Provide management consulting services on nonfinancial matters
- Operate a travel agency in connection with financial services
- Organize, sponsor, and manage a mutual fund, so long as the fund does not control
31
the entities chosen for investment, and the FHC owns no more than 25% of the
fund’s equity.
- With limitations, bring together buyers and sellers of any product or service, for
transactions that the parties themselves negotiate, such as hosting an electronic
marketplace on the FHC website.
- Lend, exchange, transfer, invest for others, or safeguard financial assets other than
money or securities.
- Provide any device or other instrumentality to transfer money or other financial services
- Arrange, effect, or facilitate financial transactions for third parties.
BANK PRODUCTS AND SERVICES
Banks provide individuals and businesses with a wide range of financial services, ranging
from traditional deposit and credit services, to nontraditional services, such as insurance sales,
securities brokerage, and electronic banking.
TRADITIONAL PRODUCTS AND SERVICES
In its simplest items, traditional banking involves accepting money from those who have it
(depositors), and loaning it to those who need it (borrowers). The difference between the
interest banks pay for deposit, and the interest they earn from loans, is the income they use to
fund their operations and generate a profit.
Why do depositors choose to save their money in a bank rather than in a coffee can buried in
the back yard ? Banks are a secure way for depositors to safeguard their savings. They also pay
depositors for the use of their money in the form of interest on savings accounts. Cusstomers
benefit from deposit accounts because they offer a safe, easy way to clear checks and pay bills.
How do loans customers benefit ? Loans significantly increase the buying power of
customers, and improve their quality of life by making it possible for them to make
large purchases.Without loans, many consumers would be unable to buy a house or a
car, or afford a college education for their children. Business customers use loans to
expand their markets, buy inventory and equipment, buy other companies, and
modernize their facilities.
Banks complement basic deposit and loan services with related products, services that
benefit individuals and businesses, while allowing banks to grow and be profitable.
The services include trusts, online bill payment, and safekeeping services :vaults etc.
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Did you know ?
The Federal Reserve reported that electronic payments surpassed check

payments for the first time in 2004. Between 2000 and 2003, check
payments declined annually on average by 4.3%. Electronic transactions
increased on average by 12.2%
Exhibit 1.6 A hypothetical financial holding company organizational chart
Financial Services Corporation

(A Bank Holding Company)
AIB National Bank and AIB Savings Bank

Trust Company
FSC Realty
FSC Mortgage Company
FSC Financial Services
FSC Insurance Company
NONTRADITIONAL PRODUCTS AND SERVICES
Since the FHC structure was authorized in 1999, banks may own companies that
engage in nonbanking activities. As a result, banks can provide securities
underwriting, offer a full range of insurance products, engage in merchant banking
and enter lines of business that were once prohibited or limited.
Banks have become financial services supermarkets, offering one-stop shopping for
customers to purchase, for example, both an automobile loan and automobile
insurance. Customers looking to invest money may choose banking products like
certificates of deposit and investment products like mutual funds.
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ELECTRONIC SERVICES
For most customers, convenience is the most important reason for maintaining a
relationship with a bank. With the advent of computer technology, financial services
have been revolutionized. Most banks now offer online banking. Customers can verify
account balances, pay bills, and apply for loans online. Now that electronic signatures
are recognized as legally valid, banks can also offer customers online loan closings.
MARKETING AND CROSS – SELLING SERVICES
One important challenge for bank marketing departments is making customers

aware of new products and services that will simplify, or enhance fulfillment of their
financial needs. Many customers still go to an insurance company for insurance, a
brokerage company for investments, and a bank for a checking account, not realizing
that they may be able to access all these services at the bank.
One strategy for broadening the purchase of bank products and services is cross-
selling. For example, if a customer wants a mortgage, a banker may cross-sell :
- a safe deposit box to store mortgage papers

- a checking account with automatic payment to ensure the mortgage is paid on time
- a homeowner’s policy through the insurance subsidiary
- a personal line of credit to help cover incidental expenses of new home ownership
Meeting customer needs is a major factor in bank profitability. Bankers who cross-sell
help customers meet their financial needs and the bank meet its financial objectives.
Cross selling
A marketing and sales practice whereby additional products and services

are offered to a current customer.
THE BANK AND THE COMMUNITY
Banks are a safe and convenient place for customers to take care of their financial
needs, but they are much more than mere service providers. When banks do their jobs
well, they improve the quality of life in a community, by helping families grow and
educate their children; similarly, they support the growth of the local economy by
helping businesses to prosper.
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FINANCIAL SERVICES
The banking industry’s response to the Community Reinvestment Act (CRA)

underscores the integral role banks play in making financial services available in their
communities, to help improve the lives of low-to-moderate-income consumers and
small business owners, and help local governments manage their cash flow.
In keeping up with CRA goals and objectives, banks are meeting neighborhood
credit and community development needs, and delivering financial services to an
increasingly diverse population. For example, many ATMs now display information in
as many as six languages.
Community Reinvestment Act
A federal law mandating that federal bank regulators regularly evaluate how
financial institutions help meet the credit needs of their communities, including low-
and-moderate-income sections of the community, and publicly rate the bank’s
performance.
CUSTOMER SERVICE
Bank customers seek knowledgeable and understanding bankers to help them assess their
financial needs, and suggest appropriate ways to fulfill them. Bankers – tellers, customer service
representatives, and branch managers – can respond to a college student’s need for an education
loan, a small-business owner’s need for a retirement savings plan, or a retiree’s need for estate
planning services. Customers’ lives are made easier by product and service solutions offered by
knowledgeable bankers who understand their customers’ financial needs.
CONTRIBUTION TO THE ECONOMY
Banks contribute to the economic well-being of their community and the nation in many ways.
Through the payment system, banks facilitate the flow of money throughout the USA and around
the world. Without the payment system, national and global economies could not function. Small-
business and agricultural loans are examples of how banks directly contribute to the economic
vitality of their local communities.
By providing jobs and generating profits for their shareholders, banks also contribute to a
vibrant local, regional, and national economy.
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Payment system
A communication system that permits the exchange of information necessary to carry out
transfers of funds. The payment system extends from the point of acceptance to the
paying bank.
COMMUNITY SUPPORT
Banks invest in countless charitable organizations through financial contributions and

volunteer support. They directly contribute to new construction or restoration through community
development foundations. Besides their employers providing capital, many bank employees are
active in community groups.
Did you know ?
National banks invested more than $16 billion in community redevelopment during
the past decade, using the public welfare investment authority known as Part 24.
These investments support urban revitalization, rural development, and job creation.
PARTNERSHIPS AND OUTSOURCING
Traditionally, banks relied on their employees and resources. This strategic approach is
changing, as the banking industry becomes more competitive, and operational technology
advances. To provide services in a more efficient, cost-effective manner, it is now common for
banks to partner with one or more other banks, or to outsource services to third-party vendors.
Outsourcing
The practice of turning over part, or all of a bank’s operations to a third-party

provider.
Banks often form alliances by offering joint lending programs and sharing management,
administration, and financing responsibilities. They may employ outside companies to service,
repair, maintain, and upgrade their computer hardware and software, thus ensuring that they
and their customers have access to the latest technology. To take advantage of opportunities in
insurance sales, many smaller banks undertake cooperative ventures with other banks. Banks
of all sizes hire consultants to provide in-house job training.
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While some banks may have relinquished their ability to customize, business alliances
supply significant cost savings and increased opportunities for customers. By reducing
operational costs through partnering and outsourcing, banks free up funds to make other
profitable investments to improve financial performance.
Since 1985 there has been a shift in the number of banks and branches. The number
of banks declined to approximately 7 600 in 2006, 45% fewer than 2 decades ago.
However, the number of branches increased from just over 80 000 to 93 700.
MERGERS AND ACQUISITIONS
For more than 2 decades, the number of banks in the USA has steadily declined. This
decline is not the result of bank failures, the banking industry historically has been very strong,
and in recent years banks have enjoyed continued profitability. Nor is the decline primarily
caused by customer migration to other financial service providers. Instead, the number of banks
is declining because of mergers and acquisitions.
Many banks combine forces (merge) or purchase other institutions (acquire) to form larger
banking companies. Through mergers and acquisitions, some banks eliminate duplication of
efforts and operations and thus become more profitable. They take advantage of economies of
scale by :
- reducing or eliminating departments that perform the same tasks

- closing branches that are in close proximity and combining their services in one location
- using data processing centers that support the larger volume of the combined banks
Banks also combine forces to enter new geographic areas and expand market share.
Through mergers and acquisitions, banks can extend their reach across state boundaries and
across the world.
Although the trend is toward large banks, small community banks still have a significant role
in the economy. They are well suited to relationship-based personal services, and financial
products that require extensive knowledge of the customer, such as lending to small businesses
and farms. Start up, de novo, banks are opening – some concentrating on traditional brick-and-
mortar branches, and others on growing their business through the Internet.
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de novo bank
A bank that has been in operation for 5 years or less. Commercial banks
operating for 5 years or less that convert to Federal Reserve membership
are subject to the de novo bank application and supervision standards.
FUTURE TRENDS
So what does the future hold for the banking industry ? Most analysts believe that
- deregulation will continue
- services will expand
- competition will intensify
- the cost of funds will pressure earnings
- technological innovations will multiply
- further geographic expansion will be necessary
- managing risk will continue to be standard operating procedure
The list of Fortune Magazine’s “100 Best Companies to work for” for
January 2006 contains several financial services companies, including
Umpqua Bank (34), Goldman Sachs (36), First Horizon National (46),
American Express (74), Capitol One Financial (84), and Synovus (98).
DEREGULATION
Although government regulation may increase in areas like national security and
bank safety and soundness – technological and otherwise – more deregulation will
occur in the area of financial services, offering more opportunities for new bank
products. Distinction between banks and other financial providers in terms of what
they offer, and where they are located will fade.
EXPANSION OF FINANCIAL SERVICES
Banks will continue to offer more premium and fee-based services. The fees
earned from these services will be equal to, or exceed interest income earned from
such products as loans and investments.
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INTENSITY OF COMPETITION
Nonbank competitors will make further forays into traditionally bank-dominated

businesses, such as payment systems, deposit gathering, and lending. For many users
of financial services, the distinctions between banks and their competitors will blur.
Banks must be determined to continue to be the one-stop, full-service provider of
financial and finance-related services for consumers and businesses.
MARGIN SQUEEZE
With intense competition comes the squeeze on the margins between the cost of
funds, including operations and the earnings on bank products and services, such as
loan interests and fees. As margins continue to narrow, there will need to be close
monitoring and constant adjustments. Earnings pressure will force banks to keep
cutting costs to provide shareholders with acceptable returns.
TECHNOLOGICAL ADVANCES
Automation – electronic delivery and maintenance of bank services and related

operations – will keep banks at the forefront of change. Shifts from employee to
technological solutions will continue. Automation and electronic services will expand
into more areas of banking. Even complex services like financial planning will find
more automated solutions to lower the cost of delivery where there is high volume.
GEOGRAPHIC EXPANSION
The push to increase volume will accompany technological advances as opportunities

for service at a distance keep developing. Banks will continue to expand their
markets. There will be more mergers and acquisitions. Small banks will merge with
other small banks to create holding companies. Larger US banks will expand well
beyond current boundaries and countries. Foreign banks will increase their activity in
the USA. Countries will become party to more treaties and agreements to standardize
accounting and commercial practices. Banking without borders will be the norm.
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SUMMARY
1. Bank employees are responsible for more than their specific job duties. They serve
bank customers in many capacities, are accountable to other employes, and uphold the
policies and procedures of the bank. They retain customer confidence by conducting
their duties ethically. Bank employees are professional in attitude, appearance, and
work habits. Individuals with these attributes will find that banking offers a wide
variety of career opportunities with great potential for advancement.
2. Most banks are corporations owned by shareholders. A bank may be closely held by
a limited number of individuals or a family or publicly held by investors. Shareholders
appoint the board of directors, and the board’s committees oversee management on
behalf of the shareholders. The chairman of the board, who often serves as the bank’s
chief executive officer, is the lead member of management. Typically, a bank is
organized into departments, each responsible for a specific area of operations – for
example, consumer banking, human resources, or marketing.
3. To better serve customers, banks continually seek ways to offer more and better
products and services, both traditional, such as deposit accounts and loans, and
nontraditional such as insurance and securities. Banks also take full advantage of new
opportunities made possible through the electronic delivery of financial services. As
with any business, profitability depends on a bank’s ability to meet customer needs.
Successful employees know both their bank’s products and their customers’ needs,
and carefully match them.
4. Banks benefit their communities in many ways, from offering the public a full range
of financial services to financing community development activities, and supporting
charitable activities.
5. To remain profitable, banks must operate efficiently and effectively. Mergers and
acquisitions, and strategic alliances with peers and vendors, allow banks to compete in
markets of all sizes.
6. Trends in banking include deregulation of restrictions on what services may be

offered; continued expansion of the financial services available to customers; new
technology for product delivery and operations; intensified competition in financial
services; narrowing margins between interest earnings and costs; and ever-wider
geographic expansion.
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SELF - CHECK AND REVIEW
1. If all bankers are expected to sell products and services as part of their job, why
is sales and business development a separate career path for bankers ?
2. Over several years, a bank has experienced losses, while other banks have been
profitable. Who ultimately is accountable for the bank’s poor financial
performance ?
3. What are nontraditional bank services, and why do banks want to provide them ?
4. How do banks contribute to their communities ?
5. What are the benefits of banking partner and outsourcing relationships ?
6. Why might a bank consider acquiring or merging with another bank ?
7. What are some trends in banking today ?
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LEARNING OBJECTIVES
After studying this chapter, you should be able to:
- describe the role of banking in the nation’s economy

- explain the evolution of the U.S. banking system
- discuss banking events and legislation in the 20th and early 21st centuries
- describe the structure and duties of the Federal Reserve System
- identify bank regulators and major bank regulations
INTRODUCTION
Understanding the role of banking in the economy and the forces behind change in
the U.S banking industry is important to understand how interactions between bankers
and consumers influence the nation’s business and social system. By passing banking-
related legislation, Congress helped lay the foundation for economic progress. The
events of the past have shaped the banking industry of today.
BANKING AND THE ECONOMY
Banks have an important role in the national economy because they manage money :
Banks safeguard the money of individuals, businesses and the government. As
financial intermediaries, banks transfer money from one party to another. They also
create money through the lending process; funding from loans is added to business
demand deposit balances and counted as currency in circulation. These new demand
deposit balances, less required reserve amounts, become the funds used for new loans
to consumers and businesses.
One important economic function of banks is to serve as a conduit for economic and
social policy. Through banks, the Federal Reserve System (often called the Fed) can
increase or decrease the money supply. As depositories for government accounts, such
as the Treasury Tax and Loan accounts, banks are a resource for the US government’s
economic policy. Banks also help achieve the government’s goals by complying with
laws and regulations that implement policy.
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Treasury Tax and Loan account (TT&L)
An account in which tax deposits may be made through any authorized

depository bank, where the deposits remain until the Treasury draws them
out, according to a predetermined schedule.
Thus, banks are influential and powerful in the nation’s economy. They fund loans,
offer financial services to consumers and businesses, provide access to the payment
system, create money, expand and contract the money supply; therefore, they are a
force for economic and social change. It was not always this way, however. The U.S
banking system as we know it, has evolved over 3 centuries and it is still evolving.
Healthy banks can be bulwarks against the propagation of financial

turmoil; in contrast, questions about the health of banks would raise
additional concerns during the course of a crisis.
U.S BANKING SYSTEM : 1700s – 1913
Banking in the 1700s and 1800s bore little resemblance to banking today. The
financial system then was unreliable. Depositors, mostly local businessmen, had no
assurance that money left in a bank would be there, when they wanted to withdraw it
– or that it would have the same value. For example, two merchants from different
areas of the country might have difficulty completing transactions because neither had
faith in the other’s bank.
Today, depositors know their money is safe in banks; for one thing, it is insured by
the Federal Deposit Insurance Corporation. Money transactions occur through checks,
credit cards, debit cards, wire transfers, and other electronic banking systems. When
today’s depositors take money to a bank, they can choose to open a checking or
savings account, or invest in a certificate of deposit, money market fund, or any
number of other products that meet their financial needs.
Passing a series of historic milestones, the U.S. banking system emerged from the
chaotic, unstructured, and unregulated days of the 1700s to the creation of the Federal
Reserve System, the foundation of the sound and safe banking system (Exhibit 2.1).
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Exhibit 2.1 Milestones in the Evolution of U.S. Banking
1st Bank of the US 2nd Bank of the US National Bank Act Federal Reserve Act
First attempt to form Second attempt to - Created national banks Successfully

a central bank failed, form a central bank - Created Office of the created a
due to opposition also failed, due to Comptroller of the central bank,
from other banks opposition from Currency the Federal
other banks - Introduced the national Reserve
banknote System (Fed)
- Established system of
required reserves
1791 1816 1863 1913
1700s-1800s Early Banking System

Unrelated and unregulated banks
THE EARLY BANKING SYSTEM
In the 1700s and 1800s, the banking system consisted of a large number of unrelated and
unregulated banks, with no common currency and no nationwide system for clearing checks.
The federal government did not issue currency as it does today. Anyone could own a bank;
there were no restrictions on bank ownership and the capital requirements were very low.
Every bank issued its own banknotes for currency.
Banknote
Currency issued by a bank promising to pay the amount of money designated on

its face, when the note is presented to the bank.
The main problem with the lack of standards was that the banknotes might not be redeemed for
gold or silver, when they were presented to the issuing bank. The bank might not have enough
gold or silver, or it might not even exist any longer. There were no standards for issuing notes
44
either, any bank could issue them in any form. The unrestricted issuance of banknotes led to
counterfeiting, printing of notes on nonexistent banks.
Counterfeit
(n) A document, currency, or coin that is forged or otherwise created to look real
and is intended to pass for real.
(v) The act of criminally forging a document, currency or coin with the intent to
profit from the act.
That the money supply could vary drastically was another concern. With every bank issuing its
own notes, the money supply could grow uncontrolled and fuel inflation. In fact, inflation was a
serious problem during the early history of banking in this country.
Inflation
A continuing increase in prices caused by too much money in the economy, and too
few goods available to be purchased.
FAILED ATTEMPTS TO FORM A CENTRAL BANK
As confidence in banks eroded, Congress approved a new central bank that had the direct
involvement of and backing from the federal government. Opened in Philadelphia in 1791, the
First Bank of the USA restored the public’s faith and confidence in banking. However, the
banks whose notes were redeemed for coin and currency issued by the new bank opposed it so
strongly that Congress refused to renew the charter. The bank closed in 1811.

During the Civil War, the Bureau of Engraving and Printing printed paper notes
in denominations of 1 cent, 5 cents, 25 cents, 50 cents, because people were
hoarding coins for their intrinsic value, creating a drastic shortage of coins in
circulation.
Without a central bank, many of the old banking problems recurred, including
poorly operated and undercapitalized banks, limited access to credit, and lack of faith
in the currency. In 1816 Congress responded by creating the Second Bank of the USA.
It functioned like the First Bank and had the added responsibility of acting as a
45
depository for the federal government. The Second Bank met the same fate as the
First Bank, for basically the same reasons. When the second bank’s 20-year charter
expired, Congress once again bowed to political pressure and refused to renew it.
Andrew Jackson, who was elected president in 1828, strongly opposed all forms of
centralized government, even a central bank.
The period from 1836 to 1863 may have been the darkest in U.S. banking history.
The need for a sound and trustworthy banking system had never been greater, yet
government was unresponsive. Geographic expansion, population growth, economic
prosperity in years preceding the Civil War created an ideal climate for commercial
banking. Yet many banks that opened then were undercapitalized, lacked prudent
management and ultimately failed, creating further mistrust of the banking system.
National Bank Act of 1863
In 1862 the US banking system and the economy in general were in serious trouble.
The country was engaged in civil war, government expenditures exceeded revenues
and inflation was high. Government intervention was needed to overhaul the banking
system. In 1863, Congress passed the National Currency Act, later renamed the
National Bank Act. The act, which was amended in 1864 and 1865, set up a new state
and federal banking system in the USA. It contained provisions that created the Office
of the Comptroller of the Currency (OCC) and national banks; introduced the national
banknote; and established a system of required reserves.
Office of the Comptroller of the Currency (OCC)
The National Bank Act created the Office of the Comptroller of the Currency (OCC)
as a bureau of the U.S. Department of the Treasury to charter, examine, and issue
regulations governing national banks. The OCC is headed by the Comptroller, who is
appointed by the President and approved by the Senate. The OCC’s objectives are to :
- ensure the safety and soundness of the national banking system

- foster competition by allowing banks to offer new products and services
- improve the efficiency and effectiveness of OCC supervision, which includes
reducing the regulatory burden on banks
- ensure fair and equal access to financial services for all Americans
National Banks
National banks were created to instill public confidence in the banking system. Like
state banks, national banks are owned privately but are chartered by the OCC, an
46
agency of the federal government. To be chartered, a national bank must be
adequately capitalized and competently managed. The addition of national bank
charters to the existing state bank charters created today’s dual banking system.
Dual banking system
The banking system in the USA today in which a bank may be chartered by
either the state or the federal government.
As an incentive for owners to convert to national banks, these were given the
authority to issue new currency, called national banknotes. To further encourage state
banks to convert their charters, Congress passed legislation imposing a 10% tax on
notes issued by state banks. To distinguish national from state banks, the former are
required to include the word “national” in their name – for example, Union National
Bank and Trust Company – or add the words “National Association” (abbreviated as
“N.A”) to their names, as in Liberty Bank, N.A.
National Banknotes
Only national banks were given the authority to issue national banknotes. With the
exception of the issuing bank’s name, the notes were a standard design that could be
recognized easily in different geographic regions, thus helping reduce counterfeiting
and facilitate commerce. National banks issuing notes were required to buy and
pledge treasury bonds as security for the notes. This requirement :
a/ raised money for the federal government

b/ gave the public confidence in the notes
c/ kept the the amount of notes each bank issued proportionate to its capital
Required Reserves
Depositors were reluctant to put money in banks, because there was no assurance that
banks would be able to meet their demands for withdrawals. The National Bank Act
addressed this problem, by establishing a system to protect depositors, in which every
national bank was required to keep reserves against its deposits & notes. The concept
behind the reserve requirement was that the bank would maintain either cash or
demand deposit balances at larger money center banks to meet depositor withdrawals.
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Reserve requirement
A mandate that each bank set aside a portion of its cash assets against its
outstanding deposits. Today reserve requirements are managed by the
Federal Reserve, as part of its monetary policy duties, and apply only to the
deposits in transaction accounts.
ESTABLISHING THE FEDERAL RESERVE SYSTEM
Although the National Bank Act went a long way toward restoring confidence in the
banking system, some weaknesses remained : an inadequate nationwide check
collection system, resulting in float and check fraud; an inflexible currency, and the
pyramid reserves. Those were addressed in the Federal Reserve Act of 1913.
Float
The dollar amount of deposited cash items (checks) that have been given
immediate provisional credit, but have not yet been collected from drawee
banks. Also called uncollected funds.
Federal Reserve Act, 1913
National check clearing system

- 12 Federal Reserve districts - reduced float - faster check collection
Decentralized reserves
- reserve requirements - bank reserves kept within each Federal Reserve district
- local control over banks
Federal Reserve notes

- notes backed by Federal Reserve assets of securities and gold
- basic form of U.S. currency today
Problems with the 1863 National Bank Act
Difficulties with check collection
The check collection system was slow, complicated, and obstructed by poor communication
systems. Checks could take weeks to travel coast to coast for posting and payment. Collection
and transportation costs were deducted from the face amount. Checks were returned unpaid
48
(sometimes months later) because accounts had closed, or funds were insufficient. When large
money center banks served as clearing centers, checks had to travel through a number of banks
before reaching their destination.
Inflexible currency
The money supply, which was tied to the level and value of government bonds, could not
expand with the economy. A national bank could only issue notes when it could buy bonds to
pledge as security. When the country expanded, the federal government received more tax
revenue; which allowed it to pay its bond debt, and reduced the ability of national banks to buy
bonds and issue more banknotes. The money supply contracted when it needed to expand to
support the needs of the economy.
Pyramiding of reserves
Having national banks hold their own reserves led to instability and bank panics. Smaller banks
used larger city banks as depositories for reserves. City banks, in turn, placed their own and
their depositors’ reserves with larger money center banks, such as those in New York City. The
result was a concentration of pyramided reserves in the money center banks. Money center
banks used deposited reserve funds to make short-term loans, usually to brokerage firms.
When smaller depositing banks needed to withdraw reserves to meet obligations, the money
center banks had to raise funds quickly by calling in loans. Payment delays led to bank panics.
Pyramided reserves
The reserve patterns of banks before the Federal Reserve System was authorized.
Smaller banks would place their reserves in larger banks, which would then place
their reserves and those of smaller banks in money center banks such as those in
New York City.
Federal Reserve Act of 1913 – Solutions
National Check Clearing Systems
The Federal Reserve accepts checks for clearing at its processing centers. These
centers route checks to other centers to eventually be presented to the paying banks,
those on which the checks are drawn. Federal Reserve Banks offer check-clearing,
collection, and return-item services to banks; they are allowed by law to charge fees
for the services.
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Federal Reserve Notes
Federal Reserve Banks issue Federal Reserve notes. As the notes do not have to be
backed by government securities, the limitations of the old national banknotes are
eliminated. Federal Reserve notes are today the basic form of U.S. currency; they are
backed by the assets of the Federal Reserve Banks, which include securities and gold.
Decentralized Reserves
The 12 Federal Reserve Districts also solved the problem of pyramiding reserves.
The Federal Reserve Board has the authority to set and change reserve requirements
as needed, within limits. Besides keeping their reserves as cash in their vaults, banks
can keep them in the Federal Reserve Bank for their district. Bank reserves are thus
spread across the country rather than centralized in one or a few locations.
Exhibit 2.2 Timeline of Banking Legislation in the 20th Century
1913 : Federal Reserve Act

1929 – 1941 : Great Depression
1933 : Banking Act of 1933 (includes Glass-Steagal Act)
1934 : Securities Exchange Act
1935 : Banking Act of 1935
1933 – 1935 : Result of Great Depression
1980 : Depository Institutions Deregulation and Monetary Control Act
1982 : Garn-Saint Germain Act
1982 – 1989 : Savings and Loan Crisis
1989 : Financial Institutions Reform, Recovery & Enforcement Act (FIRREA)
1991 : Federal Deposit Insurance Corporation Improvement Act (FDICIA)
1989 – 1991 : Result of Savings and Loan Crisis
1994 : Riegle-Neal Interstate Banking and Branching Efficiency Act
1999 : Gramm-Leach-Bliley Act (GLBA)
1913 1933 1934 1935 1980 1982 1989 1991 1994 1999
BANKING IN THE 20th CENTURY
At several points during the 20th century, Congress passed legislation in response to
events that threatened the U.S. banking system. Two pivotal events were the Great
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Depression and the Savings and Loan crisis. Laws responded to public demands for
consumer protections in banking transactions, changing financial market conditions,
and the need to offer new products and services to meet consumer needs (Exhibit 2.2)
THE GREAT DEPRESSION AND BANK PROTECTIONS
Creation of the Federal Reserve restored public confidence in the banking system
and gave a powerful boost to the economy. By the 1920s, national prosperity and
optimism were high, and the stock market soared. Investors were convinced that it
would continue to rise. No one wanted to be left out; people who did not have funds to
invest in the stock market simply borrowed from banks, paying for a percentage with
their own money and financing the rest – a practice called buying on margin. The
stock bought was used as collateral for the loans.
Buying on margin
Using borrowed funds, plus some equity, to buy assets such as stock.
On October 28, 1929 the stock market crashed, and the lives of most investors changed
dramatically. The day of the market crash, share value decreased by $14 billion. The
crash triggered the most severe economic depression this country has ever experienced.
The Great Depression lasted 12 years in the USA, during which unemployment reached
25%. Unable to collect on loans, many banks became bankrupt and closed their doors.
By 1933 over 8 300 commercial banks (about half the banks in the nation) had failed.
Customers lost about $7 billion in deposits. Many people lost their life savings. Once
again, the public lost faith in the banking system.
Risks of Buying on Margin
- Stock decreases in value

- Its value as collateral for a margin loan decreases
- Bank issues “margin call” to borrower
- Borrower must put up more money, or
- Bank sells (liquidates) the collateral
- Liquidation drives down the stock value more
- The market decline worsens
5 factors were identified as the main contributors to the blow to the national economy.
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1. Paying interest on demand deposits
Banks were allowed to pay interest on demand deposits. To attract deposit and fund
loans, banks continually increased the interest they paid. This growing interest
expense lowered bank earnings; in response, banks eased credit policies, so more
loans could be made to offset the interest expenses.
2. Underwriting Securities (Stock)
Banks were allowed to underwrite securities issues – they could buy entire issues of
new stock and place them on the market. A bank would guarantee the sale, and collect
a handling fee. A bank might also lend money to borrowers to buy stock that was
underwritten by the same bank. In theory, the bank could make money on both the
loan interest and the sale of the securities.
3. No margin requirements
Some of the more cautious banks required borrowers buying on margin to contribute
as much as 50% of their own money, but more controls were needed. If stock
purchasers had been required to put up more cash, fewer stocks would have been
purchased, and banks would not have been exposed to so much risk.
4. No depositor protection
When banks failed, depositors lost their money and had no recourse.
5. Illiquid Banks
The Federal Reserve’s stringent lending rules prevented it from lending troubled
banks enough from reserves to stay open.
THE NEW LAWS
In the 1930s, Congress enacted laws to reform the banking system and address the
factors believed to have contributed to the stock market crash. Three acts in particular
– the Banking Act of 1933; which contains sections now referred to as the Glass-
Steagall Act; the Securities Exchange Act of 1934; and the Banking Act of 1935 – had
a great influence on the banking business and, in some cases, still do.
Banking Act of 1933 (contains sections now referred to as the Glass-Steagal Act)
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- Prohibited banks from paying interest on demand deposits
- Raised the minimum capital requirements of national banks
- Prohibited banks that were members of the Federal Reserve System from
underwriting securities, and affiliating with organizations dealing in securities.
- Allowed the Federal Reserve Board to forbid member banks to use reserve credit
for speculative purposes
- Created the Federal Deposit Insurance Corporation (FDIC) to protect depositors at
FDIC-insured banks.
Securities Exchange Act of 1934 gave the Federal Reserve Authority to set
margin requirements. All loans made by banks that accepted securities as collateral
were subject to the margin requirements.
Banking Act of 1935 (also called the Federal Deposit Insurance Act of 1935)
amended the Banking Act of 1933 and authorized the FDIC to :
- set standards for operations at FDIC member banks

- examine member banks to ensure that they comply with the standards
- take action to reduce the possibility of troubled banks failing
- pay depositors if an insured bank fails
SOCIAL CHANGE AND CONSUMER PROTECTION
The Great Depression ended with the start of World War II, when manufacturing geared up,
and people returned to work to meet the demand for military equipment and supplies. Banking
reforms enacted by Congress helped keep the financial system sound and functioning.
Exhibit 2.3 Innovations in Banking in the 20th and 21st Centuries
1946 First drive-in banking service offered by Exchange National Bank of Chicago
1947 First lockbox installed by First Chicago Bank
1952 First bank credit card issued by Franklin National Bank, New York
1960 Magnetic ink character recognition (MICR) technology helps automate check
handling
1961 First negotiable certificate of deposit is offered by First National City Bank
(now Citibank) to selected corporate customers
1966 First truly paperless point-of-sale (POS) system instituted by Hempstead Bank
in Syosset, New York, in 32 retail establishments
1969 Automated teller machines (ATMs) introduced by several banks
1972 Automated Clearing House (ACH) payment mechanism established as an
electronic alternative to the traditional paper-based check collection system.
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1974 Telephone bill payment services initiated by the savings and loan industry
1980 Home banking infrastruture was first developed, laying the groundwork for
Internet banking
1994 Banks began to create a presence on the World Wide Web
2000 Electronic signatures gained legal validity for consumer transactions, breaking
down a barrier to e-commerce
2001 Electronic bill payment and presentment systems went online
2003 A new negotiable instrument, the “substitute check” was created by law to
support digital imaging of checks, and electronic payment processing.
The decades after the Great Depression were marked by restrictive regulations that limited
bank competitiveness. Nevertheless, there were several innovations in credit and investment
products to meet marketplace demands (See Exhibit 2.3). In the 1950s the credit card was
introduced. Early in the 1960s, the certificate of deposit (CD) was offered, and by the end of that
decade, automated teller machines (ATMs) appeared. launching a revolution in the delivery of
bank services.
Along with these innovations came social change. Before 1968 little if any federal law
protected consumers in their dealings with banks and other financial institutions. Consumer
protection was a state responsibility. Most states prohibited usurious interest rates, and set
ceiling rates on loans to consumers.
Usury The act of charging a higher rate of interest than is allowed by state law.
The 1968 Consumer Credit Protection Act, of which Title I is the Truth in Lending
Act, was a turning point. The act required all lenders to make meaningful disclosure of
their credit and leasing terms, so consumers could compare loan terms. Lenders were
required to give consumer borrowers specific written information on the cost of credit,
especially the two most important measures of the cost : the finance charge (amount
of money paid to obtain credit) and the annual percentage rate (APR – finance charge
expressed as an annual percentage of the funds borrowed). The APR makes it possible
to compare credit costs, regardless of the dollar amount, or the length of time over
which payments are made. Since 1968, Congress has amended the Truth in Lending
Act and other laws, so that customers receive adequate disclosure related to loan and
deposit products, and are protected against unfair and deceptive practices (Exhibit 2.4)
Exhibit 2.4 Consumer Protection Laws
Since the late 1960s, Congress has enacted a broad range of laws to protect consumers in their
financial transactions with banks. These laws include the :
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-Americans with Disabilities Act - Fair Debt Collection Practices Act
-Bankruptcy Abuse Prevention and Consumer Protection Act
-Women’s Business Ownership Act - Fair Housing Act
-Bank Sales of Insurance Act - Federal Trade Commission Improvement Act
-Community Reinvestment Act - Financial Privacy Act
-Consumer Leasing Act - Flood Disaster Protection Act
-Controlling the assault of non-solicited pornography & marketing Act (CAN-SPAM)
-Electronic Fund Transfer Act - Home Equity Loan Consumer Protection Act
-Equal Credit Opportunity Act - Home Mortgage Disclosure Act
-Expedited Fund Availability Act - Real Estate Settlement Procedures Act
-Fair, accurate credit transactions Act - Right to Financial Privacy Act
-Fair credit, charge card disclosure act -Telemarketing, consumer abuse protection Act
-Fair Credit Billing Act - Telephone Consumer Protection Act
-Fair Credit Reporting Act - Truth in Lending Act
-Truth in Savings Act - Service Members Civil Relief Act
BANK COMPETITION
Before the 1980s, banks were constrained in the types of products and services they could
offer. This hampered their ability to compete on an equal basis with other financial service
providers. For example, there were legal limits on the amount of interest banks could pay on
savings and time deposits. In 1961, in an attempt to sell a product for which banks could offer
competitive interest rates, New York banks introduced a $100 000 or greater certificate of
deposit (CD). Because of the size and terms, large-denomination CDs were exempt from interest
rate restrictions. But few customers could afford to invest $100 000 in a CD.
Meanwhile, brokerage firms introduced the money market mutual fund for consumers with less
than $100 000 to invest. For these customers, banks could offer only traditional savings accounts,
which paid considerably less than money market funds.
As interest rates increased in the mid-to-late 1970s, the gap between banks and their nonbank
competitors were offering for deposits grew. Many customers withdrew their money from
insured savings accounts in banks, and invested in higher-earning products with other financial
service providers, a process known as disintermediation. A major problem of disintermediation
for banks, and ultimately consumers, is that it decreases the supply of loanable funds.
Disintermediation The withdrawal of money from a financial institution and deposit

of the funds in another type of investment product in order to earn higher interest.
Intense competition was a new and costly experience for banks, which struggled to adjust.
State-chartered banks that voluntarily belonged to the Federal Reserve began to question
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whether their membership was worthwhile. Although as members they used Fed services, they
did not earn interest on the reserves the Fed held. Some national banks, required to be Fed
members, considered changing to state charters to free up their reserves, so that they could use
the funds to increase earnings.
The Competitors
Banking legislation enacted between 1993 and 1980 needed to be revised to respond to the
changing marketplace. For years banks competed among themselves. There was little other
competition for traditional banking services. Most bank deposits were demand deposits on which
the bank paid no interest. This all changed when nonbank institutions, not subject to the same
regulatory controls, entered the market. Today banks have, and are, major competitors in the
U.S. financial service market.
There are 8 778 banks, but there are 9 014 credit unions, 7 987 insurance companies,
7 713 mortgage & finance companies, 7 843 investment & securities brokerages today
More than 500 banks holding about 10% of the nation’s bank deposits withdrew from
membership in the Federal Reserve between 1970 and 1980. The loss of deposits
under Federal Reserve control threatened the effectiveness of the monetary policy.
Banks Publicly or privately owned corporations, chartered by the state or federal government,
which accept demand deposits, make loans, and provide other financial services. Most are
commercial banks, which make loans to businesses and individuals.
Credit unions Organizations that offer financial services to members, who by law must share a
common bond, such as teachers or federal employees. Because credit unions are exempt from
federal taxes, offer a range of services, and often occupy employer-provided facilities, they have
minimal expenses, and can offer products and services at reduced cost to their members.
Savings and loans associations Originally chartered to provide mortgage loans to

consumers. To encourage the flow of deposits into S&Ls, the Federal Reserve
allowed them to pay a higher interest rate on deposits than banks, until interest rate
ceilings were removed for banks in the 1980s. S&L may be stock companies or mutual
companies owned by depositors. For years, commercial banks preferred not to make
long-term mortgage loans to consumers, a decision that allowed the S&L industry to
grow without competition.
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Savings banks Member-owned or stock companies, many were formerly S&Ls
associations and operate the same way. They are insured by the FDIC. Many have
changed their charters and names to federal savings bank (FSB), primary to have the
word “bank” in their title. Others have dropped the word “savings” altogether to
distance themselves from S&Ls, to be recognized as offering more financial services.
Brokerage firms Firms that arrange contracts for customers to purchase stocks, bonds,
and mutual funds. Their investment products are not FDIC-insured, but the Securities
Investor Protection Corporation (SIPC) offers their customers some protection.
Finance companies Specialists in making small-to-medium-sized loans to consumers

or small businesses. The most common are personal finance and captive finance
companies. Personal finance companies attract the high-risk borrower who may have
a negative credit history. Captive finance companies, such as Ford Credit, are
subsidiaries of manufacturing companies, and help sell the company’s goods.
Insurance companies Sellers of risk protection. They accumulate funds received from
premiums, place them in relatively risk-free, long-term investments (mortgages etc).
Mutual funds Organized collections of investment funds. Their sole activity is

investing funds, usually in a diversified securities portfolio. Investors buy shares from
and sell them back to the fund, either directly or through a stock exchange.
Money market funds Portfolio investors, like mutual funds, but only in short-term
instruments, typically with a three-month average maturity. Investments include
certificates of deposit, commercial paper, banker’s acceptances and US Treasury bills.
A checking account option may allow investors to write checks, usually of $500 or
more, against these shares. Electronic transfers are also allowed.
Mortgage companies Firms that specialize in financing loans backed by real estate.
Check cashing firms Companies that cash checks for consumers for a fee. Many
“unbanked” consumers use these companies.
Leveling the playing field In 1980 the tight rein on banking powers began to relax, as
Congress enacted a series of laws that gave banks more freedom to compete.
Depository Institutions Deregulation and Monetary Control Act of 1980

This act redefined banking powers to allow banks and S&Ls to offer new products and
S&Ls and credit unions to offer commercial loans and trust services. Banks could
offer NOW accounts (Negotiable Order of Withdrawal accounts), which are interest-
bearing checking accounts, also known as “interest checking”.
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Over time, limitations on interest rates paid on deposits were phased out. FDIC coverage was
increased from $40 000 to $100 000. The act required all depository institutions (banks, S&Ls,
credit unions) to abide by Federal Reserve requirements for reserves on deposits. Today,
reserves are required for transaction account deposits.
NOW account - An interest-earning transaction account against which check-like

instruments (negotiable orders of withdrawal) may be drawn. This transaction account
is not a demand deposit account : the bank must reserve the right to require the
depositor to give 7 days advance notice before withdrawing funds.
Transaction account - A checking or similar account from which transfers can be

made to third parties. Demand-deposit accounts, negotiable order of withdrawal
(NOW) accounts, automatic transfer service (ATS) accounts, credit union share draft
accounts are examples of transaction accounts at banks and other depository
institutions.
Garn-Saint Germain Depository Institutions Act of 1982
This act allowed banks and other depository institutions to offer the money market deposit
account (MMDA), often called a “high interest savings account”, and the super NOW account.
Money market deposit account (MMDA)
A type of savings account created in 1982 that pays a market interest rate, and gives
account holders limited check-writing privileges.
Super NOW account
A transaction account that is interest-bearing, offers a higher interest rate than a NOW
account, but less than a money market deposit account. As a transaction account, it is
subject to reserve requirements, and has no limit on monthly transaction volume.
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
Full interstate banking across the country, regardless of prior federal law or state law, was
allowed. Affiliate banks within bank holding companies could function as branches for each
other. National banks could operate branches by acquiring banks in other states. However, state
law continued to control intrastate branching – the opening of branches within the state where
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the bank is headquartered – and could authorize state banks within their borders to open
branches across state lines.
But many bankers felt that Congress did not go far enough in deregulation to allow banks to
compete against brokerage firms and other providers. The Glass-Steagal Act still prohibited
banks from underwriting securities and paying interest on demand deposits.
Did you know ....... ? In 2006 the Bank Insurance Fund and the Savings
Association Insurance Fund were merged into the Deposit Insurance Fund.
Net Interest Income - The interest income on a bank’s portfolio of loans is $3.5
million. The interest paid on deposits to fund those loans is $1.5 million. What is
the bank’s net interest income ? $3.5 million - $1.5 million = $ 2 million
THE SAVINGS AND LOAN CRISIS
Not every law passed in the 1980s and 1990s was intended to break down regulatory
barriers. Banking legislation is often passed in reaction to a crisis. In the 1980s,
commercial banks suffered huge losses from deteriorating loan portfolios, and many
banks failed. Banks that had granted loans to less developed countries had to add
billions of dollars to their loan loss reserves, because full repayment became unlikely.
Banks with loans concentrated in real estate development and oil and gas industries
also experienced losses as these industries faltered. Real estate sales plummeted in
USA and overbuilding, financed largely by banks, resulted in unoccupied office space.
Because S&Ls were less regulated than banks, the consequences for them were
severe. From the late 1980s to mid-1992 many thrift institutions failed, the number of
S&Ls and savings banks declined by over 50%. The industry fallout became known as
the S&L crisis, because the Federal Savings and Loan Insurance Corporation (FSLIC)
did not have enough funds to pay depositors of failed associations.
Narrowing interest rate spreads and inexperience with new deposit and loan products
contributed to the S&L crisis. To keep or attract deposits, some S&Ls paid interest
above prevailing market rates. Others made loans in areas where they had limited
experience. S&L paid high interest rates on deposits, charged low fixed-interest rates
on long-term loans (typically mortgages). Thus, net interest income, the difference
between interest income and interest expense, was squeezed. Losses were inevitable.
Resulting Legislation
Congress enacted two laws in response to the 1980s S&L crisis :
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1/ Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA)
FIRREA reformed and consolidated the federal deposit insurance system. It disbanded
FSLIC – the FDIC would administer both the Bank Insurance Fund (BIF) and the
Savings Association Insurance Fund (SAIF). FIRREA also established the Office of
Thrift Supervision (OTS) to supervise savings associations and the Resolution Trust
Corporation (RTC) to close insolvent S&Ls, liquidate their assets, and where
necessary, pay off depositors.
2/ Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)
FDICIA set out to improve the FDIC, bank deposit insurance coverage, and bank
operations. It set new safety and soundness standards for operations and management,
such as capital standards for banks, to reduce risky lending and investment activities
and standards, for officer and director compensation. The act mandated that banks
assess their credit exposure to correspondent banks, and prohibited state-chartered
banks from engaging in activities not permitted for national banks.
On-site examinations and annual audits were now required. Bank accounting
standards were revised for both domestic and foreign-owned banks. The act curtailed
FDIC use of the “too big to fail” doctrine, whereby large banks were prevented from
failing, while small banks were allowed to fail. A $70 billion credit line for the FDIC
was established to replenish the depleted BIF – a credit line that was not used.
BANKING IN THE 21st CENTURY
Legal barriers erected after the Great Depression once prevented banks from offering
many types of financial products and services. But the barriers gradually were lowered by
legislaion, such as the Garn-Saint Germain Act, and by forward-looking regulation and
judicial decisions. For the 21st century, the prospects for the banking industry offer
opportunity, responsibility, and accountability.
OPPORTUNITY : GRAMM – LEACH – BLILEY ACT
Enacted in December 1999, the Gramm-Leach-Bliley Act (GLBA) has been hailed as
the most significant overhaul of financial services industry laws since the Great
Depression. GLBA (also known as the Financial Services Modernization Act of 1999)
repealed key provisions of the Banking Act (Glass-Steagall Act) of 1933, and gave banks
the tools they needed to compete. Banks, securities firms, and insurance companies can
enter each other’s businesses and affiliate with each other. As a result, banks may now
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offer a full complement of financial services, from loans and deposits to life insurance
and mutual funds.
GLBA is far-reaching legislation. It both opens the door for banks to enter new markets
and protects customer financial privacy. Activities authorized by GLBA are :
- lending, exchanging, transferring, and investing for others

- safeguarding money or securities for others
- underwriting and selling insurance
- investment or economic advisory services
- securitization
- securities underwriting and dealing
- “closely related to banking” activities approved for bank holding companies by the
Federal Reserve Board
- certain products offered overseas, such as travel agency services
- merchant banking and equity investment activities
Merchant banking The buying and selling by banks of unregistered securities in

companies.
Banker profile
David Shaw began his banking career as a telephone customer service

representative in Charlotte, North Carolina, right after graduating from state
college. Using the bank’s education benefits, he obtained his AIB Retail Branch
Management diploma in banking, and his AIB Sales Management certificate.
Given his demonstrated professional skills, he was promoted first to assistant
branch manager then to branch manager. Keeping his career goals always before
him, he continued his studies, partially financed by his bank. Now he has an
M.B.A and a new position as vice president of regional corporate sales. Only in
his mid-thirties and newly-married, David plans to stay with his bank, explore
training and education opportunities and further his career.
Banks may offer these products and services through holding company affiliates or
financial subsidiaries. In addition, the law authorizes the Federal Reserve Board and
the Treasury to use their regulatory powers to approve bank petitions to engage in
financial activities not listed in the law.
To facilitate engagement in new activities, the law created financial holding

companies (FHCs) and financial subsidiaries. Bank holding companies and other
financial services companies may elect FHC status. GLBA specifies the powers that
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may be exercised in each type of banking organization. For example, annuity sales
may be conducted by the bank, a bank subsidiary, or a holding company affiliate.
GLBA benefits community banks as well as large banks and FHCs. The law
removes restrictions and provides structural options and business opportunities, so that
banks may compete in the rapidly changing marketplace.
Situation
Justin opened checking & savings account when he graduated from college.
Recently he inherited money from his grandmother. Because he is satisfied
with the service at his bank, he deposits the money into his savings account
there. His banker suggests that he talk to one of the bank’s financial
counselors, who offers him a mutual fund. Justin inquires about the stock
market, and is surprised when the financial counselor can help with that,
too. He is surprised even more when he asks to withdraw money to pay his
car insurance bill, and is referred to the bank’s insurance agency for a
quote. Justin leaves thinking how convenient it is to get all of his financial
needs taken care of in one place – and with people he knows and trusts !
FINANCIAL PRIVACY AND PROTECTING THE NATION
Because it is so important to the U.S economy, banking is still one of the most highly
regulated industries. Within the last few years, banks have been assigned new
responsibilities in the areas of privacy, corporate governance, and anti-money
laundering.
Financial Privacy
Although GLBA provides business opportunities for banks, it also imposes

requirements, particularly the obligation to protect customer financial information.
Information is a major competitive advantage for banks. The increase in the types of
products and services banks may offer, brings with it an increase in the exchange of
consumer financial information. GLBA protects financial privacy, and assures
customers that their personal information will not be shared with third parties without
their permission. Banks must have a privacy policy and disclose it to their customers,
protect the security and confidentiality of customer information, not convey certain
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account information to third-party marketers, and allow customers to opt out of having
other information provided to third parties.
Protecting the privacy of customer information is critically important for bank compliance
and customer relations. Unauthorized disclosures to third parties harm customer
relationships, damaging a bank’s reputation in the community, and putting earnings and
profitability at risk.
USA PATRIOT Act
After the terrorist attacks of September 11, 2001, Congress acted to broaden the
intelligence-gathering powers of law enforcement agencies, in an effort to prevent future
attacks. In October 2001, the Uniting and Strengthening America by Providing Appropriate
Tools Required to Intercept and Obstruct Terrorism Act – better known as the USA
PATRIOT Act – was enacted. This act places responsibilities on financial institutions to
track and prevent the illegal transfer of funds by, for example :
- adopting and enforcing anti-money-laundering programs

- implementing customer identification programs
- reporting certain currency and other transactions to the government
- reporting suspicious activities, including possible terrorist financing schemes, to the
Government
Some of these requirements are not new. Banks have had to maintain anti-money-
laundering programs since 1987, and have been required to report suspicious activity since
the 1996 Bank Secrecy Act (BSA) was passed.
The FACT Act
The Fair and Accurate Credit Transaction Act of 2003 (FACT Act) contains provisions to
prevent identity theft, improve consumer access to their credit reports, enhance the
accuracy of credit reports, and limit the sharing of certain consumer information. The act
adds a new section to the Fair Credit Reporting Act by restricting the circumstances in
which consumer reporting agencies may furnish reports containing medical information
about consumers. It also prohibits creditors from obtaining or using a consumer’s medical
information, when determining eligibility or continued eligibility for credit.
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Identity theft - A crime involving the possession of identifying information not
lawfully issued for the possessor’s use, or the attempt to access the financial
resources of another person, through the use of illegally obtained identifying
information.
ACCOUNTABILITY : THE SARBANES – OXLEY ACT
In the late 1990s stock prices rose dramatically, in some cases inflated artificially through
accounting practices that exaggerated asset values or disguised losses. Some executives
and directors using insider knowledge, sold their stocks shortly before accounting
irregularities were disclosed and stock prices plummeted. These management irregularities
demonstrated weak corporate governance. Employees who invested their retirement
savings in company stock lost their savings. As investor confidence plunged, so did the
stock market.
Corporate governance The manner in which directors, management, and auditors

handle their responsibilities to shareholders.
To restore investor confidence in publicly held corporations, Congress passed the Sarbanes-
Oxley Act of 2001 (SOX). The law imposes new responsibilities on company executives, directors,
audit committees, and accounting firms. For example, a company’s chief executive and chief
financial officers must attest that reports filed with the Securities and Exchange Commission are
complete and accurate. Also, the board must have an audit committee to oversee company
accounting and financial reporting processes, and audits of financial statements.
SOX applies only to public companies, those that issue stock to the public. However, the federal
banking agencies then issued guidelines and regulations that apply SOX-like requirements to all
banks, whether publicly owned or closely held.
Exhibit 2.6 : Chronology of major banking legislation and events
1791-1811 First Bank of the USA

1811-1816 Bank failures increase
1816-1836 Second Bank of the USA
1836-1863 Chaos in the banking system
1863-1864 National Bank Act : Office of the Comptroller of the Currency established
1913 Federal Reserve Act (Federal Reserve System created)
1929-1941 Great Depression
1933 Banking Act, including Glass-Steagall Act (FDIC created)
1934 Securities Exchange Act
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1935 Banking Act (Federal Deposit Insurance Act)
1968 Truth in Lending Act
1970-1980 “Disintermediation” in the banking system
1980 Depository Institutions Deregulation and Monetary Control Act
1982 Garn-Saint Germain Depository Institutions Act
1988-1992 Savings and loan crisis
1989 Financial Institutions Reform, Recovery and Enforcement Act (FIRREA)
1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA)
1994 Riegle-Neal Interstate Banking and Branching Efficiency Act
1999 Gramm-Leach-Bliley Act (Financial Modernization Act)
2001-2003 Corporate accountability scandals
2001 Terrorist attack on the World Trade Center, New York City, 11.9.2001
2001 USA PATRIOT Act
2001 Sarbanes-Oxley Act (SOX)
2003 FACT Act
2005 Federal Deposit Insurance Reform Act (Reform Act)
2005 Federal Deposit Insurance Reform Conforming Amendmends Act
Exhibit 2.7 Structure of the Federal Reserve System
Board of Governors 12 Federal Reserve Banks

- Sets reserve requirements and approves - Propose discount rates
discount rates as part of monetary policy Exercises - Hold reserve balances for
- Supervises and regulates member banks general depositary institutions, lend
and bank holding companies supervision them at the discount window
- Establishes and administers protective - Establish and administer
regulations in consumer finance protective regulations in
- Oversees Federal Reserve banks consumer finance
Advise
- Consumer Advisory Council
- Federal Advisory Council Federal Open Market Committee
- Thrift Institution - Comprised of Board of Governors and 5 Federal Reserve
Advisory Council Bank Presidents
- Directs open market operations (buying and selling of U.S
government securities which are the primary instruments
of monetary policy.
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FEDERAL RESERVE SYSTEM
The Federal Reserve System, the Fed, is the central bank of the USA. It therefore
naturally has a central role in the banking system and the economy.
THE FED’S STRUCTURE
The Federal Reserve System consists of 12 Federal Reserve Districts. Each Federal
Reserve District contains a Federal Reserve Bank with a board of directors. The
Reserve Bank is owned by member banks in the district, which hold stock in the
Reserve Bank. However, member banks do not control Federal Reserve Banks the way
stockholders control a corporation. Although member banks elect six of the nine
directors of the local Reserve Bank, the other three directors are appointed by the Board
of Governors that controls the Federal Reserve System.
The Board of Governors consists of 7 members appointed for terms of 14 years by the
President of the USA and confirmed by the Senate. Every two years the term of one
governor expires. Once appointed, governors cannot be fired or reappointed, thus
insulating them from political pressure. No two members of the board may come from
the same Federal Reserve District. The President of the USA appoints one of the
governors as chairman & another as vice chairman for 4-year terms. These terms do not
coincide with that of the President, providing further insulation from political pressure.
Most Federal Reserve Banks also have branches. The structure of the 12 district banks
allows them to serve the needs of local banks, and to ensure local representation at the
national level. The local Reserve Banks also give the Board of Governors information
on the economy in their regions in the form of surveys, statistical reports, and tables of
financial data. Exhibit 2.7 summarizes the structure of the Federal Reserve System.
THE FED’s DUTIES
The duties of the Federal Reserve System fall into four general areas :
1. Conduct monetary and credit policy
The Fed conducts the nation’s monetary policy by influencing the cost and availability
of money and credit, for example by setting interest rates, in pursuit of full employment,
stable prices, and economic growth.
2. Supervise and regulate banks
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The Fed monitors the safety and soundness of the nation’s banking and financial
system, and protects the credit rights of consumers.
3. Maintain the stability of the financial system
The Fed provides liquidity to banks and seeks to contain systematic risk in financial
markets.
4. Provide financial services
The Fed provides certain financial services to the U.S. government, financial
institutions, and foreign official institutions; it has a major role in operating the U.S
payment system.
Control of the U.S. money supply is the primary duty of the Fed. It must ensure that
the money supply does not outpace the needs of the economy. The Fed can shape the
economic environment by taking specific actions to influence the flow of money and
credit. It has 3 tools it can use : reserve requirements, discount window operations, and
open market operations.
The Fed has the authority to issue regulations and guidelines that apply to both national
banks and state member banks. The regulations give the Fed the means to carry out
congressional policies, and control the flow of money and credit.
Discount window The lending facility of each regional Reserve Bank, through which
depository institutions may borrow short-term to meet temporary liquidity needs, and
cover reserve deficiencies (as an alternative, for example, to selling money market
securities).
Open market operations Purchases and sales of government and certain other securities
in the open market, through the Domestic Trading Desk at the Federal Reserve Bank of
New York, as directed by the Federal Open Market Committee, to influence the volume
of money and credit in the economy. Purchases inject reserves into the banking system,
and stimulate growth of money and credit; sales do the opposite.
FEDERAL RESERVE SERVICES
One of the original purposes of the Federal Reserve System was to provide basic
banking services to member banks, and until1980 it did so free of charge. Then
Congress mandated that the Fed provide services to nonmember banks as well, and
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allowed it to charge both members and nonmembers for services. Fed services that
carry a fee are special packaging, and transportation of coin and currency, check
processing, Fedwire, automatic clearing house, settlement and securities safekeeping.
Coin and currency
The Fed supplies banks with coin and currency to meet customer demands for deposit
withdrawals. It accepts shipments of coin and currency from banks, and ensures that
damaged currency is removed from circulation and replaced.
Check processing
The Fed offers banks image capture, check clearing, collection and return item services.
Fedwire
This payment service is an electronic transfer of funds and government securities

between financial institutions that have accounts at Federal Reserve banks.
Automated Clearing House (ACH)
The Fed is the primary provider of ACH services, which are paperless electronic debit
and credit transactions, such as direct deposit of payroll and social security checks, and
preauthorized payment of recurring insurance and utility bills. As with checks, the Fed
sorts ACH transactions, and presents them to the paying or receiving bank.
Settlement
When banks send checks to local clearing houses or use Fedwire, payment is made by
netting amounts presented and due to participating banks. Final postings are sent to the
Fed, which provides a settlement service (payment) through its accounts.
Services to the U.S. government
The Fed is the banker of the U.S government. For example, income tax refund checks
are drawn on the Fed. The inflow of federal government funds, such as those for
Treasury Tax and Loan accounts goes to a Fed account for later disbursement. As the
fiscal agent for the U.S. Treasury, the Fed is responsible for issuing and redeeming all
federal government obligations.
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Banks may make private investments in their communities. These private investments
“support critically needed public welfare initiatives, helping low-and-moderate income
communities and families. These investments are good for neighborhoods, good for
citizens, and good for business”.
REGULATORS AND REGULATIONS
The U.S. Banking industry is highly regulated. Each bank is regulated by at least one
agency and sometimes more; the agencies supervise banking activities, enforce
regulations, and issue guidelines.
BANK REGULATORS
The Federal Reserve System is one of 5 regulators with the authority to supervise bank
activities. The other agencies are the Office of the Comptroller of the Currency (OCC),
the Federal Deposit Insurance Corporation (FDIC), the Office of Thrift Supervision
(OTS). and state banking departments.
Federal Reserve (Fed)
The Fed is responsible for supervising and examining
- all bank holding companies, their nonbank subsidiaries, and their foreign subsidiaries
- state-chartered banks that are members of the Federal Reserve System and their
foreign branches and subsidiaries
- Edge Act and agreement corporations through which U.S banks conduct operations
abroad.
Edge Act Corporation Established under the Federal Reserve Act, a corporation that is
a national bank subsidiary for either foreign trade-related banking or foreign
investment.
Besides issuing regulations for member banks, the Fed rules on merger branching
applications of state-chartered member banks and activities of bank holding companies.
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Office of the Comptroller of the Currency (OCC)
A bureau of the Treasury Department, the OCC is responsible for chartering, examining
and supervising national banks. All applications for national bank charters, all requests
for opening new domestic or foreign branches or offering new services, and all mergers
or acquisitions involving national banks must have OCC approval. The agency issues
regulations governing bank investments, lending and other activities. It also supervises
Federal Reserve branches and agencies of foreign banks in the USA.
Federal Deposit Insurance Corporation (FDIC)
FDIC supervises and examines state-chartered commercial banks that are not Federal
Reserve System members and state-chartered savings associations. The agency also has
the authority to examine other FDIC-insured institutions for deposit insurance purposes.
National banks and state-chartered banks that choose to be members of the Fed must
belong to the FDIC. Other commercial banks may join it if they wish. Savings banks that
have been given the right to become members of the Fed also may join. The FDIC
promotes the safety and soundness of insured depositories by identifying, monitoring,
addressing risks to the insurance fund. The basic FDIC insurance amount is $100 000
per depositor per insured bank.
Office of Thrift Supervision (OTS)
All federally chartered and many state-chartered thrift institutions including savings
banks, S&Ls are regulated and examined by OTS, which is a bureau of the Treasury.
State Banking Departments
Banks that choose a state charter can choose whether to become members of the
Federal Reserve and the FDIC. Each state has its own banking department responsible
for chartering, supervising, and examining state-chartered banks within the state.
Applications for state charters are submitted to the banking department, and banks must
pass qualifying tests. If a proposed new bank desires membership in the Fed and FDIC,
its application must be approved by those agencies as well. State banking departments
also examine the branches and agencies of foreign banks operating in their state.
Exhibit 2.8 Categories of Federal Reserve Regulations
Regulation
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Monetary Policy
A Extensions of credit by Federal Reserve Banks

D Reserve requirements for depository institutions
T Credit by brokers and dealers
U Credit by banks and persons other than brokers or dealers for the purpose of
purchasing, or carrying margin stocks
X Credit to borrowers of securities
Bank Safety and Soundness
F Limitations on interbank liabilities

L Management of official interlocks
O Loans to executive officers, directors, and principal shareholders of member banks
Q Prohibition against payment of interest on demand deposits
W Transactions between banks and their affiliates
International Banking and Bank Holding Companies
K International banking operations

Y Bank holding companies and change in bank control
Federal Reserve Membership and Reserve Bank Procedures
EE Netting eligibility for financial institutions

H Membership of state banking institutions in the Federal Reserve System
I Issue and cancellation of Federal Reserve Bank capital stock
J Collection of checks and other items by the Federal Reserve Banks and funds
transfers through Fedwire
N Relations with foreign banks and bankers
S Reimbursement to financial institutions for providing financial records; record
keeping requirements for certain financial records
Consumer Protection
AA Unfair or deceptive acts or practices

B Equal credit opportunity
BB Community reinvestment
C Home mortgage disclosure
CC Availability of funds and collection of checks
DD Truth in Savings
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E Electronic fund transfer
FF Obtaining and using medical information in connection with credit
G Disclosure and reporting of Community Reinvestment Act related agreements
M Consumer leasing
P Privacy of consumer financing information
V Fair credit reporting
Z Truth in lending
BANK REGULATIONS
Banking laws and regulations protect the U.S. banking system, respond to changing
financial market conditions, and protect consumers (See Exhibit 2.8). When the U.S
Congress or a state legislature passes banking-related laws, the regulatory agencies
reporting to the excutive branch of government are directed to formulate regulations to
implement the laws. A regulation is more specific than the law, and contains more
explanatory material, such as procedures that banks can follow to ensure compliance. It
also has the force of law.
Regulation An official rule or set of rules having the force of law. Regulations are
issued by government agencies and are based on, and designed to implement, a law
enacted by legislature.
Often the Fed is given the job of writing regulations that apply to all banks, as in the
case of the Equal Credit Opportunity Act and FRS Regulation B. In some cases, an
agency writes regulations only for the banks it supervises.
When an agency writes a regulation, it first studies the history of the law to determine
the intent of Congress. Then it drafts the regulation, which is published in the Federal
Register for public comment. After the comment period passes, the agency takes the
comments into consideration and publishes a final rule.
Federal Register A daily publication of the federal government that contains, among
other material, proposed and final regulations adopted by federal agencies.
Final regulations published in the Federal Register are incorporated into (CFR) Code of
Federal Regulations. CFR codifies regulations by title and chapter numbers. Of the 50
titles, Title 12 applies to regulations issued by agencies that affect banks and banking.
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SUMMARY
1. The banking system in the USA has been evolving for more than 200 years. Major
changes in how banks are regulated are often reactions to crises. The industry has gone
from a completely decentralized and unregulated system in the 19th century, to one of
the most highly regulated sectors of the economy in the 21st century.
2. Early on the U.S. banking system, unstructured and unregulated, could not effectively
and fairly support the needs of a growing industrial nation. The two attempts to establish
a central banking system both failed. Then in 1863, Congress passed the National Act,
which created national banks, the OCC, national bank notes, and a system of reserves.
The act solved many of the problems plaguing the banking system, but not all. The
national banknote was an inflexible form of currency. There was no check collection
system, and reserves were concentrated in money center banks. Bank panics resulted.
3. The Federal Reserve Act of 1913 was passed to address weaknesses that remained
after the National Bank Act. The Federal Reserve Act established the Federal Reserve
System & by creating 12 Federal Reserve Districts, it solved the problems of pyramided
reserves and lack of an effective check collection system. The Federal Reserve note,
our basic currency today, solved the inflexible currency problem.
4. The economy’s rapid expansion after World War I led to some ill-advised investment
and banking practices. The stock market crash of 1929 that followed also contributed to
many bank failures, helped bring on the Great Depression. In 1933, Congress passed the
Banking Act, which contains the Glass-Steagall Act, and which placed significant
controls on banks. The act prohibited payment of interest on demand deposits, bank
underwriting of stocks, and bank affiliation with organizations dealing in securities.; it
also raised capital requirements, authorized the Fed to forbid use of reserve credit for
speculative purposes, and created the FDIC.
5. Before 1968 little if any federal law protected consumers in their dealings with banks
and other financial institutions. The 1968 Consumer Credit Protection Act, of which
Title I is the Truth in Lending Act, was a turning point. The act requires, among other
things, that lenders give consumers information about financial charges and the APR.
6. In 1980 an era of deregulation began. Congress passed the Depository Institutions

Deregulation and Monetary Control Act. The law phased out interest rate ceilings on
deposits, and allowed banks to compete more effectively with nonbank financial
services companies, by lifting some restrictions on banking activities, such as allowing
the NOW account, an interest-bearing checking account. The Garn-Saint-Germain Act
allowed banks to compete with mutual funds, and other sellers of investment products,
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by offering money market deposit accounts. Later the Riegle-Neal-Interstate Banking
and Branch Efficiency Act of 1994 allowed national banks to operate across state lines.
7. In the late 1980s such factors as narrowing interest rate spreads and inexperience
with the new deposit and loan products caused unprecedented losses to S&Ls and some
commercial banks. In passing FIRREA in 1989, Congress stepped in to avert significant
individual losses. FIRREA gave the FDIC greater administrative control over both bank
and savings association insurance funds. In 1991 FDICIA was passed; it required banks
to meet new safety and soundness standards.
8. The 21st century brings new opportunities and responsibilities. The Gramm-Leach-
Bliley Act provides opportunities for banks to offer other financial services, such as
investment and insurance products. At the same time, public concern over identity theft
and the privacy of financial information imposed new legal obligations on banks. The
terrorist attacks of September 2001, for example, led to the enactment of the USA
PATRIOT Act, which now requires banks to implement customer identification
programs, and report suspicious activities to federal government agencies.
9. The Federal Reserve has the authority to issue regulations and guidelines that apply
to both national banks and state member banks. The Fed controls the flow of money and
credit by using reserve requirements, discount window operations, and open-market
operations. The Fed also provides many basic banking services to member and
nonmember banks.
10. Bank regulators in addition to the Fed are the Office of the Comptroller of the
Currency, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision
and state banking departments.
11. When the US Congress or a state legislature passes banking-related laws, regulators
are directed to draft regulations to implement the laws. Proposed and final federal
regulations are published in the Federal Register, and final regulations are incorporated
into the Code of Federal Regulation.
SELF – CHECK AND REVIEW
1. What is the role of banks in the U.S. economy ?
2. What is inflation ?
3. Why is the National Bank Act of 1863 important ?
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4. What is meant by the dual banking system ? Does it still exist ?
5. What was the singular achievement of the Federal Reserve Act ?
6. What federal agency was created by the Banking Act of 1933 and why ?
7. What are the 4 basic duties of the Federal Reserve ?
8. What events contributed to bank failures in the late 1980s and early 1990s ?
9. What legislation stipulates that a bank customer’s financial records will be kept
private ? What are the basic privacy provisions ?
10. What five regulatory groups have the authority to supervise bank activities ?
LEARNING OBJECTIVES
After studying this chapter, you should be able to
- describe the functions and properties of money

- define the components and measures of the money supply
- discuss money supply and the flow of economic activity
- explain the role of banks in money creation
- discuss how the Federal Reserve (the Fed) effects monetary policy in the economy
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INTRODUCTION
If one were to ask anyone on the street “What is money ?”, the likely response
would be a look of incredulity and statements such as “Money is what I use to pay for
the things I want”. Or “Money is what’s in my bank account”.
Each of these answers is correct to some extent. Money is simply an accepted means
of making and receiving payments. Whether in currency and coin or checkable
deposits, money serves as a means to complete transactions between parties within
the economy, and as a measure of a nation’s economic health. Money is also the raw
material of banking.
THE EVOLUTION OF MONEY
In its simplest forms, money is anything that two parties to a transaction agree for
value. The recognition of money in a particular form, and as an official medium of
exchange evolved over many centuries. Even today, money continues to change its
physical form and delivery method. Money in its modern form consists of coin,
currency, and checkable deposits and their associated methods of transfer.
While barter may well have been the earliest form of exchange, it had some
problems even in the early days. For example, a potato-grower who wanted bananas
had to be where bananas were available to make an agreed-on exchange – and both
parties to the transaction had to need the others’ goods. An immediate form of
exchange eventually become necessary.
Money
(1) Legal tender

(2) Anything that serves as a generally accepted medium of exchange, a standard of
value, and a means for saving or storing purchasing power.
COIN AND CURRENCY
As early as 560 B.C, the Lydians of the Asia Minor Region that is now Turkey began
turning gold and silver into coins, because the metals were relatively scarce. Coins
used today evolved from pure gold and silver coins, which are so soft they wear out
quickly from daily use. When a less expensive and more readily available metal, such
as copper or nickel, is added to gold or silver, the coins are more durable.
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Before money could be accepted generally as a medium of exchange, coinage had
to be standardized. Government minted coins to particular specifications and stamped
them in a carefully protected process. Until the 16th century when machinery was
introduced, coining was a manual job.
Early coins were considered to have intrinsic value – they carried their value with
them, although historically governments were known to debate coins by lowering the
amount of precious metal they contained.
During the Middle Ages; countries, city-states, banks, and even individuals produced
their own coins. In time the profession of money-changers emerged to meet the need
to be able to exchange one kind of coin for another.
Representative Money
Gold and silversmiths were so careful with their assets that others began to leave their
valuables with them. The receipts issued by the gold and silvermiths for items left in
their possession were representative money, the presursors of modern currency. The
receipts represented claims on items of value held in a central depository, such as a
goldsmith’s locked box. Because the holder of representative money could redeem the
receipt with goldsmiths, silversmiths, or money changers (depositories) for commodity
money or bullion, people accepted their value.
Representative money Token coins or certificates that can be exchanged for a fixed
quantity of a commodity; such as gold, silver, or perhaps water, oil, or food.
Commodity money A medium of exchange whose value comes from the thing of which
it is made, such as a precious metal or salt.
In the next evolutionary step, receipts were exchanged instead of coins. After all they
were easier to use than bags of precious metals. The letters customers sent with the
receipts instructing the depositories to pay out assets to another person were probably
the first drafts.
In time, some money-changing operations (depositories) evolved into banks. As

with coins, however, too many entities were writing receipts. Time and again
governments had to intervene to further standardize paper currency.
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The Potential for Fraud
Early metal coins were easy to”clip” – bits were nicked off the edges and melted
down to make new coins. This not only created unauthorized coinage, but lessened the
intrinsic value of the coin. To make clipping obvious, governments began to ripple, or
mill, coin edges.
Because it was also easy to counterfeit banknotes, issuers began using increasingly
elaborate designs. Multicolored notes were invented in 1777, and two-sided notes
were introduced in 1826 to make forgery more difficult.
Even today there is potential for fraud, but governments are making it ever more
difficult to counterfeit currency.
FIAT MONEY
Fiat money, the third stage in the evolution of money, emerged in the 16th century in
Europe. Governments mandated the value of the money and backed it by the power of
law and the state (fiat means “let it be”). Today all coin and currency is fiat money.
Coin and currency cannot be exchanged for commodities such as precious metals.
Fiat money - Money that has little or no intrinsic value as a commodity, usually in the
form of tokens or pieces of paper. It is not redeemable for a commodity, but its value is
mandated by a government, and backed by the law and the power of the state.
Until 1971 the USA, like many industrial countries, operated first under a gold
standard, and then under a bimetallic standard, meaning the government guaranteed
that its paper money could be converted to gold, and later to gold or silver at a
predetermined weight ratio. Problems arose, however, when countries could not agree
on the value standards, and the supply of gold and silver rapidly diminished.
After World War II, the victorious allies met in Bretton Woods, New Hampshire
and established the fixed exchange rate system, commonly referred to as the Bretton
Woods system. Central banks agreed to buy and sell their country’s currency to
maintain a fixed exchange rate. This system collapsed in 1971 and was replaced by
the floating exchange rate system, also known as the managed float system. Exchange
rates now change in response to the market, although central banks may intervene to
limit the range of the float rates.
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The Dollar Coin
In 2000, the U.S. Mint issued a new gold-color dollar coin. The coin bears the image
of Sacagawea, the Native American woman who guided Lewis and Clark Expedition.
The coin was the 8th attempt by the federal government to put a dollar coin into
widespread circulation. Proponents of dollar coins contend that if the coins are used
instead of dollar bills, the government will save a substantial sum of money. Dollar bills
must be replaced continually, making them more expensive than dollar coins over time.
The public, however, prefers dollar bills to coins for daily transactions. Dollar coins
have been rejected as too bulky, too hard to distinguish from lower denomination coins,
and too heavy to carry in a pocketbook or wallet. Some evidence supports the idea that
dollar coins would be accepted if the government removed the dollar bill from
circulation. Several countries have put a high denomination coin in circulation, but only
by discontinuing the corresponding paper currency.
THE FUNCTIONS AND PROPERTIES OF MONEY
A great deal has been said over time about money and its function and properties.
Samuel Butler explained this very well in the 19th century when he wrote “ Money
indeed may be considered as the most universal and expressive of all languages. For
gold and silver coins are no more money when not in the actual process of being
voluntarily used in purchase ... Pounds, shillings, and pence are recognized covenanted
tokens, the outward and visible signs of an inward and spiritual purchasing power, but
till in actual use, they are only potential money .... It is the power and will to apply the
symbols that alone give life to money, and as long as they are in abeyance, then money
is in abeyance also; the coins may be safe in one’s pocket, but they are as dead as a log
till they begin to burn in it ......”
FUNCTIONS OF MONEY
Money has 3 basic functions : medium of exchange, unit of account, and store of
value.
Medium of exchange
Provided people are willing to accept an item in exchange for goods, services, or the
settlement of a debt, the item serves as money. In its simplest sense, money is nothing
more than a country’s generally accepted medium of exchange.
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For an item to work well as a medium of exchange, it must be acceptable as a
medium of exchange, easily portable, readily divisible without loss of value, stable
(able to keep its value), and relatively scarce.
Unit of account
Money is also the standard of measurement for the relative value, or worth, of goods
and services. It is a nation’s unit of account. To illustrate, a consumer knows that a
$450 television set is twice as expensive as a $225 set. With an after-tax income of
$750 a week, buying the more expensive set will cost the customer the pay he or she
receives for 3 days of work.
Money’s unit of account function is most obvious on a company’s balance sheet. A

bank loan officer examining the inventories, fixed assets, and raw materials listed on
the balance sheet of a potential business borrower, actually is assessing the value of
those items using money as the unit of account.
Unit of account A standard of measurement for the relative worth of goods and
services.
Store of value
Money also functions as a store of value. In this role, money allows us to hold value
and accumulate additional value by acquiring more money. That is, money does not
have to be spent immediately. By saving money, we can store up purchasing power
for future use.
This function is what distinguishes a money economy from a barter economy. In a

barter economy, the traders determine the value of the exchange, no assurance is
given that the item a person possesses will be accepted in trade. There is no assurance
that goods will preserve their quality and condition, if held for future exchange.
In a money economy, the coins and currency the government declares to be legal
tender – and thus acceptable for use as a medium of exchange – can be stored and
used as needed in a variety of transactions. Providing the economy is sound, money
will have value in exchange for goods. Holding money to build purchasing power is
what savings accounts and similar financial products are all about.
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Legal tender - Currency and coin declared by a government as acceptable payment for
goods and services, and for settling debts.
Economy A country’s system of production, distribution and consumption.
PROPERTIES OF MONEY
Money can only fulfill its basic functions if people are willing to use it. That means
money must be :
Acceptable as a medium of exchange
A farmer must be willing to take an amount of money for his tractor considered equal
to the value of the cow or two pigs that otherwise would be accepted in barter.
Divisible without loss of value
If you run up a grocery bill of $50 and give the cashier 3 twenties, the $10 you get in
return means you have lost no value, by advancing the total of $60 to cover the bill.
Relatively scarce and in controlled supply
Sand is not going to work as a medium of exchange in the Sahara (although water
might). Managing the money supply in the USA is one of the jobs of the Fed.
Stable in value
The amount of money in the system must be enough to keep the unit value relatively
stable. This is part of the Fed’s money management responsibilities in the USA.
Portable
Modern money makes it possible to carry value around without carrying bulky or
heavy items that are difficult to transport.
MONEY VERSUS BARTER ECONOMIES
Money economy An economy in which access to goods and services is based on the
capacity to pay in money.
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Barter economy An economy in which goods and services are accepted in exchange for
commodities (useful goods) based on the mutual needs of the parties to the transaction.
BARTER CLUBS The barter system has not completely vanished. Today swap clubs
exist in both planned community settings and on the Internet. In societies around the
world - from the poorest to the most developed economies – people have resorted to
barter during times of great economic stress and skyrocketing inflation.
Argentina’s barter clubs, which reemerged in the late 1990s, are an example.
Through a barter club, an Argentine can exchange a personal possession for barter
credits that look like play money, but can be exchanged for necessities such as food or
clothing. In 2001 professionals, including dentists, lawyers, journalists and others,
exchanged goods and services in about 1 200 Argentine barter clubs.
ALTERNATIVES TO CASH
Convenient as money is, to be useful in transactions sometimes it has to be converted

into even more useful forms than currency and cash. For example, when a telephone
bill must be paid to a distant office, most of us send a check, or pay via a credit card or
electronic transfer.
Checks
A check drawn on a checkable deposit account was, for many years, the most popular
alternative to cash. Until recently, U.S. customers, businesses, and government
entities used checks to make the vast majority of commercial and personal payments,
as measured by dollar volume. Billions of checks worth trillions of dollars are still
processed annually. Checkable deposits make up the core component of the nation’s
money supply.
Check A draft on an account in a bank that the owner of the account signs, to direct the
bank to pay a certain amount to the payee.
Electronic methods of transferring money have gained ground in recent years, but
checks still provide advantages to bank customers, including :
- the ability to use the same instrument to spend small or large amounts
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- deterrence of theft or counterfeiting because of the signature requirement
- the ability to stop payment after a transaction is made
- written proof of payment is the form of a canceled check
- a clear audit trail through the check collection process that allows for identification
of errors or improper transactions
- float, which is the extra use of account funds during the time required for checks to
be collected by recipients and their banks, although advances in technology have
steadily reduced the float time.
Credit Cards
Credit cards are used by most U.S. families. A credit card is not a strict medium of
exchange, rather, it is a deferred payment device that uses a line of credit (the card’s
maximum allowed balance) issued by a bank. Credit card users must pay their credit
card debt, usually with checkable deposits.
Credit card - A plastic card or its equivalent used by the holder to obtain money, goods,
or services; possibly using an open-end line of credit established by the card issuer.
Stored Value Cards
A stored value card is a prepaid card that contains a microchip that stores a
predetermined dollar value amount used for purchases or specific transactions, such as
telephone calls, tolls, public transit fares, or photocopying. As the card is used, the
amount is deducted from the balance until the funds are used up. Some cards can be
reloaded to replenish the balance. The following are other electronic deposit options
available to consumers :
Debit card A card with which goods or services may be purchased at the point of sale.
Payment is deducted automatically from the designated checking or savings account.
Electronic funds transfer (EFT) A method of transferring electronically from one bank
account directly to another. The transfer of funds is initiated through an electronic
terminal using a credit card, ATM, the Fed’s wire, or a POS (point of sale) mechanism.
Examples of Near-Monies
U.S. government bonds, corporate bonds, cash value of life insurance policies, money
market shares, pension funds, certificates of deposit, interest-bearing time deposits.
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Internet banking The banking service that uses the Internet is the delivery channel
through which customers conduct transactions with browser software residing on the
bank’s Internet server.
Exhibit 3.1 Components of the Money Supply

Amount *
(in billions of dollars)
M1 Currency and coin $ 749.9
Traveler’s checks 6.7
Demand deposits 300.0
Other checkable deposits on commercial banks 175.9
Other checkable deposits in thrift institutions 127.0
Total M1 $ 1 359.5
M2 M1
Savings deposits at commercial banks 2 933.0
Savings deposits at thrift institutions 813.5
Small denomination time deposits at commercial banks 776.0
Small denomination time deposits at thrift institutions 403.3
Retail money funds 826.7
Total non-M1 $ 5 752.5
Total M2 $ 7 112.0
Memorandum
Item
Institutional money funds ** $ 1339.4
* Data for February 2007, seasonally adjusted
** Institutional money funds are not part of non-M1 M2
THE MONEY SUPPLY AND THE ECONOMY
A nation’s money supply is the sum of all the funds individuals and businesses have
immediately available for spending in the domestic economy (See Exhibit 3.1 for the
components and amounts in February 2007). Careful management is necessary to help
the money supply from growing too fast. If the supply grows too fast, inflation results; if
it grows too slowly, a recession may result. In the USA, the Fed makes and applies
monetary policy to regulate the money supply.
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Money supply (Money stock) The sum of all the funds individuals and businesses have
immediately available for transactions and investment in the domestic economy.
Recession A period of slower economic activity defined by economists at two or more

consecutive quarters of falling gross domestic product (GDP) and rising unemployment.
The money supply is not synonymous with the amount of coin, currency, and checkable
deposits in the economy, because spending decisions are not based solely on how much
of these money items are held. In fact, most of the public’s financial wealth is not held
in cash but in near-monies, which are liquid noncash items that have acceptable
standards of value, and can be converted quickly to cash.
Economists have trouble predicting spending behavior, because they are not sure
which assets consumers prefer for long-term savings, and the extent to which near-
money assets influence spending decisions. Hybrid accounts, such as money market
funds that can be assessed by a limited number of checks, add another complication,
as does the fact that consumers and business people often move assets around to take
advantage of interest-earning opportunities.
HOW THE MONEY SUPPLY IS MEASURED
The Fed uses a variety of money-supply measures to predict and control the pace
and direction of U.S. economic activiy. The most important of these are M1 and M2.
The central bank is also a factor in the measure of debt.
M1
M1 is the most common and narrowest measure of the money supply. It counts all
mediums of exchange and consists of :
- currency and coin outside the U.S. Treasury Department, Federal Reserve banks,
and commercial banks.
- traveler’s checks from nonbank issuers
- demand deposits in commercial banks – except those due to domestic or foreign
commercial banks, certain foreign official institutions, and the U.S government –
less cash items in the process of collection.
- other checkable deposits (OCDs) consisting of negotiable orders of withdrawal
(NOW) accounts, and automatic transfer service (ATS) accounts at depository
institutions, credit union share accounts, and demand deposits at thrift institutions.
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M2
M2 incorporates M1 and adds these near-monies:
- savings and money market accounts at banks and thrifts

- time deposits at depository institutions with minimums of less than $100 000, except
individual retirement accounts and Keogh accounts
- balances in retail money market mutual funds, less IRA and Keogh balances.
Note that neither of these measures counts money and near-monies held by banks or
the government. Banks hold reserves primarily to meet Fed requirements and liquidity
needs. The government holds tax receipts and loan proceeds at thousands of banks and
thrift institutions, and disburses money from accounts at Federal Reserve banks. To
include these in the money supply would distort the link between money supply growth
and economic activity, because funds held by banks and the government are not used
for immediate spending. Accounts kept in U.S banks by foreign commercial banks and
governments also are not measured, because the funds generally are not used in
domestic transactions.
Debt Measure
The debt measure used by the Fed to get supplementary insight into potential
customer and business spending behavior primarily consists of :
- debt instruments issued by federal, state, and local governments

- private debt, including corporate bonds, commercial and residential mortgages,
loans made by banks to individuals and businesses, and commercial paper.
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Exhibit 3.2 The Circular Flow of Economic Activity
Income :rent, profits

wages, interest
Money creation
Factors of production :
land, labor, capital,
entrepreneurship
Lending
Gross Domestic
Consumer
Product GDP Financial Commercial Monetary
Institution Banks policy
Economy’s Business
spending Federal
sectors Taxes Financial
Reserve
Government intermediaries
Brokers and
Dealers
Production : Goods Saving

and Services
Spending : consumption
investment, govern. spending
Gross Domestic Product GDP = C + I + G + Xm
C = personal consumption spending I = gross private domestic investment

G = total government spending Xm = net exports (exports less imports)
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THE FLOW OF ECONOMIC ACTIVITY
“Money is a singular thing. It ranks with love as man’s greatest source of joy .... and with death
as his greatest source of anxiety. Over all history, it has oppresed nearly all people in one of 2
ways : either it has been abundant and very unreliable, or reliable and very scarce”.
This quote by John Kenneth Galbraith sums up the connection of money to a country’s
economy and the lives of its people. To paraphrase the citizen on the street “Money makes the
economy go round”. A money economy expedites the production and consumption of goods
and services, using money as a measurement to gauge the economy’s health and growth.
The most basic measure of an economy’s size and performance is its gross domestic product
(GDP), which represents the total value of new goods and services produced within a country
for a given period. GDP reflects the interaction of consumer, business, government spending.
These sectors supply each other with factors of production in the form of land labor, capital,
entrepreneurial talent. In turn they receive wages, rent, interest, profits; for the government,
taxes. These forms of income are spent to buy the goods and services they help produce.
Factors in Gross Domestic Product (GDP)
Production = Total dollar value of all new goods and services

Income = Total income received by consumers, businesses, and governments
Spending = Total money spent by consumers, businesses, and governments
Because we live in a global economy, GDP is also adjusted by the net flow of money in imports
and exports. Total spending on domestic goods is reduced by the amounts spent on imports, and
increased by the amounts foreigners spend on the country’s exports. The net effect is the
difference between the value of imports and exports.
Consumers, businesses, and governments have different motivations for spending, saving,
and borrowing. Consumer spending depends on the wants and needs of individuals and
families, such as food, health, and education. Business spending is directed toward making a
profit, for example, by investing in more employees and training them, or replacing old
machines with ones that are more efficient. Governments have a variety of social and other
public objectives, such as defense and public safety.
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The roles of Savings and Lending
Savings consist of income not used to buy goods and services. Savings represent a leakage
from the circular flow of economic activity (See Exhibit 3.2 on the previous page) because
saved funds could have been used to buy goods and services or generate immediate income.
If savings were actually kept out of circulation, the economic consequences could be
devastating. If goods are not bought, producers might cut back production and lay off workers,
who, now unemployed, would spend less, so even fewer goods would be bought causing the
economy to spiral down into recession. Recessions end when hoarded savings are put into
circulation.
On the other hand, when sales decline, producers might sell their product inventory by
cutting prices. Lower prices and a smaller money supply may absorb all available goods and
services, and keep the economy in balance. Wages, rents, and interests, however, are also
prices, and the people who receive them usually are not willing to cut them. So while the
principle is sound, tightening up the economy as a whole might not be productive.
In fact, savings usually are not kept, but deposited in financial institutions. These financial
intermediaries, especially commercial banks, pump the savings back into the flow of the
economy by lending to consumers, businesses, and governments. Savings, passed on through
lending, may be used by businesses to take on long-term projects, that help build the economy.
Loans enable individuals, businesses, and governments to spend more on capital expenditures
such as houses, raw materials, and roads than their current incomes normally would allow.
The vast pool of loanable funds in the USA has helped keep the country’s economy strong.
Because each year the nation’s financial institutions extend more new credit than is repaid; the
total amount of credit outstanding increases every year.
Measures of Economic Activity
The U.S. Department of Commerce tracks the performance of the economy, using such
measures as real GDP, net domestic product, and disposable income, among others.
Real GDP
The total U.S. output of goods and services measured at market prices over a one-year period.
Total production using current prices (nominal GDP) is adjusted for inflation by selecting a
base year (currently 1996) against which prices for the current year are compared.
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Net domestic product
The country’s total output of goods and services, less the amount of capital consumed to
produce them. It is the result of subtracting depreciation (wear and tear) on capital goods used
in production from real GDP.
Disposable personal income
A measure of the amount of income people have available after they pay taxes, about 96% of
which is actually spent (consumption). The rest is saved.
BANKS AND MONEY CREATION
Commercial banks, savings and loans, credit unions, insurance companies, pension plans, and
money market funds all function as financial intermediaries. Financial intermediaries take in
funds consumers are saving, and lend them to consumers who choose to borrow.
Commercial banks for a long time were the largest suppliers of loan funds to consumers and
businesses, but changes in the 1980s and 1990s brought new competition from nonbank
companies, such as American Express and General Electric. At the same time, corporations
began raising funds by selling their own commercial paper (short-term uncollateralized
promissory notes) directly to the public. Although savings banks and, increasingly, credit unions
are making business loans, commercial banks are still the main financial-institution source of
loans to businesses and thus, are central to the money creation function in the economy.
Financial intermediary A financial institution that facilitates the exchange of funds by taking in
deposits from savers, and then lending those funds to borrowers and investors.
Money creation The process by which banks use their reserves to make loans, thereby increasing
the amount of funds in checkable deposits and the money supply.
Duties of the Federal Reserve System

- conduct monetary and credit policy
- supervise and regulate banks
- keep the financial system stable
- provide financial services to banks and the federal government
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MONEY CREATION
Traditionally, banks differed from other financial intermediaries in that only banks could
“create” money, by making loans that generate new checkable deposits – the core medium of
exchange in the U.S. economy. Tbat is why the Fed primarily uses the nation’s banks to
implement monetary policy. Exhibit 3.3 illustrates the process of money creation using the
multiple deposit process.
To create money, a bank must have reserves in excess of the amount it needs to meet its
reserve requirement set by the Fed. These excess reserves can be funds on deposit at a Federal
Reserve bank, in a pass-through account at a correspondent bank, or vault cash. The more excess
reserves a bank has, the greater its potential for expanding earnings, because it can continue to
make new loans and investments. The fewer excess reserves a bank has, the closer its reserves
are to what it needs to remain liquid, and the less potential it has to expand earnings. Restricting
the proportion of a bank’s balance sheet that can be loaned is one tool a central bank such as the
Fed can use to control the money supply.
In theory, if a bank was not subject to reserve requirements, it could make new loans and
create new demand deposits using every dollar it held. When the proceeds of these new loans
were disbursed, and the loan funds were transferred through the check collection process,
however, the bank would lose a dollar in cash for every dollar it had created.
A bank creates money using the multiple deposit process, which involves the interplay of the
bank’s loan assets, deposit accounts, and required reserves. Using this process, the bank creates a
deposit amount that is greater than its initial reserve amount.
Exhibit 3.3 Banks and Multiple Deposit Creation
The following example illustrates the effect of a bank commercial loan on other banks as
newly created deposits move from bank to bank.
Assumptions
- All bank-created deposits stay in the banking system

- All newly created funds are held as checkable deposits
- Each bank creates loans equal to every available excess reserve dollar
I. Initial transaction
Bank One receives a cash deposit of $100 000 from a corporate customer. The Fed’s reserve
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requirement for transaction accounts is 10%, so the bank must hold $10 000 in reserves against
the deposit, making $90 000 available as excess reserves, which the bank lends.
The bank now has liabilities of $190 000, $100 000 for the original deposit and $90 000 for the
deposited loan amount; and assets of $190 000, $100 000 in cash ($10 000 required reserves and
$90 000 excess reserves) and $90 000 for the new loan.
Bank One (after the initial loan)
Assets Liabilities
Cash assets + $ 100 000* Checkable deposits + $ 100 000
New business loan + $ 90 000 Checkable deposit created for borrower + $ 90 000
* Required reserves $ 10 000
Excess reserves $ 90 000
II. Subsequent Transaction
The business customer uses the loan proceeds to purchase equipment, paying with a check
drawn on Bank One. The equipment company deposits the check in its account at Bank Two.
When the check clears, Bank One removes $ 90 000 as a deposit liability, and now has
$100 000 in assets and $100 000 in liabilities, which changes the composition of Bank One’s
assets to $10 000 in cash and $90 000 in loan assets.
Bank One (after check collection)
Assets Liabilities
Cash assets + $ 10 000 Checkable deposits + $ 100 000
Loan assets $ 90 000
III. Bank Two
$ 90 000 in deposits created by Bank One is now a deposit by the equipment company in its
account at Bank Two, causing Bank Two’s liabilities and assets to increase by $90 000. Bank
Two must keep 10% in reserve, but remaining $81 000 is excess reserves that can be loaned to
other customers who may deposit the amounts at another bank. In this way the multiple deposit
creation process continues. The following illustrates Bank Two’s balance sheet & transactions.
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Bank Two (after check collection)
Assets Liabilities
Cash assets + $ 90 000* Checkable deposits + 90 000
Excess reserves $ 81 000
Bank Two (after loan and check collection)
Assets Liabilities
Cash assets $ 9 000* Checkable deposits + 90 000
Loan assets $ 81 000
Excess reserves $ 0
THE FEDERAL RESERVE AND MONETARY POLICY
As the central bank of the USA, the Fed is responsible for conducting monetary and credit
policy, supervising and regulating banks, keeping the financial system stable, and providing
financial services. These duties are closely related. Certainly monetary policy can be applied
effectively only in a stable financial system. Stability is maintained, in part, by monitoring what
banks are doing. Furthermore, the Fed has a role in the payment system by processing
checkable deposit transactions for banks across the country.
Monetary policy The management of a nation’s money supply by a central bank, such as the
Federal Reserve, to ensure the availability of credit in quantities, and at interest rates consistent
with specific economic objectives.
Monetary policy sometimes is confused with fiscal policy. Fiscal policy refers only to how
governments manage their money through the budget process, which may indeed affect
monetary policy by, for example, reducing taxes or increasing spending on infrastructure such
as highways, both of which may stimulate the demand for goods and services. Exhibit 3.4
compares the methods the Fed uses to manage the money supply.
RESERVE REQUIREMENTS
As the institution responsible for maintaining the stability of the financial system, the Fed
tries to ensure that the deposits (money) created by the nation’s banks are neither too much nor
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too little for the needs of the economy. It does this by controlling the amount and cost of the
reserves banks have available to lend to their customers.
Fed requires banks to set aside a portion of their cash as vault cash, in a noninterest-bearing
reserve account at a Federal Reserve bank, or in a pass-through account at a correspondent
bank. By changing the reserve requirement – decreasing or increasing the amount of money a
bank has available to lend – the Fed influences the money supply in the economy.
Apart from the legal requirement to hold reserves, banks need to hold a percentage of their
assets as cash, or on deposit with other banks to maintain the liquidity necessary to meet
demands for cash withdrawals, and to pay the claims of other banks presenting depositors’
checks for collection. If banks did not set aside such reserves, they would soon find themselves
without the necessary liquidity to operate as depository institutions.
To build reserves, banks are free to compete for customers with each other, against other
financial intermediaries, and in other markets. The Fed only is concerned about the total
amount of reserves available, not about individual shares. To meet a reserve deficiency, banks
can market themselves to attract more deposits or borrow from another bank through federal
funds transactions.
Fed discount rate The rate the Fed charges on its loans to banks.
Fed funds rate The rate banks charge one another for overnight loans of reserve funds.
Federal funds (Fed funds) Funds immediately available to lend from reserve accounts at Federal
Reserve banks. These generally are one-day loans from one bank to another. A bank buys
(borrows) or sells (lends) federal funds.
Fed funds transactions, typically occurring overnight, adjust the reserves of the two transacting
banks on the Fed’s account books. The rate charged, known as Fed funds rate, is set by the
banks, not by the Fed. The Fed, however, announces the target rate and influences the rate by
increasing or decreasing reserve requirements and thus reserves availability. By doing so, the
Fed brings the Fed funds rate into alignment with its monetary policy goals.
DISCOUNT OPERATIONS
The Fed is the lender of last resort for banks that have short-term funding problems. Banks
are expected to turn to the Fed only when other alternatives are limited.
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The Fed also influences the economy using the discount rate, which is the rate the Fed
charges on its loans to banks. The rate is set by each of the 12 Federal Reserve banks, subject
to veto by the Board of Governors. To increase the money supply, the Fed might lower the
discount rate, thereby lowering the cost of funds to banks, and encouraging borrowing and,
thus, business growth and activity. To decrease the money supply, the Fed might raise the
discount rate, thereby increasing the cost of funds to banks to discourage borrowing, and slow
the growth of the money supply.
The Fed does not use the discount rate alone to control money supply. Instead, it keeps the
discount rate one percentage point above the Fed funds rate, and encourages banks to borrow
from each other using Fed funds transactions.
Exhibit 3.4 Fed Tools and Their Effects
Reserve Increase Rarely used because its effects can be too disruptive; decreases
requirements the money supply.
Decrease Stimulates the economy by increasing the supply of loanable
funds; rarely used.
Discount Increase Can have moderately fast effect on banks and economy
operations discount rate Borrowing can lead to a reduction in the money supply when
inflation is becoming a problem
Decrease Has opposite effect during economic slumps when the Fed wants
discount rate to expand business activity
Open market Purchase Immediate, powerful effect on the economy, increases money
operations securities supply available for purchases by creating the reserve accounts
of banks
Sell securities Tightens credit by reducing the money supply in times of rising
inflation
OPEN - MARKET OPERATIONS
The Fed’s most powerful monetary policy control is the open-market operations conducted by
the Federal Reserve Bank of New York for the Federal Open Market Committee (FOMC).
The Federal Open Market Committee (FOMC)
The FOMC consists of all 7 members of the Board of Governors and 5 Reserve Bank
Presidents. It meets 8 times a year, although its members consult each other more often. If
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economic or financial conditions warrant, the FOMC will meet or teleconference as needed.
After the meetings, a directive is given to the Federal Reserve Bank of New York to buy or sell
government securities in the open market through selected dealer firms. The Fed’s purchase or
sale of government securities immediately increases or decreases the money supply, and
affects the availability of short-term credit.
The Federal Reserve Bank of New York is the only district bank authorized to implement
open-market operations. Its trading desk buys and sells government securities as directed by
the FOMC, on behalf of the entire Federal Reserve System. It also plays a unique international
role, because it buys and sells foreign currencies in New York, when there is disorder in the
foreign exchange market, and also buys and sells U.S. government securities on behalf of
foreign central banks.
Effects of Open Market Operations
If the Fed decides to buy securities from banks, thereby increasing the amount of cash and
reserves on deposit with the Fed, banks have more reserves to lend in their communities, or in
the Fed funds market. This, in turn, causes interests rates to decline. As the money is lent, it
turns into new deposits that can be re-lent, multiplying the effect on credit in the economy. This
situation is more likely to happen when the Fed is concerned about deflation and recession.
If Fed decides to sell its securities, bank reserves will decline – the banks get the securities
and the Fed gets their reserves – so banks will not have as much to lend. When this happens,
the Fed funds rate, the prime rate, other bank lending rates rise. This is more likely to happen
when the Fed is concerned about inflation. The FOMC’s ability to influence the economy
through open-market operations is why it is so closely watched by the financial markets.
Sometimes Fed policy can conflict with bank goals. For example, loans are bank assets, but
when inflation is increasing, the Fed wants to restrain bank lending to hold down credit-induced
buying. In this situation, the Fed will drive up market interest rates, forcing banks to raise their
own prime and other lending rates. In this environment, banks find it hard to originate new
loans. Rising interest rates also generate paper losses on securities held in bank portfolios that
were bought when rates were lower.
On the other hand, in recessionary times when there is less demand for loans, the Fed may
provide banks with additional reserves they can use to lend and drop interest rates to stimulate
loan demand. Declining interest rates also increase the value of securities that were bought at
higher rates, which can be very helpful, considering securities tend to be a major component of
most banks’ assets.
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SUMMARY
1/ Money can be anything that 2 parties to a transaction agree has value. Over time, money has
taken many forms. In its modern form, money consists of coins, currency, and checkable
deposits. As money evolved, civilizations used commodity, representative, and fiat money.
2/ Money has 3 basic functions : medium of exchange, unit of account, and store of value.
Money can fulfill these functions only if it is acceptable as a medium of exchange, divisible
without loss of value, relatively scarce and in controlled supply, stable in value, and portable.
Economies also use alternatives to cash, such as checks, credit cards, and stored value cards.
3/ A nation’s money supply is the sum of all the funds individuals and businesses have
immediately available for spending in the domestic economy. In the USA, the Fed makes and
applies monetary policy to regulate the money supply, among other things. The Fed analyzes
M1 and M2, which are measures of components of the money supply. Debt measures are also
studied to determine spending trends.
4/ Unlike a barter economy, a money economy expedites the production and consumption of
goods and services. The most basic measure of an economy’s size and performance is its gross
domestic product (GDP) – the value of the country’s total production of goods and services for
a given period. GDP reflects the interaction of consumer, business, and government spending.
5/ Savings consist of income that is not used to buy goods and services. When savings are
deposited in banks, the money becomes available to be loaned by the banks to consumers and
businesses, who in turn use the funds to buy goods and services. Because savings in banks can
be loaned, they help keep the economy functioning. The U.S Department of Commerce tracks
the performance of the economy using such measures as real GDP, net domestic product, etc
6/ As financial intermediaries, banks are able to create money. When they make loans, new
checkable deposits are generated – the core medium of exchange in the U.S. economy. To
create money, banks must have excess reserves. Managing the amount of reserves that can be
loaned by applying reserve requirements is one way the Fed controls the money supply.
7/ As the country’s central bank, the Fed is responsible for conducting monetary and credit
policy, supervising and regulating banks, maintaining the stability of the financial system, and
providing financial services to banks and the federal government. The Fed implements
monetary policy 3 ways : setting reserve requirements, managing its discount operations, and
conducting open-market operations. The last is the most powerful tool. The 12-member Federal
Open-Market Committee (FOMC) meets at least 8 times a year to decide whether to purchase
or sell government securities in the open market, and to set the Fed funds target rate. The
Federal Reserve Bank of New York manages the trading of government securities – the open-
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market operations – on behalf of the FOMC, and also buys and sells foreign currencies when,
for example, there is disorder in the foreign exchange market.
1. How do the properties of money reinforce the basic functions of money ?

2. What is the difference between a money economy and a barter economy ?
3. If there were no reserve requirements, could banks create an infinite amount of demand
deposits ?
4. How does money flow in an economy ? 5. What is the difference between M1 and M2 ?
6. How does the Fed manage the money supply ?
7. Why does the Fed need to manage the money supply ?
CHAPTER 4 - DEPOSIT ACCOUNTS
LEARNING OBJECTIVES
After studying this chapter, you should be able to :
- describe common deposit accounts banks offer

- identify deposit-related services to customers
- describe types of account ownership
- explain requirements for opening deposit accounts
- describe banking regulations for deposit products and services
- discuss federal deposit insurance coverage
INTRODUCTION
Checking, savings, money market, and time deposit accounts are traditional “core” deposit
products banks offer customers. Banks use funds generated by deposits to stay liquid and to
make loans and investments. In turn, loans and investments generate income that enables
banks to pay interest on certain types of deposits. Along with deposit products, most banks also
feature services, such as banking on the Internet, to make it more convenient for customers to
manage their financial affairs.
Whether the owners of deposit accounts are consumers, businesses, or government entities,
account titling and identification is important. Bank regulations, policies, and procedures
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address legal concerns. Because the deposit function is important to customers and to the
economy, bank regulations address reserve requirements, electronic funds transfers, funds
availability, account disclosures – all of which affect a bank’s relationship with its depositors.
THE DEPOSIT FUNCTION
The deposit function is the basic banking activity of accepting customers’ checks, currency,
or other financial instruments for credit to their accounts. Without deposits, banks would not
have enough funds to lend, lending in turn brings in funds to allow banks to pay interest to
depositors (See Exhibit 4.1).
Millions of dollars are deposited in and withdrawn from banks each day. Consumers and
businesses still accept checks for making payments; the total dollar amount of checks deposited
is greater than the amount of coin and currency deposited. As technology improves, electronic
payment methods are rapidly becoming the methods of choice for customers. But in managing
the deposit function, banks are responsible for ensuring the safety of customer accounts and
transactions, however they are made.
Exhibit 4.1 : A Bank’s Relationship with Depositor and Borrower
lends $
DEPOSITOR  BANK  BORROWER
deposits $ pays interest * repays $ plus finance charges
* The bank pays interest on accounts such as savings, NOW, and MMDAs
Demand deposit accounts do not earn interest.
SAFETY
Banks are responsible for safeguarding customer deposits at all times, and ensuring that
funds are available for withdrawal. By law, banks must operate in a safe and sound manner.
Through their investment and lending policies, banks ensure prudent use of customer deposits.
Bank policies also establish practices to honor legitimate requests for withdrawals, and ensure
that creditworthy borrowers have access to bank loans. If an unauthorized withdrawal occurs on
a customer’s account, and proper steps are taken to notify the bank, the customer’s funds can
be protected.
Customer deposits are insured and protected up to federal deposit insurance limits. Deposit
insurance comes into play when a bank fails, and there are not enough funds to pay depositors.
The Federal Deposit Insurance Corporation (FDIC) manages the Federal Deposit Insurance
Fund (FDIF), which protects customer deposits.
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When insured banks merge, the deposits from the predecessor banks continue to be insured
separately for at least 6 months after the merger. This grace period gives depositors time to
restructure their accounts, if necessary.
CUSTOMER CONVENIENCE
Consumers value convenience. By maintaining free-standing branch offices and branches in

grocery and other retail stores, banks make it easy for customers to deposit money. Banks also
offer long banking hours, and make drive-up windows and automatic teller machines (ATMs)
available. ATMs are in fact one of the great advances in customer convenience. Through
linked ATM networks, customers can access their accounts for cash withdrawals worldwide.
Not only are ATM machines a convenience for customers, they also reduce transaction costs,
and allow banks to offer round-the-clock service.
Banks also deliver account services through other electronic means. The majority of banks
now offer services through the Internet from opening accounts to paying bills. Other payment
methods are electronic funds transfers (EFTs), such as direct deposits, and point-of-sale (POS)
transactions.
Point-of- sale (POS) A terminal used to transfer funds from a bank account to a retailer to pay
for purchases.
Demand deposit Funds that a customer may withdraw from a bank with no advance notice,
usually by writing a check or using an ATM.
DEPOSIT ACCOUNT PRODUCTS
Banks offer a wide variety of products and services to meet deposit needs, but before
considering deposit account products and services, it is important to understand the differences
between transaction, savings, and time deposit accounts.
TYPES OF DEPOSIT ACCOUNTS
Customers may deposit money in a checking, savings, or time deposit account. They make
checking account deposits, because they intend to withdraw funds soon to pay bills and meet
expenses – that is, engage in transactions. Checking, or transaction accounts, may be demand
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deposit, or interest-earning checking accounts, also known as negotiable order of withdrawal
(NOW) accounts. The funds customers put in savings and time deposit accounts are those they
do not need immediately; these accounts pay interest. In fact, they tend to pay a higher interest
rate than NOW accounts, as an incentive to attract depositors.
Demand deposit transaction accounts
Demand deposits are so named because the total amount on deposit is payable “on demand”
and can be converted into coin and currency, as soon as the deposited funds are collected. A
customer with a balance of $100 in a checking account can write a check for that amount, and
present it to a teller for an immediate $100 in cash. Demand deposits do not pay interest.
Interest-earning transaction accounts
Traditionally, checking accounts existed only at commercial banks as demand deposits. In

the late 20th century, however, thrift institutions, credit unions and brokerage firms went
competing aggressively with banks for checking accounts by introducing interest checking, and
credit unions offered share drafts, which are similar to checks.
Share draft A bill payment device offered by some credit unions. Members of a credit union can
write these check-like instruments against their savings share accounts.
With passage of the Depository Institutions Deregulation Act (1980), commercial banks were
able to offer negotiable order of withdrawal (NOW) accounts. Withdrawals are made using
check-like forms. Because NOW accounts earn interest, banks have the legal right to require a
seven-day notice before any withdrawal, though they rarely do.
Savings and time deposit accounts
Savings accounts differ from demand deposit transaction accounts, because technically they
cannot be withdrawn on demand. As with interest checking transaction accounts, banks can
require a seven-day notice of withdrawal. In practice, few do. Unlike interest checking
accounts, transfers are limited to six a month. Savings accounts, like checking accounts, have
no maturity date. Deposits and withdrawals can be made on any day.
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Time deposit accounts, such as certificates of deposit, have specific maturity dates, starting
at least 7 days from the date of deposit. Whenever a time deposit is withdrawn before maturity,
an interest penalty is imposed. Banks pay interest on both savings and time deposit accounts.
Ratio of transaction accounts to savings and time deposits
The ratio of transaction account deposits to savings and time deposits is important to banks for
2 reasons. First, a bank has reserve requirements for transaction accounts. Second, the turnover
rate for transaction account deposits is higher than for savings or time deposit accounts.
Every deposit accepted from a customer is a liability – not an asset – for the bank. The
deposit is an obligation that must be repaid at some future date. Deposits are the largest
percentage of liabilities on almost all bank balance sheets.
At the same time, as the bank’ raw material, these deposits are the primary source of funds
for banks to put to profitable use as loans and investments. Because time deposits with stated
maturities remain with the bank longer than demand deposits, these funds generally are used
for longer-term bank loans and investments. High-turnover demand deposit funds are put to
short-term use.
Liability
(1) An amount owned

(2) A source of financing, such as a deposit in a bank
(3) A legal obligation to make good loss or damage that results from an action or transaction.
COMMON DEPOSIT ACCOUNT PRODUCTS
Some of the more common products offered to consumers are various checking and savings
accounts and certificates of deposit.

40% of adult Americans say they have separate emergency savings funds. Of these, 52% save
automatically through regular transfers of funds from a checking to a savings account, and 31%
save automatically through direct payroll deposits into their savings accounts.
Checking account
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A transaction account that offers check-writing privileges. Depending on the account, banks
may require a minimum balance to avoid a service charge, and allow unlimited check-writing
privileges. Some accounts offer an ATM, check debit card, or both, so customers can make
withdrawals at an ATM, or payments at POS facilities. A demand deposit account earns no
interest. A NOW account earns interest and it may have a withdrawal notice requirement.
Some checking account types are marketed to select groups, such as seniors.
ATM debit card - A plastic access card that enables the cardholder to withdraw cash through an
ATM, and that in some retail locations can be used for point-of-sale transactions after a personal
identification number (PIN) is entered. The cost of the transaction is debited from the card
holder’s bank account.
Check debit card - A plastic access card that enables the cardholder to purchase goods or
services, or withdraw cash online through a point-of-sale terminal and offline upon signing a
receipt. The transaction cost is debited from the cardholder’s deposit account. The card, which
may be used for ATM transactions as well, may carry a VISA or Master Card logo.
Statement savings account
An account that pays interest on deposits periodically, often monthly or quarterly. Account
transfers are limited to six a month. A bank legally may require a notice of withdrawal.
Statements are rendered monthly when there is activity on the account. Withdrawals and
deposits may be transacted at the teller window, by mail, by telephone, or electronically
through the Internet.
Savings club A special purpose savings account used for end-of-year holiday purchases, to pay
off high credit card bills due in January, or to save for purposes like a vacation.
An account, first introduced by brokerage firms, that usually has a higher yield than a savings
account and limits monthly transfers to six, three by check and three by preauthorization.
Legally, a bank may require 7 days notice before a withdrawal.
Certificate of deposit (CD)
A time deposit with a fixed maturity, usually 7 days to 5 years, and a fixed interest rate tied to
the maturity and the purchase amount. Withdrawal before maturity incurs a penalty charge.
Retirement savings account
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An individual retirement account (IRA), Roth IRA, or simplified employer plan IRA (SEP-IRA)
that helps individuals and the self-employed save for retirement. Savers can make tax-
deductible deposits that earn tax-deferred interest.
Coverdell savings account (Education IRA)
An account that allows families to save for educational expenses by making tax-deductible
contributions that earn tax-deferred interest. Often referred to as a 529 plan.
Did you know .......... ?
Savings balances grow because of compound interest. For example, if you save $75 a month for
5 years and earn 5% interest, the $4 500 you contributed would grow to $5 1 222 because of
interest compounding.
Health savings account
A tax-deferred account. Contributions are tax-deductible annually up to 100% of the required

deductible of an individual’s high deductible insurance plan. Distributions are made according
to plan guidelines, normally involving a withdrawal request form of debit card, and are
excluded from an individual’s gross income as long as funds are used for defined medical care.
Some deposits products offered to businesses are :
Business checking account
A business transaction account through which other services are accessed, such as night
deposit, merchant services, and cash management services. Offers detailed statements to help
customers organize transaction activity. May be subject to a monthly service charge or a charge
for each check deposited and paid, unless a specified average daily balance is maintained.
Usually a demand deposit account.
Business savings account
An interest-earning account used by businesses to accumulate funds for anticipated bills, such
as quarterly tax payments.
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Concentration account
A central account for all deposits not invested. Used to gather deposits from other accounts, or
from other financial institutions, usually electronically. Used to fund disbursement accounts.
Disbursement account
Usually a zero-balance account funded by the concentration account, when payments must be
made. Any excess funds at the end of the day are transferred to the concentration account.
Certificate of deposit (CD)
Offers higher interest rates than a savings account. Terms range from 91 days to 10 years, with
the interest rate tied to term and amount. A penalty usually applies for withdrawals before
maturity. A negotiable CD generally requires a minimum $100 000 deposit, and can be short-
term, such as 7 days.
Like a consumer MMDA, the account usually pays higher interest than business savings
accounts, allows 6 transfers per month, and legally may require a seven-day notice of
withdrawal. Business-related banking services may be attached to the account.
Customer Service Tip : Establish Good Saving Habits
Pay yourself first
Determine in advance how much money you plan to keep on deposit each month. If you receive
a raise, increase the amount.
Use bank technology
Consider automatic payroll deductions, or automatic transfers from checking to savings. Arrange
to have a specific amount transferred to your savings account every pay period.
Pay bills on time and pay more than the minimum amount
Schedule a time every month to pay bills, and put them in the mail in time to get to the creditor
by the due date.
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Determine needs versus wants
Do you need to eat out every day for lunch ? By bringing your lunch to work a couple of days a
week, you can save hundreds of dollars a year.
Shop around
Be selective, get the best prices, services, convenient locations, and lowest fees for credit cards,
bank accounts, mortgages, and CDs.
Consider investments
For long-term goals, such as saving for a home or retirement; look into bonds, mutual funds, real
estate, and stocks.
Consult your local bank
Your banker is the best source of information about accounts and interest rates available.
DEPOSIT – RELATED SERVICES
Banks provide many services to support deposit accounts, such as facilitating deposits,
processing deposits once they are made, and giving customers access to their money and
account information.
OPTIONS FOR DEPOSITING FUNDS
Customers may make deposits in a number of different ways.
Automatic teller machine (ATM)
A convenient way to both make deposits and collect cash from an account, inquire about
balances, and transfer funds between accounts.
Teller window
Face-to-face interaction with tellers in bank branches. Some customers prefer this, so they can
obtain a receipt proving when the bank received the deposit.
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Night depository
A locked, secured safe into which the customer may place deposits. The customer is given a
key or card to access the night depository after the bank is closed. Deposits are processed at the
beginning of the next business day. Small businesses usually use this service.
Direct deposit
An electronic, banking service that allows depositors to have periodic payments – such as
paychecks, Social Security checks, regular dividend payments, and annuity or pension checks –
automatically credited to a specified deposit account. Direct deposits are processed through the
automatic clearing house (ACH) payment system.
Payroll card
An access card much like an ATM or debit card. Employers have banks set up accounts, or
subaccounts of a company’s payroll account, for employees. Instead of issuing paper checks, or
using direct deposit to employee accounts, employers have banks issue payroll card to
employees, who use the cards to withdraw funds at ATMs, make purchases at POS terminals.
Some payroll card services also offer convenience checks and electronic bill payment.
Automatic clearing house (ACH)
A clearing facility operated for the convenience of banks in a region, generally through the
regional Federal Reserve Bank. An ACH electronically processes interbank credits and debits.
Automatic transfer service (ATS)
A service that allows for automatic transfer of funds from, for example, a savings account to a
checking account, to cover checks and prevent overdrafts. By prior arrangement
(preauthorization), banks move funds from the savings to the checking account as needed.
Overdraft
A negative (minus) balance in a customer’s checking account resulting from the paying (posting)
of checks for an amount greater than the account’s available balance.
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Electronic funds transfer (EFT)
A service that allows funds to be transferred to and from deposit accounts electronically rather
than physically. EFTs can be handled by telephone or through the Internet.
Remote deposit capture
An electronic banking service that uses EFT and imaging technology. Checks received at
business locations are scanned to create an image or an ACH data transmission, which is then
transmitted in encrypted form over the Internet to the bank for deposit. A customer needs a
personal computer (PC), an Internet connection and a check scanner.
Wire transfer
An electronic transfer of funds, sometimes internally or from an account at one bank to one at
another. This service is often used to move large amounts of money.
Mailed deposit
An option when customers are away from home, or do not want to go to the bank or an ATM.
Customers complete deposit slips, endorse checks, and mail both to the bank.
Courier and armored car services
Convenient and secure deposit pickups for business customers, when large amounts of cash or
valuable securities are involved.
TYPES OF DEPOSITED ITEMS
Banks are responsible for collecting funds on most items deposited into accounts and for
making them available to customers. Banks act as agents for customers and, depending on the
type of item deposited, collect the funds. (See Exhibit 4.2)
Exhibit 4.2 Characteristics of Deposited Items
Cash items Noncash items
- Give customer immediate, provisional - Give customer delayed (deferred) credit

account credit
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- Create float (time lag between - Do not create float (account not credited until
account crediting and collection) collection is completed)
- May be payable on demand - May or may not be payable on demand
- Must not have documents attached - May have documents attached
- Must not carry special instructions or - Require special individualized handling, may carry
require special handling specific instructions
- Inexpensive : can be processed in bulk - Are more expensive to handle
- Payable in U.S. funds - May or may not be payable in U.S. funds
Example Examples
- Checks - Promissory notes
- Drafts with attached documents
- Clip coupons for Municipal Bonds
- Checkd drawn on banks outside the USA
Coin and currency
Coin and currency do not require collection. Businesses may use bank courier and armored
car services to deliver coin and currency to banks. Most customers deposit coin and currency to
their accounts, and the bank typically makes funds available that day or on the next business
day. There are expenses relating to these deposits : teller salaries for handling and processing-
cost of shipping excess cash to the Federal Reserve, fraud prevention, and security. Business
customers, such as large grocery stores (though not individuals or small businesses), may be
charged a fee for bank handling of coin and currency deposits.
Cash items
A cash item is, for example, a check in U.S. currency that flows through the collection
process without special handling. Banks make funds available from account deposits, according
to a federally regulated schedule.
Noncash items
Noncash items require special handling, they cannot be processed in bulk. A draft that cannot
be paid unless an auto title is attached, is an example of a noncash item. So is a foreign check
that must be converted in U.S. dollars. Upon receipt of noncash items, a teller enters them for
collection, or sends them to a special department for processing.
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ACCESSING FUNDS AND ACCOUNT INFORMATION
Customers have a variety of options for accessing funds and account information. They can
come into the branch, call their bank’s call center, and use the ATMs. Internet banking, debit
cards, and stored value cards such as payroll cards have become popular alternatives in writing
checks and in branch banking.
In recent years, Internet banking has grown rapidly, as more customers use their home or
office personal computers (PCs) to access personal and business account information, including
balances, transaction history, and statements. Often both consumer and business customers can
reconcile their accounts online, authorize fund transfers, buy certificates of deposit, open
deposit accounts, and apply for loans.
OWNERSHIP OF DEPOSIT ACCOUNTS
Ownership of the account determines what documentation the customer must present to open
an account. It also determines the type of account that may be opened and the account’s title,
both of which determine the rights, obligations, liabilities of the parties to the account. Exhibit
4.3 shows the two general types of deposit account ownership : consumer and business.
Exhibit 4.3 Account Ownership
Consumer Business
- Individual - Sole proprietorship - Partnership
- Joint - Corporate - Public funds
- Fiduciary - Unincorporated Organization
CONSUMER ACCOUNT OWNERSHIP
Types of consumer account ownership are individual, joint, and fiduciary.
Individual accounts
An individual account is opened for and owned by an individual. The individual is the sole
owner of the account, and no other person has any rights in it. When the customer dies, the
account normally becomes part of the customer’s estate. Sometimes a customer may want to
give someone else the authority to sign checks, or make other decisions for the account. This
can be accomplished through a power of attorney.
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Power of attorney A legal document that authorizes a person named as an agent (attorney-in-
fact) to act on behalf of another person (the principal).
Principal The person or company that appoints another (an agent) to act on his (her) behalf.
Powers of attorney vary depending on the wishes of the account owner (the principal). A
general power of attorney gives unlimited authority over the account to the person designated.
A special power of attorney limits the authority to a specific duty or function for a limited
period. For example, a customer may give someone a power of attorney for a checking account
so that bills can be paid, but not for a savings account or certificate of deposit. A power of
attorney ceases at the death of the person who grants it.
Joint accounts
A joint account is opened in the names of, and owned by, two or more depositors.
Establishing identification is just as important in opening joint accounts as it is in opening
individual accounts. Joint account holders should be present to sign the signature card. In most
circumstances, the account agreement holds each account holder responsible for the
transactions on a joint account, including overdrafts.
Joint accounts can be held either in joint tenancy with full right of survivorship, or as tenancy
in common.
Joint tenancy Tenancy-in-common
Bill Wiltshire or Peggy Wiltshire Bill Wiltshire and Peggy Wiltshire

Word “or” separates the names of the Word “and” separates the names of the account
account holders. holders
Only one signature is required on the Account holders must act together. Both signatures
check. Either account holder may make are required for withdrawal from the account.
deposits, write checks, make withdrawals,
transfer funds, access the account Requires more monitoring. Bank verifies that all
electronically, stop payment on checks, or account holders sign checks or withdrawal slips. If
close the account. checks are paid with only one signature, bank
could be liable to the account holders who did not
Full right of survivorship. sign.
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Fiduciary accounts
A fiduciary account is opened by a representative for the benefits of another person. Examples
are trust accounts, estate accounts, and guardianships.
Right of survivorship The right of surviving tenants to take full possession of specific assets,
such as account funds, upon the death of other tenants, without establishing an estate but subject
to state laws.
Fiduciary An individual, bank, or other party to whom specific property is turned over under
the terms of a contract, and who acts for the benefit of another party on a basis of trust and
confidence.
Did you know ......? Some banks allow “authorized signers” on accounts. These signers have the
authority to sign checks on behalf of the account owner. The account owner may revoke the
authorization at any time.
Trust account A simple trust, for example, is opened by a mother and father, “in trust for” a
minor child. When opening the account, the bank obtains identification from the
representatives (the parents) as it it were opening an account for an individual.
Estate account An account established for an estate of a decedent that requires specific
documentation, often a document issued by the Probate Court appointing an individual as the
administrator or executor of the estate.
Guardianship account An account set up by a court-appointed guardian to manage funds

intended for a ward, a minor, or an incapacitated person. A guardianship account requires
substantial documentation. Laws vary by state, but in general, a guardianship account may be
opened only with court documentation, and often withdrawals may be made only by a court
order. These accounts usually require special handling by experienced bank officers.
In all cases, the fiduciary account has a representative ( guardian ...) and a beneficiary (minor
child ....) or person for whose benefit the account is held. The accounts take many different
forms, and require different types of documentation depending on the fiduciary relationship.
BUSINESS ACCOUNT OWNERSHIP
Sole proprietorship
A sole proprietorship account may be opened up in the name of the proprietor (the person
owning and operating the business) or in a trade name. “Trading as” (t/a) or the phrase “doing
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business as” (d/b/a) may be used. For example, if Tabatha Thompson owned a business called
The Gift Shop, the account would read “Tabatha Thompson d/b/a The Gift Shop”.
When a proprietorship is operated under the individual’s own name, a bank requires
identification, references, and signature cards to open the account, just as in case of an
individual. Often there is no way to distinguish a sole proprietorship from the indidual who is
the owner. However, when any name other than the individual’s is used, the connection
between the owner and the fictitious trade name should be established legally. The proprietor
provides the bank with the legal registration form required by the state. This may be a business
certificate, a fictitious name registration, or a certificate of registration of trade name.
A sole proprietorship has the right to open an account, make deposits, stop payments, and
manage the account. Checks payable either to the owner or to the proprietorship may be
deposited to the account. The proprietor can authorize another individual as a signer on the
account, but this person would not have the same rights to the account as the owner.
Partnership
A partnership account may be opened under the names of the individual partners or under a
trade name. Partnerships are businesses operated by two or more individuals that are not
incorporated. Depending on the terms of the partnership agreement, any partner may be
empowered to act for the others : one partner’s actions are legally binding on the others. In
opening an account for a partnership, a bank requires it to submit a partnership resolution with
signatures from all partners authorized to act on behalf of the partnership. The bank also
obtains a copy of the partnership agreement, and if the partnership operates under a trade
name, a copy of the business certificate on file.
Partnership agreement A legal agreement stating the contributions each partner has made to the
business, the nature of the business, and the proportions in which each partner will share in
profits or losses.
Partnership resolution A document containing language certifying that the name of the
partnership is exactly the same as the one provided to the bank, and listing who is authorized to
write checks and sign for loans on behalf of the partnership.
Corporation
A corporate account is opened in the name of the corporation, which is the owner of the
account. The bank legally interacts with the corporation, not the stockholders, directors, or
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officers. A corporation is identified by its legal name, which usually must include
“Corporation”, “Incorporated”, or “Limited”, or an abbreviation of one of those.
A corporation – like an individual, sole proprietorship, and partnership – is a legal entity, but
the similarity ends there. The corporation cannot act independently; it must act through
representatives. Stockholders, who own the corporation, elect the board of directors. The board
of directors, which is the governing body of the corporation, is responsible for conducting the
corporation’s business. It establishes who can open and operate a bank account on behalf of the
corporation.
To verify authority to open an account, the bank requires the customer to submit a certified
corporate resolution, which is filed with the bank. The bank keeps on file the names, titles, and
signatures of persons who are authorized to transact business on the corporation’s behalf. This
file is updated with new signature cards, as new people are given authority, or a previous
authority is terminated.
Corporate resolution A document filed with a bank that defines the authority given to the
corporation’s officers, and specifies who may sign checks, borrow on behalf of the corporation,
and otherwise conduct business, and issue instructions to the bank.
Besides knowing who can transact business for the corporation, banks keep records on the
authority limits of each signer. The president, for example, may have unlimited authority, but
the vice president of finance may sign checks only up to a specific amount. Depending on the
resolution, it may be necessary for several people to sign checks for certain amounts. The
following is an example :
Individual Combined (any two)
Vice President $5 000 Comptroller $5 000 $ 10 000

Secretary $ 5 000
Unlike an individual or a partnership account, neither a corporate account nor the operation
of the corporation is affected by the death of a stockholder, officer, or director.
Government or ageny ownership
A public funds account is opened by a unit of federal, state, or local government to receive and
disburse funds on behalf of communities and citizens. The unit of government officially
appoints the banks with which it opens accounts. Federal, state, and local laws usually
prescribe the procedures for setting up public funds accounts.
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Documentation generally consists of signature cards listing authorized signers, and an
official letter or notice appointing the bank as a depository, which is typically issued by the
head of the government unit. By law, these accounts are secured by specific segregated assets
held by the bank; for federal agencies these are usually U.S. Treasury securities.
Unincorporated Organization
Banks are asked to open deposit accounts for all sorts of unincorporated organizations, such
as churches, soccer teams, class reunions, and charitable relief funds. Although these are not
businesses in the traditional sense, banks usually treat them as business accounts.
Signature cards are required when an account is opened for an unincorporated organization,
and so is a taxpayer identification number, even if the organization does not pay taxes, and is
not designated formally as a nonprofit organization under tax laws. Each situation dictates what
additional letters, forms, agreements, or special documents should be obtained. The bank’s
attorneys, compliance officers, and policy and procedures manual should be consulted when
establishing accounts for such organizations.
OPENING A DEPOSIT ACCOUNT
A customer must open an account before the bank can accept items for deposit. The account-
opening process entails much more than filling out forms. The bank :
- establishes the identity of the person opening the account

- determines that the person has the legal capacity to open the account
- ensures that the person is authorized to open the account
By opening an account, a bank enters into a contractual relationship with the account holder
and assumes risk. There is the risk that the customer will write checks for more than the amount
in the account. There is also the risk that deposited items will be returned. The same principle
applies no matter what kind of account is opened : know your customer !
ESTABLISHING IDENTITY
To protect against loss, a bank establishes the identity of the person opening the account.
Unfortunately, there is no completely foolproof way to verify identity. Forgers can counterfeit
driver’s licenses, auto registrations, credit cards, and other forms of identification. A passport is
often regarded as ideal identification, but not everyone has a passport, and passports are subject
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to fraud as well. Bankers must use good judgment and evaluate the identification that is offered,
according to the bank’s customer identification procedures.
Customer identification program
The USA PATRIOT Act introduced after the terrorist attacks of September 11, 2001 requires
financial service providers, including banks, to set up a customer identification program (CIP) for
new accounts. The intent was to stop terrorists from using the U.S. financial system to launder
money and finance crimes. A bank’s written CIP must incorporate reasonable procedures to :
- collect identifying information about individuals opening an account (name, address, DOB... )
- verify customer identification (Social Security or taxpayer identification number ......)
- maintain records of the information used to verify a customer’s identity
- determine if a customer appears on any government agency lists of suspected terrorists
The act also specifies minimum standards for the identification collected, its verification, and
record keeping.
EVALUATING CAPACITY AND AUTHORITY
Although they want to attract new business, banks must be selective in opening accounts. A
bank is not obligated to open an account if the potential customer fails to meet its requirements.
Capacity
Before opening an account, a bank determines that the person opening the account has the
legal capacity to do so. That means that the person or organization is recognized under the law as
a legal entity with the right to open an account.
Most people have the capacity to open accounts, but a person who is considered a minor or
incompetent normally does not. Although minors can have checking accounts, the accounts are
co-owned or otherwise guaranteed by a responsible adult. Organizations are also required to
provide proof that the corporation, partnership, or unincorporated organization exists.
Authority
The person opening the account is asked to prove authority to open and use the account.
Individual opening accounts in their own names need to prove their identity. Those opening
accounts on behalf of other individuals, estates, corporations, or partnerships must present
official documents that establish their authority to act for the other parties.
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The Federal Reserve Bulletin, which periodically publishes bank reserve requirements, defines
transaction accounts as follows :”Transaction accounts consist of demand deposits, NOW
accounts, share draft accounts, automatic transfer service accounts, and any other accounts or
deposits from which payments or transfers can be made. (Money market deposit accounts,
however, are not classified as transaction accounts)”.
DEPOSIT REGULATIONS
The federal government enacts laws to protect banks and the consumers and businesses that
establish deposit relationships with them. Federal bank regulators supervise and enforce these
laws. State banking authorities may supervise, enforce laws that define the deposit relationship.
When Congress passes a law, it delegates rule-making authority to a banking agency like the
Federal Reserve. Examples of regulations that apply to deposit functions are FRS Regulation D,
Reserve Requirements for Depository Institutions; FRS Regulation E, which implements the
Electronic Fund Transfer Act; FRS Regulation CC, which implements the Expedited Funds
Availability Act; and FRS Regulations DD, which implements the Truth in Savings Act.
RESERVE REQUIREMENTS
The Federal Reserve Act requires depository institutions to keep a certain percentage of their
assets on reserve with the Fed. FRS Regulation D, Reserve Requirements for Depository
Institutions, sets the requirements for transaction accounts or non-personal time deposits.
Regulation D defines such deposits and requires reports of total deposits to the Fed. The
regulation sets withdrawal penalties and transaction limits on deposit accounts like savings and
money market deposit accounts.
Depository Institution A financial institution that obtains funds mainly from deposits by the
public. It includes commercial banks, savings and loan associations, savings banks, credit unions.
ELECTRONIC FUNDS TRANSFER
The Electronic Fund Transfer Act, implemented by FRS Regulation E, establishes the rights,
liabilities, and responsibilities of parties to electronic funds transfers (EFTs). It requires
disclosures related to EFTs, including recurring credits to deposit accounts. For example, if the
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third party does not notify the customer when a recurring preauthorized credit, such as a direct
deposit, has or has not been made as scheduled, the bank must do so, or provide a telephone
number to the customer to call for more information. Regulation E also outlines the customer’s
and bank’s responsibilities, for reporting and resolving disputed or erroneous EFTs and for
servicing payroll cards.
EXPEDITED FUNDS AVAILABILITY
FRS Regulation CC implements the Expedited Funds Availability Act. Generally, the same
availability schedule is applied whether the funds are deposited through a teller or an ATM.
Depending on the time of the deposit and the location of the ATM, however, funds deposited
may take longer to be available than if they were deposited with a teller. Banks must alert
customers to their funds availability policies, which are usually posted near teller windows. The
following types of deposits are made available on the first business day after the day of deposit
(next-day availability) :
- cash deposited in person

- electronic payments received for deposit
- U.S. Treasure checks deposited in an account held by the payee, including those deposited at
an ATM owned by the bank (a proprietary ATM)
- U.S. Postal Service money orders deposited in person into an account held by the payee
- Federal Reserve Bank and Federal Home Loan Bank checks deposited in person into an
account held by the payee
- state or local government checks deposited in person into an account held by the payee, if it is
in the same state as the payor
- cashier’s, certified, or teller’s checks deposited in person to an account held by the payee
- checks drawn on an account held by the drawee bank (on-us checks)
TRUTH IN SAVINGS
The Truth in Savings Act implemented by FRS Regulation DD, requires that banks give
customers the information they need to compare deposit account features. Regulation DD
requires banks to use one of two methods to calculate interest : the daily balance method, or the
average daily balance method. When the account is opened, the bank must disclose the interest
rate, annual percentage yield (APY), frequency of interest compounding, minimum balance
requirements, fees, transaction limits, and other important information.
The act requires periodic statements of the APY, amount of interest earned, fees imposed, and
length of statement period. Customers must be given advance notice of changes in terms that
would affect the account, such as the APY fees, or maturity dates.
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Annual percentage yield (APY) A rate reflecting the total amount of interest paid on a deposit
account, based on the interest rate and the frequency of compounding for a 365-day period.
FDIC INSURANCE PROTECTION
In the midst of the Great Depression, the Banking Act of 1933 created the Federal Deposit
Insurance Corporation (FDIC), federal deposit insurance is now the main protection for
depositors. If a bank for savings association fails, depositors can withdraw funds up to the insured
amount, which is backed by the U.S. government.
The FDIC insures only deposits at banks and savings associations that pay premiums to the
Deposit Insurance Fund. Insured banks must display an official sign at each teller window or
station, where deposits are regularly received. FDIC insurane covers deposits to checking,
savings, NOW, MMDA, certificates of deposit, and retirement accounts. The coverage does not
extend to products like securities and insurance policies.
The coverage is now generally $100 000 per depositor, but for self-directed retirement accounts
the limit is $250 000. The insurance limit is indexed for inflation, the first possible adjustment
was scheduled for January 1, 2011. Insurance coverage is based on where the deposits are held
and how the accounts are titled. Deposits in separate branches of an insured bank are not
separately insured, but accounts of the same depositor in two different insured banks are
separately insured.
Self-directed retirement account A retirement account for which the owner, not a plan
administrator, has the right to direct how the funds are invested, inluding directing that the funds
be deposited at a specific FDIC-insured bank.
How accounts are titled determines the current coverage. Thus it is possible for a customer to
benefit from FDIC insurance in amounts above $100 000 at one insured bank. FDIC insurance
covers a number of account ownership categories : individual accounts, retirement accounts, joint
accounts, revocable trust accounts, irrevocable trust accounts, employee benefit plan accounts,
business accounts, and government accounts.
To help depositors understand coverage rules, the FDIC publishes on its website Your Insured
Deposit, and maintains the Electronic Deposit Insurance Estimator (EDIE), which helps
depositors determine how much of their deposits is insured.
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SUMMARY
1. Through the deposit function, banks provide a safe place for customers to keep money, and an
economical way to pay checks customers write. Deposit account services are easily accessible to
customers through bank branches, ATMs, and the Internet.
2. Banks offer a wide variety of deposit products and services. Deposits may be placed in a
checking, savings, or time deposit account. Customers make checking account deposits, because
they intend to withdraw the funds to pay bills, and meet expenses. Customers generally place
funds in savings and time deposit accounts, if they do not need the funds immediately.
3. Deposit account products offered to consumers include personal checking accounts, savings
accounts, savings clubs, money market deposit accounts, certificates of deposit, retirement saving
accounts, health savings accounts. Deposit account products for businesses include checking and
savings accounts, concentration accounts, certificates of deposit, money market deposit accounts.
The standard maximum FDIC-insurance amount is allocated
- per depositor; per insured depository institution, not branch; per account ownership category
4. Customers enjoy a number of deposit-related services, including the teller window, night
depository, direct deposit, automated transfer service (ATS), electronic funds transfers (EFT),
ATMs, wire transfer, mailing deposits, courier or armored car services. Electronic access to
deposit accounts and services is widely available. A rapidly growing number of customers bank
on the Internet.
5. Bank customers can deposit funds in a variety of forms : coin and currency, cash items, and
noncash items. Banks must accept cash items, such as checks in U.S. currency, and certain
noncash items, such as checks in foreign currency.
6. The type of deposit account a customer opens, and how the account is titled determines the
ownership of the account, what identification is required, and what documentation is necessary to
establish capacity and authority to open the account. An individual more than one person (joint
ownership), or an individual in a fiduciary capacity may open consumer accounts. Examples of
fiduciary accounts are trust, estate, and guardianship accounts. Sole proprietorships, partnerships,
corporations, public agencies, and unincorporated entities may open business accounts.
7. Bank employees must exercise caution in opening accounts, and ensure that the consumer
gives the bank proper identification. Before opening an account, the bank must determine that
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the potential customer has legal capacity and authority to do so. The USA PATRIOT Act
establishes minimum standards for consumer identification.
8. A number of federal laws and regulations apply to deposit products and services offered by
banks, among them Federal Reserve Regulation D, Reserve requirements for Depository
Institutions, FRS Regulation E, which implements the Electronic Fund Transfer Act, FRS
Regulation CC, which implements the expedited Funds Availability Act, and FRS Regulation
DD, which implements the Truth in Savings Act.
9. Federal deposit insurance resulted from the Banking Act of 1933 enacted during the Great
Depression to, among other things, create the Federal Deposit Insurance Corporation (FDIC).
FDIC rules determine how deposits are insured by the Deposit Insurance Fund. Coverage is
based on where the deposits are held, and how they are owned. The FDIC publishes, on its
website, information for depositors and bankers that explains its insurance.
1. Why are deposits so important to banks ?
2. What are the basic differences and similarities between a checking account and a
savings account ?
3. How do automatic transfer services benefit a customer ?
4. What deposit account would you recommend to a customer who wants to earn interest
and would like the option of writing a small number of checks (no more than three)
every month ?
5. How can customers make deposits into their accounts without going to the bank ?
6. How do account transactions differ from joint accounts held in joint tenancy versus those
held as tenants-in-common ?
7. When a deposit account is opened, why is it important for a bank to establish the authority
of the customer to use the account ? What three steps does the bank take to accomplish this ?
8. What types of deposit transactions are covered by FRS Regulation E ?
9. Constance Gardner has a single checking account for $10 000, a single savings account for
$30 000, and a single certificate of deposit for $35 000. She also has three joint accounts
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for $125 000, $75 000 and $50 000. Because there are two owners for each account, her
interest is half of the balances or $125 000 of the $250 000 total. Her insured interest in the
joint accounts is $100 000. Is the remaining $25 000 uninsured ?
LEARNING OBJECTIVES
After studying this chapter, you should be able to :
- describe the care and distribution of coin and currency

- describe the components of a check and a negotiable instrument
- identify the types of bank checks and endorsements
- explain the check payment process
- identify typical check fraud schemes
- explain banking laws and regulations related to payment processes
INTRODUCTION
Throughout history, people have used countless items to facilite the exchange of goods and
pay for services, among them brass rings, salt bricks and precious metals. In today’s society,
payments are made through both simple and technologically sophisticated systems.
The payment system consists of instruments and procedures used to transfer money, make
payments, and settle debts for consumers, businesses and governments. Checks and cash are
more traditional forms of payment. Legislation and related regulations govern payment
processes to protect the economy, the banking industry, businesses, and consumers.
CASH AS A PAYMENT SYSTEM
Cash is one payment system in our economy that everyone uses to some degree. Minting,
printing, and distributing coin and currency begin with the U.S. Treasury Bureau of Engraving
and Printing for Currency and the U.S. Mint for coins. After it is produced, cash is processed
through the Federal Reserve System to consumers. For banks that are not members of the
Federal Reserve System, correspondent banks serve as the intermediary connection.
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Cash (1) Money in the form of bills or coins (2) Money on hand or in the bank
UNITED STATES LEGAL TENDER
In the USA, legal tender is known as Federal Reserve notes. The 12 Federal Reserve Banks
put notes into circulation pursuant to the Federal Reserve Act of 1913. Member banks obtain
notes from their district Reserve Bank, and pay for them by drawing down their accounts with the
district bank.
Federal Reserve banks obtain the notes from the Bureau of Engraving and Printing, which it
pays for producing them. The notes are then liabilities of the Federal Reserve, and obligations of
the U.S. Government. Federal Reserve banks hold collateral equal in value to the notes each
receives, chiefly in U.S. securities. Since 1933 the notes are not redeemable in gold, silver, or
any other commodity. Because they are legal tender, Federal Reserve notes, which are the U.S.
currency, are essentially backed by all the goods and services in the U.S. economy.
Today’s currency is ever safer and more secure. Every 7 to 10 years, the design of U.S.
currency is changed to protect against counterfeiting. The recent series started changing in 2003
with the new $20 note, followed by new $50 and $10 notes. The redesigned $5 note is scheduled
for release in 2008; the $100 note has been redesigned but does not yet have a release date.
The most noticeable differences in the new designs are the subtle background colors, which add
complexity to the bill, and make it more difficult to counterfeit. Because different background
colors are used for different denominations, they can be more easily distinguished.
Denominations of U.S. Coins and Currency
Coin : penny (1 cent) nickel (5 cents) dime (10 cents) quarter (25 cents)
half-dollar (50 cents) dollar (100 cents)
Currency in circulation : $1 $2 $5 $10 $20 $50 $100
DAMAGED COIN AND CURRENCY
Coin and currency shipments are prepared for and received in a dual custody procedure.
Federal Reserve banks value notes by their face amounts, and coins by weight. When Federal
Reserve banks receive cash, it is processed through high-speed sorting machines.
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Dual custody (Dual control) A security technique that uses 2 or more individual parties
operating together to protect sensitive functions, information, or assets. Both are equally
responsible for physically protecting materials in vulnerable transactions. Neither may access nor
use the materials independently.
Mutilated and suspected counterfeit currency is removed from circulation. Suspect currency is
sent to the U.S. Secret Service. Federal Reserve banks destroy mutilated currency – what is torn,
weak, limp, written on, missing a portion, or otherwise damaged – on behalf of the Treasury.
Coins have a life span of about 30 years. Uncurrent coins (those that are worn but recognizable
and machine countable) are redeemed by Federal Reserve banks and returned to the U.S. Mint
for disposition. Mutilated coins (those that are bent, chipped and not machine readable) are
redeemed only through the U.S. Mint facility in Philadelphia, Pennsylvania. All uncurrent and
mutilated coins are melted and reused in the manufacture of coin.
The eye and the pyramid shown on the reverse side of the $1 bill are in the Great Seal of the
USA, kept officially by the Department of State. The pyramid symbolizes strength and durability,
that it is unfinished means that the USA always will grow, improve, and build. The “All-Seeing-
Eye” above the pyramid symbolizes divine guidance in favor of the American cause. The
inscription ANNUIT COEPTIS translates as “HE (GOD) has favored our undertakings” and
NOVUS ORDO SECLORUM translates as “A new order of the ages”.
CHECKS AS A PAYMENT SYSTEM
Checks are a convenient and safe method of payment. A person or business can transfer
money to another person or business, simply by filling in blank spaces on a check. A completed
check tells a bank how much money should be transferred, when, and to whom.
Checks are a universally accepted form of payment. There are rules and practices that govern
their negotiability, their processing, and the liabilities of the parties to the transaction.
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Exhibit 5.1 U.S Cash Distribution System
Delivers Holds new currency

U.S. Treasury Bureau Federal Reserve
new in custody until
of Engraving and agents ( Presidents of
currency issued
Printing Fed. Reserve banks)
Federal Reserve Fed. Reserve banks

Orders for new banks sort and count
currency deposited currency,
destroy old currency,
replaced with fit and
Cash issued to all new currency.
depository institutions
C Excess cash
Commercial banks
C shipped to Federal
and other depositories
Reserve banks for
credit to reserve
accounts
Cash Cash
paid out deposited
Individuals and
business depositors
Exhibit 5.2 Parties to a Check
ROBERT W. LARKIN Drawer 2 740

123 Main Street May 15, 2011 15-4 20
Anywhere, USA 12345 540
Pay to the order of American Gas & Electric Co Payee $61.79
Sixty – One and 79 / 100 DOLLARS
LAST NATIONAL BANK Drawee SAMPLE
Memo : 0 540 000 43 : 5 500 265 2 740 Robert W. Larkin Drawer
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ELEMENTS OF NEGOTIABLE INSTRUMENTS
A check is a negotiable instrument involving 3 parties : the person writing the check (the
drawer), the person to whom the check is written (the payee), and the bank that holds the
checking account (the drawee). See Exhibit 5.2.
For drawees, the check is a convenient way to pay for goods, services, or other obligations. For
payees, the expectation is that checks will be exchanged for cash at a teller window, or credited
to their bank accounts. The collection process and the governing laws are taken for granted.
As negotiable instruments, checks are governed by the legal requirements of Article 3,

Negotiable Instruments, and their collection process is governed by Article 4, Bank Deposits and
Collections, of the Uniform Commercial Code (UCC). A check must have all the required
components to be negotiable.
Payable to Bearer or to Order
A negotiable instrument is payable to bearer or to order if the word “bearer” or “cash” is used,
or if it otherwise indicates that the person in possession of it is entitled to payment. A check
payable to an identifiable person and endorsed by that person becomes a bearer instrument. See
(1) of Exhibit 5.3. Thus, any person in possession of an instrument payable to bearer is the holder
of the instrument and may present it for payment.
Negotiable instrument An unconditional written order or promise to pay a certain sum of money.
The document must be easily transferable from one party to another by endorsement and
delivery, or delivery alone. Every negotiable instrument must meet all requirements of Article 3
of the Uniform Commercial Code.
Uniform Commercial Code A set of laws adopted by states to govern commercial and financial
transactions between parties. Many states add their own amendments to the basic code.
Endorsement A signature (other than the signature of the maker, drawer or acceptor) that is
made on an instrument, such as a check, for negotiating the instrument, restricting payment, or
transferring liability of the instrument to another party.
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Exhibit 5.3 Elements of a Negotiable Check
ROBERT W. LARKIN 2740

123 Main Street (4) May 15, 2011 15-4 20
Anywhere USA 12345 540
(2) pay to the order of (1) American Gas & Electric Co. $61.79
(3) sixty – one and 79 / 100 DOLLARS
LAST NATIONAL BANK Sample (5) Robert W. Larkin
Memo : : 054 000 043 : 5 500 265 2740
(1) Payable to order of or bearer (4) payable on demand or at a definite time

(2) unconditional order to pay (5) written and signed
(3) fixed amount of money
Negotiable instruments are
- an order or promise to pay - payable to bearer or to order of

- payable without conditions - payable for a specific, fixed, amount of money
- payable on demand or at a definite time - in writing and signed by the issuer
Unconditional Order or Promise to Pay
A negotiable instrument is an unconditional order or promise to pay. Checks contain a written

order to the bank to pay the amount of the check to the payee. This order cannot depend on any
conditions – it must be unconditional. See (2) of Exhibit 5.3. For example, a check may not
contain the statement :”If he paints the house, pay to the order of Leonard”. An instrument that
carries a condition to payment is not a negotiable instrument.
Fixed amount of money
The unconditional order or promise to pay must be for a fixed amount. See (3) of Exhibit 5.3.
The amount, which can be in U.S. dollars or a foreign currency, must be specified clearly on the
face of the instrument, in monetary terms. It may not be stated in terms of something of value
that could be converted to money, such as one ounce of gold, even though the value of one ounce
of gold can be easily determined.
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Payable on demand or at a definite time
The date stated on the check determines when it is payable. See (4) of Exhibit 5.3. A check may
be postdated or antedated. If a check is not dated (intentionally or unintentionally), the date of
the check is considered the date it is presented for payment; the check is payable on demand.
Written and signed
To be a negotiable instrument, the check must be in writing and signed by the drawer. See (5) of
Exhibit 5.3. A negotiable instrument signed by a signature machine or stamped with an
individual’s signature is considered valid, as are “identifying marks” like Xs. Some banks may
have specific procedures for the latter, and may arrange for solutions ahead of time, often calling
on the services of a notary public to witness the drawer putting the identifying mark on the check.
Notary public A public officer who acknowledges or otherwise attests to, or certifies deeds and
other writings or copies of them as authentic, usually under an official seal.
OTHER TYPES OF CHECKS
Besides personal and business checks, banks provide cashier’s, teller’s, and certified checks
for certain transactions.
Cashier’s check
Cashier’s checks are issued by and drawn on a bank. Thus, the bank is both the drawer and the
drawee. Often banks use cashier’s checks to pay their own obligations, or to pay out loan
proceeds. Banks also may sell these checks to customers who have been asked to provide
payment using a bank’s official instrument.
Situation Franco and Lena are closing on a house tomorrow. The mortgage company will not
accept a personal check for the closing, for fear it will be dishonored. Franco and Lena do not
want to bring a large amount of cash to the settlement, so they decide to purchase a cashier’s
check to pay for the down payment and closing costs.
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Teller’s check
A teller’s check is like a cashier’s check but it is issued by one bank and drawn on another. The
issuing bank’s obligation for these checks is the same as for cashier’s checks. In other words,
even if the purchaser decides it does not want to pay, once a teller’s check is issued, the bank is
obligated to honor the check.
The payer bank supplies teller’s checks and maintains the blank check stock, reconciles the
teller’s check account, stores the paid checks, and provides service to both the customer and the
issuing bank.
Certified check
A certified check is accepted by the bank on which it is drawn. Essentially, it is a depositor’s

check stamped with the word “certified” and a signature and date. The original order to pay
becomes the bank’s promise to pay; certified checks are legal liabilities of the bank.
Typically, a customer presents the personal check to be certified. The bank sets aside the
funds for the check, debits the customer’s account, and credits a “certified checks outstanding”
account. The bank then places an official bank stamp and signature on the check. The magnetic
ink character recognition (MICR) line is covered with the certified check account number or
mutilated, so that it will not pass through the customer’s account.
THE CHECK PAYMENT PROCESS
The payment process starts (See Exhibit 5.4) when a check is transferred from one person or
company to another person or company. The transfer is authorized by the signature on the bottom
of the check. Presentation of the check to a bank for payment starts a collection process that
results in the transfer of money from the drawer to the payee.
THE DRAWER
The first stage in the check payment process begins when the drawer writes a check on his or
her account payable to bearer, cash, or an identifiable person.
Checks payable to an identifiable person
Negotiation of a check payable to an identifiable person requires endorsement by that person,

and delivery or transfer of the check. An identifiable person is an actual person or a legal entity,
such as a corporation.
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If the endorsement of the payee is forged, the negotiation is invalid. A depositary bank that
takes a check with a forged endorsement is subject to a claim directly from the payee, or from
the drawee bank.
Checks payable as “And or “Or”
A check payable to joint payees requires the endorsement of both. If one did not endorse the
check, and did not benefit from the proceeds, he or she may file a claim against the other.
However, if the check is payable to one or the other payee, either can negotiate the check.
Checks payable to Bearer
Instead of being made to an identifiable person, checks can be made payable to “cash” or
“bearer”. Negotiation is by delivery alone, and does not require an endorsement. Thus, any
person in possession of an instrument payable to bearer is the rightful holder of the instrument.
If the bearer takes the check to a teller to obtain cash, most banks would require the check to
be endorsed, so as to identify the person to whom the cash was given. If the endorsed check is
dishonored; the endorser, after being given timely notice, is obligated to take the check back.
Exhibit 5.4 Check Payment Process
Dave’s Check
Dave : Drawer Utility Company : Payee
Dave’s checking account statement Depositary Bank
Dave’s Bank : Drawee  Federal Reserve Bank :
Clearing Agent
The check payment process begins when a check is written by the customer (drawer) on his or
her bank account, and ends when the check amount is debited from the customer’s account and
recorded in the account statement.
Situation Ben Watson presents a Pebble Bank teller a check for $3 000 that in addition to stating
“payable to the order of XYZ Company” also notes that the drawer “promises to protect the asset
securing the payment”. Although the additional wording is not typical for checks received for
payment, the teller pays it. The additional wording is acceptable under UCC Article 3.
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Holder A person who is in possession of a negotiable instrument, and who is entitled to receive
payment of the instrument.
Holder in due course One holding a negotiable instrument (check, etc) and taking the instrument :
- for value
- in good faith
- without notice that it is overdue or dishonored
- without knowledge that it has an unauthorized signature, or is altered
- without knowledge of claims to the instrument
- without knowledge of defenses against payment
Holder in Due Course
The person in possession of a check is the holder. As checks proceed through the check
processing system, they come into the possession of businesses, banks, and Federal Reserve
banks. Individuals, businesses, and banks can accept a check as a negotiable instrument without
being liable for any claims and defenses, if they possess the check as a holder in due course.
A holder becomes a holder in due course by showing that at the time the check was transferred,
the holder paid value for it, took it in good faith, and had no notice of any defenses against
payment or other claims to the check.
For value Something of value is given in exchange for the check. A teller giving cash to a
customer for a check, has given something of value.
Good faith The holder acted honestly and fairly when accepting the check, and believed the
check was not legally defective in any way.
Without notice The holder takes the check without notice of any defect, defense, or claim
against the payment of the check. A clear defect, such as lack of a signature or
an altered amount, is considered notice. A stolen check is an example of a
check that has a defense against payment.
THE PAYEE
After the drawer writes the check, the next step is for the payee to accept it. The payee can
transfer the check to another person, convert it to cash, or deposit it to an account. What the
payee intends to do with it depends on how it is endorsed. The payee endorsement area is
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confined to the top inch and a half of the back of the check. The principal types of endorsements
are blank, special, and restrictive.
A blank endorsement (or an endorsement in blank), the most common endorsement, is the
signature of the payee. A check endorsed in blank becomes a bearer instrument that can be
negotiated without any other endorsement, and used for any other purpose.
A special endorsement names another designated person. The endorsement may state “Pay to
the order of”, and then the payee signs under that statement. Only the designated person can
negotiate the check. A special endorsement may be used, if the payee is mailing the check to
another person.
With a restrictive endorsement, the payee or other holder of a check restricts the purpose for
which a check may be used. A common restrictive endorsement, used for depositing an item to
an account, is “For Deposit Only”. Any use other than for deposit to an account is prohibited.
Blank endorsement Special endorsement Restrictive endorsement
ENDORSE HERE ENDORSE HERE ENDORSE HERE

John Q. Public Pay to the order of For deposit only
Harry Johnson
John Q. Public John Q. Public
Do not write, stamp or sign Do not write, stamp or sign Do not write, stamp or sign
below this line below this line below this line
Reserved for financial Reserved for financial Reserved for financial
institution use institution use institution use
The endorser can cancel any endorsement, including a restrictive endorsement by deleting it or
scratching through it, and endorsing the check in another manner. The deletion, however, should
bear the payee’s or holder’s initials.
Bank-Provided Endorsement
Under Article 4 of the UCC, the bank automatically becomes a holder of an unendorsed
instrument when it is accepted for deposit to the account of the payee or other holder, or is
cashed for the payee or holder. The bank becomes the holder of the instrument for all purposes,
having become a holder in due course.
A bank can still supply a missing endorsement. If a customer failed to endorse an item, and the
item itself did not require the payee’s personal endorsement, the bank could endorse it, stating
“For deposit to the account of the within named payee”. This endorsement is usually stamped on
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the item at the time it is deposited. The bank typically supplies the endorsement, when items are
received for deposit through the night depository, the mail, or an ATM.
THE DEPOSITARY BANK
Continuing with the check payment process, after the depositary bank accepts the endorsed
check; it is proofed, encoded, captured, sorted, and cleared for presentment to the drawee.
Most people think a check is being cashed when it is presented to a teller. However, the
difference between paying and cashing a check is important.
Depositary bank The bank in which a check is first deposited. The bank also may be the paying
bank (drawee) if the check is drawn on, payable at, or payable through the bank.
Paying checks
A bank is obligated to its own customers to pay a check drawn on it that is properly payable.
When a person presents an on-us check to a teller, it is deposited in an account, or paid over the
counter. In either case, the teller is making final payment on the check. But if it is paid or
accepted by mistake, the check is deemed not to have been paid or accepted in spite of final
payment.
Because making final payment on an on-us check is a risk for the bank, it is important that the
teller examine the check, and the account on which the check is drawn, to ensure that:
1/ the person presenting the item is properly identified

2/ there are no stop payments on the check, or holds on the account
3/ sufficient funds are available in the account to cover the check.
On-us check A check deposited or otherwise negotiated at the bank on which it is drawn.
Stop payment An order by a depositor to the bank (the drawee) to not pay a previously issued
check or item.
To inspect a check, a teller can perform both visual and nonvisual tests ( Exhibit 5.5). Online
systems now allow tellers to view an image of the bank’s record of the customer’s signature, so it
can be compared to the actual signature on the check. This helps reduce the incidence of forged
signatures. To ensure that the funds are available when the posting process is completed later
that day, many banks also place a teller’s hold on the funds when the check is paid.
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A bank may pay a check on a customer’s account only if the check is properly payable. Under
UCC Article 4, Bank Deposits and Collections, a check is properly payable if it is authorized by
the customer, and is in accordance with any agreement between the customer and the bank.
Exhibit 5.5 Visual and Nonvisual Tests for Inspecting a Check
Nonvisual Elements Visual Elements
1. Has a stop payment order been placed on the 5. Is the item an actual check drawn on the
check ? bank ?
2. Has a hold been placed on the account ? 6. Is the signature genuine and authorized ?
3. Is there sufficient available balance to cover 7. Has the check been altered ?
the check ? 8. Is the check properly dated ?
4. Is the account balance available to the drawer ? 9. Is the check properly endorsed ?
1 9 : paying a check 7 9 : cashing a check
Wrongful Dishonor
A bank is required to honor a check that is properly payable. If it fails to do so, the bank could
be liable to the customer for wrongful dishonor of the check. Unless the bank has an agreement
to pay checks in overdraft, it is not liable when it dishonors a check that would overdraw the
account. A bank is liable for wrongful dishonor if it :
- fails to pay an item drawn on sufficient collected funds

- pays a check that is subject to a stop payment order, and then dishonors other checks that would
otherwise have been paid
- places a hold order on the wrong account pursuant to an attachment order, or IRS levy and then
dishonors checks presented for payment
- mistakenly applies funds against an obligation not owed by the depositor, leading to the
dishonor of checks
- closes its depositor’s account without giving reasonable notice of the closure, and dishonors
checks that were outstanding before the account was closed.
Wrongful Dishonor Failure of the drawee (paying bank) to pay a properly payable check.
Paying versus Cashing a check
- Paying a check : giving cash in exchange for an on-us check.

- Cashing a check : giving cash for a check drawn on another bank
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Cashing checks
A teller cashes a check by giving cash in exchange for a check drawn on another bank. Cashing
checks has greater risk than paying checks. When cashing a check, the teller can verify only
whether the check has not been altered, and was properly dated and endorsed. Although there is
additional risk in cashing a check, banks generally do so for at least 2 reasons. First, the person
presenting the check usually has an account with the bank. Second, the drawer may have other
relationships with the bank, such as loans.
If the bank cashes a check and it is not paid by the drawee, the bank may collect the amount of
the check from the person who cashed the check or any previous endorser. The bank also may
look to the drawer for payment.
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Exhibit 5.6 : Presenting Checks for Payment and Posting
Branch Branch Other Corporate Presenting FED

department Customer Bank
Item prep.
Proof and
encoding
Item
capture &
sorting
(Local checks) (On-us checks)

Cash letter Bulk
preparation filing
(Transit) Local and transit

checks
Clearing FED Other Statement
house banks rendering
Local Local Payer Payer Customer

bank bank bank bank
Check Preparation
Once a check is accepted by the depositary bank for cash, payment, or deposit, it is processed
for collection (See Exhibit 5.6). The first step is preparation for proofing and encoding.
Preparation includes removing staples, paper clips, and rubber bands. All checks are arranged
face forward and right side up. Only checks to be captured are sent through the proof and
encoding function.
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Proofing and Encoding
Most banks process checks in batches, bundles that may come from business customers to
branch banks. In proofing, each transaction is checked to see that the dollar amount of the debits,
such as checks, equals the dollar amount of the credits, such as deposit slips. This is where errors
in addition, extra items not reflected on the deposit ticket, and items listed but not included are
found. The proof operator either balances the checks, or passes them on to another area in the
proofing department to do so.
Exhibit 5.7 Magnetic Ink Character Recognition (MICR) Line

a b c d e
706001 021302268 123407889 0687 0000010295
a : auxiliary number appearing only on commercial checks

b : the routing number (Federal Reserve routine symbol, American Bankers Association’s ABA
institution identifier, and check digit)
c : the account number on which the check is drawn
d : the number of the check
e : the amount of the check
Encoding is the process of inscribing or imprinting magnetic ink character recognition (MICR)
data on checks. High-speed reader-sorters can read the MICR data and capture information
(amount, account number, check number) which expedites transaction posting & check clearing.
MICR data are printed at the bottom of the check in a line that is 5/8 inches deep. The line has
5 fields : an auxiliary number field for commercial checks only, routing number field, account
number field, check number field, and check amount field. The routine number field contains the
Federal Reserve routine symbol, the American Bankers Association’s ABA institution identifier,
and the check digit number.
When checks are ordered, most MICR encoding information is preprinted on the check. Proof
operators use the same magnetic ink to add the check amount to the information already on the
MICR line.
Item Capture and Sorting
After being proofed and encoded, checks are sent to another area that reads (captures) the
encoded information, and sorts the checks and other items for further processing. The item
capture and sorting department uses equipment that electronically reads (captures) the
information from the MICR line, which is then read again to be sure the transactions balance.
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The reader-sorter equipment also films, or images, each check and endorses it with the bank’s
information. It also sprays or stamps each check with a sequence number that identifies where
the check is located in the bank’s film or image archives. Some banks scan the entire check and
convert the image into a digitized format that is stored on computers and used for research,
presented in court, or sent with customer statements.
Once the information is captured, the reader-sorter automatically sorts checks into bins or
pockets. Sorting involves more than one pass or cycle. On the first pass, checks generally are
sorted for local, nonlocal, and on-us checks. Other passes separate the checks from other paper
documents, and sort them by account number, or statement-cycle cutoff dates.
Local check A deposited check drawn on another bank in the same Federal Reserve check-
processing region.
Nonlocal check A deposited check (transit check) that is drawn on another bank located in a
different Federal Reserve check-processing region.
For the first pass, the ABA institution identifier number on the check identifies the bank on
which a check is drawn. For local clearing and transit items, the bank typically captures only the
check amount, and the ABA institution identifier. For on-us items, the entire MICR line is
captured, including account number, amount of the check, and sequential check number. This
information is stored for processing later, when debits and credits are posted to the accounts.
Local and nonlocal checks are sorted and prepared for shipment to Federal Reserve banks,
correspondent banks, local clearinghouses, or directly to drawee banks. As pockets in the reader-
sorter fill, checks are removed and banded together into batches. Headers identify the dollar
amount and list the items in the batch. Then a cash letter is completed with the dollar amount of
checks in all batches. The cash letter generates the credit that is deposited into the depositary
bank’s account. Exhibit 5.8 illustrates the check sorting process.
Sometimes during the first pass, the reader-sorter cannot read checks, because of an encoding
error or a defect in the magnetic ink. “Rejects” are repaired and reentered into the system.
Cash letter An interbank electronic or paper transmittal form, resembling a deposit slip, used to
accompany cash items sent from one bank to another.
Dr. Kenneth B. Elredge, staff scientist at Stanford Research Institute, was awarded U.S. Patent
Number 3 000 000 for his invention of the magnetic ink character reader machine. The machine
and the magnetic-ink “common machine language” developed by the American Bankers
Association in 1956 revolutionized check processing.
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Clearing Local and nonlocal checks can be presented to the drawee bank by sending them
directly to the bank, using a clearing house, or using a Federal Reserve, or a correspondent bank.
Most banks use a combination of these methods, taking into consideration availability, deadlines,
price, and transportation. The clearing methods are :
Direct presentment
Bank messengers or couriers carry checks directly to local banks. Many banks agree to swap
items free of charge. The settlement method may be by check, credit, debit due to and due from
bank accounts, Fedwire, or credit to a Federal Reserve or correspondent bank account.
Correspondent bank
A bank that maintains an account with another, and usually larger bank, often relies on the
correspondent bank to present and collect checks. In processing and collecting checks,
correspondent banks accept the day’s deposited items, credit the sending bank’s account, sort the
items, and present them to drawees.
Correspondent bank A bank, often a larger bank, that maintains an account relationship, or
engages in an exchange of services with another, usually smaller bank. Sometimes called
upstream correspondent bank. The bank that uses the services is the respondent bank.
Did you know .... ? In 1899 to 1900, the Boston Clearinghouse began a uniform procedure for
clearing checks for all New England banks. Remittances would be at par, and any bank that
refused to pay at par, would be subject to an exchange charge.
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Exhibit 5.8 Check Sorting and Bundling
Main Street Bank receives and processes the checks

and sends them to proof and item processing.
The checks are sorted and bundled
Nonlocal checks On-us checks Local checks
Batch # 1 Batch # 1
Batch # 2 Batch # 2
Batch # 3 etc. Batch # 3 etc.
Cash Letter (total of all batches) Cash Letter (total of all batches)
Item processing sends cash letters via

courier to the Federal Reserve (or clearing house)
The Federal Reserve Bank credits Main Street Bank

for the amount on the cash letters
The Federal Reserve Bank then sorts and

sends the checks to the paying banks.
Clearing houses
Although clearing houses operate like correspondent banks, a clearing house is an organization
of banks in a city or region. Rather than paying each other for checks presented, members make
one “net” payment to a clearing house that reflects the difference between total credits received
and total credits due. A clearing house is established specifically to facilitate clearing checks
written on accounts of participating banks.
Federal Reserve
The Federal Reserve established the first nationwide system for collecting nonlocal checks.
Federal Reserve district banks serve as a center for check collection, so that nonlocal checks
flow efficiently among the districts. Efficiency is enhanced through Federal Reserve branch
offices and regional check processing centers that supplement the collection activities of the 12
Federal Reserve banks.
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THE DRAWEE
The drawee (paying bank) receives checks directly from other banks through a clearing house
or from the Federal Reserve (a process called in-clearing capture). Regardless of how checks are
received, banks must follow basically the same payment procedures.
In-clearing Capture
When a bank or the Federal Reserve presents checks to the drawee, the drawee must prepare
them for capture, then capture the data, and settle the checks. In-clearing capture procedures are
similar to the depositary bank’s capture procedures except for one main difference. Because the
checks are all drawn on the paying bank (drawee), the entire MICR line must be captured. If the
reader-sorter cannot read the MICR characters, checks are rejected, and the error is corrected for
accurate posting.
Because the depositary bank did the encoding, the checks do not have to be encoded. Instead,
they are filmed with their assigned sequence numbers encoded and passed to the posting system.
Posting
Data from capture runs, including items presented over the counter and from in-clearings, are
stored throughout the day. At the end of the day, when the bank has completed all capture runs,
transactions are posted to accounts.
Posting is the process of adding deposits to an account balance, and subtracting checks and other
withdrawals from that balance. Usually deposits and other credits are posted first; then debits.
Exception Items
Checks rejected from the normal posting process require special handling. These are commonly
referred to as exception items. Checks may require special handling for a number of reasons :
nonsufficient funds (NSF), an uncollected balance, so that there are insufficient funds; a stop
payment order on the check, or a hold placed on the account.
Nonsufficient funds An expression indicating that a check or item drawn against an account
exceeds the amount of funds available in the account.
Hold A restriction on the payment of all or any part of the balance in an account.
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Each exception item requires an action. If a check is to be returned to the depositary bank, it is
removed manually, stamped with the reason for the return, and sent back to the depositary bank,
which reviews the reason for the return, and determines what to do. The check either is charged
back (debited) to the customer’s account, or if it was returned for nonsufficient funds (NSF) , it is
redeposited and sent back through the system again for payment.
Banks place holds on customer accounts for various reasons. The bank may want to examine
the signature on every check presented on a particular account, because of a special situation or
a reason for suspicion. Or the bank may have received a court order to freeze the funds.
Whatever the reason, checks drawn on an account on which a hold is placed must be rejected,
examined, paid, or returned. If a bank places a hold with the intention of not honoring checks
drawn on specific deposits, the bank must meet the requirements of FRS Regulation CC,
Availability of Funds and Collection of Checks, which governs bank check collection and
payment practices involving consumers.
Document Examination and Filing
Banks use bulk filing procedures for on-us checks. In a bulk, file checks are sorted daily by
statement cycle and filed in bundles. If the bank examines the signatures, dates, or other details
of the checks, they are sorted separately into account number sequence. Some banks use either
film-based or image-based automated signature verification. At statement time, checks are
sorted into account number sequence, with dividers to separate accounts. Checks that will be
returned to customers are taken to a statement preparation area to be processed.
Statement Rendering
When a customer receives a statement in the mail listing the previous month’s checking
account deposits and debits, the check payments process has come full circle.
An account is assigned a statement cycle date, the date on which the statement is produced. On
the statement the bank prints the date each check was paid, the amount, and the check number.
Customers can use this information to reconcile their account with their own records. Some
customers receive cancelled checks with their statements, and are responsible for storage of the
statements. Most customers now receive image statements only. Traditionally, customers
received separate statements for each checking account, but many customers now have
combined statements.
Image statement A statement that contains an image of each paid check. An image scanner is
used to scan checks, and print the small images on regular statement paper, which is easier to
store than actual checks. Imaged checks usually are available for on-line banking, whether or
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not a printed image is sent with the statement to the customer. Banks save on postage and
handling expense, sorter passes, and statement preparation time.
Combined statement A statement that combines information from a number of accounts into a
single statement, such as checking, savings, bank card, time deposits, and loan information.
Regulations prohibit including information about uninsured investment products, such as
annuities, money market mutual funds, and other nontraditional types of accounts. Like image
statements, combined statements may reduce bank processing costs.
ELECTRONIC CHECK PROCESSING
Technological advances are increasingly moving the U.S. toward a checkless society. Yet
checks remain, although the physical collection and clearing process may soon become obsolete.
In 2004 a new negotiable instrument was created to help overcome the obstacles to fully
electronic check processing. The Check Clearing for the 21st Century Act – commonly known as
“Check 21” – created the subsitute check. The Federal Reserve issued amendments to FRS
Regulation CC to implement the act. Adding Check 21 to existing electronic check processing
technologies is stimulating greater interest in operational efficiencies that improve workflow,
enabling remote image capture, truncation, and image check exchange. These new efficiencies
generate substantial savings for banks. A substitute check is the legal equivalent of its original
for all purposes, provided the check :
- contains an image of the front and back

- conforms to industry standards, including MICR (with some exceptions) and physical
characteristics of a check
- is suitable for automated processing
- accurately represents all information on the original check
- bears the following legend :”This is a legal copy of your check. You can use it the same way
you would use the original check”
- includes all endorsements
- includes identification of the party creating it.
Substitute check A paper reproduction of the original check drawn from an electronic file that
contains an image of the front and back. It bears the full MICR line as allowed by industry
standards for such checks, conforms in paper stock and dimensions to the standards, and can be
processed through automated check systems.
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Using the Check 21 process, a bank converts the paper check into an electronic image and then
transfers the image file, rather than the physical check, through the Federal Reserve system. If a
bank somewhere along the processing chain does not exchange checks electronically, or if a
customer wants a copy of the check, the electronic file can be converted back into a paper item at
any point.That paper item is the substitute check, and it is the legal equivalent of the original
paper check. It can be processed through high-speed check processing equipment, and is
acceptable for all legal purposes.
Check imaging fosters innovation in the check clearing system without mandating that checks
be received in electronic form. Creating a substitute check makes it possible for banks to
truncate checks at any point in the collection process, regardless of state laws or agreements that
may otherwise require delivery of the original paper check. Banks do not have to truncate checks
for their own customers, but they must accept substitute checks from banks that do not truncate.
When customers receive a substitute check in their monthly statement, or when they request a
copy of a check, they must accept a substitute check as the legal equivalent of the original check.
Truncation A generic term for banking systems designed to reduce the need to send or physically
handle checks for customer accounts.
CHECK FRAUD
Check fraud is a major cause of financial loss for banks. The losses continue to grow even as
check use declines. Criminals find novel ways to defraud others. The broad term “check fraud”
encompasses a variety of schemes, including counterfeiting, alteration, forgery, paperhanging,
and check kiting.
CHECK COUNTERFEITING
Banks are expected to detect alterations, are responsible for paying checks only as originally
drawn. Counterfeiting may entail stealing a blank check, retrieving a discarded canceled check,
or removing a check used to pay a bill from a mailbox. A personal computer, software, scanner,
laser printer, or high-resolution photocopier may counterfeit checks as well.
Checks are altered by removing the payee’s name or dollar amount but leaving the authorized
signature. Information on the check can be erased through check washing. Payee’s name, dollar
amount, check serial number, and date are changed, but the authorized signature remains.
Altered check A check on which a material change, such as the dollar amount, has been made.
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Forged endorsement A common type of check fraud : A criminal steals a check, endorses it,
and presents it for payment at a teller window or a store, using bogus personal identification.
Paperhanging Criminals fraudulently obtain blank checks or reorder checks on closed accounts.
Check kiting A criminal opens several checking acounts in different banks, in different areas of
the country, often with a cashier’s check or cash. Checks are written to transfer funds from one
account to another. Transfers occur so frequently that actual funds do not exist in a given account
when a check is written. At this point, the customer usually leaves town with more money than
originally deposited. By using “float time”, check kites thus create fraudulent balances.
BANK EFFORTS TO COMBAT CHECK FRAUDS
One of the best weapons in the war against check fraud is still vigilant tellers and other bank
employees. Knowing some of the indicators of check fraud helps bank employees thwart
fraudulent transactions. To identify a bogus check, bank employees inspect for the following :
1. Check lacks perforations, is stained or discolored, or has an odd “feel”. Most check paper
has the same weight and texture.
2. Check number is either missing, does not change, or is low (between 100 and 500). 90%
of returned checks have low check numbers. Low check numbers indicate a recently opened
account, and therefore a possibly riskier check.
3. Font used to print the customer’s name looks visibly different from the font used to print the
address.
4. Additions to the check are hand written
5. Customer’s address or bank’s address is missing
6. Existence of erasures or alterations
7. MICR numbers are missing or are shining. Fraudulent checks often subsitute regular toner or
ink for magnetic ink
8. MICR encoding does not match the check number, the bank district, or the routing symbol in
the upper right-hand corner of the check.
9. Name of the payee appears to have been printed by a typewriter. Most payroll, expense,
and dividend checks are printed by computer.
10. Word VOID appears across the check
11. Check lacks an authorized signature
Technology and software are helping banks stem losses from check fraud. Modern check
processing technology has reduced float time, making it more dificult for check kiters to exploit
processing delays. For example, check imaging deters check kiting, because check clearing and
settlement do not require a time-consuming physical inspection before payment. The reduction
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or absence of physical checks from the payment system will reduce opportunities for check
fraud.
Software, such as that used to support positive pay, is helping tellers detect duplicate check
numbers that appear out of sequence, and to compare signatures to detect fraud.
Positive pay A bank service that pays a business’s checks, only if they match the check data on
an electronic list of issued checks that the business sends to the bank.
The federal government has enacted a number of laws governing payment systems. Federal
bank regulators supervise and enforce these laws.
COLLECTION OF CHECKS AND FUNDS TRANSFERS
The Collection of Checks and Funds Transfers, FRS Regulation J, covers check collection and
returns, cash and noncash items processed through Federal Reserve Banks and funds transferred
through Fedwire. It aims to provide rules for collecting and returning items and settling balances.
EXPEDITED FUNDS AVAILABILITY ACT
FRS Regulation CC implements the Expedited Funds Availability Act that requires depository
institutions to make funds deposited into transaction accounts available for withdrawal on a set
schedule. The availability of the deposited items is based on the type of check (government,
cashier’s or personal) and on whether the check is local or nonlocal.
Banks may hold funds beyond the general funds availablity schedule under certain safeguard
exceptions, including funds in excess of $5 000, and funds from checks the bank has reasonable
cause to believe are uncollectible. If a bank invokes an exception, it must notify the customer in
writing.
FRS Regulation CC requires depositary bank to ensure that its endorsement is in the proper
location of the check; that the customer does not interfere with the area designated for the
depositary’s endorsements, and that the depositary accepts a returned check, even if delayed,
because of improper placement of the endorsement, or a customer obscured the endorsement.
Regulation CC was amended to include rules for Check 21 that require banks to :
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- educate customers about substitute checks and provide special customer notices in certain
Situations
- provide warranties and indemnities to protect parties handling substitute checks
- establish a process by which customers may receive an expedited credit of amounts paid
if they believe a substitute check they received was incorrectly charged to their account.
UNIFORM COMMERCIAL CODE (UCC)
The UCC sets up fair practice standards in commercial transactions. Individual states decide
whether they will adopt the UCC. UCC, Article 3, Negotiable Instruments, provides standards for
negotiable instruments, describes endorsements, defines holder in due-course, outlines liabilities
of all parties to a transaction, and sets rules for presentment of a negotiable instrument. UCC,
Article 4, Bank Deposits and Collections, describes the responsibilities of depositary, collecting,
and paying banks in the check collection process.
Exhibit 5.10 Check 21 Expedited Re-credit
1. Paying bank must provide consumer with original check, substitute check, or recredit within
10 days of claim up to $2 500 per check.
2. Amounts up to $2 500 must be recredited to consumer within 45 days
3. Paying banks must make claim to reconverting bank within 120 days of transaction that gave
rise to claim.
4. Reconverting bank must provide recredit, original check, or substitute check within 10 days
of paying bank claim.
SUMMARY
1. Cash is still used for payments today. Coins are minted by the U.S. Mint, and currency is
printed by the U.S. Bureau of Engraving. The Federal Reserve distributes both coin and currency
to banks, and it collects and destroys damaged currency as a service to the U.S.Treasury.
Damaged coin is returned to the U.S. Mint facility in Philadelphia, Pennsylvania for disposition.
2. A check is a negotiable instrument involving 3 parties : the person writing the check (drawer),
the person to whom the check is written (payee), and the bank that holds the checking account
(drawee). Articles 3 and 4 of the Uniform Commercial Code establish the legal requirements for
checks as negotiable instruments. Negotiable instruments are payable to the bearer or to order,
contain an unconditional promise to pay a fixed amount of money on demand, or at a definite
time, and are written and signed by the drawer.
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3. Besides personal and business checks, banks provide cashier’s, teller’s, and certified checks.
4. The check payment process begins when a drawer writes a check on his or her account at a
bank. The person who takes possession of the check is the holder. After the check is written, the
next step in the check payment process is for the payee to accept the check. Individuals,
businesses, and banks can accept checks without liability for claims and defenses, if they are a
holder in due course. What the payee intends to do with the check depends on whether the
endorsement is blank, special, or restrictive.
5. The endorsed check is then accepted by a depositary bank, which also endorses it. A bank is
required to honor a check that is properly payable. Failing to do so could make the bank liable to
the customer for wrongful dishonor. A bank will pay an on-us check, and may cash a check
drawn on another bank, which carries more risk. Once a check is accepted by the depositary bank
for cash, payment, or deposit, it is processed for collection.
Checks are proofed, encoded, read (captured), sorted (as on-us, local and nonlocal), batched,
and, with a cash letter, presented to the drawee through the selected clearing arrangement (direct
presentment, correspondent bank, clearing house, or Federal Reserve bank).
6. The drawee receives checks for in-clearing capture. In preparing the checks, the full MICR
line is captured. Data from capture runs are stored throughout the day, and posted to accounts at
close of business. Checks rejected during posting are exception items that require special
handling. Checks are sorted daily in bundles by statement cycle and then filed. Once a month,
customers receive account statements either with paper checks, or with check images.
7. The Check Clearing for the 21st Century Act (Check 21) created the substitute check. Banks in
the clearing and payment chain can convert a paper check into an electronic image file for
transfer, and reconvert it back into a paper substitute check as necessary. The substitute check is
the legal equivalent of the original paper check. Check 21 is helping banks move to fully
electronic check processing.
8. Check fraud is a major cause of financial loss for banks. It encompasses a variety of schemes,
including counterfeiting and alteration, forgery, paperhanging, and check kiting.
9. Among the many laws and regulations that govern the bank payment process are the
Collection of Checks and Funds Transfers. FRS Regulation J, Expedited Funds Availability Act,
FRS Regulation CC, and Uniform Commercial Code Article 3. Negotiable Instruments, and
Article 4, Bank Deposits and Collection.
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1. What five things make a check negotiable ?

2. Who are the parties to a check ?
3. What is the difference between a blank endorsement and a special endorsement ? Discuss
when each is used.
4. What are the differences between a cashier’s check, a teller’s check, and a certified check ?
5. In check preparation, proofing and encoding, the depositary bank performs what functions ?
6. What are some examples of checks that might be rejected from the normal posting process,
and require handling as exception items ?
7. What is dual custody ? Provide an example of where it is used.
8. What are at least three signs of a fraudulent check ?
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LEARNING OBJECTIVES
- discuss major developments in electronic banking

- describe electronic banking services commonly used by consumers
- identify electronic banking services used by businesses
- describe some current developments and future trends in electronic banking
- explain provisions of the Electronic Fund Transfer Act, Expedited Funds Availability
Act, FRS Regulation J, Collection of Checks and Funds Transfers, Check Clearing
for the 21st Century, and the E-Sign Act
INTRODUCTION
The Internet, online banking software, personal digital assistants (PDAs), “smart
phones”, and other information management technologies have fundamentally
changed the financial landscape, by enabling banks to improve efficiency and offer
the 24/7/365 service customers have come to expect.
ELECTRONING BANKING - WHAT AND WHO
The term electronic banking encompasses all the technologies that allow customers
to perform banking transactions electronically without visiting a brick-and-mortar
institution. Terms commonly used in connection with electronic banking include
personal computer (PC) banking, Internet or online banking, virtual banking, home
banking, remote banking and telephone banking. Electronic technology provides
many of the services consumers and businesses now take for granted, from wire
transfers to credit card payments to telephone bill payments.
THE ROOTS OF ELECTRONIC BANKING
Banks always strive to deliver better service. For several centuries, payments had
to be made in person or by mail that was delivered on foot, by horse, or by ship.
Improvements to transportation (trains, cars, trucks and planes) helped speed mail
delivery. The most significant advances, however, came with the advent of electricity
and related wired technology. The telegraph, telex, and telephone allowed
transactions to be conducted rapidly across continents and oceans.
1
With these developments and the continued inventiveness of both science and
business, the 20th century brought forth more improvements to speed the delivery of
banking services and bank operations. Today’s innovations in check processing build
on imaging technology that converts document information into digitized formats
computers can read – technology that was state of the art a decade ago and, in fact,
was derived from other technologies that also were considered amazing in their day.
For example, for years banks processed checks by reading the magnetic ink character
recognition (MICR) symbols printed on the lower edge of checks. New imaging
technology takes the check reading process one step farther. The entire image of the
check is captured through scanning, stored as an electronic record, and then
transmitted for processing. Check imaging now occurs not just at banks but also at
commercial operations such as retail stores and business accounting offices.
Magnetic Ink Character Recognition (MICR) Numbers printed in magnetic ink near
the bottom of the front of a check to facilitate automated processing. The position and
content of the MICR line are governed by industry standards. MICR encoding
includes the bank’s recording number, the customer’s account number, the number of
the check, and often the amount of the check.
EFT AND ACH
Electronic Funds Transfer (EFT) systems and services are indispensable for
modern banking. An EFT is any transfer of funds initiated through an electronic
terminal, telephone, computer, or magnetic tape that instructs a financial institution to
either credit or debit a customer’s account.
Electronic funds transfer (EFT) A transfer of money from one bank account to
another that is initiated through an electronic terminal, telephone, computer, or
magnetic tape.
Banks use EFTs to borrow funds from each other, invest daily surplus funds, settle
clearing balances in the check collection process, and provide instantaneous transfer
services for depositors. EFT consumer services include automated teller machine
(ATM) transfers, direct fund deposits or withdrawals, transfers initiated by telephone,
point-of-sale (POS) terminals, debit cards, and electronic check transactions.
2
Many of these services are provided by the Automated Clearing House (ACH)
network, which is responsible for processing such services as online bill pay, direct
deposit, and direct debiting. ACH has proven to be a viable, faster, and more cost-
effective alternative to paper check processing. The network consists of more than
12 000 financial institutions, 650 industry councils, and other regional ACH
associations. The National Automated Clearing House Association (NACHA) governs
the ACH network, and is responsible for issuing rules for its use.
Banks, corporations, individuals, governments use ACH to make recurring payments,

such as payroll deposits, less expensively and more conveniently than by paper
checks. Banks process customers’ credit and debit information, which they forward in
batches, to either a Federal Reserve bank or the ACH. Customers use ACH to
authorize payments of insurance premiums, mortgages, loans, other recurring bills.
The bank originating the ACH transaction is the originating depository financial
institution (ODFI); the bank receiving the transaction is the receiving depository
financial institution (RDFI). Once the customer directs the ODFI to originate the
transfer (using a pre-authorized transfer), the transaction is batched with others and
sent to ACH. The ACH sorts, settles, and sends credits and debits to the RDFI to credit
or debit the specified accounts.
Originating depository financial institution (ODFI) The term adopted by the National
Automated Clearing House Association (NACHA) to refer to the bank that receives
payment instructions from the originator, and then forwards those instructions (entries)
to the automated clearing house (ACH) operator.
Receiving depository financial institution (RDFI) The term adopted by the National
Automated Clearing House Association (NACHA) to refer to the bank that receives
automatic clearing house (ACH) entries from the ACH operator, and then posts them
(either as credits or debits) to the accounts of its depositors, the receivers.
THE INTERNET
Banks have seized the opportunities provided by the evolution of the Internet.
Today banks use the Internet to provide all forms of credit, payment, and deposit
services to consumers and businesses and to communicate with different audiences for
a multitude of purposes. Most bank websites will have, for example :
- public relations information, such as company history, annual reports, press releases
- marketing information about products and special promotions
3
- product information and applications
- secure sites for customers to access account information and authorize transactions
- access to customer service representatives or other bank officers
Like other commercial enterprises, banks use the many features of e-commerce to
promote their business lines and to partner with other businesses. Many banks also
promote deposit or loan products as banners on other commercial websites. Some
banks bundle information and services in useful ways, making their websites
electronic resource centers and virtual malls, with links to other services and vendors
from whom they generate referral fees and commissions. A bank’s website also may
provide virtual personal assistants that can help with shopping for such items as
automobiles, travel services, and other personal tasks.
USERS OF ELECTRONIC BANKING
Businesses use a myriad of electronic banking services, from wire transfers and direct
deposits to online account reconciliation and, more recently, remote deposit capture.
Because electronic banking services improve business efficiency, using them lowers
operating expenses. Although branch banking still ranks first among consumers, young
customers are more likely to use electronic options. Exhibit 6.2 illustrates the
generational differences in the preferred delivery of banking services.
4
Exhibit 6.1 Process Flow for Preauthorized Payment
Maxwell Sampson completes the necessary Icon Energy’s billing department

documentation to arrange a preauthorized makes arrangements with Edison Bank
debit for his monthly utility payments with to start the recurring preauthorized
Icon Energy. payments for Maxwell.
Icon Energy submits preauthorized payment Edison Bank verifies preauthorized

information to Edison Bank & Icon Energy payment information, submits batched
also sends statements to its customers information to ACH settlement.
Maxwell receives his Icon Energy statement

in the mail and notes the payment amount
in his check register.
Edison Bank credits Icon Energy for the ACH settles the preauthorized payment
preauthorized payment batch. The  information. ACH credits Edison Bank
preauthorized credit is posted on Icon for the total amount of the Icon Energy
Energy’s statement. preauthorized payments
AND
Maxwell’s financial Maxwell’s financial ACH debits and sends preauthorized
institution’s institution debits his payment information to the individual
statement shows  designated account payors’ financial institutions, which
the Icon Energy for his Icon Energy debit the individual payor’s accounts,
payment payment-due amount including Maxwell’s financial
institution.
When consumers were asked what banking method they use most often,
approximately one-third said branches. Although banking at a local branch was the
clear favorite of nearly half those over age 55, customers under age 34 ranked branch
banking behind online banking at 35%. Electronic banking is clearly the wave of the
future, and young people are ready to surf it.
ELECTRONIC BANKING SECURITY
The increasing popularity of electronic banking raises unique bank security questions.
Laws and regulations are part of the answer, but improved technology and related
bank policies and procedures also play a role. Banks now use a number of policies,
technologies, and procedures to help keep customer information secure when it is
electronically stored or transported.
5
Generally, only bank employees who have a need to use or view electronically
stored customer information can access the data. Bank systems housing such
information are kept behind security firewalls that make access difficult for
unauthorized individuals. Furthermore, when customer data are transmitted
electronically, they are encrypted, so anyone who attempts to intercept the
tranmission will not be able to view the data.
All internet banking sites use secure sockets layer (SSL) technology to securely
transmit encrypted private documents and payments over the Internet. Internet users
and bank customers know they are on a site that uses SSL, when they see an Internet
address, or URL, that starts with https : instead of http :
Encryption A process that transforms plain (readable) text into cipher (unreadable)
text using mathematical formulas (cryptography) for security or privacy. At the point
of initiation, the transaction or message is encoded (encrypted); at the destination
point it is decoded (unencrypted) for processing.
Direct deposit A process by which funds are deposited electronically to bank

accounts. Commonly used for payroll and Social Security payments.
CONSUMER BANKING
For many customers, the most familiar aspect of electronic banking is the direct
deposit of wages, dividends, or benefit payments. Many other electronic banking
services, however, are increasingly more visible and accepted.
Exhibit 6.2 Users of Electronic Banking
Age % Children % Employment Status %

Total 18 35 Full Part Not Retired
% – – 55+ Yes No time time employed
34 54
Branches 32 17 32 47 24 37 27 29 28 48
Online 26 35 29 13 34 22 35 29 17 13
banking
ATM 26 33 27 20 28 26 26 30 35 20
Telephone 5 7 4 4 7 4 5 6 5 4
Mail 5 3 3 9 4 5 3 5 7 7
Other / 6 5 5 7 3 6 4 1 8 8
None
6
CARD ACCESS TO FUNDS
Using an access card, consumer and business customers can withdraw cash, use
credit, make a payment, or transfer funds between accounts.
ATM cards
Using an ATM card – a plastic access card – to get quick cash, or make a deposit now
is commonplace. For years, customers have used ATM cards at retail POS terminals to
pay for purchases by electronically debiting their accounts. At many ATMs, customers
can buy stamps or cash checks. Some of the larger banks have linked their ATMs to
the Internet, so customers also can pay utility bills and buy concert tickets.
Debit cards
The debit card, also called a check card, is quickly replacing the ATM card. Like
checks, debit cards allow customers to pay for purchases or services directly from
their checking account. Debit cards usually are embossed with either the VISA or
Master Card logo, and use the credit card associations payment system to effect the
transaction at the customer’s bank. Like credit cards, debit cards may be used at POS
terminals, for signature-receipt payments, and for transactions over the telephone or
Internet. Exhibit 6.3 illustrates the processing of a debit card transaction.
Credit cards
Traditional credit cards allow customers to access funds in their credit card account
at a bank. Like debit cards, they can be used at ATMs to get cash advances or make
purchases. The difference is that credit card accounts are assessed an immediate
finance charge for cash advances, although no finance charge is assessed for credit
card purchases, if the statement balance is paid in full each month. Many customers
use credit cards rather than debit cards, and then pay off their balances from interest-
earning transaction accounts.
Customer Service Tip : Debit Cards
- Check your statements immediately on receipt. Make sure you made all the listed
card transactions.
- Keep your receipts. Check the receipts against your statement.
- If your card is lost, stolen or subject to fraudulent use, contact your bank right away
- Memorize your PIN number. Never store PIN number with your ATM or debit card
- Know your cash withdrawal and purchase limits.
7
Stored Value Cards
Unlike ATM, debit or credit cards; stored value cards are access cards with an
encoded amount of cash. Although these cards once were issued primarily by
transportation systems and retailers, banks now offer stored value (gift) cards through
their affiliation with Visa, Master Card and American Express. Governments issue
these access cards for electronic benefits transfers (EBTs) for people who do not have
bank accounts into which funds can be deposited directly. Private industry also has
adopted EBTs, issuing payroll cards to employees, so they may access their wages
through company-selected bank ATMs.
8
Exhibit 6.3 Debit Card Point–of–Sale Transactions
Descriptive
Customer Bill or
Statement
Unlike using credit cards, the
customer is not billed
at the end of the Receipt
Debit Card PIN /
month in a POS
Signature
debit card transaction.
The purchase amount is
electronically deducted
Merchant’s Terminal
directly from
customer’s
bank
account at
Debit Authorization
Notification Card
Data
the time of
sale. The
customer Switching and Processing
authorizes Center
transactions
by
providing a
debit card
and a Tape of
personal Daily
identification Transaction
number
(PIN) or a
signature.
Merchant’s Automated Clearing Customer’s

Bank House Bank
Payment
9
Electronic benefit transfer (EBF) A system for electronic payment of government-
sponsored benefit programs using plastic cards and point-of-sale (POS) technology.
Some stored value cards, such as gift or telephone cards, have a one-time encoded
value. Once that value is depleted, the card is obsolete. Other cards can be reloaded
with additional funds, often through the POS system used by the issuer. For example,
the same machine on buses that accepts payment in cash or by stored value card, also
allows customers to add value to their cards, using cash or a credit or debit card.
Contactless Payment Devices
With traditional debit and credit cards, information is transferred to a card reader,
through a series of contact points on the card. But in the past few years, interest has
focused on contactless cards that use radio frequency identification (RFID) technology
to transmit information to the card reader. The technology allows customers to wave
the card in front of the device, eliminating the need to hand over the card, sign a
receipt, or input a personal identification number. These cards also have a standard
magnetic strip, so they can be used in traditional contact (swipe) machines.
Because of their convenience, contactless cards are used for small ticket items such
as fast food or convenience store purchases. Visa and Master Card are introducing
RFID technology for debit as well as credit cards.
Radio frequency identification (RFID) An automatic identification method that relies

on storing and remotely retrieving data, using devices that can be attached to, or
incorporated into products such as tags or transponders.
INTERNET BANKING SERVICES
PC banking, precursor to Internet banking, allows customers to execute transactions

from a personal computer, using the bank’s proprietary financial software. Customers
dial into the bank’s system and download data, such as account balances and
statements. Some banks also allow for bill payment and account transfers. Although
PC banking is still offered, for the most part it has been replaced by Internet banking.
With Internet banking, customers conduct transactions using browser software

residing on the bank’s Internet server rather than on their PC. Customers enjoy the
10
same services offered with PC banking - opening accounts, submitting loan
applications, viewing check images, and making investments – plus protections that
use account authentication and encryption.
Internet loans
Banks – and many of the financial companies with which they compete – are making
it easy for customers to apply for loans on their websites. Mortgage services include
financial calculators, home shopping information, and a range of rates and loan
applications based on the customer’s answers to a few basic questions. Some bank
websites combine electronic and personal service. For example, a standard loan
application for both personal and mortgage loans is provided, followed by a call from
a customer services representative after the application is processed.
Internet Investments
Online investing is a growing phenomenon – one for which banks face considerable
competition. For example, Federal Reserve banks offer investment opportunities,
because they manage the U.S. Treasury Department’s Treasury Direct system. It is a
convenient way for individuals to hold Treasury securities directly rather than through
a depository institution such as a bank. Customers buy directly from the Treasury,
when the securities are issued, or by instructing brokers to deposit securities in their
Treasury Direct account. The Treasury then uses the ACH to directly deposit interest,
or principal payments to the customers’ accounts at their depository institution.
Most banks are responding to the Internet investment challenge by, for example,
offering different independent investment options on their websites. These range from
education savings accounts to investment trusts, usually with the option of getting
advice from a financial consultant.
Internet Banking Account Management
Internet banking sites allow customers to order checks, view their deposit history,
make transfers between accounts, and pay bills. Customers also can view up-to-the-
minute account balance information, and interim statements that show current activity
as well as previous statements. Some banks offer an electronic statement customers
can download, others allow customers to view electronic front and back images of
paid checks.
To facilitate account reconciliation, many banks allow customers to download a file

containing account activity, including deposits made, checks paid, and transfers
11
posted. Items that cannot be matched to the customer’s monthly statement, because
they have not cleared, are entered manually for reconciliation. Then a summary of
debits and credits is posted, and the customer is given a final balance.
Using Internet banking, customers can access and make transfers between accounts,
and instruct their bank to make recurring transactions automatically. Usually, banks
provide a confirmation number when a funds transfer is completed.
Did you know ..... ? By early 2006 approximately 35% of US households were using
Internet banking .
Electronic Funds Transfers using the ACH Network
Direct Deposit Credits Pre-authorized Debits
Payroll payments Club or association dues

Social Security payments Utility payments
Interest payments Insurance premiums
Pension payments Tax payments
Dividend payments Loan and credit card payments
Mortgage loan payments
Internet Bill Payment
Internet bill payment, the financial service that lets customers pay recurring bills, uses
ACH network capabilities. Generally customers set up a list of payees, persons or
companies they regularly pay, and then instruct their bank to make the payments. The
information provided usually includes the payor’s name (company or person), the
account receiving the funds for deposit, the receiving depository’s name, the account
from which funds are to be drawn, the payment amount and date, the payee’s name,
the transaction type, and the origination date.
In the Internet bill payment process, the ODFI receives the customer’s Internet
instructions for payment, consolidates all payments going to particular payees (utility
companies etc), and provides the payees with a list of the amounts and payors
included in the consolidated payment. Payments then are sent through ACH to the
RDFI or, if necessary, checks are printed and mailed to the payees. The transaction
then is listed on the originating customer’s statement.
12
E-checks
The next evolution of check imaging and Internet banking is the electronic check (e-
check), a computer file processed and exchanged electronically. Using e-checks,
consumers and businesses can issue, receive, process payments electronically; either
singly or in batches. Simple computer software allows everyone, from individuals at
home to large corporate accounting systems, to generate and process e-checks.
E.checks must be properly signed and endorsed using a digital signature that is
encrypted to protect against forgeries. Digital signatures make it possible to verify
transaction information each step of the way – a major advantage over paper checks.
Encryption also means e-checks cannot be modified without invalidating the
signatures, another protection against forgery.
Electronic check An electronic version of a paper check that includes the date, payee
name, payment amount, and signature. Checks bear a digital signature security code
proving payment was authorized by the account holder.
BUSINESS BANKING
Most electronic banking benefits enjoyed by individual consumers are also available
to businesses.
Direct deposit is probably the most widely known and promoted business service.
Even small companies, especially if they use an outside payroll vendor, often arrange
to have wages sent directly to employees’ bank accounts. Vendor payroll companies
and banks compete for this account service. When a bank manages a direct deposit
program, the business provides a list of its payroll employees. The bank then debits
the business’s account, and sends the funds to the banks where individual employees
have their accounts. The federal government does the same with benefit checks such
as Social Security payments.
Most cash management services now are supported by Internet banking technology,
so company finance managers have online access and flexible tools with which to
review, direct, and authorize company deposits, withdrawals, transfers, payments, and
investments. Letters of credit, which have supported merchant transactions for
centuries, are now processed electronically. Many services offered to businesses are
13
supported by bank-owned electronic systems or organizations., of which banks are
members or customers.
Letter of credit An instrument issued by a bank at the request of a customer, generally

a buyer of goods, that substitutes the credit of the bank for the credit of the buyer. The
letter stipulates the issuer will honor drafts or other demands for payment in
compliance with the conditions specified in the letter.
ELECTRONIC BILL PRESENTMENT AND PAYMENT (EBPP)
One Internet bill paying service that focuses on business needs is electronic bill
presentment and payment (EBPP). This service allows major companies to send their
bills to customers online, and for customers to pay online. The two systems currently
marketed are biller direct and bill consolidator. Each system reduces the cost of
billing, and accelerates vendor receipt of payments.
Biller direct The company posts consumers’ bills on its website. Consumers access
the site and pay their bill through an ACH transfer or credit card.
Bill consolidator A third-party presenter collects bills from some companies, makes
them available to consumers on its website. Consumers access the site and pay their
bills through the site by ACH transfer or credit card. Banks operate as consolidators.
Customer Tip : Electronic Checks
Before you agree to electronic check conversion, you should first ask yourself
- Do I understand that the information from my check will be used to make an

electronic payment from my account ?
- Do I have enough money in my account to cover the payment ?
Before you leave the store, you should ask yourself

- Did I receive a receipt ?
- Does the amount on the receipt match the amount of my purchase ?
- Was the check returned to me and voided ?
When you receive your statement from your financial institution, you should
- make sure the charges on your statement match your records
- contact your financial institution right away if you notice a problem
14
IMAGING AND REMOTE DEPOSIT CAPTURE
Although the number of checks processed each year continues to decline, banks still
process millions annually. Today technology and the law allow a paper check to be
scanned to create an electronic image that then is transferred as an electronic file for
collection, reducing operator error and check payment risks.
Retail merchants scan checks into a check reader that converts the data to an
electronic transaction. The merchant then returns the check to the customer and the
electronic check is processed for payment.
Other business customers & banks are using check imaging. Many small businesses
now scan checks and send the images to the bank for deposit, a process known as
remote deposit capture (RDC), or check truncation. Some scanners capture both sides
of the check. For businesses and banks, check imaging reduces the cost of processing
checks and records, while making it easier to store and transmit financial data.
Check imaging makes it possible for businesses with outlets in several states to
consolidate their accounts at a single bank, thereby reducing the need to deposit
checks in a local bank. The technology also enables community banks to extend their
geographical market area, by offering check-imaging and related services to more
businesses of various sizes and structures.
Remote deposit capture (RDC) A service that allows consumers or businesses to scan
checks and transmit the scanned images, or automated clearing house data in an
encrypted form to a bank for posting and clearing.
FEDWIRE, CHIPS and SWIFT
The 2 major wholesale EFT systems that banks use to borrow from each other, invest
daily surplus funds, settle clearing balances, and give better service to depositors and
borrowers are the Fedwire Funds Service, and the Clearinghouse Interbank Payments
Systems (CHIPS). The Society for Worldwide Interbank Financial Telecommunication
(SWIFT) is another international messaging network used by financial institutions.
15
Fedwire Funds Service
The Fedwire Funds Service – the Fed’s EFT network – is used for transfers of
reserve account balances of depository institutions, and US government and federal
agency securities, almost all of which are only in electronic form. Fedwire also is used
to transfer certain third-party payments – usually those that are large-value and time-
critical – to bank customers. Clearing systems, such as CHIPS, also may engage
Fedwire for settlement purposes.
All banks use the service. Fedwire’s more than 9500 participants can initiate EFTs
that are immediate, final, and irrevocable. In November 2006, Fedwire processed, on
average, more than 630 000 transactions valued at more than $4 trillion each day.
Fedwire funds transfers are processed individually, rather than in batches like ACH
transfers. Each transaction is processed in seconds, all are guaranteed by the Fed.
A related Fed service is the Fedwire Securities Service, which provides safekeeping,
transfer, and settlement services for securities issued by the US Treasury Department,
federal agencies, government-sponsored enterprises, and certain international
organizations. Federal Reserve banks act as fiscal agents for these entities. Securities
brokers and dealers do not use Fedwire directly; they have accounts at depository
institutions that are Fedwire participants.
SWIFT
The Society for Worldwide Interbank Financial Telecommunication (SWIFT) runs a

worlwide network by which messages concerning financial transactions, such as
letters of credit, payments, and securities transactions, are exchanged among banks
and other financial institutions. SWIFT, which is industry-owned, serves nearly 8 100
financial institutions in 207 countries and territories. Members include banks, broker-
dealers, and investment managers. SWIFT also encompasses corporate and market
support systems for payments, securities, and trades.
OTHER FEDERAL RESERVE SERVICES
The US payments system is the largest in the world. Most of the payments underlying
those transactions flow between depository institutions, a large number of which
maintain accounts with Federal Reserve banks. The Fed therefore is a crucial
intermediary for the clearing and settling of interbank payments.
16
National Settlement Service
The National Settlement Service, owned and operated by the Federal Reserve banks,
is offered to depository institutions that settle for participants in clearing houses,
financial exchanges, and other clearing and settlement groups. Settlement agents
acting on behalf of those institutions electronically submit settlement files to a Federal
Reserve bank, which then processes them and automatically posts the entries to the
Federal Reserve bank accounts of the depository institutions. Once posted, entries are
final and irrevocable. The service improves operational efficiency, and controls and
reduces settlement risk for participants.
Federal Reserve Intraday Credit
In the course of a day, so much electronic money flows in and out of the nation’s large
banks so quickly that banks sometime inadvertently pay more than they have on
deposit. This usually occurs when there’s a mismatch in timing between the settlement
of payments owed and the settlement of payments due. These daylight overdrafts
typically last for only a few minutes, but in a fast-paced technological environment
that is still a considerable risk. The Federal Reserve banks therefore extend intraday
credit, also known as daylight or daily overdraft credit, to facilitate settlements and
ensure the smooth functioning of the US payments system, subject to a series of rules.
Settlement The conclusion of a transaction, including completing all necessary

documentation and making the necessary payments, the point at which claims and
obligations are satisfied.
Daylight overdrafts (1) A negative balance created in an account when payments

made during business hours exceed incoming funds actually received.
(2) An overdraft in a bank’s reserve account at a Federal Reserve bank during
business hours.
The Fed uses an automated system to measure an institution’s intraday account

activity, and calculate the fee it charges for the intraday credit.
DEVELOPMENTS AND TRENDS
Reviewing the past and looking toward the future, what lies ahead for electronic
banking ? Trends indicate it will continue to become more and more important in most
all areas of banking. For example, consumers using electronic bill payment services
17
report significantly greater satisfaction with their banks. Consumers appreciate the
convenience, due-date reminders, assured on-time payments, and environmental
benefits. They also are more likely to recommend their bank’s online bill payment
services to family members and friends, and are less likely to switch providers.
These levels of satisfaction are encouraging banks to deliver better services, often
by blending personal service with the speed and convenience of electronic banking.
VIRTUAL BANKS
Many banks have websites as well as brick-and-mortar branches, although some

banks, known as virtual banks, only have websites. Customers bank with virtual banks
online or by phone.
Sample list of Virtual Banks Bank Direct, Bank of Internet USA, Net Bank, Virtual
Bank, First Internet Bank of Indiana.
The success of Internet services banks provided in the 1990s led to the development
of virtual banks. These banks do not have the traditional banking infrastructure of
physical branches, a cost efficiency that allows them to offer savings accounts with
higher interest rates, and loans with lower interest rates than most traditional banks.
The first fully operational virtual bank was the Security First Network Bank (SFNB),
which began operations in 1993. Based in Atlanta, Georgia, SFNB was the first virtual
bank to be insured by the Federal Deposit Insurance Corporation (FDIC). After three
years of operation, it was acquired by the Royal Bank of Canada (RBC). Although
SFNB did not make profit initially, it demonstrated that the concept of virtual banking
could work. Like all banks, virtual banks must comply with banking laws.
For both traditional and virtual banks, a major challenge is how to provide excellent
personalized services along with convenience. Although customers are demanding
new ways to access products and services, they also expect seamless delivery of, and
access to, a bank’s products and services – and consistent service across all delivery
platforms.
WIRELESS BANKING
The USA has been slow to adopt the practice of using mobile phones for financial
transactions, though the technology is quickly being adopted eslsewhere in the world.
18
Popular in Europe, the practice also is expanding rapidly, in sub-Saharan Africa,
because of the scarcity of bank branches in some countries.
One U.S test in late 2005 linked mobile phones with contactless communications. At
Philips Arena in Atlanta, 150 fans with a Cingular subscription and a Visa credit card
account with JP Morgan Chase used their phones to pay at concession stands. When
the trial ended, Visa concluded that transactions using contactless technology were up
to 25% faster than those involving cash.
To resolve concerns about cell phone security, most data related to bank accounts
will not be stored in the phone’s memory. Instead, cell phones will be used purely as
access devices. Consumers will be given identification numbers to access personal
data, and after a transaction, the data will be erased wireless from the cell phone.
Electronic banking received official recognition in the Electronic Fund Transfer

Act, a federal law enacted in 1978 that defines the rights and responsibilities of users
and providers of consumer EFT services. Other banking laws, such as those discussed
below, also affect electronic banking activities. The laws are implemented by bank
regulators. Regulations that apply to traditional methods of banking also apply to
electronic banking, as do federal privacy laws. Banks, the government, and the public
all have vested interests in ensuring that electronic banking services function well,
fairly, and securely.
ELECTRONIC FUND TRANSFERS
The Electronic Fund Transfer Act, implemented by Federal Reserve System (FRS)
Regulation E, establishes the rights, liabilities, and responsibiliies of participants in
EFT systems, such as ATM transfers, telephone bill payment services, retail POS
terminal transfers, and preauthorized transfers from or to consumers’ accounts, such as
direct deposits and Social Security payments.
The law refers to all transactions initiated through an electronic terminal telephone,
computer, or magnetic tape that instruct a financial institution to credit or to debit a
consumer’s asset account. For example, FRS Regulation E limits the customer’s
liability for unauthorized use of an access device, such as a debit card, to $50, if the
customer informs the financial institution promptly that the card has been lost or
stolen.
19
FUNDS AVAILABILITY
FRS Regulation CC implements the Expedited Funds Availability Act (EFAA). The
EFAA requires banks to make funds deposited in transaction accounts available to
their customers, within specified time frames, to pay interest on interest-bearing
transaction accounts, no later than the day the bank receives credit, and to disclose
their funds availability policies to customers.
Although the regulation states that proceeds of local checks generally must be made
available for withdrawal by the second business day after deposit, with nonlocal check
proceeds available by the 5th day, this requirement is under review now that electronic
systems mean distance has little or no relevance to the clearing of checks .
CHECK COLLECTION AND FUNDS TRANSFERS
FRS Regulation J, the Collection of Checks and Funds Transfers, applies to checks &
other transactions moving through Federal Reserve banks, and funds transfers through
Fedwire. FRS Regulation CC and Regulation J set the rules under which depository
institutions, such as banks return can unpaid checks with check images, through the
system.
CHECK CONVERSION
Check 21 – the Check Clearing for the 21st Century Act – made the substitute check
possible for designating it as the legal equivalent of the original check for all
purposes, provided the substitute check contains an image of the front and back, has
the MICR line and physical characteristics of a check, accurately represents all the
information on the original check, states that it is a legal copy of the check, includes
all endorsements, and identifies the party creating it. If a bank does not exchange
checks electronically, or if a customer wants a copy of the check, the electronic file
can be converted back to a paper item.
ELECTRONIC SIGNATURES
The Electronic Signatures in Global and National Commercial Act (E-SIGN Act)
2000 gives e-contracts and e-signatures the same status as paper records. Both parties
must agree to the electronic contract. Thus, prior to obtaining agreement, a bank must
inform customers that :
- they can have their records in paper form and the procedures for obtaining a paper
copy of an electronic record.
20
- they can withdraw their consent, the consequences for doing so, such as an end to the
agreement, and the procedures for withdrawing consent.
- they need certain hardware and software to access and retain their electronic
records.
Banks must abide by the rules of the E-Sign Act and the related Uniform Electronic
Transactions Act (UETA), which was adopted by many states to further e-contracts
and electronic commerce for many Internet-related banking activities, such as
providing electronic disclosures to consumers for loan or deposit transactions.
SUMMARY
1/ Electronic banking is becoming an increasingly important delivery channel for

customer services. Internet banking is a common form of electronic banking today,
although electronic banking has been prevalent for decades. For many years, MICR
symbols on the front of checks provided identifying information for automated
processing. Automated processing now is being replaced with check imaging, a
technology that enables banks and other commercial establishments to capture an
electronic image of a check that can be transferred for paperless processing.
2/ Banks use EFT systems to borrow funds from each other, invest daily surplus
funds, settle clearing balances and provide services to customers. Banks, corporations,
and governments use batch-processing ACH services to make recurring payments,
such as payroll deposits. Customers use ACH when they authorize automatic
payments of insurance premiums, mortgages, loans, and other bills.
3/ When banks market on the Internet, they bundle information and services to make
their websites electronic resource centers for customers. They can also generate fees
when they link to other services and vendors. Some banks offer travel and shopping
services.
4/ Direct deposit is the most familiar electronic banking service for most consumer &
business customers. A business gives its bank a list of its payroll and instructs the bank
to debit its business account and send the funds to the banks where the individual
employees have accounts. The federal government uses this method to transmit Social
Security and other benefit payments.
5/ E-banking allows customers to access funds, make purchases, and, in some cases,
make deposits and transfers using ATM, debit, credit, stored value cards. Contactless
21
payment devices using RFID technology are becoming popular. Other electronic
services increasing in importance are Internet banking services such as account
management, bill payment, loan application and servicing, and investment services.
6/ Check imaging technology scans paper checks to create an image that can be cost-
effectively transferred as an electronic file for collection. Businesses also use imaging
to make deposits directly from their offices, a service called remote deposit capture
(RDC). E-checks, on the other hand, allow payments to be processed without the need
for paper at any point. They are signed and endorsed using digital signatures.
7/ Banks process EFTs initiated by business and consumers using EFT systems.
Fedwire is used for interbank, government, and customer transfers. CHIPS is used for
transfers in the international market. Because so much electronic money flows
through the Fedwire system, the Fed extends intraday credit to facilitate settlement.
Federal Reserve banks also operate the National Settlement Service, which allows
financial institutions that participate in clearing houses to do so efficiently and with
reduced risk. SWIFT is an industry-owned cooperative that supplies secure messaging
services and interface software to large institutions worldwide.
8/ A number of banks have no brick-and-mortar branches, providing services only

through the Internet. These virtual banks may not be as convenient for customers to
use, but often offer more competitive yields and lower fees. Many institutions in the
USA are experimenting with cell phone banking. The technology is similar to what
banks use on their websites. Data related to bank accounts will not be stored on the
phones, however, due to security concerns.
9/ The main laws and regulations that relate directly to electronic banking are the
Electronic Fund Transfer Act, implemented by FRS Regulation E, which covers EFT
transactions, the Expedited Funds Availability Act (EFAA), implemented by FRS
Regulation CC, and FRS Regulation J, which covers check collection and funds
transfers through Wedwire. The E-Sign Act is important for the electronic delivery of
disclosures and contracts to consumers, such as those supporting the delivery of bank
services through the Internet.
SELF –CHECK AND REVIEW
1. How are electronic funds transfers (EFTs) and Automated Clearing House (ACH)
services related ?
2. How do contactless payment devices work ?
22
3. How is check imaging used ?
4. How do Fedwire and CHIPS work ?
5. What Fed regulations apply directly to electronic banking ?
6. How do virtual banks operate ?
23
CHAPTER 7 LENDING
LEARNING OBJECTIVES
- explain the importance of the lending function

- describe lending products and services for bank customers
- describe the steps in the lending process
- explain how the bank board of directors governs loan policy
- describe laws and regulations relating to lending
INTRODUCTION
Since the dawn of civilization, borrowing and lending money have been financial
activities. In the ruins of ancient Babylon, archeologists discovered written evidence
of a loan made to a farmer, who promised to pay it back with interest after he sold his
crops. In the Middle Ages, goldsmiths, who held precious metals and other valuables
belonging to their customers for safekeeping, often made loans against the value of
those assets. In the 18th century, two Continental Congresses financed the American
Revolution in part through loan certificates. The federal government has since
borrowed to finance every war involving the USA.
Banks offer a wide variety of affordable loans to consumers, businesses, and

governments. To maintain the quality of a bank portfolio, bankers must adhere to the
bank’s loan policy and carefully complete the lending process. Taking the application,
matching financial need to the appropriate product, establishing customer
creditworthiness, properly documenting the loan, and carefully rendering a credit
decision are all vital aspects of the loan process. Following the legal and regulatory
requirements ensures that the bank is balancing its operating objectives for liquidity,
safety, and income.
THE LENDING FUNCTION
As one of the three cornerstones of banking – the deposit, payment, and lending
functions – the lending function represents a significant source of income. Lending is
one of the most traditional elements in the relationship between a bank and its
customers. Under the Community Reinvestment Act, banks are evaluated and given a
public rating on their record of helping to meet the credit needs of their communities,
such as making loans to individuals for home mortgages, small businesses, and small
24
farms, including loans to low-to-moderate-income customers. The quality of its loan
portfolio often is critical to a bank’s survival, and lending is essential for a healthy
growing economy.
SOURCES OF CREDIT
Today credit is available from many sources. Consumers can apply for credit from a
finance company. They can borrow from an insurance company against their life
insurance policies, or from a brokerage firm against the value of their securities.
They can buy merchandise on credit from a retailer, obtain a home mortgage or home
equity loan from a savings bank, commercial bank, credit union, mortgage broker. As
savings depositors, consumers may use their account balances as security for loans.
Commercial enterprises also may choose among many sources of credit. Although
commercial banks traditionally have been the primary source of business loans, in
recent decades competitors have emerged. Savings banks offer business loans. One
business may extend credit to another by releasing merchandise in advance of
payment. Insurance companies often make large long-term loans for constructing
shopping centers, office buildings, and factories.
Many large corporations offer consumer and business loans through captive financing
companies, such as General Motors through GMAC Financial Services, and General
Electric through G.E. Capital Corporation. Commercial financial firms are another
source of credit. Businesses may go to these nonbank asset-based lenders, or non-bank
factors, to finance operating needs, such as building inventories, consolidating debt, or
increasing cash reserves. Also, instead of borrowing from financial institutions, many
large corporations with excellent credit ratings borrow in the money markets, by
issuing unsecured, short-term promissory notes known as commercial paper.
Federal, state, and local governments use various short-and-long term borrowing
techniques to raise funds. Banks often borrow directly from one another by using, for
example, Fed funds or the facilities of the Fed Reserve to obtain short-term credit.
Business (commercial) loans A loan to a business to meet short-or-long term needs.

Asset-based financing A financing method usually focused on the cash flow of a
particular asset, or asset group for return on an investment or loan.
Factor A firm that buys a business’s accounts receivable and collects on the accounts
Commercial paper Negotiable, short-term, unsecured promissory notes in bearer form
issued by major corporations with unquestioned credit standing as means of borrowing
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BANKS AS LENDERS Although there are many sources of credit, banks are a very
important lending source. They can offer attractive rates because their cost of funds is
relatively low. Small & large businesses, governments and consumers take advantage
of the variety of loan products banks offer. A bank loan term may be as short as 30
days or as long as 30 years. Although some loans are secured by collateral, many are
unsecured, the bank relies only on the consumer’s written promise to repay.
LOAN CATEGORIES
Banks divide their loans into categories for reporting to government agencies and
for internal monitoring and planning. The major categories are : consumer loans,
business loans, real estate loans, government and government-sponsored loans.
Different operations centers may manage different types of loan. Home equity
loans and lines of credit often are managed by the consumer loan department, for
example. Many banks classify business loans by industry to monitor how much of their
portfolio is committed to certain sectors of the economy : petroleum, aerospace, etc.
If problems arise in an industry, an astute banker will be aware of the number and
size of loans that may be affected, and will act to limit the bank’s exposure.
CONSUMER LOANS
The demand for consumer loans is growing, prompting banks to direct attention to
serving this profitable market. Consumer loans have proven attractive to banks.
- Interest income contributes to bank profits

- Most consumer loans are repaid as agreed
- Consumer loans are part of full-service banking
- Other bank services, such as deposit products, can be cross-sold to build long-term
customer relationships.
To meet the diverse needs of this segment, banks offer a wide range of consumer
loan products, but generally they fall into 2 broad categories : open-end (revolving)
credit and closed-end (installment) loans.
Consumer loan A loan extended to consumers, either individually or jointly, primarily

for the purpose of buying goods and services for personal use.
Types of consumer loans personal, automobile (direct and indirect), automobile

leases, mobile home, recreational vehicle, marine (boat), home improvement, home
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equity or second mortgage, home equity line of credit, bank card credit, noncard
revolving credit, education, unsecured line of credit.
Open-end credit
In an open-end (revolving) line of credit, a customer may draw on funds for an agreed
period up to an agreed amount. The balance may fluctuate from zero up to the credit
line maximum. Two examples are a home equity line of credit and a credit card.
A home equity line for credit is secured by the customer’s residence. Because it is
secured, the interest rate typically is lower than for open-end unsecured credit, and the
interest paid may be tax-deductible. The customer may borrow money at any time
before the stated maturity date, and up to the amount of the credit line. Funds may be
used for any purpose, including home remodeling, paying off high-interest-rate loans,
taking a vacation, or purchasing a new car.
Secured loan A loan for which the customer has pledged some form of collateral to
protect the lender in case of default.
Credit cards are a flexible source of credit. The cardholder can control how and when
to use credit. Instead of obtaining a single lump-sum loan up front, as in a personal
closed-end loan, the cardholder can use the credit line to travel, entertain etc .
Because they are easy to use, credit cards are a preferred customer credit choice.
The customer receives a monthly statement from the bank listing purchases made that
month and has the option to pay the entire balance, make a minimum payment, or pay
an amount in between. A few states require banks to give the customer a period of
time (a “grace period”) to make the monthly payment. Generally, there is no finance
charge, if the entire outstanding balance is paid before the payment due date.
Credit cards carry a high amount of risk for the bank, primarily from fraudulent
charges to stolen cards. Also, credit card debt generally is unsecured. For these
reasons, credit cards typically carry higher interest rates than other types of credit.
Closed-end Credit
Closed-end loans have a specified amount and maturity date. They may be single
payment loans, or they may amortize over the course of the loan term with payments
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made in installments on specific dates. The customer receives a lump sum up front.
For payment, the bank may automatically debit the customer’s deposit account, or
provide coupons to accompany payments. The customer sends coupon and payment to
the bank to credit the loan account.
Amortization The periodic reduction of the principal amount due on a mortgage or

other term loan. When the full amount is repaid, the loan is fully amortized.
With an automatic preauthorized debit, the bank charges the customer’s deposit
account for the loan payment, and transfers it to its own accounts if it is the creditor, or
sends it to another creditor electronically. The payment is then listed on the
customer’s deposit account statement.
Closed-end loans may be secured or unsecured. The car being purchased, for
example, may secure an auto loan, and the bank holds the car title until the loan is
paid in full. In making such loans, banks rely on the customer’s ability to repay as
agreed in a signed promissory note.
Promissory note A written document with the customer’s (maker’s) promise to pay a
certain sum of money to the bank (the payee), with or without interest, on demand or
on a fixed or determinable future date.
A home equity loan is a secured closed-end loan. Like a home equity line of credit,
it is secured by the customer’s residence. The interest may be tax-deductible.
Whereas a home equity line of credit may be used whenever the customer needs
funds, a home equity loan is for a one-time borrowing need. Both home equity loans
and lines of credit may offer a fixed or a variable interest rate.
REAL ESTATE LOANS
Real estate loans can be for consumer and business purposes. Banks are involved
primarily in two areas of real estate financing : short-term construction loans, and
longer-term mortgage loans.
Construction loans
Often a real estate developer requires funds to demolish and clear property, and
begin erecting a new structure, such as a shopping mall, an office park, or a residential
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complex. Consumers use construction loans when they are building a home. A bank
may write a construction loan to accommodate either developer or consumer.
Construction loans are relatively short-term, with maturities consistent with the
construction period. The customer makes periodic interest payments on the loan, and
at the end of the term, the bank may convert it to a mortgage loan. Often, one bank
provides the construction loan, and another or a combination of banks extends
mortgage credit, when the project is completed.
Mortgage Loans
Mortgage loans are closed-end, long-term credit with terms of up to 30, or even 40
years. To secure the loan, the customer pledges property as collateral. Banks extend
mortgage loans on homes, office buildings, apartment houses, and shopping centers.
Because they are closed-end loans, scheduled payments cover both interest and
principal. Gradually, the loan balance is reduced over time as payments are made.
The adjustable rate, or variable rate, loan has made the mortgage lending market
attractive to both customers and lenders. A lender, if the promissory note allows, may
adjust the interest rate on the mortgage during the loan term, as market conditions
change. If interest rates decline, the customer benefits from the lower rate. Interest for
adjustable rate loans is based on an index, such as the prime rate, plus a percentage.
As the index rate changes, so will the interest rate on the loan. Terms for most
adjustable rate mortgages are between 5 and 15 years; the mortgages must be paid off
or refinanced at the end of the term. Other pricing methods for consumer and real
estate loans are defined in Exhibit 7.1
Exhibit 7.1 Consumer Loan Pricing Methods
Simple interest Interest is computed by applying a daily periodic interest rate to

the principal amount outstanding. If the customer pays additional
amounts on principal, the loan’s total interest amount is reduced.
Discount method Interest payment is deducted up front from the requested loan
amount, so that the borrower receives less principal than requested
Add-on method Total interest due on the loan is calculated as principal loan amount
times the interest rate. This amount is then added to the principal,
and the total is paid in equal installments over the life of the loan.
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Rule of 78s A determination of the amount of interest rebate a customer is
entitled to receive, if the loan is paid before the maturity date. The
sum of the digits 1 through 12 is 78. The sum of the digits for the
loan term’s remaining months is divided by 78. A 12-month loan
paid off in 9 months entitles the customer to a 7.69% rebate on the
total finance charge.
Compensating The interest rate applied is determined by the balance the

balance customer must maintain at the bank.
Adjustable rate mortgage (ARM) A mortgage on which the rate is subject to periodic
adjustment. The rate is usually tied to a widely published market index or interest
rate.
Prime rate The interest rate the bank will offer its most creditworthy customers, and
the base rate used to set interest rates for other loans.
Foreclosure A legal procedure undertaken to permit a creditor to sell property that is

collateral for a defaulted loan.
The pricing and availability of home mortgage loans are based on the customer’s
income and creditworthiness and the appraised value of the property. Because
mortgage loans are secured by the property, if the customer is unable to make the
payments, the lender may proceed with foreclosure, and sell the property at aunction
to recover the unpaid balance on the loan.
BUSINESS LOANS
Business loans are one of the largest components of most bank loan portfolios. Banks
offer a wide variety of business loan products, because businesses have diverse
financing needs. A garden nursery, for example, may need a seasonal line of credit to
finance purchases of plants and gardening equipment each spring. An airplane
manufacturer may need a term loan to expand a manufacturing facility. Secured or
unsecured, business loans typically are categorized by type and by maturity – that is,
as either short-term or long-term.
Short-term Loan Repayable in one year or less. For businesses, used to finance
current assets, such as inventory or accounts receivable.
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Long-term Loans Repayable in more than one year. For businesses, used to finance
fixed assets, such as equipment and real estate.
The following are some of the most common types of business loans.
Working capital loan
Short-term loan (typically 30 to 90 days) to provide immediate funds for a one-time

need, such as raw materials for a toy manufacturer to make toys for the holiday
season.
Working capital line of credit
Funds provided, like a consumer line of credit, for businesses to access for recurring
financing needs throughout the year. Banks often require that the credit line be fully
paid within 30 days during the business’s annual operating cycle. Rates typically are
variable and based on the prime rate.
Term loan
Loans with maturities of 1 to 5 years used to purchase fixed assets other than real
estate. Generally the payment schedule is tied to the useful life of the asset. Plant
equipment, for example, is financed over a longer period than are personal computers.
Participation loan
A loan made to a single customer by 2 or more banks acting together. Common in

business lending, these loans usually are made when the amount exceeds one bank’s
loan policy or legal lending limit. Also known as syndicated loans, these allow the
lending banks to share the risk of extending considerable credit.
Indirect or third-party loan
Loans made to customers of dealerships, such as automobile or appliance dealers.

Banks work directly with, and obtain loan applications through the dealers. These
loans are a source of new consumer business for banks.
Floor plan loan
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Loans to a dealer to finance consumer goods for display and sale. The consumer
goods, such as automobiles or appliances, are collateral for the loan.
Letter of credit
An instrument issued by a bank that substitutes the bank’s credit for the credit of the
buyer of goods. This can allow a buyer to pay after goods have been received, and
thus conduct more transactions.
Lease financing
An arrangement whereby the bank owns the collateral and leases it to the customer
for use for a specified period and monthly payment. Depending on the terms,
ownership may transfer to the customer when the lease ends.
Asset–based loans
Short-term loans secured by salable business assets, such as inventory (raw material
and finished goods) or accounts receivable.
Leveraged-buyout (LBO)
Loans made to finance mergers and acquisitions. One example of LBO loan use is
to help finance the purchase of a company by a group of investors, including insiders,
who plan to return value to the business under different management.
Banks also lend to agricultural concerns, such as farm, ranch, fish, poultry, and other
livestock operations. These loans support crop planting, harvesting, livestock care and
feeding. Many agricultural loans are supported by federal government-sponsored
programs such as those offered by the U.S. Department of Agriculture or the Federal
Agricultural Mortgage Corporation (FARMER MAC).
Other financial institutions also may be bank loan customers. Banks lend to other
banks, insurance companies, finance companies, and brokerages. One of the most
common bank-to-bank lending methods is associated with the Federal Reserve’s bank
reserves requirements. Banks lend their excess reserve amounts to other banks that
need the funds through arrangements known as Fed fund loans. These are typically
overnight transactions.
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Business Loan Pricing
Business loans may be priced like consumer loans. Often, however, business loans
require more complex analysis, structuring, and therefore pricing. Two common
methods are cost-plus pricing and relationship profitability pricing.
Cost-plus pricing
The interest rate is determined by setting it at a fixed amount or percentage above

the costs to make the loan. Costs include such items as the cost to the bank to raise
funds for the loan amount (such as interest on deposits), an amount for default risk
(loan loss), and a profit margin.
Relationship profitability pricing
The customer’s total banking relationship is considered : all the revenues less all the
costs associated with the relationship divided by the requested loan amount. The result
determines the net return to the bank for the relationship and the loan.
GOVERNMENT AS BORROWER AND LOAN SUPPORTER
Like consumers and businesses, state and local governments borrow from banks.
There may not always be enough tax revenues on hand to finance road equipment or
meet other working capital needs. Therefore, a goverment entity will seek approval
from its board or elected oversight body to obtain a bank loan for a specific purpose.
Governments often seek financing with terms similar to business loans. Banks also
may provide short-term loans based on anticipated tax revenues to pay off the loan.
Government-sponsored loan programs are another way for banks to lend. Through
legislative mandates, government-sponsored bank loan programs promote social and
economic objectives, such as affordable housing, access to higher education, and
small business development.
Affordable Housing
Through loan subsidies and guarantees, federal agencies such as the Veterans
Benefit Administration (VBA) and the Federal Housing Administration (FHA) make
mortgages available to people who are otherwise unable to afford them. States may
subsidize mortgage loans for low-income or first-time home buyers.
Access to Higher Education
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The federal government provides student loans through, for example, Sallie Mae.
Student loan programs offer low-interest or fully subsidized-interest loans, with
repayment deferred until after the student graduates.
Small Business Development
The Small Business Administration (SBA) guarantees loans made to qualified small
businesses, thus transferring some of the risk from the lender to the SBA.
Other Government-Sponsored Lending
Government-sponsored enterprises, such as the Federal National Mortgage

Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation
(Freddie Mac), play an important role in the mortgage lending market. Through the
secondary mortgage market, Fannie Mae and Freddie Mac buy loans granted by
mortgage lenders and issue mortgage-backed securities (MBS) for sale to investors.
Secondary mortgage market Transactions involving selling and purchasing mortgages.

Mortgage loans originate in the primary mortgage market. The later sale of those
loans occurs in the secondary market.
Mortgage-backed securities Pools of mortgages used as collateral for the issuance of

securities in the secondary market. Commonly referred to as “pass-through”
certificates, because payments on the principal & interest of the underlying loans are
passed through to investors. The interest rate on the security is lower than the interest
rate of the underlying loan to allow for payment of servicing and guaranty fees.
The Government National Mortgage Association (GNMA or Ginnie Mae), a

corporation within the U.S. Department of Housing and Urban Development,
guarantees the principal and interest of pools of residential loans insured by the
Federal Housing Administration (FHA) or guaranted by the Department of Veterans
Affairs (VA). GNMA-approved lenders with a pool of such loans having similar rates
and maturities can issue an MBS in the amount of the loan pool. Other eligible
guarantors or issuers of loans are the Department of Agriculture’s Rural Housing
Service (RHS), and the Department of Housing and Urban Development’s Office of
Public and Indian Housing (PIH).
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Farmer Mac, federally chartered by Congress in 1988 and stockholder-owned,
fosters a secondary market program for agricultural real estate and rural housing
loans. Among other services, Farmer Mac will purchase eligible mortgage loans from
lenders, securitize the loans, and sell the MBS in the secondary market.
THE LENDING PROCESS
Although banks differ in their credit standards and policies, all follow a general
lending process that includes the loan application and interview, investigation,
documentation and credit administration.
Each step has a cost and a risk to the bank. Larger loans require more detailed
investigation, documentation, and management than smaller loans. Lenders assess
each request in terms of its risk, cost, and profitability, and then apply that assesment
to the steps in the lending process.
Regardless of the type or size of credit, a rigorous lending process helps protect the
bank against loss. There is, however, always some risk in lending. No formula or
system positively guarantees full and timely repayment of loan principal and interest.
Exhibit 7.2 charts the lending process.
Exhibit 7.2 THE LENDING PROCESS

Start
Yes Yes Yes
Complete the Is the preliminary Does Do investigation Is applicant
application interview / application and analysis of creditworthy ?
and collect negotiation meet loan loan application
data successful ? policy criteria?
?? No
No No
Stop Stop Stop
Yes
Bank Structure the loan Customer signs Book Manage Monitor and
approves and prepare loan loan documents the the loan maintain the
loan ? documentation and receives loan loan until
funds completion
No
Stop Dispense Loans vs
documents to paid off
1. Credit Dept.
2. Collateral Dept.
3. Note Dep.
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* This step will be completed first only if it is a consumer loan.
Otherwise it becomes a component of the loan interview.
THE APPLICATION AND INTERVIEW
The lending process starts with the application & loan interview. The goal of this step
for the bank is to understand the customer’s needs, gather supporting documentation,
and help the customer, if eligible, to choose the most appropriate loan product.
To gather preliminary information, banks have customers complete a loan application.

The information may be elicited beforehand on a form, or during the loan interview
which may take place in person, over the phone, over Internet or through a third party.
The nature and details of the loan requested determine the interview process. A loan
officer may meet several times with a business owner who is seeking a complicated
business loan, so as to understand the company’s financial situation. However, a car
dealer (a third party) will interview the customer for a consumer automobile loan.
Exhibit 7.3 lists some questions typically asked of an applicant during a loan interview
Exhibit 7.3 Sample Loan Interview Questions
How much money do you need ? Who owns the collateral ?

How did you arrive at your loan request ? Where is the collateral located ?
How will you use the loan proceeds ? How is the collateral valued ?
What financing needs are you projecting ? Are there guarantors ? If so, who are they,
What terms are you requesting ? what is their relationship to you, and what
How did you decide what terms are is their financial strength ?
best for you ? What banks do you currently use ?
What is your repayment source ?
What is your income ? Have you approached other banks with
the loan request ?
Do you have loans outstanding with other
Will personal assets be pledged creditors ?
as security for the loan ? What is the nature and extent of these
loans ?
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After the application and interview are completed, the bank decides whether to
continue with or deny the loan request, ask for additional information, or direct the
customer to other financing sources. Loan officers must be aware of bank policy and
the relevant law throughout the lending process. If the loan request is inconsistent with
bank lending policy, it should be rejected. Consumer protection laws, such as the
Equal Credit Opportunity Act and the Truth in Lending Act, impose specific
requirements on lenders, beginning with loan solicitation and application.
Payment Protection
At this time the lender may offer the consumer a payment protection plan that will
ensure repayment of the loan during difficult times. Payment protection may be an
insurance or a fee-based product.
Payment protection Products that are sold in conjunction with loans so that the loan
can be paid if the customer dies, is injured or disabled, or loses a source of income.
Credit insurance is issued by an insurance company and may cover life, disability
(accident and health insurance), or loss of income. The insurance premium is added to
the loan amount, and the premiums are paid with the loan payments.
Bank fee-based products include debt cancellations (DCA) and debt suspension
agreements (DSA). These services are purchased separately from the loan and paid
for, when the loan is consummated. DCAs pay part or the entire debt in case of certain
events, such as the customer’s death. DSAs suspend payments for a time, such as
while a customer is unemployed or disabled.
Lending over the Internet
The Internet has advanced the delivery of loan products. Through interactive
websites, banks offer consumer and business loans to prospective customers. Today,
the entire lending process - from application to approval - can be conducted online.
Most bank websites offer tools for customers to determine the type of loan they
need, compare different terms and interest rates, calculate payments, and determine
whether they qualify for a loan. Then the customer can submit an online application,
and receive a decision on the loan request online shortly thereafter. Customers also
can make loan payments online, or direct the bank to periodically withdraw payments
from a deposit account.
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THE INVESTIGATION
A credit investigation is conducted to evaluate a customer’s ability to repay the loan.

When making credit decisions, banks evaluate information on the loan request and
balance it against the potential cost and risk of making the loan. An incomplete credit
investigation can increase the bank’s risk of a loss.
Consumer credit investigations
Credit investigations usually consist of verifying the applicant’s employment, income,

credit history, and current debts. Most lenders subscribe to a basic standard when
credit is evaluated, especially when analyzing creditworthiness. The standard is
known as the five Cs of credit : character, capacity, collateral, capital and conditions.
Exhibit 7.4 Five Cs of Credit
Character : The borrower’s willingness and determination to repay the loan. Usually
considered the most important of the Five Cs of Credit.
Capacity : The borrower’s ability to repay the loan, that is, to generate enough funds
and manage those funds to make loan payments.
Collateral : The assets the borrower pledges as a source of loan repayment in case of
loan default. It is usually viewed as a secondary source of repayment only.
Capital : Other assets that may be used to pay the loan. For businesses, capital often
consists of the equity an owner has in the business.
Conditions : External factors that may affect the borrower’s ability to repay the loan,
such as a change of employment.
A first step in credit investigation is to check records held in the bank and by other
lenders. Banks also rely on credit reporting agencies for information. Credit reporting
agencies keep detailed records on consumer credit histories and activities. These
agencies can give a bank daily input on new loan applications, repayments, rejected
requests for credits, and delinquencies. Information the applicant provides is cross-
checked with agency reports to determine its accuracy.
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If a bank declines a consumer loan request on the basis of unfavorable credit
information, it is required to inform the consumer that a credit report was used to
make the decision. Creditors also must provide the reason for the denial, or a
statement that the consumer may request the reason.
Banks often rely on credit scoring to improve the efficiency and objectivity of a
credit investigation. A credit score relies on a mathematical formula to determine the
likelihood that a consumer will repay a loan, should there be adverse circumstances.
Many factors are considered in the credit score, including amount and type of
outstanding credit, repayment patterns, and credit history.
Credit scoring also is used with electronic underwriting. The electronically

generated score determines whether the applicant profile falls within the bank’s
acceptable range. This cost-effective procedure allows the bank to process a large
number of loan applications. Only loan applications that fall into a defined gray area
are referred to a loan officer for further evaluation.
Did you know ......... ?

Most credit reporting agencies provide credit scores, fraud detection, social security
number discrepancies, and legal notices such as liens, lawsuits, and encumbrances.
Types of credit information
credit history, income, employment, residence, collateral value.
Sources of credit information
application, internal bank files, directly from other financial institutions, credit
reporting agencies, public records.
Business Credit Investigations
Because of the larger amounts and complexities, the investigative process is more
detailed for business than for consumer loans. Many sources of information are used :
Loan analysis (credit) department
Credit files on business accounts provide a history of the bank’s relationship with a
customer. They contain reports of interviews, copies of correspondence, financial
39
statements supplied by the customer, internal memos, previous credit analyses,
average balances, previous loans, overdrafts, and loan approval documentation.
Credit agencies
Agencies like Dun & Bradstreet publish regular business reports that provide current
financial information on a company. Reports cover the firm’s history, management
structure, products, scope of operations, and payment history with suppliers.
Suppliers
Because most merchandise is sold with credit terms, the bank must know a company’s
history of paying suppliers. Information can be found in credit agency reports or
through direct contact with the borrower’s supplies.
Internet
Many companies have their own websites, where banks can access annual reports
and information about a company’s products, services, and history.
Tax returns and financial statements
Accountant-prepared financial statements and tax returns provide information about

growth and earnings, industry trends, and repayment sources.
Credit files contain : copies of loan documents, financial information, credit inquiries
and reports, collateral information, correspondence and memos, information like
business annual reports.
Sample loan documentation for a home equity line of credit
promissory note with disclosure of credit, mortgage agreement (deed of trust),

insurance binder, title search, appraisal, flood determination (flood plain check),
rescission notice.
LOAN DOCUMENTATION
Loan documentation begins at the time of application, and ends with completion of
all forms necessary to secure the lender’s interest, and comply with federal and state
requirements.
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The purpose of loan documentation is to have a written, legally enforceable
understanding of the obligations of both lender and borrower. Failure to properly
document the loan could make the loan agreement unenforceable. Proper loan
documentation is an important responsibility for the lender because it helps to :
- protect the bank’s investment

- ensure that the customer understands the loan terms
- prevent litigation against the bank
- prevent losses on the loan for the bank
- avoid penalties for failure to comply with regulations
Loan documentation is a detailed process to ensure that all federal and state
requirements have been met. The loan officer ensures that all sections are complete,
all calculations and the collateral description are correct, signatures and dates are
obtained, and if necessary witnessed, and any alterations are understood, accepted,
and initialed by all parties.
Lenders also use documentation to meet their obligation to inform customers about
the major components of the loan. Federal law, notably the Truth in Lending Act,
requires that consumer customers be informed of the repayment program, annual
percentage rate (APR), total cost of the loan, consequences of not paying on time, and
information about collateral. Lenders use disclosure forms and the contract to provide
the necessary detail at this stage.
Different types of loans require different types of documentation; the requirements

also vary from bank to bank, and from state to state.
Did you know .... ? The Tax Reform Act of 1986, which made interest on home equity
loans up to $100 000 tax-deductible for most consumers, opened up even wider the
rapidly growing field of home equity loans. Now home equity loans and home equity
lines of credit are a significant part of consumer loan portfolios.
Collateral
The documentation of collateral is governed by federal and state statutes, because a

variety of assets can be pledged as securities for a loan. Government obligations such
as U.S. Treasury bills, securities, savings account balances, residential or commercial
property, and vehicles are among the assets that can be pledged as collateral.
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Banks can take physical possession of paper collateral, such as stocks, bonds, or
certificates of deposits. In doing so, the bank takes responsibility for safekeeping and
control of the collateral.
A bank cannot hold other collateral, such as a vehicle or a house, so the bank’s right
to it must be documented. A security agreement is the standard document for
establishing this right; it creates a security interest in the collateral. State law dictates
how the security agreement must be registered to perfect the security interest.
Although it should never be the sole reason for approving a loan, collateral may
strengthen a borrowing position. A bank does not succeed by foreclosing,
repossessing, or seizing real estate, automobiles, or factories. Usually, it incurs
additional costs if it must do so, sometimes resulting in a loss.
Security interest The right a lender has to obtain possession of the collateral, sell it.
and retain the proceeds (up to the amount of the remaining debt) if the customer is
unable ro repay the loan.
Perfection The process by which a secured party protects its security interest from
third parties by possession, certificate of title, control, filing, recording documentation
of the security interest in local or state public records.
LOAN DECISION
In deciding whether to approve an application for credit, a bank evaluates all the
information collected from credit reports to financial statement analyses. If at any
time during the lending process, it becomes clear that the purpose, amount, or terms of
the loan do not meet the bank’s lending standards; the loan request should be rejected
though the bank may want to offer an alternative credit arrangement, or direct the
applicant to another lender.
If the decision is made to reject the loan, the Equal Credit Opportunity Act and
Regulation B require that the bank provide the applicant with a written “adverse
action” notice explaining why the request was denied.
Customer Service Tip : Credit Warning Signs
- paying only the minimum amount month after month

- being out of cash constantly
- being late in making important payments, such as rent or mortgage
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- taking longer and longer to pay off balances
- borrowing from one lender to pay another
LOAN ADMINISTRATION
The loan is finalized when all documents are complete, forms are signed, funds
disbursed, and documentation filed. At this point, the loan moves into the
administration phase. Loan asministration includes :
- mailing regular statements

- receiving and posting payments
- keeping address information current
- ensuring that the bank’s security interest is recorded, filed, and returned to the bank
- answering customer inquiries
- reporting the loan to credit reporting agencies
- maintaining documentation for examination by internal and external auditors and
regulatory agencies
- taking the loan off the books when the final payment is received
After it has been approved and placed in the bank’s loan portfolio, the bank
monitors the loan to ensure it does not become a problem loan – one in which the
customer is not adhering to the terms of the agreement. For business loans, the loan
officer monitors the company’s financial performance, and usually keeps in contact
with the company to stay informed about developments that could affect loan
repayment. Consumer loans are also monitored for failure to adhere to repayment
terms, or other signs that the loan may become a problem.
LOAN REVIEW AND ASSET RECOVERY
Because interest income on loans is a major source of bank revenue, and loan
portfolio quality is vital to overall bank asset quality, loan losses and underperforming
loans are of serious concern to stockholders, directors, and regulators. Loan review
gives management and directors assurance that :
- lending officers are staying within their authority

- lending policies, procedures, laws, and regulations are being followed
- investigation and analysis are adequate
- all necessary documentation on each loan has been obtained and filed
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Loan review The function of examining loan documents to ensure they are accurate,
complete, conform to laws, regulations and the bank’s loan policies and procedures.
If the size of the portfolio warrants, the review may cover unsecured and secured
loans, loans made previously and new loans. Inevitably, some loans become problem
loans. In such cases, asset recovery departments help prevent losses by taking timely
action to collect late payments and, if necessary, restructuring the terms of a loan for
the benefit of both bank and customer. Asset recovery officers watch for any
indications of poorly performing loans. They examine loans that have late payments,
identify existing or potential problems, and recommend corrective action, perhaps
including an increase in the bank’s loan loss reserve.
Regulators examine bank loan portfolios for soundness, and banks are rated on the
quality of their assets. Loans found to be an immediate risk are labeled substandard,
doubtful or loss loans, and are assigned a weighted numeric value that is then
compared with bank loan loss reserves and capital, to determine a bank’s safety and
soundness. If it is determined unsafe, the regulators may require changes in bank
policy and practice, or higher loan loss reserves or capital levels.
Substandard loan A high-risk loan, given the collateral and the loan’s structure.
Doubtful loan A loan that probably will not be collected and poses default risk.
Loss loan An uncollectible loan, or a loan that is not an appropriate asset for the bank.
LOAN POLICY
As the governing body of the bank, the board of directors, along with the bank’s
chief financial and credit policy officers, sets bank loan policy and oversees the
lending function.
A loan policy contains all the information necessary to the bank’s lending practices.
As the guiding document for all bank employees, it covers areas such as :
- organization of the lending function

- lending objectives
- loan criteria and standards
- loan risk rating standards
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- levels of loan authority
- review and charge-off procedures
- policy on loans to bank officers and directors
The board of directors reviews and approves the loan policy annually. Directors,
usually working through a loan committee, are actively involved in these activities :
- determining the types of loans the bank will consider or refuse to make.
- tightening credit standards when conditions warrant.
- establishing and monitoring both legal lending limits and minimum loan amounts.
- determining policies that define loan collateral and maturities, outline maximum
lending to certain business sectors, and set standards for down payments on
automobiles or residences.
- assigning lending authority to bank loan officers, so that they know the maximum
amount they can approve individually, and the combinations of higher authority
needed for larger loan approvals.
- authorizing loans above a stipulated amount, that is, loans that exceed the authority
of any combination of officers’ lending authority.
- reviewing outstanding loans to ensure that the bank is meeting the credit needs of its
customers and the community, in compliance with the Community Reinvestment
Act.
- conducting periodic reviews (audits) of the loan portfolio to ensure that proper
procedures are followed, and no undue risks are taken.
Collection and recovery objectives
- keep delinquencies and losses within set limits

- generate loss recovery at desired levels
- counsel customers who have difficulty managing debt
- ensure adherence to bank objectives
- manage collection and recovery efficiently
State banking departments and federal agencies – the Office of the Comptroller of
the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Federal
Reserve (Fed), and the Office of Thrift Supervision (OTS) – ensure that loans comply
with regulations, and periodically monitor the quality of bank loan portfolios.
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Bank lending is especially subject to regulation to ensure that depositors’ funds are
lent wisely, customers are given appropriate information, credit applicants are not
improperly discriminated against, loans are made within the community, and loans to
bank insiders are restricted.
Because banks are limited as to the maximum amount they can lend to any single
customer, they are encouraged to offer many customers the benefit of lending
programs. The requirement also enables banks to participate with other banks when
offering large loans.
EQUAL CREDIT OPPORTUNITY ACT
The Equal Credit Opportunity Act (ECOA) of 1974 and FRS Regulation B prohibit
lenders from denying a loan based on personal characteristics or conduct unrelated to
creditworthiness. Specifically, lenders are prohibited from discriminating against
applicants on the basis of age, race, color, religion, national origin, sex, marital status,
or receipt of income from public assistance programs. Regulation B requires lenders
to give consumer applicants a written reason when a loan application is rejected or a
statement that they may request the reason. Similar rules apply for business loans.
TRUTH IN LENDING ACT
The Truth in Lending Act and FRS Regulation Z apply to loans “primarily for
personal, family, or household purposes”, not business loans. There are times,
however, when a loan made to a business customer could be considered a personal
loan and subject to the regulation.
FRS Regulation Z prescribes uniform methods for computing the cost of credit,
disclosing credit terms, and resolving errors on certain types of credit accounts.
Disclosures for these loans include the cost to the consumer for the credit (the finance
charge, the annual percentage rate, and the calculations used to derive these), the
credit terms, the consumer’s right to rescind in certain types of credit transactions (like
home equity loans), and the consumer’s fair credit billing rights (for open-end credit).
Annual percentage rate (APR) Finance charge expressed as an annual percentage of

the funds borrowed. It is from an equation that considers the amount financed, finance
charge, and the term of the loan. APR allows a comparison of credit costs regardless
of the dollar amount of the costs, or the length of time over which payments are made.
COMMUNITY REINVESTMENT ACT (CRA)
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The Community Reinvestment Act of 1977 and FRS Regulation BB address what
Congress perceived to be unfair treatment of prospective customers by financial
institutions, on the basis of arbitrary considerations, such as geographic location.
Therefore the law prohibits redlining.
Redlining Excluding potential loan customers because they are from a certain
geographic area, regardless of whether they are depositors, or meet all other criteria
of creditworthiness.
CRA affirms that every financial institution has an obligation, consistent with safe
and sound practice, to help meet the credit needs of its entire community, including
individuals and businesses in low-and-moderate income neighborhoods. Although
CRA is often thought of as a consumer-related law, business loans are also taken into
account when assessing a bank’s compliance with it.
CRA gives regulators the authority to assess a bank’s record of meeting the needs
of its entire community, and to take that record into account in evaluating the bank’s
applications for mergers, acquisitions, and branches. To comply with CRA, banks must
demonstrate that they are lending actively in all parts of their communities, including
low-and-moderate income areas.
In 1999 the Gramm-Leach Bliley Act required banks and community groups to make
public the full text of any CRA settlement agreement involving a payment of more
than $10 000, or loans in excess of $50 000. The Federal Reserve implements this
through FRS Regulation G. The purpose of the requirement is to allow residents in a
community to assess the CRA performance of financial institutions and community
groups that claim to represent residents. An annual report on such agreements must be
filed with the bank’s federal regulator.
LOANS TO BANK INSIDERS
FRS Regulation O implements the insider transaction restrictions of the Federal

Reserve Act, and the Financial Institutions Regulatory and Interest Rate Control Act
of 1978. FRS Regulation O places tight restrictions on Fed member banks in extending
credit to their executive officers, directors, and principal shareholders. The FDIC
implements Regulation O for banks that are not members of the Fed.
HOME MORTGAGE DISCLOSURE ACT
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FRS Regulation C implements the Home Mortgage Disclosure Act (HMDA).
HMDA requires banks to keep records of purchase mortgage and home improvement
mortgage lending by geographical area. Its purpose is to allow the public to determine
whether banks are serving the housing credit needs of the neighborhoods and
communities where they are located.
REAL ESTATE SETTLEMENT PROCEDURES ACT
The Real Estate Settlement Procedures Act (RESPA) and Department of Housing
and Urban Development (HUD) Regulation X require that customers be given
information about expenses involved in residential real estate settlement. Under
RESPA, a good faith estimate of closing costs is required at the time of loan
application and HUD-1 settlement statement disclosures generally are required at
closing. RESPA also contains prohibitions against kickbacks and unearned fees. For
example, a bank cannot accept a fee for services in connection with settlement of a
mortgage loan, unless it provided the services itself.
FAIR CREDIT REPORTING ACT
The Fair Credit Reporting Act (FCRA), passed in 1970, ensures fair and accurate
credit reporting, and protects consumers’ rights to privacy concerning their credit
reports. It was amended in 2006 by the Fair and Accurate Credit Transaction Act
(FACT Act) with the objective, among others, of making credit reports more accurate.
Customers are entitled to one free credit report a year from each credit reporting
agency, and may have access to credit scores for a reasonable fee. Also, any bank
submitting negative information to a national credit reporting agency must give
consumers a written notice that they have done so, or may do so.
Banks cannot report information they know or believe is inaccurate, and they must
investigate claims that the information they furnished was inaccurate. The Federal
Reserve implements these FACT Act provisions through FRS Regulation V, Fair
Credit Reporting.
The FACT Act also added to FCRA provisions regarding medical information.
Creditors cannot obtain or use medical information in credit decisions unless
permitted by certain regulatory exemptions. Consumer reporting agencies are
restricted in disclosing or sharing medical and related information with affiliates. The
Federal Reserve implements this through FRS Regulation FF, Obtaining and Using
Medical Information in Connection with Credit.
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Medical Information Under the FACT Act, which amended FCRA, information, oral
or recorded in any form, created by or derived from a health care provider or the
consumer that relates to the past, present, or future physical, mental, or behavioral
health or condition of an individual, the provision of health care, or payment for the
provision of health care.
THE FAIR DEBT COLLECTION PRACTICES ACT
Enacted in 1977, the Fair Debt Collection Practices Act eliminates abusive, deceptive
practices in credit collection without putting reputable debt collectors at an unfair
disadvantage. The Federal Trade Commission has the authority to enforce the act.
BAND LENDING LIMITS

Lending limits are set to prevent banks from placing too much capital in loans to
any customer. The limits safeguard depositor funds by spreading bank loan risk over
more borrowers. In 1982, the Garn-Saint-Germain Depository Institutions Act imposed
more lending limits. The OCC issued regulations to implement the requirements of
the act, which the OTS also adopted.
SUMMARY
1. Because lending contributes a significant portion of a bank’s income, the

profitability of any bank depends, to a large extent, on the quality of its loan portfolio.
Bank loans also serve a valuable economic need, they are an essential source of
financing for individuals, businesses, and governments.
2. Most banks divide loan operations into categories that reflect their primary
customer bases : consumer, real estate, business, and government. To meet the
diverse credit needs of these customers, banks offer an assortment of loan products.
Customer loans are either open-end (revolving) credit or closed-end (installment)
loans. These loans may be unsecured, such as credit cards, or secured, such as a home
mortgage. Real estate loans include construction and mortgage loans.
3. Business loans, which may make up a large proportion of a bank’s total loan
portfolio, are lines of credit and short-and-long term loans, and may be secured and
unsecured. Purposes may be working capital, inventory, letters of credit, lease
financing, or leveraged buyouts. Two business loan pricing methods are cost-plus and
relationship profitability pricing.
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4. State and local governments borrow from banks to meet working capital needs that
tax revenues cannot immediately finance. Banks also offer a variety of loan products
in conjunction with government-sponsored or supported programs.
5. The loan process begins with the loan application and interview. The bank then
decides whether to continue with the loan request. A decision to decline a loan may be
made at any time during the loan process, in which case the customer must be given a
written adverse action notice. If the bank continues with the loan request, the next
step is to conduct a credit investigation, which includes obtaining a credit report for
consumer loans, and extended inquiries and analysis for business loans.
Loan documentation begins at the time of application, and includes all the
forms necessary to secure the lender’s interest, and comply with federal and state
requirements.
6. After the loan is properly documented and closed, it moves into the loan
administration phase. Loan administration includes such activities as posting payments
and maintaining files and documentation. Loans are periodically reviewed to ensure
the quality of the portfolio. Asset recovery specialists monitor loans for potential
problems, and take action as needed to prevent losses. Regulators rate banks on the
quality of their assets, including loans. Loans at immediate risk may be labeled as
substandard, doubtful, or loss loans.
7. The board of directors and bank executive management establish bank loan policy
and oversee the lending functions. The directors’ responsibilities include reviewing
the loan portfolio, assigning lending authority, and adjusting credit standards.
8. Lending is highly regulated. Some of the laws or regulations that apply are the
Equal Credit Opportunity Act (FRS Regulation B), Truth in Lending Act (FRS
Regulation Z), Community Reinvestment Act (FRS Regulation BB), Disclosure and
Reporting of CRA-Related Agreements (FRS Regulation G), insider lending
restrictions (FRS Regulation O), Home Mortgage Disclosure Act (FRS Regulation C),
Real Estate Settlement Procedures Act (HUD Regulation X), Fair Credit Reporting
Act, Fair and Accurate Credit Transactions Act (FRS Regulations V and FF), Fair Debt
Collection Practices Act, and guidelines on bank lending limits.
1. Why is the lending function so important to banks ?

2. What is the difference between open-end and closed-end credit ? Give some
examples of each type of consumer loan
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3. Why are home equity loans and lines of credit popular ?
4. If a business wants to purchase a piece of equipment, what loan type is appropriate
- working capital or term loan ? Why ?
5. Name the Five Cs of credit. Is collateral the most important ? Why or why not ?
6. What kinds of payment protection are available to consumers ?
7. What are some activities involved in loan administration ?
8. What is the function of loan review ?
9. What roles does the bank board of directors play in the lending function ?
10. What are some laws with which a loan officer must comply when making a
mortgage loan ?
UNIT 8 - PERSONAL FINANCIAL PLANNING
LEARNING OBJECTIVES
- explain the need for financial planning services

- describe the financial planning tools and process
- identify the insurance, investment, and trust products banks offer
- explain how banks offer investment, insurance, and trust services
- identify retirement plan considerations and products
- discuss laws, regulations, and expectations for banks and bankers engaged in
providing investment, insurance, and trust services
INTRODUCTION
Many bank customers, whatever their financial situation, want guidance on how to
manage their finances. Some want to prepare themselves to deal with major expenses
such as college or postgraduate education for themselves or their children, most
realize that as their life expectancy increases, they must be prepared to finance their
retirement years for longer than their parents or grandparents.
In the past, many banks offered their wealthier customers trust services, but with
full service banking now available on a broader scale, banks are expanding their trust
business by offering more products and services relevant to almost all customers’
financial goals. Whether a bank offers financial planning guidance as an integrated
service or through customer-focused financial education seminars and workshops, the
intent is to provide the resources bank customers need to achieve their financial goals.
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FINANCIAL HEALTH EQUALS PERSONAL WEALTH
The financial status of the typical American household is of great concern. As Sheila
Bair, Chairman of the Federal Deposit Insurance Corporation (FDIC), said :”As a
nation we are not doing a very good job of saving these days ....(in 2006). US personal
savings amounted to a negative $92 billion. That is, Americans spent $92 billion more
than they took in as disposable income. That result .... marked the second consecutive
year of dis-saving by American households”.
Federal and state governments, employees and the public at large are concerned
about this negative trend in savings and the concurrent rise in household debt. In
response, government, industry leaders, educators, and consumer interest groups have
joined forces at the grassroots and national levels to educate Americans of all ages on
the value of, and methods for obtaining, maintaining, and restoring financial health.
The word “wealth” conjures different images, from opulent splendor to simple
peace-of-mind and the assurance that bills are paid and the basic food, shelter and
clothing needs are met. Most would agree, however, that personal financial wealth
consists of assets accumulated free and clear of any obligations.
No matter what their income level, Americans face wealth management challenges.
In fact, a recent survey of Certified Trust and Financial Advisors (CFTAs) revealed
that many high-income customers make costly mistakes in estate, retirement, and tax
planning. Access to a trusted advisor and customized advice are services more banks
are providing their customers - and customers appreciate it.
Customer Service Tip : Financial Teachable Moments for Children
When depositing your paycheck, talk to your kids about
1/ budgeting some of your paycheck to pay for things such as rent, food and clothing
2/ saving a portion of your paycheck to build a nest egg for future expenses such as
college tuition and retirement.
When grocery shopping, talk to your kids about
1/ deciding between a need and a want. Example : milk is a need, and candy is a want
2/ using coupons, buying in bulk, and other ways to save money on groceries
When using your credit card, talk to your kids about
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1/ paying for purchases each month when the credit card statement comes in the mail
2/ equating the use of a credit card to taking out a small loan for each purchase
When giving children an allowance, talk to them about
1/ setting up a budget : deciding how much to save, spend, or share with others in need
2/ setting a financial goal (buying a new bike etc) and figuring out how to achieve it.
When you pay bills each month, talk to your kids about
1/ writing checks to take money out of your account at the bank to pay bills
2/ keeping track of the checks you’ve written in the check register, so you don’t spend
more than you have in your account.
When using an ATM machine, talk to your kids about
1/ ensuring there is money in your account because the money withdrawn from the
ATM is coming from your account at the bank.
2/ recording withdrawals in your check register so you don’t overdraw your account.
BANKS AND FINANCIAL PLANNING
Banks are offering personal wealth management services from the most basic
financial planning information to complex high-end trust and investment services. By
doing so, they are fulfilling their fiduciary role as trustworthy financial resources and
serving their communities and the nation’s economy.
Banks serve as investment advisers and financial planners for consumers,

corporations, pension plans, endowments, and public agencies.
FINANCIAL PLANNING GOALS
Financial planning is the drafting and implementation of a plan to achieve specified

financial objectives. The goal is to maximize income, and minimize expenses to attain
short-term objectives, such as an automobile purchase, and long-term objectives, such
as higher education for children, or a comfortable retirement.
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Banks offer financial planning for a number of reasons, from meeting customer
requests for such services to developing long-term customer relationships. Customers
who buy investment and trust products do more business with their bank over time,
thereby greatly contributing to their bank’s fee income. More generally, providing
financial planning services helps banks position themselves as credible and
trustworthy advisers in their community.
TIME VALUE OF MONEY
“Remember that time is money”, said Benjamin Franklin. Indeed, when building
personal wealth, money and time are closely related in many ways. The values of
assets, liabilities, and earnings are all affected by time.
Inflation can undermine the value of assets, while appreciation can increase their
value. Similarly, interest can have both a negative and positive effect, because
interest earned on assets such as savings accounts and bonds adds to income and
ultimately to the value of the assets. On the other hand, interest paid on loans such as
real estate mortgages adds to the cost of the asset and increases the owner’s liability.
Most homeowners count on their home to appreciate in value over time to offset, and
eventually reward them for the debt they assume to acquire such a significant asset.
Appreciation An increase in value (price)
Financing planning therefore takes into account the interplay of time and value. To
reach wealth management goals, financial plans should ensure that earnings on assets
offset and surpass inflation’s effect on the value of money and, thus, the assets’ value
as measured in terms of money. Simply put, earnings on assets should exceed the
inflation rate.
RISK MANAGEMENT CONSIDERATIONS
An important aspect of financial planning is managing the risk / return tradeoff by

choosing investments and assets that are appropriate for the customer’s goals and life
stage. The general assumption is that younger people are willing to take more risks in
the hope of greater return, but as people approach retirement, they look for safer
investments, because they have less time to recover from market shifts that may result
in losses. Customers’ risk tolerance level and their personal situations, however, will
determine how risk will be managed in their financial plan. Some conservative 25-
year-olds, for example, are more concerned with safety than return.
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Financial advisers often think in terms of a risk pyramid for investments. (See
Exhibit 8.1). Like the broad base of a pyramid, most people have more assets invested
in cash, cash equivalents, and other liquid investments.
Risk / return tradeoff A relationship signifying that more risk generally means a
higher return, and vice versa.
Factors in risk level choices Financial goals over time, how long money can be
invested, ability to take on more financial risk, inflation risk.
Exhibit 8.1 THE RISK PYRAMID
High Risk / Higher Return Potential
Options
Futures
Collectibles
Real Estate
Mutual Funds
Small–Cap Companies
Mid–Cap Companies
Large–Cap Companies
High–Income Bonds
Government Bonds
Money Market Funds
Certificates of Deposit
Cash and Cash Equivalents
Low Risk / Lower Return Potential
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THE ROLE OF THE PLANNER
The financial planner is an adviser who helps customers by providing direction and
meaning to their financial decisions. Planners understand the short-and-long term
effects of financial decisions on other areas of finances and the attainment of financial
goals. An effective plan will take into account such objectives as
- a short-term safety net

- debt reduction
- housing options
- investment options
- asset protection (such as insurance)
- education plans (personal and for dependents)
- estate planning
- planning for such emergencies as disability
- retirement strategies
The planner’s job is to help the customer set objectives that are financially appropriate
and to help set priorities. To do this, the plan must help the customer stay ahead of
inflation, minimize costs, manage unexpected expenses, and fulfill life-stage short-
term and long-term needs and objectives.
ETHICAL STANDARDS
As in every other aspect of banking, bankers providing financial planning services

must be professional and behave ethically. The first duty to the customer is to provide
objective information, uncontaminated by considerations that certain financial
products bring more income for the bank. To avoid any potential conflict of interest,
the banker must fully disclose all costs and requirements, such as fees, commissions,
and penalties, that are associated with a recommended product.
The financial planner is a generalist who helps the customer coordinate the work of
specialists such as accountants, brokers, lawyers, and insurance agents. When offering
financing planning services, bankers must be careful not to stray into areas beyond
their professional expertise and licensed qualifications, such as giving specific legal
advice that is more appropriate for a lawyer or tax advice that is more appropriate for
a certified public accountant. Although the planner can provide information on the
elements of a will and affordable investments that would achieve the plan’s
objectives, the choice should remain with the customer.
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THE VALUES OF MONEY
Time value of money The idea that a dollar today is worth more than a dollar in the
future, because the dollar received today can earn interest until the time the future
dollar is received.
Present value The amount in today’s currency that future income or outlay would be
worth if received or paid today.
Future value What money or assets currently in hand will be worth if left to grow at a
given rate.
Net present value The difference between the cost of an investment and the
discounted present value of that investment’s future earnings.
Net future value The difference at a specific future date between the sum of the
future values of all earnings, and the sum of the future values of all costs resulting
from a current investment
MINIMIZING TAX LIABILITY
Although bankers must be careful to avoid the unauthorized practice of law, they can
inform customers about the tax deferral features of products the customer is
considering for the financial plan. In addition to contributions to deferred
compensation plans, such as 401 K plans, customers may open individual retirement
accounts (IRAs), or buy annuities to be drawn on, after they are of retirement age, and
typically in a lower tax bracket.
They may choose to invest in municipal bonds, the income from which traditionally
is exempt from federal taxes. They may donate to charitable organizations, or they
may set up trusts into which they put assets for the benefit of others, and thus avoid
estate taxes on those assets when they die. For the same reason, customers may buy
life insurance. Minimizing costs or liabilities, including taxes, should be factored into
a customer’s financial plan.
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Trust A fiduciary relationship in which one party (a person or a corporation) holds
title to property for another party based on a legal agreement and the fiduciary
principles of law.
FINANCING PLANNING PROCESS
The financial planning process begins with an analysis of a customer’s current

position, including net worth, and a discussion about his or her financial needs and
goals. Using this information, cash flow and investment strategies are designed and
incorporated into a plan, which then is implemented by the customer and required
experts. Financial plans should be reviewed, usually annually, to identify any needed
modifications related to changes in the customer’s life and goals.
CUSTOMER LIFE STAGES
While everyone needs a financial plan, a customer’s life stage will affect the services
and products a bank might recommend. Knowing the customer’s situation and life
stage helps the financial planner build a relationship, understand the customer’s
financial position, and make meaningful contributions to the customer’s plans.
Young Adults
People in their early 20s are fairly new to the job market. They are still getting their
bearings as they handle an independent life, and take on adult responsibilities. Most
need savings accounts to build liquidity in case of emergency. Many have experience
using checking accounts, debit cards, and credit cards, but it is a good idea to inquire
whether they are managing these bank services well. They probably will want to buy
a vehicle and, eventually, a home, and will need loans for these purchases. Young
adults usually do not need much life insurance, and might benefit more from disability
insurance. Even if they receive disability insurance from their employer, they may
need more depending on their life style and working situation. When they are ready to
invest, depending on their risk tolerance level, young adults usually begin at the
middle of the risk pyramid, buying stocks that have potential for appreciation.
Working adults with young children
Adults in their 20s and 30s with children need formal financial planning. They
probably should aim for long-term growth without high risk because they need to build
assets as well as meet current needs such as housing and education. Working adults
may elect to invest in aggressive growth stocks and a growth mutual fund, with
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perhaps a conservative municipal bond fund, such as those at the lower-and-mid
levels of the risk pyramid, in addition to their more liquid savings accounts. Working
adults should take advantage of any workplace 401 (k) benefits and put some money
into long-term certificates of deposit.
Because they have children, working adults might be interested in educational

savings accounts. In addition, both spouses need life insurance and should ensure that
their mortgaged property is properly ensured for replacement cost, and that they have
plenty of other property and liability coverage.
Given their responsibilities, they should be encouraged to make wills, specifically

naming guardians for the children, and begin thinking seriously about other aspects of
estate planning, especially trusts for their children if their income allows.
Estate The assets (property) a person owns : real estate, cash, stocks, bonds, and all
other personal property, and the person’s liabilities (debts) and other legal obligations.
Empty Nesters
Older adults who no longer have to worry about raising and educating children can
live with less growth and more stability. For investments they might put half or more
of their money in a mix of short-and-long term municipal bond funds, some in money
market funds, and perhaps 20% in an aggressive growth fund. They will not need
much life insurance, once the children are independent, but should certainly consider
long-term care insurance. Empty nesters definitely should be thinking about estate
planning, if they have not done so already.
Variations on standard life stages
Although these descriptions and possibilities apply in most situations, financial

planners undoubtedly will encounter variations. Some young adults have been
working since their teen years, and already have a good liquidity position in their
savings accounts. Some may have inherited a small fortune, and have no experience
handling large sums. Other customers never will enjoy an empty nest, because of the
need to care for a parent or a child with special needs. In all situations, there will be
bank products – from savings to insurance to investments and trust-related services –
that meet the unique needs of customers.
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Financial Planning Steps
- determine customer’s needs
- prepare a net worth statement
- identify short-medium, long-term goals
- prepare a cash flow strategy
- draw up a full plan
- put the plan into action
- releases the plan regularly
– decide how to bring the present position into balance
FINANCIAL PLANNING GOALS
After listening carefully and gathering all the necessary background information,
financial planners then discuss with customers the specific areas that need to be
addressed when building their plan. Goals need to be set to :
- cope with current demands, such as food, housing and transportation

- protect against personal risks, such as physical incapacity and property loss
- set aside funds for emergencies, education, and investments
- prepare for retirement
- minimize taxes
- provide for heirs
Some financial advisers think in terms of “buckets” for different purposes, one for
immediate needs and others for a variety of future needs. A good financial plan will
cover how assets will be managed and by whom. Investments in a mutual fund, for
example, require less customer attention than managing individual stocks.
Among other considerations, financial plans must ensure that funds are available
when they are needed, liquidity is important for stability.
Liquidity (1) The ability to meet current obligations
(2) The quality that makes an asset quickly and readily convertible to cash without
significant loss.
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FINANCIAL SERVICES PRODUCTS
Banks now provide brokerage services, including investment management services,

through subsidiaries or affiliates. Trust department also provide these services, usually
once a trust is established. By providing a mix of savings, insurance, and investment
products, banks help consumers achieve their investment goals such as maintaining
liquidity, preserving capital, minimizing risk, or generating income.
Safe assets (low risk)
Traditional bank products such as checking accounts, savings accounts, money market
accounts, and certificates of deposit are safe assets. They are used to meet everyday
expenses, and often provide a small investment return. Many of these products are
FDIC-insured and liquid. (See bottom level of risk pyramid in Exhibit 8.1)
Income and growth assets (moderate risk)
These assets have more income-earning potential, but are not expected to grow
substantially in value. Rather, income and growth assets provide a regular income
stream. These investments are not FDIC-insured. The income they generate can be
taxable or tax-deferred. Shares in medium-to-large-cap companies or fixed-income
mutual funds are examples. (See mid-level of risk pyramid).
Speculative assets (greatest risk and highest return)
Speculative investments are characterised by high risks that offer the possibility of
high returns. Examples include options and futures. Only very knowledgeable
investors with ample income and liquidity usually consider these investments.
Because the risks are great, these investment products often are part of a diversified
portfolio and not a main investment vehicle. (See top level of risk pyramid).
NET WORTH STATEMENT
Everything financial eventually is reduced to numbers. After gathering information

about needs and goals, the fine details of a customer’s financial position must be
analyzed to assess his or her current net worth. Exhibit 8.2 is a simple worksheet that
both the financial planner and consumer can use as a starting point. To determine net
worth – or a person’s personal wealth – deduct total liabilities from total assets.
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Assets (owned) – Liabilities (owed) = Net worth
Net worth The difference between total assets and total liabilities as calculated for an
individual or business.
Exhibit 8.2 : Net Worth Worksheet
Assets Liabilities
Cash on hand Accounts payable
Checking accounts Credit cards
Savings accounts Health care bills
Stocks, bonds, other securities Other
Cash value of life insurance Notes payable
Amounts owed by others Vehicle notes
Cash Installment purchases
Promissory notes Bank loans
Life insurance loans
Real estate Taxes due
Home Federal
Vacation home Property
Income-producing real estate State and local
Vested pension (present value) Mortgages
Home
401 (k) or other company plan Informal loans from others
Annuities Other
Investments in a business
Home furnishings (discount 15% a year
since purchase, or estimate 5% of the
home’s value)
Sports equipment
Art, antiques. and other collectibles
Cars, boats, and RVs (Blue Book values)
Total assets Total liabilities
Minus total liabilities
Net worth
Assets that are accumulated for personal wealth should be separated from assets that
are used for current needs and that do not appreciate. For example, a typical
automobile may be an expensive asset for a young adult, but it depreciates in value as
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soon as it is purchased and used. Thus the asset is not an investment that will
accumulate personal wealth, but one that is used to satisfy current needs.
The net worth analysis helps clarify where current allocations are out of balance. Is
the customer spending too large a percentage of his or her income on housing, or to
pay down debt, for example ? Often customers have not thought about the elements of
their financial situation that go into a net worth analysis. That is part of the value of
financial planning; it forces a person to honestly think about what is available, where
current spending goes, and where the gaps are between the current financial picture
and the one the customer envisions for the future.
Suggested allocations of current income :
Housing 25-35% Transportation 10-15% Savings 10-15%

Charitable gifts 10-15% Food 5-15% Utilities (phone etc) 5-10%
Health care 5-10% Personal 5-10% Recreation 5-10%
Debt repayment 5-10%
CASH FLOW STRATEGY
Every goal has a price tag. The net worth analysis helps refine and prioritize goals,
identify them as long or short term, and draw up a cash flow strategy. For most
customers, this information will be used to generate a monthly budget, calculate
monthly income and expenses, and make adjustments to their overall financial plan.
Exhibit 8.3 illustrates a monthly cash flow strategy for a young bank customer.
In combination, the net worth analysis and cash flow strategy help the financial
planner and customer objectively consider how the plan can accommodate life’s
unexpected financial crises – acute inflation, job loss, a natural disaster, home
damage, or a debilitating accident. Recognizing such possibilities while they still seem
remote is the foundation of a good financial plan. The plan will ensure that, in addition
to cash for day-to-day needs, liquid assets will be available to cover emergencies and
insurance coverage will protect against specific crises.
INSURANCE PROTECTION
Insurance, an established way to protect assets, is vital to risk management and thus
to a financial plan. Most states require property and liability insurance for motor
vehicles, for example, and banks usually require insurance for homes on which they
hold the mortgage.
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The Gramm-Leach-Bliley Act (GLBA) permits banks to sell a full range of insurance
products. Banks may act as brokers by offering product lines from different insurance
companies, financial holding companies may underwrite insurance and annuities
either directly or through a nonbank affiliate. Insurance products tied to investments,
such as whole and variable life insurance policies and annuities, are considered
nondeposit investment products and are not insured by the FDIC. Some of the
noncredit-related insurance products banks now offer include life, health and
disability, long-term care, property, and liability insurance.
Nondeposit investment product Any financial product with an investment component

that is not a deposit product, and thus not insured by the Federal Deposit Insurance
Corporation (FDIC). Stocks, bonds, insurance products, government and municipal
securities are examples.
LIFE INSURANCE
Life insurance replaces the income the policy holder was contributing to the
family when he or she died. Single people with no dependents usually need only
enough life insurance to cover funeral expenses and unpaid debts. Adults with
dependents may need more to ensure that their dependents’ future living expenses are
covered. Life insurance generally is categorized as term or whole life.
Exhibit 8.3 Monthly Cash Flow Plan For a Single Working Person
Income
Current Change Adjustment

Salary $ 2 350 $ 2 350
Commissions 250 250 250
Interest on savings 500 500
Other income
Total income $ 3 100 $ 250 $ 3 100
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Expenses
Current Changes Adjusted

Rent $ 950 $ 950
Renter’s insurance 30 30
Electricity 20 20
Transportation 50 50
Water 25 25
Telephone 50 50
Internet service 45 45
Insurance 50 50
Charitable donations 0 0
Credit card interest 25 25
Groceries 250 250
Clothing 200 - 50 150
Student loan payments 100 100
Gym fees 80 80
Entertainment 200 - 50 150
Miscellaneous 100 100
Total expenses $ 2 175 $ - 100 $ 2 075
Monthly net $ 925 $ 1 025
Available to save, invest, or contribute $ 925 $ 1 025
Term life insurance
The purchaser pays a specified amount of money for a specified amount of term life
insurance for a period of 1 to 30 years. At the end of the period, no excess premium
remains and the contract terminates. Premiums for term life insurance may start low,
but rise dramatically as the insured ages.
Premium
1/ The payment for insurance coverage either in a lump sum or in installments.

2/ The amount or percentage above face value at which securities are bought or sold.
Time life versus whole life
Term life Short-term insurance with no savings element.

Whole life Long-term insurance with a savings element.
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Whole life insurance
Whole life insurance allows the policy owner to borrow funds from the policy’s
accumulated cash value during his or her life, as well as providing life insurance
coverage. Insurance premiums are held by the insurance company and invested in
stocks, bonds, money market instruments, or other assets, depending on the product
features. The policy may pay a fixed or variable return, and income taxes on the gain
do not have to be paid until the policy is cashed. Premiums for whose life insurance
tend to be higher in the early years than the cost of term insurance, because they are
used to build up the policy’s cash value, whose life premiums then level off or lessen
as the insured ages.
Other types of life insurance
Other types of life insurance products include variable life insurance, and universal
life insurance, both of which separate the insurance protection from the savings part of
the policy. This means the buyer assumes more risk on the savings end in the hope of
getting a better return. Both are interest sensitive; in contrast, traditional whole life is
not interest sensitive. This means that whole life insurance is inherently safer, but
because it is safer, the return is lower and the cash value builds more slowly.
Life insurance may not be the best way for all customers to build cash for later
years. If life insurance is not needed to take care of a spouse or dependents,
customers might be better off putting their money into alternative investment vehicles
such as certificates of deposit, U.S. Treasury securities, mutual funds, or bonds.
HEALTH, DISABILITY, AND LONG-TERM CARE INSURANCE
Rising health care costs have made it expensive to be injured or sick. For this
reason, health insurance should be an important part of any financial plan. Group
health insurance premiums through an employer, or a professional association
generally are lower, although if the insured leaves the group the coverage may end, or
the cost of the insurance may increase.
Most basic policies set time and dollar limits on benefits for hospital room and
board and do not pay all medical and surgical costs. Because basic policies stop
paying benefits when certain time or dollar limits are reached, customers might want
to buy supplemental medical insurance for additional protection against the high cost
of serious and continuing illnesses or injuries. Insurance policies also are available
that cover vision, dental care, prescription drugs, and nursing home care.
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Disability insurance is as important as health insurance because statistically a
person is more likely to be disabled – temporarily or permanently – before retirement
age than to die. Because the chances of becoming disabled increase with age,
coverage is just as important for older workers as it is for younger workers. Disability
insurance pays a weekly or monthly income benefit, if the policy holder is partially or
totally (depending on the policy) disabled due to a covered injury of illness.
Employers often offer group disability income coverage to their employees, but
individual policies also are available.
Long-term care insurance is becoming a necessity as life expectancy increases. A

healthy retirement fund or savings plan can be depleted quickly by the cost of nursing
home care. A long-term care policy supports an individual who is chronically ill or
functionally handicapped, characterized as being unable to walk, or perform other
basic daily living activities. Services covered may include home health care, care in
assisted living facilities and nursing homes, respite care, and hospice care. Long-term
care policies typically are issued to individuals between ages 30 and 85. As the U.S.
population ages, the percentage of people needing long-term care will increase.
Consequently, long-term care policies have become a popular form of insurance.
PROPERTY, TITLE, AND VEHICLE INSURANCE
Property insurance protects the value of things a consumer owns – homes, boats,
jewelry, silverware, money, and so forth – that can be lost to fire, theft, lawsuits,
natural disasters, or other events. Home replacement cost coverage, which normally
covers the cost to rebuild a structure using modern materials according to current
building standards, is recommended.
Title insurance protects home buyers from financial loss due to questions about
property ownership. It differs from property insurance in that it protects the title of the
property rather than the property itself. If someone came forward with a valid claim
on property that, for example, had been surveyed incorrectly, title insurance would
reimburse the owner for the loss.
Vehicle insurance – typically including liability and collision – covers the insured’s
liability arising from the ownership, maintenance, or use of automobiles, motorcycles,
all-terrain vehicles, and snowmobiles. Vehicle insurance policies provide liability
coverage for the pain and suffering of those who have been injured and for damaged
property, and collision coverage against losses arising from physical damage, to a
covered vehicle or other object. Vehicle insurance usually is required by state law.
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LIABILITY INSURANCE
Liability or casualty insurance protects an individual or business against losses

resulting from bodily injury or property damage to other persons. These policies
normally cover legal expenses, medical expenses, and funeral expenses incurred by
persons who are injured or killed, and the cost of repairing or replacing damaged
property. Professional liability insurance protects the insured against claims arising
out of the practice of professional services.
INVESTMENT SERVICES
Bank subsidiaries or financial holding company affiliates may offer investment and
brokerage services through third-party, joint venture, and in-house organizational
structures.
Third party
Banks arrange for a licensed brokerage firm to operate on their premises, for which
they are paid a fee. Bank earnings are lower this way than if they offered the services
themselves, but they have fewer responsibilities. This arrangement simply makes the
services available to the bank’s customers.
Joint venture
Banks arrange with broker-dealers to sell securities, with employees working

directly for either the bank or the broker-dealer. Those working for the broker-dealer
generally are licensed and registered representatives who have taken qualifying
exams. The licensed broker-dealer must supervise any brokerage functions performed
by bank employees.
In house
Banks sell brokerage products through their own discount to full-service brokerages,
formed either as bank subsidiaries or as holding company affiliates. Discount
brokerages sell investment products and services but do not offer investment advice;
typically they are less expensive than a full-service brokerage. Full-service
brokerages sell securities and offer investment advisory services. They may perform
the same services as large nonaffiliated brokerage houses, including underwriting and
dealing in equity securities.
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Because investment products (stocks, bonds, annuities, mutual funds...) are not bank
deposits, they are not insured by the FDIC. Banks must ensure customers understand
this important difference before they purchase a nondeposit investment product.
INVESTMENT STRATEGIES
The 3 basic investment strategies are conservative, aggressive, speculative. The

appropriate strategy depends on the customer’s risk tolerance level, which is defined
by life stage, personal circumstances, and financial plan goals. Common motivations
are to safeguard or increase principal, produce income, or pursue high returns.
The investment choices shown in the risk pyramid in Exhibit 8.1 correspond to
investment strategies. Conservative investors looking to safeguard principal probably
will have a portfolio heavily weighted toward cash equivalents where return is
guaranteed, such as certificates of deposit, and safe investments, such as U.S.
Treasury bills that pay slightly higher interest, with a few stocks and bonds.
Aggressive investors probably will diversify their portfolio, so it includes some totally
safe investments, as well as growth stocks whose price is likely to appreciate.
Speculative investors also will carry diversified portfolios, although theirs probably
will include more high-risks, high-return bonds, and the stock of new companies as
well as investments in options, futures, and hedge funds.
Portfolio The assets owned by one organization or person and managed as a

collective whole to reach specific investment goals.
Diversification A method of decreasing the total risk of investments by investing

funds in different kinds of assets.
Stocks
A share of stock represents a share of ownership interest in a company. For the issuing
company, stocks provide capital. For investors, stocks often provide a share of the
company’s earnings in the form of dividends (although dividends are not guaranteed),
and an increase in the stock’s price as the result of appreciation. Because a stock can
lose value, it is a higher-risk investment than an insured bank product such as a
certificate of deposit. But historically the return on stocks has outpaced that of many
other investment types, making them a good investment choice for the long term.
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Bonds
Investors who buy bonds in effect are lending money to the issuing corporation or
government authority. Corporations use the loans to improve their businesses, state
and local government authorities use them for specific purposes, such as building
sewer systems or schools. Interest usually is paid at specified times until the bond’s
maturity date, at which time the face value is returned to the investor. Income from
most municipal bonds usually is exempt from federal, state, and local income taxes.
Municipal or corporate bonds carry varying degrees of risk, depending on the

issuer’s fiscal soundness, fluctuations in interest rates, and the nature of the funded
project. Like stocks, bonds can lose or gain value. This happens when a bond’s
interest rate is less than or more than the prevailing interest rates for similar bonds.
Mutual funds
Mutual fund companies use funds supplied by shareholders to invest in other

companies. They make it possible for individual investors to own shares in far more
companies than would be practical, if the shared had to be bought separately.
Furthermore, mutual funds are managed by investment professionals who know more
about the market than the average investor. The initial investment often is low, and
risk is spread over all the securities in the fund’s portfolio.
Mutual funds may specialize narrowly, perhaps investing only in health care stocks,
companies operating internationally, or municipal bonds. Funds may invest for
aggressive growth, income, or safety. Index funds buy the stocks featured in a specific
market index, such as the Dow Jones Industrials. Funds also may be either closed-end
or open-end.
Annuities
The primary benefit of annuities is to pay financial benefits during the lifetime of
the annuitant, who usually is the investor. In effect, investors are paying the insurance
company that sold the annuity to help them manage their money.
The 2 basic types of annuities are deferred (pay-in), for which the investor makes
regular contributions over time and defers payment until later; and immediate
(payout), in which the investor puts the money first, and then has disbursements at
regular intervals over a set period, or the annuitant’s lifetime.
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Annuities can cover more than one person (“joint and survivor”) and the rates of
return can be fixed or variable. Fixed-rate annuities promise the same payout amount
throughout the annuitant’s lifetime. Various annuities come in several forms,
depending on how the insurer invests the funds. The payout amount and the interest
rate of variable annuities are not guaranteed.
Annuity An insurance product that provides a systematic payment for a specified

period, usually a number of years. Payments typically are made monthly but can be
made quarterly, semiannually, or annually.
Annuitant The beneficiary of an annuity, the person insured under an annuity plan
and on whose life expectancy annuity payments are based.
PORTFOLIO MANAGEMENT
Successful investors not only buy stocks and hold them for long periods, they also
regularly monitor how their investments are doing. At least once a year, they review
everything they own to make sure it is still making the expected contribution toward
their financial goal. Securities held by the mutual funds in which they are invested are
reviewed, to make sure the funds are offering the required diversity.
Any change, such as the birth of a child, should trigger a review of the customer’s
financial plan and investments, so that the portfolio can be rebalanced accordingly.
Most banks do more than just sell investment products. Through holding company
affiliates or nonaffiliated broker-dealers, banks provide investment management
services and advice to both individuals and corporations.
Asset management accounts
Asset management accounts provide a convenient way for customers to consolidate

investments, which then can be accessed via check or debit card. Typically, a
minimum initial investment is required and a fee is charged, although the fee may be
waived if a required minimum balance is maintained.
In return, customers are provided up-to-date account information online or in monthly

statements, an annual summary statement that recaps all account activity, a daily
sweep of credit balances, direct deposit services, and dividend reinvestment services.
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Trading accounts
Trading accounts allow customers to research and place trades either online or
through a bank-affiliated financial consultant. Access to proprietary research such as
third-party stock research and mutual fund profiles, typically is offered. Customers
may trade in a wide array of investments, including stocks, bonds, and mutual funds.
Trades are subject to commissions and fees, which may be waived for active traders
and customers who maintain high balances in bank-affiliated investment or deposit
accounts. Customers usually have online access to trade confirmations, account
histories, balances, and positions
RETIREMENT PLANNING
Customers today must plan for much longer retirements than previous generations.
Medical breakthroughs and the transfer of strenuous work from people to machines
are among the factors that have increased life expectancy.
As with other aspects of the financial planning process, customers’ current financial
positions must be known before their needs can be assessed. Retirement planning
necessitates answers to questions such as these :
- What are the customer’s current expenses ?

- What major expenses (for a chronic medical condition etc...) are likely to continue ?
- What major expenses, such as college tuition or medical care, are likely to occur ?
When will they begin and end ?
- Does the customer have life, health, and property insurance ? How will insurance
needs change over time ?
- When does the customer or the spouse plan to retire ?
- Where does the customer plan to retire ? In the same area and home or elsewhere ?
- What does the customer plan to do in retirement ? If plans include work, what
income can be expected ?
- What health problems might prevent the customer from working ?
- What assets does the customer already have for retirement ?
- How much, therefore, will the customer need for retirement ?
Answers to these questions will help customers identify a retirement income goal.
Customers will be able to estimate what they will need and begin to think about how
to reach their goal. Doing so may mean acquiring skills to do a new kind of work, or
putting more money aside now so it can grow for retirement.
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SOCIAL SECURITY AND PENSIONS
Most Americans contribute to Social Security throughout their working lives and
become eligible for full benefits in their mid-60s, but the age is edging upward.
People born between 1943 and 1954, for example, can receive full benefits when
they are 66; for those born in 1960 or later, the age is 67. It is possible to get Social
Security benefits, reduced by 30%, starting at age 62. People who work after full
retirement age eventually can get a larger benefit.
The future of Social Security is being questioned by the federal government, tax
payers, and beneficiaries. In its 2007 annual report, the Social Security Board of
Trustees published these projections.
- Tax revenues are likely to fall below program costs in 2017

- Trust funds may be exhausted in 2041
Given this situation, adults of all ages are encouraged to save for their retirement
needs without factoring in potential Social Security payments.
While there are still some people who belong to defined benefit pension plans, the
number is shrinking. More companies are turning to defined contribution plans, such
as 401(k)s, that put more of the responsibility and cost on the employee, although
employers may match employee contributions up to a certain percentage. Annual
contributions up to a certain legal limit and earnings on those contributions (interest
received) are tax-deferred until they are withdrawn from the plan. Those who are
self-employed can set up Keogh accounts that are similar to 401(k)s.
Deferred benefit plan A pension plan that guarantees the payment of a specified
benefit at retirement.
Defined contribution plan Retirement plan fund that takes in employee contributions,
which may or may not be matched by employer contributions, and then invests the
contributions into one or more investment alternatives determined by the employee.
Customer Service Tip : Retirement Saving Worksheet
Using a simple worksheet like this one can help customers understand where they
are today, where they’d like to be tomorrow, and what must be done to get there.
Before starting, customers need to decide how much income they will need annually.
A common rule of thumb is 75% of current income. Computers also must decide how
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long they will need that much annual income. For people retiring at age 65, 20 years is
reasonable. Customers then might plan to take 5% a year out of principal accounts,
such as an IRA.
The Social Security Administration sends annual statements of the monthly benefit
a tax payer might expect to receive on retirement. This amount should be multiplied
by 12 to calculate the annual income.
Income Source Principal Annual Income
Social Security NA $
Pension NA
Total available annual retirement income
Annual income needed
Annual income surplus or shortfall (+ / -)
INDIVIDUAL RETIREMENT ACCOUNTS
Most banks and many financial institutions offer individual retirement accounts
(IRAs) that provide some tax advantages for retirement savings. An IRA can be
funded by cash or cash equivalents, and investment choices vary from savings
accounts to mutual funds to securities. Three common retirement products are the
traditional IRA, the Roth IRA, and the SEP-IRA.
IRA
The IRA accumulates funds for use during retirement using savings accounts,
certificates of deposit, mutual funds, or securities. Taxes due on both annual account
contributions (up to a limit), account earnings are deferred until withdrawn. Penalty-
free distributions (withdrawals) may begin at age 59 ½ but must begin by 70 ½ .
Roth IRA
Contributions to Roth IRA accounts are not deducted from taxable income, but there
is no tax on account earnings. Certain distributions to the account holder or
beneficiaries may be made without tax penalty at any time. There is no requirement to
begin distributions by age 70 ½ .
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Simplified employee pension plan (SEP) IRA
The SEP IRA is designed for the self-employed or small business owner. Employees
do not pay taxes on SEP contributions until they are withdrawn. Employers receive a
business deduction for contributions made to SEP IRAs on behalf of employees.
Employees set up the IRA to accept the SEP contributions.
ESTATE PLANNING
Estate planning – planning for the disposition of assets both before and after the
customer’s death – should be part of a comprehensive financial plan. Some states
require decedent’s assets of $10 000 or more to go through probate, whether or not
the decedent had a will. Certain assets may avoid probate, however, including :
- assets owned jointly with a right of survivorship

- life insurance, annuities, retirement accounts, and brokerage and bank accounts for
which a beneficiary is named
- assets in revocable living trusts
Objectives of estate planning include ensuring the right people receive the right
assets, and that taxes are minimized for the customer and customer’s beneficiaries.
One savings product available to most customers is the result of the Uniform
Transfer to Minors Act (UTMA), which replaced and continued the custodial account
arrangement of the Uniform Gifts to Minors Act in 1983. Basically, a UTMA account
can be used to make an untaxed transfer of assets to a minor, thus reducing federal
income taxes on earnings from the assets. Legally, the account transfers to the child
the responsibility of paying income tax, which would be taxed at the minor’s tax rate.
The account is managed by a designated adult (trustee) until the minor is 21 years old.
Trusts are another way for the wealthier to manage assets. Trusts can be used to :
- build up assets for a specific purpose or person over time through the accumulation
of interest or dividends until the beneficiary reaches a specified age.
- receive the proceeds of an insurance policy for the benefit of minor children.
- give money to charity, either by providing a steady income over time or arranging
for income to go to another beneficiary with the principal going to the charity after the
designated individual dies.
- keep irresponsible beneficiaries from squandering capital by allowing the trustee to
distribute only interest, not principal.
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Estate planning requires expert advice, which bank trust departments can provide
customers who have sufficient assets.
BANK TRUST SERVICES
Trust services complement other banking services and facilitate a total financial
relationship with individual and business customers. To offer trust services, the bank’s
federal or state charter must accord it trust powers. Many banks have applied for and
received trust powers so they can serve the growing wealth management market.
The trust structure has 4 requirements :
Trust The property (cash, stocks, bonds, real estate, or any other item of value) with
which the trust is created.
Trustor The person creating the trust
Trustee The person or entity that takes control of the trust property and administers
the trust.
Beneficiary The person for whose benefit the trust was established.
When banks provide trust services, they act in a fiduciary capacity which, by law,
requires adherence to fiduciary principles, such as acting in the sole interests of the
beneficiaries, avoiding conflicts of interests, carrying out duties with prudence, care,
loyalty. Banks, in their role as trustee, must observe the following fiduciary principles.
Prudent investor principle Banks are required to act with caution, skill, diligence, and
a sense of responsibility. The standard is applied to the total portfolio, not to isolated
investments, and to the overall investment strategy. The bank has a duty to diversify
investments, unless it is not prudent to do so. The bank must be loyal and impartial,
delegate authority, and select supervising agents. The costs the bank incurs must be
reasonable in amount, and appropriate for the services provided.
Segregation of trust assets Assets of each trust must be kept separate from those of
other trusts & from the bank’s own assets. Trust departments are segregated from the
rest of the bank, with their own vaults, data processing equipment, and other facilities.
Prevention of conflicts of interest Banks should have no interest whatsoever in the

investments bought or sold for trust funds. The bank should not purchase or benefit in
any way from property or other assets held in trust.
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Depending on market needs & business volume, banks offer personal trust services :
estate settlement, trust administration, guardianships, and personal agency services.
ESTATE SETTLEMENT
When a person dies, a trust officer will help settle the deceased person’s estate.
Outstanding debts or taxes may need to be paid, and the estate assets distributed to the
decedent’s heirs.
A trust department’s estate planner usually advises customers to leave a will that
describes the property owned and its location. The will also should designate the
beneficiaries to whom the property will be left and the person or entity (such as the
bank) that will settle the estate. That person or entity is referred to as the executor or,
in some states, the personal representative. The executor may be a relative, friend,
estate heir, bank, lawyer, or some combination thereof.
If the decedent did not leave a will, or if the will is invalid, the estate is distributed
in accordance with the laws of the state. If the will is valid, the court appoints an
administrator to carry out its terms if the executor cannot or will not serve. Basically,
the duties of executors and administrators are the same.
- Take inventory to determine the exact value of the estate. Itemize and show a dollar
value for each of the decedent’s assets.
- If necessary, take control of some or all of the assets
- File federal and state tax returns and pay all taxes on the basis of the estate’s value
- Settle all debts and claims against the estate
- Distribute the remaining assets, either according to the terms of the will or as
directed by state law.
When a bank acts as administrator or executor, it must by law keep detailed

records, and is accountable to the court and beneficiaries for its actions.
TRUST ADMINISTRATION
The most common types of trust funds administered by banks are testamentary
trusts, living trusts, and charitable and institutional trusts.
Testamentary trust
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Trusts created under the terms of a decedent’s will. As trustee, the bank is
responsible for managing assets turned over to it by the executor or administrator, and
for making payouts to the beneficiaries as specified in the will.
Living trust
Trusts created by living individuals, who execute a trust agreement and transfer
property to the trust. Individuals often want to avoid the details of probate, or keep the
transfer private. Sometimes individuals no longer wish to manage their affairs
because of sickness, extensive traveling, or lack of financial expertise. The trustee
then manages the trust’s assets.
Charitable and institutional trust
A trust set up by an individual to benefit a university, hospital, or other charitable

organization. (Sometimes the beneficiary may make the actual arrangements for the
trust on behalf of the individual). The trustee then manages the trust’s investments.
GUARDIANSHIP
A guardianship (sometimes called a conservatorship) is established by court order

for the benefit of a minor or incapacitated person, known as the ward. A bank trust
department often is appointed to manage the property for the minor or incompetent
person. To prove that all the proceeds are being used for the person’s benefits, the
trust department periodically provides an accounting to the court.
PERSONAL AGENCY SERVICES
Bank trust departments may offer agency services, which, by law, differ from trust
services. Trustees assume legal title to property turned over to them; agents do not.
Instead, an individual who retains legal title to the asset gives specific authority to the
agent. Safekeeping, custody, investment advice, investment management are the most
common agency services banks provide individuals. A bank functioning as investment
advisor or agent must act in accordance with the highest fiduciary standards.
Safekeeping
Banks accept, hold, and on request, return stocks, bonds, other assets to the customer.
Custody
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The bank holds assets in safekeeping and collects income. Custodians buy and sell
securities when specifically instructed to do so by the customer or an appointed agent.
Banks provide custody services for individuals, correspondent banks, and government
agencies.
Investment advisor
The bank performs the duties of a custodian plus other responsibilities granted to it
by the individual. When handling securities, the bank may review investments, and
suggest the retention, sale, exchange, conversion or purchase of new securities. As
investment advisors, banks may handle real estate. The bank may act in an agency
capacity to collect rental income, pay property taxes, arrange for property upkeep and
maintenance, and disburse any net income as directed by the owner.
Investment manager
The bank, acting as investment manager, also may make financial decisions on the
customer’s behalf, based on previously established investment criteria.
Starting in late 1999 the banking industry began offering full financial servicing due
to the passage of the GLBA, which was designated to modernize the nation’s financial
system. The primary vehicle for reform is the financial holding company, which can
engage in any activity that is “financial in nature”, including underwriting, selling
insurance, and dealing in securities. Banks also may petition for the authority to
engage in any financial activity through a nonbank affiliate that is not specified in the
GLBA. The functional regulation system, as established by the GLBA, applies to all
functions now open to banks, including insurance, investments, IRAs, and trusts. The
following are examples of applicable laws and regulations.
Functional regulation system

A regulatory principle incorporated in the Gramm-Leach-Bliley Act that requires
certain authorized banking activities to fall under the authority of federal and state
regulators other than principal federal bank regulators.
RETAIL SALES OF NONDEPOSIT INVESTMENT PRODUCTS
Because investments such as stocks, bonds, annuities, and mutual funds are not bank
deposits, they are not insured by the FDIC. Bank regulators recognized the need to
protect bank customers who were purchasing these products. In 1994 the regulators
issued the Interagency Statement on Retail Sales of Nondeposit Investment Products,
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which emphasizes that banks must ensure customers understand that these products
are not FDIC-insured. Banks selling investment products must take many precautions :
- marketing nondeposit investments in a manner that does not mislead or confuse
consumers about the products or the risks, including separating retail deposit-taking
and retail nondeposit sales functions.
- prohibiting bank employees, such as tellers, from offering investment advice
- refraining from offering uninsured retail investment products with a product name
identical to the bank’s name.
- conspicuously disclosing that investment products are not FDIC-insuted, are not
obligations of, or guaranteed by the bank, and carry investment risk and possible loss
of principal.
CONSUMER PROTECTION IN SALES OF INSURANCE
Under the GLBA, authorized federal banking regulators issued an interagency

regulation that applies sales disclosure, and practice rules to retail sales of insurance
products sold for personal, family, or household purposes. The requirements are
similar to those of the Interagency Statement on Retail Sales of Nondeposit
Investment products. Basically, customers must be made thoroughly aware that
insurance products are not FDIC-insured. The disclosures must be given both orally
and in writing, and consumers must acknowledge their receipt in writing.
HEROES EARNED RETIREMENT OPPORTUNITIES
In 2006 the Heroes Earned Retirement Opportunities (HERO) Act was signed into
law. Previously, combat pay could not be used as earned income for purposes of
funding an IRA, because it was excluded from gross income and, thus, nontaxable and
earned outside the USA. This meant those only earning combat pay could not make
IRA contributions. The HERO Act counts combat pay as gross income for tax years
beginning January 1, 2004. Service members have 3 years from the date the act
became law, to make catch-up contributions to traditional or Roth IRAs, taking into
account contribution limits.
UNIFORM LAWS
Trust law incorporates provisions of the uniform laws developed by the National
Conference of Commissioners on Uniform State Laws (NCCUSL) to give the states
models for their trust laws, and minimize the differences among state laws. The
following uniform laws are among those relevant to trust law. (In 2000 most of the
trust-related uniform laws were brought together as the Uniform Trust Code).
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Uniform Probate Code (1991)
Pertains to the succession of property at an owner’s death, as controlled by will,

intestacy statute, and the probate process.
Uniform Prudent Investor Act (1994)
Provides rules for investing trust assets and requires trustees to apply modern
portfolio theory to investment decisions and to invest as a prudent investor would,
namely, taking into account the purposes, terms, distribution requirements, and other
circumstances of the trust and using reasonable skill and care.
Uniform Principal and Income Act (1997)

Sets forth rules for allocating a trust’s principal and income, appportionment of
income, the right to payment, and the trustee’s powers to adjust principal and income,
with regard to prudent investor obligations and other duties.
SUMMARY
1/ Governments, employers, and the public at large are concerned about the negative
trend in savings and the concurrent rise in household debt. Educating Americans about
these issues is a priority. Banks provide personal wealth management services from
the most basic financial planning information to more complex high-end trust and
investment services. By doing so, they fulfill their fiduciary role as trustworthy
financial resources.
2/ Financial planning is the development and implementation of a plan to achieve a

person’s overall financial goals, including maximizing income and minimizing
expenses, so both short and long-term objectives are attainable. The financial planner
advises customers with regard to their financial decisions, and helps customers
coordinate the work of specialists such as accountants, brokers, lawyers, insurance
agents. Because financial planners are generalists and not specialists, thsy must be
careful to avoid the unauthorized practice of law. Financial planners, however, can
inform customers about the tax-deferred features of products they are considering for
their financial plan.
3/ The financial planning process begins with an analysis of the customer’s current
position and a conversation about his or her financial needs and goals. The analysis
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takes into account factors such as inflation. the time value of money and the risk-
reward factor for each asset and investment choice. Net worth is calculated and a cash
flow strategy drawn up. The customer and the necessary experts put the plan into
action and then reassess the plan, usually annually, for needed modifications.
4/ Many banks offer noncredit-related insurance products, including life, health and
disability, long-term care, property, and liability insurance. Two general life insurance
categories are term and whole life. Property insurance protects the value of anything
consumers own that might be lost due to fire, theft, lawsuits, or other events. Title
insurance protects home buyers from losses, due to questions about the ownership of
the property. Vehicle insurance policies provide liability coverage and optional
collision coverage.
5/ Bank subsidiaries or holding company affiliates offer investment and brokerage

services through third parties and joint ventures, or as an in-house function. Banks
must fully disclose that these products are not FDIC-insured. Whatever the investment
strategy – conservative, aggressive or speculative – diversification usually is
recommended.
6/ Stocks, bonds, mutual funds, annuities are the most common investments used in
financial plans. Whatever investment mix a customer chooses, the portfolio should be
evaluated regularly to ensure the results meet the goals set out in the financial plan.
Banks also offer portfolio management services, such as asset management and
trading accounts.
7/ Retirement planning must take into account increased life expectancy. Many
people will receive Social Security benefits, some will receive pensions from defined
benefit plans, and many will receive income from defined contribution plans, such as
401 (k)s. Most banks today offer traditional, Roth, and SEP-IRAs.
8/ An estate plan prepares for the disposition of assets both before and after the
customer’s death. The objectives of estate planning include ensuring the right people
receive the right assets, and that taxes are minimized for both the customer and the
customer’s beneficiaries. One savings product that is available to most customers is a
Uniform Transfer to Minors Act account that can be used to make an untaxed asset
transfer to a minor, thereby reducing federal income taxes on the asset’s earnings.
9/ Trust services complement other banking services and facilitate a total financial
relationship with individual and business customers. The trust structure has four
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requirements : the trust, the trustor, the trustee, and the beneficiary. As trust services
providers, banks act as fiduciaries and must abide by the prudent investor principle,
segregate trust assets from bank assets, and ensure against conflicts of interest. Trust
services provided by banks to individuals include estate settlement and the
administration of testamentary trusts, living trusts, charitable and institutional trusts.
Trust departments also provide guardianship and personal agency services, including
safekeeping, custody, investor advice, and investment management services.
10/ While the GLBA allows the wider banking community to offer insurance and
investment services, banking laws and those pertaining to other specialized areas still
apply. Examples relate to the sale of retail nondeposit investment products and
consumer protections regarding the sale of insurance. The Uniform Probate Code, the
Uniform Prudent Investor Act, and the Uniform Principal and Income Act, all of which
were compiled later under the Uniform Trust Code of 2000, are other examples. More
recently, the Heroes Earned Retirement Opportunities (HERO) Act gives service
members the right to contribute combat pay to their IRAs.
1. Are Americans spending more than they save, and who is concerned ?
2. What factors and effects must be taken into account in financial planning ?
3. What are a financial planner’s ethical responsibilities ?
4. What are the preliminary steps in financial planning ?
5. What is the purpose of life insurance and who needs it ?
6. What are the three basic investment strategies and motivations that influence
investment choices ?
7. What are the two basic types of personal trusts ?
8. How do banks deliver investment products ?
9. What are the requirements for the sale of retail nondeposit investment products ?
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CHAPTER 9 BUSINESS AND INTERNATIONAL BANKING SERVICES
LEARNING OBJECTIVES
- identify cash management services for businesses

- identify insurance products banks offer to businesses
- describe capital market products and services
- explain bank trust services available to businesses
- discuss international banking services that foster foreign trade
- describe some laws and regulations that pertain to business and international banking
services
INTRODUCTION
Traditionally, banks provided customers with checking, savings, and loan accounts.
Today they seek a full customer relationship and serve all the customers’ financial
needs. With the Gramm-Leach-Bliley Act (GLBA) and technological advances in
payment and information systems, banks have become full service providers to a far
greater extent than in the past.
For business customers, full service means providing payment, investment, cash
management, loan services with financial expertise appropriate to the nature, size,
and scope of the business. Business products and services include trusts, investments,
insurance, capital market services, and international banking. Banks offer business
products and services in different combinations, sometimes directly, sometimes in
partnership with other service providers or through subsidiaries or affiliates.
BUSINESS BANKING SERVICES
The most basic bank services for businesses are deposit, cash management, credit,
and other fee services. Deposit-related services include checking, savings accounts,
certificates of deposit, and money market deposit accounts. Closely aligned with
deposit accounts are cash management services.
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CASH MANAGEMENT
Banks offer cash management services to both businesses and consumers. Cash
management services help businesses collect incoming payments quickly, manage and
reconcile outgoing payments efficiently, keep surplus funds invested, and obtain
timely and complete information on their bank accounts.
Cash management services are attractive to corporations and small businesses that
have significant billings and payments, or that need to put their money to work,
instead of leaving balances in noninterest-bearing demand deposit accounts.
Account management
Essentially, with account management services, the bank handles bookkeeping and
accounting functions for the business. The bank pays incoming invoices for the
business, manages accounts receivable for payments coming into the company,
handles payroll and employee benefit accounting, disburses dividend payments,
balances accounts, and performs all the other accounting tasks required for the
business working operations.
Cash vault services
Cash vault services help business safely deposit funds while maximizing their
availability. Deposits are delivered directly from the business to the bank’s cash vault.
To ensure the safety of deposits in transit, banks offer such safeguards as tamper-
evident deposit bags, video surveillance, and dual custody processing. Because
company employees do not carry cash to the bank, they are not put at risk. The bank
provides expedited processing so that deposits received by the deadlines are given
same-day credit.
Account Reconciliation
With account reconciliation, banks provided detailed reports on payments made and
outstanding and the amount of each, balance the accounts, and keep the records.
Various analytical reports can be generated to allow company managers to monitor
operations and determine possible new approaches. In addition to check truncation
and electronic payment services, most banks offer online access to current, real-time
account reports. Thus, for a fee, businesses realize efficiencies in operations and cash
management opportunities.
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Positive pay
A related cash management tool that is also anti-fraud tool is a positive pay.
Businesses electronically send banks lists of issued checks with account numbers,
check numbers, and dollar amounts. Banks then match checks presented for payment
against the lists of checks. Those that do not match are rejected as exception items and
reported to the customer. A check image may be sent as well. The customer then
notifies the bank whether the exception check should be paid.

72% of organizations experienced attempted or actual payment fraud in 2006. Of
these, 93% experienced check fraud, 35% ACH fraud, 17% consumer credit-card
fraud, and 14% corporate card fraud. About 86% of companies tried to curb fraud risks
by using positive pay services.
Receivable An amount owed to and not yet delivered or accepted by a company.
Lockbox Service
Lockbox services help companies access their incoming payments (receivables) faster.
Before the advent of lockbox services, a customer would mail a payment directly to
a business, a government unit, a correspondent bank, a university, or a hospital
accounts payable office. These payments were subject to delays at every point –
transit, processing, deposit, and collection.
With lockbox services, payments are sent directly to a post office box managed by
the bank. The bank retrieves payments from the lockbox, deposits them immediately,
and sends the business a record of payments made and by whom. Delays in collection
and deposit processing are reduced. Traditional lockbox services were enhanced by
Check 21, and continue to be improved with advances in electronic banking. For
businesses, the fees for lockbox service are offset by improved funds availability and
lower staff requirements, so the net cost is lower.
Remote deposit capture
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With advances in check imaging, the advantages of account reconciliation and
lockbox services have been greatly enhanced. Remote deposit capture, also referred
to by one of the check conversion variants – accounts receivable entry (ARE), point of
purchase (POP), and back office conversion (BOC) – allows businesses to scan checks
and convert the data into automated clearing house (ACH) debits that they send to
their banks for credit to their accounts. In all instances, customers must be notified of
the intent to convert an eligible check for payment, and be allowed to opt out of check
conversion. Businesses may allow their customers to use alternative payment
methods.
POP conversion takes place at the point of sale. ARE and BOC check conversion
can be done by the company’s own accounting office, its bank (as with paper-based
check processing), or a third-party processor.
Banks are benefiting from remote deposit capture services such as business use of
back-office conversion. For example, the cost of processing paper checks is reduced.
Also, the service allows banks of all asset sizes to strengthen current customer
relationships, and expand their geographic boundaries to attract more customers,
without incurring the costs of a branch location.
Direct Deposit
Direct-deposit transactions processed electronically through an automated clearing

house enable businesses to deposit net pay, reimbursements, commissions, retirement
plan payments, pension benefits, dividends, and other payments into the checking or
savings accounts of the intended recipients. For businesses, direct-deposit services
eliminate the cost of creating and distributing paper checks, and reduce exposure to
check fraud. For recipients, direct deposit expedites their access to funds and offers
the convenience and security of having payments posted electronically to a bank
account, thus avoiding a trip to the bank to deposit a paper check.
With electronic benefit transfers (EBT), payroll cards, employees do not need to
maintain a separate bank account. Instead, a company arranges with a bank to provide
the payroll cards, similar to ATM debit cards or stored value cards to their employees.
Each payday, the employer credits the employee’s account or a subaccount of a

company account for the employee’s compensation. The employee then uses the
payroll card to withdraw the funds at an ATM, and to make purchases at merchant
point-of-sale terminals. Payroll card products can substitute for traditional consumer
transaction accounts at a financial institution.
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Controlled disbursement
This service provides same-day notification of the dollar value of checks that will
clear against the company’s disbursement account, so that payments can be funded
immediately from the company’s concentration account or line of credit. The company
must fund the disbursement account that day, to prevent an overdraft when the full
value of the checks that are to clear posts against the disbursement account.
Cash concentration
With cash concentration accounts, businesses collect balances from various deposit
accounts into one account. To collect the funds, the business initiates ACH debits to
the various deposit accounts and credits the concentration account. Cash concentration
and controlled disbursement allow companies to take advantage of overnight
investment opportunities, because surplus funds are consolidated in the concentration
account. Exhibit 9.1 illustrates the relationship between the cash concentration
account and various deposit accounts.
Zero-balance account
A zero-balance account is a demand deposit account that maintains a zero balance

because it is linked to a concentration account or a line of credit. As checks are
presented for payment, the bank automatically transfers funds from the concentration
account or line of credit to pay the checks, and to keep the account balance at zero. A
positive balance in the account is transferred to the concentration account to earn
interest or for investment, or to the line of credit to pay the balance.
Depository Transfer
This service facilitates cash concentration. Preprinted, unsigned, restricted-payee

checks known as depository transfer checks (DTC) create transfers of cash from
corporate accounts in various banks to the company’s central account at another bank.
The service may be paper-based or electronic. Companies with widely scattered
locations use this service, so that branch managers can use local banks.
Depository transfer check (DTC) A preprinted, unsigned, restricted-payee instrument

used to transfer cash from the account of a corporation in one bank to its central
account in another bank. Paper-based or electronic, it is used in conjuction with cash
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concentration account services.
Remote deposit capture benefits to business Reduced payment processing costs, low
item costs, greater efficiency, more centralization of back office functions, expedited
returns, expanded markets, reduced transportation costs, easier account reconciliation.
Exhibit 9.1 CASH CONCENTRATION
Corporate Eastern Corporate Northern Corporate Southern

Regional Office Regional Office Regional Office
(Cash Receipts) (Cash Receipts) (Cash Receipts)
Bank A Bank B Bank C

$ 400 000 $ 400 000 $ 400 000
Federal
BankReserve
D
$1.2 million
Bank D
$1.2 million
Corporate
Cash Concentration Account
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Wire transfer
This electronic funds transfer service facilitates the customer’s cash management.
At the direction of the customer, funds are wired to another bank to fulfill a business
transaction. Banks also offer wire collection services.
Merchant Card Service
Banks make it possible for merchants to accept customer payments by credit or debit
card or electronic check. The market for merchant card services includes retailers,
online businesses, telephone and mail order companies. Banks that offer merchant
card services supply businesses with the equipment to process transactions, including
card terminals and receipt printers.
The business has an account with the merchant bank card processor, which provides
settlement services for a fee, usually a percentage of each customer transaction.
Merchant card services provide immediate approval of transactions, reduce the risk of
returned payments, reduce the labor costs associated with check handling, and make
funds available more quickly.
Sweep Account
In this business account service, banks transfer (sweep) excess funds from the
customer’s business account every night to aggregate with the surplus funds of other
customers. The aggregated funds are then invested, usually in overnight government
securities and repurchase agreements, on behalf of participating customers. The
interest each customer earns is based on the amount invested.
Repurchase agreement (repo; RP) A sale of securities with a simultaneous agreement

to buy back the same securities at a stated price on a stated date. It is the most
common form of overnight investment for corporate funds, supported by securities
(usually Treasury bills) from the bank’s (or broker’s) inventory.
OTHER BUSINESS BANKING PRODUCTS AND SERVICES
In providing full service to businesses, banks go beyond deposit & accounting related
services to assist businesses of all sizes with their financing and insurance needs.
Business Financing
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Banks are the primary source of working capital loans for small businesses. For
larger corporations, banks facilitate financing through, for example, letters of credit,
lines of credit, and for larger business needs, participation or syndicated loans.
Insurance
Through insurance affiliates or partnering companies, banks can provide businesses

with insurance products for employees, such as health and key person insurance.
Health insurance
Coverage is provided for the cost of physician and hospital care. Companies are the
biggest purchasers of health insurance, buying for their employees. The health
insurance business is flourishing, and policies are sold that cover vision, dental care,
and prescription drugs. If employer-provided health insurance is not available,
employees of business customers may buy an individual policy personally. Retirees
buy health insurance to supplement their Medicare hospital & medical care coverage.
Key person insurance
This product is purchased by a company to cover the loss by death or disability of

those employees whose absence would financially hurt the company. Executives and
other employees with specific managerial or technical expertise usually are insured.
Small businesses, which are more vulnerable than larger ones to the loss of a key
employee, often buy key person policies.
Proceeds from a key person policy can be used to recruit and train a replacement and
help replace profits the company might have earned had the employee been working,
such policies help reassure creditors and suppliers about the continuity of the business.
CAPITAL MARKETS
Banks offer a variety of services to help companies raise money for their operations
by accessing public and private equity and debt markets. Many of these services may
be offered through an affiliated broker-dealer. The capital market services provided
to corporate customers range from specialized lending and asset management to
advisory services. Among them are :
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- structuring and distributing debt securities supported by company assets (asset-
backed securitization)
- underwriting and distributing corporate equity, debt, and preferred shares
- structuring and syndicating loans
- providing assistance on structuring and negotiating the sale or purchase of business
assets in mergers and acquisitions
- structuring and distributing private placements
- underwriting and distributing the debt securities of state governments, municipalities
and other public institutions
- providing financing to specialized businesses, such as real estate developers.
Merchant Banking
Merchant banking and investment banking are important commercial financing

operations that serve both domestic and international trade. The GLBA permits
nonbank affiliates of financial holding companies to offer a wide variety of merchant
banking services, among them direct investment by a financial holding company in
nonfinancial companies. The GLBA refers to these investments as “mercbant
banking”. The financial holding company is an actual investor, and may assume an
active role in the company in which it has invested, including having a representative
serve on the board. In addition to providing capital, merchant banking may extend to
corporate lending, leveraged finance, investment banking, and other corporate
financing solutions.
Investment bankers help companies find ways to raise capital in the form of debts
(bonds) or equity (stocks). Stocks and bonds offered to the public for the first time –
new issues – are not listed on the trading exchanges, the secondary market; rather, the
investment banker creates a primary market.
Generally, the investment bank buys the company’s entire new issue and sells it to
the public at a markup that is the fee the investment bank earns. All the shares may be
sold to the public (a fully subscribed issue) or all may be sold to a single investor (a
private placement). If the issue is too large or carries too much risk, an underwriting
syndicate consisting of more than one investment bank will make the sale.
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Exhibit 9.2 CORPORATE TRUST CHAIN of EVENTS for a BOND OFFERING
Company has legal counsel prepare

page
the indenture
The bank trust department reviews for

acceptability
- Can the trust department fulfill its
responsibilities to bondholders ?
- Is the company able to meet its
obligations to bondholders ?
- Is there any potential conflict of
interest with this trust ?
Trust department’s legal counsel

reviews the indenture agreement
to ensure that it allows the trustee
to take action to fulfill its
responsibility
For a secured bond issue, the trustee

holds title to the collateral, or ensures
the collateral is maintained
The issue corporation and the

trustee then sign the indenture
document
The trustee delivers the bonds to

investors, guaranteeing authenticity,
and the payment for the bonds to the
corporation
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With bond issues, the investing public wants assurance that periodic earnings will
be distributed, and at maturity the principal investment will be redeemed. An
investment bank does not do this, but a bank trust department does.
Securitization The packaging of receivables, such as those from credit cards or

residential mortgage loans, as a unit to be sold to outside investors. In the case of
loans, the loans are then no longer assets of the bank, although the bank may continue
to service them for investors.
Investment banking The marketing of new security issues, usually through an

investment banker or underwriter.
Primary market The market in which an issuer sells new securities to investors.
Among middlemen who aid in the sale of a company’s securities are underwriters,
brokers and dealers.
Secondary market A market for the resale of securities (such as the dealer market, a
stock exchange, or the mortgage-backed securities market) where ownership is
transferred from one owner to another. The first sale of any security is in the primary
market; all subsequent sales are in the secondary market.
Underwriting The assumption of a risk for a fee, such as for insurance or investments.
Insurance underwriting guarantees cash payment if there is a loss or casualty.
Investment underwriting guarantees the purchase of new offerings of corporate stock,
or debt securities of a corporation or government entity, by purchasing the entire
offering and then selling it in the market.
BUSINESS TRUST SERVICES
In the early years, trust services were offered only by trust companies. In time trust
companies assumed commercial bank functions; they accepted deposits, extended
credit, and obtained state banking charters to become bank and trust companies. With
the Federal Reserve Act of 1913, national banks were allowed to offer trust services.
A bank may serve as a corporate trustee for a corporate or municipal bond issue. In
that capacity, it monitors compliance with the indenture agreement between bond
issuer and bondholders, often handles periodic interest payments to bondholders, and
protects the interests of bondholders if the issuer defaults.
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Trust services complement other business banking services and facilitate a total
financial relationship between the bank and the business and its owners. If a bank is to
offer trust services, its federal or state charter must accord it trust powers. Many banks
have applied for trust powers, so that they also can offer wealth management
counseling to their business customers.
Corporations need expert safekeeping and administration of company assets.

Banks traditionally have served in this fiduciary role. Two main lines of trust business
are corporate agency services and employee benefit services.
CORPORATE AGENCY SERVICES
The financial needs of companies are similar to those of individuals and the legal
relationship of the trust department to the customer is the same as agent and principal.
For corporations and government agencies, banks provide paying agent, registrar, and
transfer agent services.
Paying agent The bank pays interest or dividends to holders of bonds or stock issued
by a corporation or government unit, and redeems debt issues as they mature.
Registrar The bank trust department keeps records of purchases and sales of bonds or
stock and of cancellations and reissues. The corporation establishes the maximum
number of bonds and shares of stock that may be issued, and the bank ensures that
there is no overissuance.
Transfer agent The bank trust department is responsible for changing ownership title
on the corporation’s shares of stock, as is required when shares change hands. Old
shares are canceled, and new shares issued in the name of the new shareholder. Stock
certificates are signed by the officers of the corporation, the transfer agent, and the
stock registrar, if there is one. Bank trust departments mostly facilitate securities
transfers, using electronic book entry rather than just physical delivery of securities.
Additional bond and stock agency services include :
- paying principal when a bond matures or is cancelled or called.

- processing default on bonds.
- safekeeping collateral for a secured bond issue or not-yet issued stock certificates.
- replacing and record keeping lost stock certicicates.
- responding to stockholder inquiries.
- reporting shareholder demographic information to the corporation.
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Indenture A contract underlying a bond issue, signed by the issuing corporation and
the trustee, who acts for the bondholders. It sets forth the rights and responsibilities of
the corporation, trustee, and bondholders and the terms of the issue.
Agent A person or company that acts for another person or company (the principal) by
the latter’s authority.
Book entry A method for electronically registering and keeping a record of securities
ownership without issuing a physical certificate to owners. Securities are not in printed
form but exist on the books of the issuer’s agent. Transfer is by electronic debit and
credit.
Call The right of a corporation to repurchase a bond obligation or stock.
Trust A legal structure created to hold property or other assets.
Trustor Person creating the trust.
Trustee Person or entity taking control of the trust property and administering the
trust.
Beneficiary Person for whose benefit the trust was established
- sending corporate information to shareholders : annual reports, shareholder meeting

notices, and proxy statements.
- rendering stock during a company acquisition by either paying company owners for
their stock in cash, or converting the stock to the acquiring company’s stock.
- handling stock conversions in mergers.
- managing stock subscriptions, buybacks, warrants, options, and rights.
EMPLOYEE BENEFIT SERVICES
Managing trust funds for paying pension and other benefits to employees of
corporations, large nonprofits such as trade associations, and state and local
governments is one of the fastest-growing and mot competitive trust areas. Employee
benefit programs generally are benefit welfare or benefit pension programs.
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Employee benefit welfare program
A program established by an employer or employee organization to benefit the

participants or beneficiaries, such as health insurance, sick leave, vacation, disability
pay, and training.
Employee benefit pension program
A deferred compensation program established to provide income for employee

retirement, usually categorized as a defined benefit, or a defined contribution plan.
Proxy statement A document intended to give shareholders the information they need
to vote knowledgeably on matters brought up at shareholder meetings.
Employee benefit program A program established or maintained by an employer,

employee organization, or both to provide employees with a certain benefit or set of
benefits, such as pensions, profit-sharing, stock bonuses and life, health, accident, and
disability insurance.
Deferred compensation The contractual postponement of payment for services

rendered until a future date; commonly used with respect to retirement benefits
(qualified or nonqualified) to be paid in the future.
Defined benefit plans
Also referred to as target plans, defined benefit plans are funded entirely by the
employer and the retirement benefit is defined (targeted or predetermined) up front.
The employer is responsible for the benefit payments and the investment risk. Annual
contributions are determined on an actuarial basis. Benefits, payable upon retirement,
are made as an annuity distribution. Plans are either qualified or nonqualified.
Actuarial calculation The mathematical determination of rates and premiums for life
insurance, disability insurance, and pension benefits based on tables detailing the
frequencies of mortality (death) and morbidity (disability).
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Trustee’s fiduciary responsibilities
- act solely for beneficiaries

- avoid conflicts of interest
- be a prudent investor
- delegate authority to other experts
- select supervisory agents
- segregate trust assets
Exhibit 8.3 Qualified Plan Requirements
Plan The plan must be exclusively for the benefit of employees who are
exclusiveness participants; no other groups may participate
Formal The plan must be adopted formally by the employer and governed by
construction a plan document
Non- The plan cannot discriminate against any class of employee in the
discrimination organization that otherwise qualifies to participate. Restrictions on
participation must be fair, and generally based on criteria such as
legal age, time of service, citizenship, full-time employment, and
whether the employee is a member of an employee association
subject to good faith bargaining and a separate defined benefit plan
Contribution The plan must maintain annual compensation limits, annual
limits contribution limits, and limits on the payable benefit
Active funding Contributions must be made annually according to the plan formula
Plan disclosure The plan regularly discloses to employees in an understandable way
features such as the summary plan description, individual participant
benefit statements, and summary of any amendments to the plan
Plan The plan should be designed and maintained to be permanent. There
performance should not be a termination date
Investment The plan’s trustee, investment manager, and administrator must take
prudence a prudent approach to the investment and management of plan funds
Vesting Participants should have a nonforfeitable vested interest in the plan
at some point. It may allow vesting immediately, 100% after so
many years of service, or graduated percentage over time
Established The plan must have provisions for normal retirement age and for
retirement age early and late retirement
Calculation of Plans may vary. Most allow for full benefits at the established
benefits at retirement age, such as 65; a reduced benefit for early retirement,
retirement such as at age 55, and an increased benefit for employees who leave
after the full retirement age
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Constructive Contributions and earnings to the retirement plan are tax deferred
receipt for the employee. However, when the money is paid and available to
the employee (constructive receipt), it is taxable
Plan Employers offer many plans. Within allowable parameters, they may
integration integrate the plans to determine the employee’s pension benefit
Pension A government-owned corporation, PBGR administers an insurance
benefit program that guarantees defined benefit plan participants the basic
guaranty at or vested retirement benefit payments if the plan is terminated, or
retirement lack funds to make payment. The employer pays an annual premium
for this protection.
Qualified retirement plan
These plans must meet the requirements of the Internal Revenue Service and such
laws as the Employee Retirement Income Security Act (ERISA), so that employers
can deduct contributions made and reduce company income taxes.
Nonqualified retirement plan
Called supplemental employee retirement plan (SERP) or salary compensation plan,

this is a deferred compensation plan established by an employer for select employees.
Employer contributions are taxable to the employer but are tax-deductible to
participants once payments are made. Depending on how the plan is structured, the
earnings before distribution may be taxed to employees, and the assets may be subject
to claims by the company’s creditors. It is a benefit often provided to key employees.
Defined contribution plans
Unlike defined benefit plans, defined contribution plans determine the contributions
allowed and not the future benefit. The plan provides a pension benefit at the time of
retirement; but it may vary depending on annual contributions to the plan, its gains or
losses, and its expenses. The basic plan types are money purchase, profit-sharing,
401 (k), 403 (b), and employee stock ownership (ESOP).
Money purchase The employer makes a fixed contribution to the plan on behalf of
each employee, thus controlling how much it contributes. Generally this is a
percentage of the employee’s annual compensation, weighted for years employed and
investment performance.
Profit sharing An employee receives a share of the net profits of a business. The
shares may be distributed periodically, often annually, as cash bonuses, or they may
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be accumulated for the employee in a deferred retirement plan, and paid if a specified
event (retirement, death, termination, layoff, or disability) occurs. The employer is not
committed to making contributions, but if he does, contributions can be made
according to a formula, or at the discretion of the board of directors.
Other IRS Qualified Plan Requirements

- Begin paying benefits no later than April 1 of the year after participant reaches 70 ½
- Protect plan assets if there is a merger
- Designate the type of qualified plan
- Allow for option to roll over lump-sum distribution
Other employee benefit services
Stock options, physical exams, vision care, sick days, severance pay, bonus / incentive
compensation, dependent care, life insurance, travel and entertainment, parking and
commuting reimbursement, tuition reimbursement.
Trade categories
- Trade in goods : raw materials, crops, manufactured goods

- Trade in services : engineering, scientific, personal, processing
- Capital exchange : long-term plan investment, short-term financing, stock
ownership.
401(k) It also is called a salary reduction plan. Employees make pretax contributions
that reduce income and thus taxes. Additional taxable contributions also may be made.
Tax on earnings is also deferred unril funds are withdrawn, usually at retirement.
Employers may, but do not have to, make matching contributions up to certain
percentages, in different forms, including employer stock. Participants are given
investment options, but cannot hold the employer or the plan’s trustee responsible for
the performance of the investments they choose.
403 (b) This plan is available to educators, health care workers, and employees of
religious institutions and nonprofit organizations. Often referred to as a tax-sheltered
annuity, it was once restricted to investments in annuity contracts.
Employee stock ownership plan (ESOP) Usually a supplemental retirement plan, it

allows employees to invest in the securities of the employer.
Accounting, legal, insurance, actuarial and banking experts can advise employers
about establishing retirement plans. Bank trust departments help employers determine
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the type of plan to use, whether the employee contributions should be a plan feature,
plan qualifications, and how the plan should be administered. Unless benefit plans are
for insurance only, the law requires that bank assets be held by a trust.
As trustee, a bank may directly control or delegate others to receive regular

contributions from the employer and the participants, invest the contributions, keep
detailed records to show the accrued value for each employee, make disbursements,
provide details of transactions, and file tax reports. Trust departments may provide the
service directly, or contract for the professional experts needed, such as investment
managers, actuaries, plan administrators, accountants, or legal counsel.
INTERNATIONAL BANKING
Commerce always has had an international character. “When the produce of any
particular branch of industry exceeds what the demand of the country requires, the
surplus must be sent abroad and exchanged for something for which there is a demand
at home. Without such exportation, a part of the productive labor of the country must
cease, and the value of its annual produce diminish”.
International commercial activities include trade in goods, trade in services, and

foreign exchange. International banking services meet the needs of businesses
operating in a world where countries are increasingly dependent on one another, and
money flows with no regard for geographic boundaries. Each day billions of dollars
are transferred electronically among international money centers such as Hong Kong,
London, Tokyo, New York. Bank products and services facilitate all these activities.
To conduct international business, banks may establish international departments,

overseas branches, Edge Act corporations, foreign representative offices, subsidiaries,
and joint ventures. Banks that do not have their own international structure work
through domestic correspondent banks that do. The following international banking
structures are used today :
Edge Act Corporation
Established under the Federal Reserve Act, these corporations are national bank
subsidiaries for either foreign trade-related banking or foreign investment. Through
such corporations, banks can open domestic offices outside their home state to transact
international business only, and thus offer services to international customers and
correspondent banks. Most are located in New York City.
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Foreign branch
To open a full-service branch operating in a foreign country, banks obtain the

permission of the host government, and approval of the Federal Reserve Board. Once
established, the foreign branch must comply with local banking rules, exchange
controls, and regulations. Its activities are subject to examination by both the host
country and U.S. banking authorities. Usually, capital of a foreign branch is
segregated from the capital of its domestic parent.
Shell branch
A special-purpose overseas branch, a shell has no physical location and does not
conduct transactions in the local economy, but does serve particular banking or
investment purpose, such as taking Eurodollar deposits or “warehousing” loans
originated in a foreign country.
Eurodollars Deposits denominated in US dollars at banks and other financial

institutions outside the USA. Although the name originated because large amounts of
such deposits were held at banks in Western Europe, similar deposits in other parts of
the world also are called Eurodollars.
International banking facility (IBF)
These facilities are established by banks to participate in the Eurodollar market

without the expense of an overseas branch. They allow domestic banks to accept
deposits and offer loans to foreign customers and businesses. The accounts are
separated from those of the bank’s domestic offices. Any US bank, Edge Act
corporation, or US branch or agency of a foreign bank may establish an IBF. Although
Federal Reserve Board approval is not required, banks must notify the Fed in advance
of their plans and agree to comply with regulations.
Foreign representative office
This is an office of a US bank, usually located in another national capital, that does
not provide the extensive services of a foreign branch. The representative builds
business for the bank, and calls on customers but cannot take deposits or make loans.
Instead banking services are provided by the US bank or one of its foreign branches.
Foreign bank representative offices in the USA must register with the Federal
Reserve, and may be licensed by the states in which they operate.
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Foreign subsidiary
It is a foreign company in which a US bank has a majority interest or some other form
of control. It is used where foreign branches are not permitted or to perform functions
that the host country exhibits for branches such as securities and investment activities.
Foreign joint venture
In this structure, a US bank shares ownership and management interest in a foreign

company with other banks. Operating under its own name, the joint venture functions
as an independent bank.
INTERNATIONAL PAYMENTS
Businesses active internationally need a safe and efficient payment system.

Commercial banks provide this service. Although domestic payments are made using
the services of central banks, such as the Fed in the USA, international banking uses a
system of links between correspondent banks.
To facilitate the exchange of funds, correspondent banks set up Due To (loro or

vostro accounts) and Due From (reciprocal or nostro accounts). Foreign banks set up
Due To accounts in US correspondent banks to facilitate payments in US funds. US
banks set up Due From accounts in a foreign correspondent’s bank to facilitate
transactions in the currency of that country. Agreements are made for payment forms
such as cash, sight and time drafts, banker’s acceptances, letters of credit, and
electronic fund transfers.
Foreign draft
A negotiable instrument drawn by a bank on a foreign correspondent bank, this

draft may be issued in any currency and is used when payment accompanies
documents, such as an order for goods, an invoice paid in foreign currency or a bill of
lading. Most common are sight drafts and time drafts.
Draft A signed order by one party (the drawer) addressed to another (the drawee)
directing the drawee to pay, at sight or at a definable time in the future, a specified
sum of money to the order of a third person, the payee.
Sight draft A draft payable on demand when presented to the drawee.
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Time draft A draft payable at a fixed or determinable future time.
Banker’s acceptance
This draft is drawn by a company on a bank and “accepted” by the bank that is
instructed to pay a designated party a certain sum of money at a specified time. The
bank that accepts the draft assumes the obligation of making payment when the
acceptance matures, usually within 30 to 180 days.
Letter of credit
Issued by a bank, this instrument substitutes the credit standing of the bank for the
credit standing of the importer (buyer) of goods. It guarantees that the bank will pay
the exporter (seller) if all the terms of the contract are met. It protects the buyer by
assuring that no payment will be made until the contract has been fulfilled. It is
underwritten and analyzed like a loan, and the customer signs an agreement with the
bank. Revocable letters of credit are rare today, most are irrevocable.
Revocable letter of credit A letter of credit that may be withdrawn by the issuer at any
time without prior notice to the beneficiary.
Irrevocable letter of credit A letter of credit that once issued cannot be cancelled, and
can be modified only with the consent of all parties to the credit, including the
beneficiary (often an exporter).
Standby letters of credit are paid when something does not happen in the course of
the transaction, such as when a contractor does not complete a project on time, they
have a maturity or renewal period and simply reinforce a customer’s credit standing.
Clearing house interbank systems
Used primarily for large dollar transfers, these electronic funds transfer systems are
similar to domestic automated clearing houses such as NACHA or the Fedwire system
but are used for international transactions; examples are the Clearing House Interbank
Payments System (CHIPS) in New York, the Swiss Interbank Clearing System (SIC).
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FOREIGN EXCHANGE SERVICES
Foreign exchange is another service large banks make available to corporations

operating around the world. International commerce cannot occur unless money can
be exchanged easily from one currency to another. US banks that offer foreign
exchange send and receive payments in all major currencies worldwide.
International banking departments offer corporate customers the ability to send and
receive payments in dozens of currencies. Payment can be made by wire, traveler’s
checks, draft, international ASH, and foreign currency banknotes (cash), or through
other channels using other financial instruments. A key function of international
banking departments is to monitor the exchange rates of the world’s currencies to
keep current with what the US dollar is worth in euros, yen, or other currencies.
Exchange rates then can be calculated immediately for international transactions.
Foreign change Trading in or exchange of foreign currencies for other foreign

currencies.
Today many bank charters include trust powers that require banks to comply with
state and federal common law fiduciary principles. The National Conference of
Commissioners on Uniform State Laws (NCCUSL) has drafted a uniform trust act that
has been adopted by many states. Trustees are subject to all state laws that are not
preempted by federal law.
Before the GLBA, banks that engaged in securities underwriting and dealing did so
through “Section 20” firms. Section 20 of the Banking Act of 1933, the Glass-Steagall
Act, which separated commercial from investment banking, prohibited banks from
affiliating with firms engaged principally in underwriting and dealing in securities.
So banks formed subsidiaries called Section 20 broker-dealer firms that could

engage in securities activities, although there was a limit on the amount of revenue
they could earn. The GLBA repealed Section 20.
The International Chamber of Commerce (ICC) establishes uniform rules that

govern international trade, such as the Uniform Customs and Practices for
Documentary Credits (UCP 500) and the Uniform Rules for Collection. These
international trade rules support and supplement the Uniform Commercial Code
Article 5 rules for letters of credit, with which US banks must comply.
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FIDUCIARY ACTIVITIES OF NATIONAL BANKS, REGULATION 9
Title 12, Chapter 1, Part 9, of the Code of Federal Regulations (Regulation 9)

governs the fiduciary activities of national banks; it sets out specific rules on trust
administration and custody of assets, among other topics. Regulation 9 applies to
national banks acting in a fiduciary capacity under the trust powers granted in their
charters. It covers such fiduciary activities as collective investment funds established
by a bank, or an affiliate for the investment and reinvestment of money the bank
manages as a trustee, executor, administrator, guardian, or custodian under the
Uniform Transfer to Minors Act, or as the fiduciary for retirement, pension, profit-
sharing, stock bonus, or other trust funds exempted from federal income tax.
GRAMM – LEACH – BLILEY ACT
In 1999 GLBA Congress incorporated underwriting, dealing in, and making a market
in securities in its list of permissible “financial-in-nature” activities. This authority
allows banks to underwrite and deal in commercial paper, asset-backed securities, and
corporate debt and equity, unrestricted by revenue limitations. Banks also can deal in
mutual funds and make a market in securities, unrestricted by percentage limits.
The GLBA requires that banks conduct securities activities through a nonbank
entity, either a national bank financial subsidiary, or an FHC nonbank affiliate. In the
GLBA system of functional regulation, these subsidiaries or affiliates are subject to
Securities and Exchange Commission (SEC) regulations. However, the GLBA
recognizes that banks engaged in securities activities that are associated with
traditional bank products and services should not have to register as broker-dealers
and be subject to SEC oversight, such as investments that banks traditionally have
made in US government and agency securities.
UNIFORM COMMERCIAL CODE ARTICLE 5
Rules governing letter-of-credit transactions are derived primarily from UCC

Article 5; another source of rules for international banking is the ICC’s UCP 500.
Some requirements of Article 5 are :
Agreement by the parties
Unlike a negotiable instrument, there is no particular form required for a letter of

credit, but it must be on record and authenticated by signatures, or in another manner
agreed to by the parties.
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Enforceability
A letter of credit is irrevocable unless it states otherwise. It becomes enforceable

against the issuer, when the issuer sends or electronically transmits it to the adviser or
to the beneficiary.
Payment responsibility
When the required documents are received from the beneficiary, the issuer must
examine them to ensure that they comply with the letter of credit, but the issuer does
not need to determine if the contract terms have been explicitly met. For documentary
drafts, the issuer may take up to the end of the 7th business day after receipt of
documents to make a payment decision. If there is a discrepancy, it must dishonor the
draft and either return the documents or notify the presenter that they are being held
for further instruction.
Wrongful dishonor
The issuer’s responsibility to the beneficiary if a court decides it has wrongfully

dishonored a letter of credit payment, is the amount of the dishonored draft and any
damages, interest, reasonable attorney’s fees, and other litigation expenses that may
have been incurred.
SUMMARY
1. In addition to basic banking products such as checking and savings accounts and
loans, banks offer businesses various specialized services, such as cash management,
insurance, capital markets products, trust services, and international banking.
2. Cash management services help busineses collect income and payments quickly,
manage and reconcile outgoing payments efficiently, obtain timely and complete
information on their bank accounts, and invest surplus funds for additional income.
Banks help businesses achieve these objectives through cash vault, positive pay,
account reconciliation, lockbox services; remote deposit capture, direct deposit
systems, controlled disbursement services that use cash concentration and
disbursement accounts; zero-balance accounts; and depository transfer systems, wire
transfer, merchant card services, and sweep accounts.
3. As a result of the Gramm-Leach-Bliley Act, banks can now offer their customers
insurance products. The law also permits financial holding companies to underwrite
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insurance products. For businesses, banks will sell and manage health and key person
insurance.
4. By accessing public and private equity and debt markets, large banks offer a
variety of services to help companies raise money for their operations. Capital market
services for corporate customers include specialized lending; structuring, distributing,
and underwriting debt; merchant banking; and facilitating sales of assets in mergers
and acquisitions.
5. Banks offer companies trust and agency services. Corporate agency services
include safekeeping of stocks and transfer, registrar, and paying agent services. Bank
trust departments manage employee benefit programs such as those for employees’
welfare (insurance and payments for sick leave, vacation, disability, and training) and
retirement programs, such as defined benefit and defined contribution plans.
6. More than ever before, banking covers the world. To stay competitive, banks offer
services to customers that transact international business through various structures;
among them Edge Act Corporations, foreign branches, shell branches, international
banking facilities (IBF), foreign representative offices, foreign subsidiaries, foreign
joint ventures. Correspondent banking relationships are important for international
banking, and payment services, such as letters of credit, banker’s acceptances, and
foreign exchange, protect the interests of both buyers and sellers in the international
market place.
6. Among laws and regulations pertaining to business and international bankings are
Regulation 9, Fiduciary Activities of National Banks, which provides rules on trust
administration, custody of assets, and other trust-related issues; the Gramm-Leach-
Bliley-Act, which allows banks to underwrite and deal in commercial paper, asset-
backed securities, and corporate debt and equity, unrestricted by revenue limitations;
and UCC Article 5, supplemented by the ICC’s UCP 500, which provides rules
governing letter-of-credit transactions.
SELF- CHECK AND REVIEW
1. What types of cash management services help a corporate customer optimize the
interest earned by deposits, or reduce the interest expense of loans ?
2. What check imaging advance is rapidly gaining acceptance in the business
community, and changing the way banks deliver cash management services ?
3. What is the purpose of key person insurance ?
4. What types of customers need capital market services ? What are some examples
of capital market services that banks provide ?
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5. What corporate trust services do banks typically provide ?
6. What organizational structures can banks use to facilitate delivery of international
banking services ?
7. How does a letter of credit protect the interests of both the buyer and the seller of
goods ?
8. Your company is importing widgets from Europe. Each widget costs €100 . The
current exchange is €1 = $1.15. How much does each widget cost in US dollars ?
9. What does UCC Article 5 govern ? What are some sample rules ? Is there an
international law similar to UCC Article 5 ?
CHAPTER 10 - BANK INVESTMENTS AND PERFORMANCE
LEARNING OBJECTIVES
- describe the annual report, profit and loss statement, statement of condition, and
statement of cash flows
- explain why financial statements are important to bank constituents
- discuss the function of the Asset and Liability Management Committee and its funds
management objectives
- explain how banks maximize loan and investment returns and fee income
- identify typical performance measures in banking
- describe the role of budgeting in achieving bank objectives
- identify laws relating to financial statements and other financial reports
INTRODUCTION
Banks, like other businesses, supply products and services, generate assets and
liabilities, and produce a profit for shareholders. As businesses, banks report their
performance through financial statements and ultimately in the annual report to
owners that also is made available to customers, employees and regulators. These
reports demonstrate the performance of a bank and its employees. They show where
and how the bank acquired funds and put them to work, and the results it achieved.
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THE ANNUAL REPORT
Once a year, a bank issues an annual report that presents a picture of its operations
and financial condition. The annual report is management’s summation of the bank’s
achievements over the course of the year. It describes management’s perspective on
the past year, including significant achievements, and presents objectives for the
future. It includes information about the bank’s financial position and business
performance. An annual report has 4 main components : promotional information,
analysis, financial statements, and an audit report. Many banks post their annual
reports on the Internet.
Promotional information
Promotes the company to investors using photographs of the bank at work, reports
of employee contributions and achievements, and nonfinancial statistics, such as
contributions to the community.
Analysis
Discusses management’s business strategies, how they played out in the previous
year.
Financial statements
Set out the numbers that support performance : statement of condition, income
statement, and perhaps statement of cash flows (usually with comparisons to previous
years).
Audit report
A written statement by outside accountants attesting to the integrity of the financial

reports provided.
The 2 key financial statements for a bank are the statement of condition (balance
sheet), and the profit and loss statement (income statement). The annual report usually
contains these in abbreviated form. Because the reports are important for
understanding a bank as a business, they are read with interest by various bank
constituencies. A financial statement that may not be in the annual report, but is used
by management is the statement of cash flows.
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STATEMENT OF CONDITION
The statement of condition – balance sheet – is prepared as of a specific date. It

reports total assets, liabilities, and capital accounts of a bank as of, for example,
December 31 of a given year. (See Exhibit 10.1).
A statement of condition lists all bank assets and liabilities and its net worth
(shareholder equity or capital). An asset is anything of value the banks owns or is
owwed; a liablility is anything a bank owes. For example, loans owed to the bank by
borrowers are assets. Deposits owed by the bank to depositors are liabilities.
Exhibit 10.1 Consolidated Statement of Condition
Assets December 31
(In thousands of dollars) 20XX 20XX Change
Cash and due from banks $ 1 649 334 $ 1 332 586 316 748
Overseas deposits 458 313 460 396 (2 083)
Investment securities
US Treasury securities 881 081 982 654 (101 573)
Securities of other US government 199 318 243 420 (44 102)
agencies and corporations
Obligations of states and political 738 813 396 948 341 865
subdivisions
Other securities 88 278 92 032 (3 754)
Total investment securities 1 907 490 1 715 054 192 436
Trading account securities 14 846 66 140 (51 294)
Funds sold 168 600 108 450 60 150
Loans (net of reserve for loan 9 715 728 8 074 132 1 641 596
losses and unearned discount)
Direct lease financing 147 860 134 472 13 388
Premises and equipment, net 133 506 132 320 1 186
Customers’ acceptance liability 372 835 248 271 1 24 564
Accrued interest receivable 133 840 123 719 10 121
Other real estate owned 34 332 13 668 20 664
Other assets 103 939 131 711 (27 772)
Total assets $ 14 840 623 $ 12 540 919 $ 2 299 704
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Liabilities and Stockholders’ Equity December 31
(In thousands of dollars) 20XX 20XX Change
Demand deposits $ 3 543 141 $ 2 937 065 $ 606 076

Savings deposits 3 585 808 3 485 886 99 922
Savings certificates 1 635 215 1 391 107 244 108
Certificates of deposit 1 827 420 1 601 707 225 713
Other time deposits 424 592 313 811 110 781
Deposits in overseas offices 1 468 003 722 950 745 053
Total deposits 12 484 179 10 452 526 2 031 653
Funds borrowed 897 189 924 501 (27 312)
Long-term debt 44 556 43 766 790
Acceptances outstanding 373 022 249 088 123 934
Accrued taxes and other expenses 142 756 122 064 20 692
Other liabilities 171 904 122 890 49 014
Total liabilities (excluding 14 113 606 11 914 835 2 198 771
subordinated notes)
Subordinated notes :
8.25% capital note to Wells 25 000 25 000
Fargo & Company, due 20XX
4.5 % capital notes due 20XX 50 000 50 000
Total subordinated notes 75 000 75 000
Stockholders’ equity :
Capital stock 94 461 94 461
Surplus 300 036 251 512 48 524
Surplus representing convertible 10 065 14 589 (4 524)
capital note-obligation assumed
by parent corporation
Undivided profits 247 455 190 522 56 933
Total stockholders’ equity 652 017 551 084 100 933
Total liabilities and stockholders’ $ 14 840 623 $ 12 540 919 $ 2 299 704
equity
A statement of condition is usually a snapshot of the assets, liabilities, and capital

of a bank or a company on a given day. It also may be a monthly, quarterly, or annual
average of the balance in the bank’s accounts.
Major categories of assets listed on the statement of condition are :
Equity The investment interest of all shareholders in a corporation, equalling the

excess of assets over liabilities and including common and preferred stock, retained
earnings, surplus, and reserves.
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Asset category Description
Cash on hand and Coin and currency held in the vault, checks in process of
due from other collection, and balances with correspondent banks and the
banks Federal Reserve.
Investments Obligations of the federal government and its agencies,

obligations of state and local units of government, and stock in
the Fed if the bank is a member.
Loans and lease
financing All indebtedness to the bank, usually subdivided by category.
Fixed assets Real estate owned by the bank; furniture, fixtures, equipment
Other short-term For example, Fed funds sold and securities purchased under an
assets agreement to resell.
The following types of liabilities appear on the statement of condition :
Liability Category Description
Deposits Subdivided into demand, savings, time, domestic, and global

deposit accounts
Taxes payable All federal, state, and local taxes that are due
Dividends payable Dividends to shareholders that have been approved by directors
but not yet disbursed
Other short-term For example, Fed funds purchased and securities sold under
liabilities the agreement to repurchase.
Dividend A periodic payment, usually made each quarter, by a corporation to its

shareholders as a return on their investment. All dividend payouts must be approved
by the corporation’s board of directors.
Depending on the size and scope of bank operations, other assets and liabilities may
be listed in the order of liquidity, so that the first item in each category is the most
current and most easily converted into cash. Therefore, “cash and due from banks” is
the first asset shown, and “deposits” is the first liability listed. Besides showing
balances in the asset and liability accounts, the statement of condition also provides
information used to calculate certain performance measurements, such as return on
assets (ROA) or return on equity (ROE).
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For banks, how loans are reported on the balance sheet is a major consideration.
Despite a bank’s best efforts, it is a fact of banking that not all loans will be repaid as
scheduled. Therefore, each bank calculates a loan loss reserve (sometimes called loan
and lease reserve) on the basis of its past experience with losses, the quality of its
current loan portfolio, and the economic and political climate.
Loan loss reserve (also known as loan and lease reserve account) A balance sheet
(statement of condition) account where retained earnings are set aside to cover
possible loan losses. As loan losses occur, they are charged to the reserve account.
Statement of Condition (Balance Sheet) A detailed list of a company’s assets,

liabilities, and capital (equity) on a specified date.
Profit and Loss Statement (Income Statement) Summary of revenue, expenses, and
net income earned by a company during a stated period, such as a quarter or a year.
Each bank is permitted to reduce its total loan amount by this reserve, which is not
to be considered an admission by a bank that the full amount of the reserve will be
used for charge-offs. Rather, the reserve is a best guess about how much loan loss
protection the bank needs against events that may take place.
Unless a bank is insolvent, its total assets are greater than its total liabilities. The
excess of assets over liabilities shown in the capital accounts is the bank’s net worth,
also called shareholder equity. A fundamental equation in accounting states that total
assets must equal total liabilities plus net worth. Thus, if all a bank’s liabilities were
paid by using assets, what is left would be its net worth. The standard equation is :
Assets = Liablities + Net worth (Shareholders’ Equity)
A statement of condition in an annual report may include other liabilities not included
in the totals. Because there are contingencies for financial events that may occur and
legal commitments, they are not considered part of the current financial picture.
PROFIT AND LOSS STATEMENT
The profit and loss statement – the income statement –covers a bank’s operations
over time, such as a quarter of the year, the fiscal year, or the calendar year. It shows
all revenues and expenses, and the resulting profit or loss for the period. The profit
and loss statement lists all categories of income and expense. Expenses, which are
shown subtracted from income, reflect either the profit or the loss experienced by a
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bank during the period. The following major sources of bank income are typically
listed, in order of size and importance :
- interest and fees earned on loans

- interest and dividends earned on investments
- fees, commissions, and service charges
The major items of expense, also listed in order of size and importance, are :
- interest paid on deposits
- salaries, wages, and benefits
- taxes (federal, state, and local)
Fiscal year The 12-month period selected by a business or government as an

accounting period, at the end of which the books are closed, and profit or loss
determined. It may correspond to the calendar year.
Exhibit 10.2 Consolidated Profit-and-Loss Statement
Interest Income December 31

(Thousands of dollars) 20 XX 20 XX
Interest and fees on loans $ 823 415 $ 693 463

Interest on Fed funds sold 6 429 3 496
Interest and dividends on investment securities :
US Treasury securities 69 938 59 883
Securities of other US government agencies 16 520 25 228
and corporations
Obligations of states and political subdivisions 22 504 15 846
Other securities 7 067 7 268
Interest on overseas deposits 24 394 37 658
Interest on trading account securities 4 419 3 478
Direct lease financing income 33 371 32 560
Total interest income 1 008 057 878 880
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Interest Expense December 31
Interest on deposits 463 733 414 832

Interest on federal funds borrowed and repurchase 35 193 33 019
agreements
Interest on other borrowed funds 17 751 12 882
Interest on long-term debt 21 232 19 079
Total interest income 537 909 479 812
Net interest income 470 148 399 068
Provision for loan losses 41 028 46 379
Net interest income after provision for loan losses 429 120 352 689
Other Operating Income December 31

Trust income 21 635 19 649

Service charges on deposit accounts 25 511 24 254
Trading account profits and commissions (268) 1 690
Other income 43 797 23 324
Total other operating income 90 675 68 917
Other Operating Expense December 31

Salaries 168 085 145 746

Employee benefits 41 028 32 126
Net occupancy expense 34 919 31 636
Equipment expense 20 648 19 234
Other expense 94 331 68 317
Total other operating expense 359 011 297 059
Income before income taxes & securities transactions 160 784 124 547
Less applicable income taxes 73 484 61 076
Income before securities transactions 87 300 63 471
Securities gains (losses), net of income tax effect of (1 020) 40
$(1, 233) in 20XX and $48 in 20XX
Net income $ 86 280 $ 63 511
Income per share (based on average number of
common shares outstanding) :
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Income before securities transactions $ 4.03 $ 3.16
Securities transactions, net of income tax effect (.05)
Net income $ 3.98 $ 3.16
A profit and loss statement produces a net, or bottom line, figure that represents
revenues less expenses. This net figure is used to calculate earnings per share, a
figure that tells shareholders how much each share of outstanding stock earned during
the period. If a bank’s total expenses for the period exceed its income, the net figure
is negative, indicating a loss. A bank can use the profit and loss statement to analyze
its profits and determine its major sources of income and expense. (See Exhibit 10.2).
It also can compare its income and expense by category with those of peer banks. If
its expenses are higher than its peers, a bank can adjust its operations to bring them in
line. Many resources, such as data from the Federal Deposit Insurance Corporation
(FDIC), are available to help banks make peer comparisons.
STATEMENT OF CASH FLOWS
The third financial statement that may be in a bank’s annual report is the statement of
cash flows. While the balance sheet describes the bank’s financial position on a given
date and the income statement for a given period, the statement of cash flows
illustrates a bank’s sources and use of cash; it details the bank’s financing, investing,
and operating activities over time. The statement of cash flow can give bank
managers and owners more complete understanding of where the bank’s money came
from and how it was used.
Statement of cash flows
A financial statement that reports the flow of cash into and out of a company in a
given fiscal year. Often part of an annual report, it categorizes cash receipts and
disbursements by activities of operations, investments, and financing. Known as the
statement of changes in financial position, or the sources and uses of funds statement.
To illustrate how the bank funded its business activities and to reconcile changes in
cash and liquid assets for a given period, the statement of cash flows uses information
from two balance sheets and one income statement for the period such as a fiscal year.
Bank management uses information from the statement of cash flows to draft financial
strategies by anticipating changes in balance sheet items, such as a fall in deposits,
and determining how the bank would fund itself if those changes actually occurred.
Exhibit 10.3 shows the banking industry’s statement of cash flows for a given year.
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Exhibit 10.3 Banking Industry Statement of Cash Flows (billions of dollars)
Sources of funds XXX2 XXX1 Uses of funds XXX2 XXX1
Earnings $134 $122 Additions to near-cash assets $ 45 $ 71

Additions to deposits $557 $630 Additions to loans $602 $ 688
Additions to borrowings $158 $170 Additions to securities $ 33 $ 89
Additions to other ($22) $ 21 Additions to premises $ 93 $ 181
liabilities and fixed assets
Sale of stock $ 19 $151 Cash dividends $ 73 $ 65
Total $ 846 $1 094 Total $ 846 $ 1 094
IMPORTANCE OF FINANCIAL INFORMATION
The information in a bank’s financial statements and reports is important not only to
management and the board of directors, but also to shareholders and investors,
regulators, other banks, customers, and employees.
SHAREHOLDERS AND INVESTORS
Shareholders and investors are interested in a bank’s financial data because the
information can have an immediate effect on stock value. For example, if reported
earnings are higher than expected, the value of bank stock often rises. If the financial
data suggest that a bank is performing poorly, the stock value typically will fall.
REGULATORS
Regulators are interested in bank financial reports because they help reveal the true
financial condition of a bank. Regulators are interested particularly in a bank’s capital.
OTHER BANKS
Banks judge their own performance relative to their peers and to their own goals.
Using ratio analysis, they analyze the performance of comparable banks as a way of
judging their own performance.
Ratio analysis A technique for analyzing a financial statement that examines the
relationships between certain values reported in the statement.
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Banks seeking to expand through mergers or acquisition are particularly interested
in the financial reports of other banks. Potential acquirers are looking for bargains. If
its performance ratios suggest operational inefficiencies, a bank could be a prime
candidate for acquisition. The potential acquirer may be able to reduce expenses or
take advantage of economies of scale to turn a lackluster bank into a top performer.
CUSTOMERS
After federal deposit insurance was established, for many years consumers were
less concerned about the strength of financial institutions. However, because banks
occasionally fail, and deposits are insured only up to $100 000, many people now are
interested in the financial strength of banks. Consumers not only shop for interest
rates, they also shop for financial stability.
EMPLOYEES
The financial information produced by a bank affects its employees. Many take
pride in the financial results of their organization, and are interested in how their bank
compares with competitors. Their salaries, bonuses, benefits, and compensation may
be tied directly to bank performance. In addition, many banks maintain compensation
plans for executives that are based on performance, including performance in relation
to bank peers.
A primary goal of both management and employees is to increase shareholder

value by ensuring that bank financial results are positive. Attaining financial goals
helps motivate employees, especially if, as in many banks, there is a profit-sharing
plan that gives the employees a stake in the bank’s financial results. Some banks are
entirely employee-owned.
MANAGEMENT OF BANK FUNDS
Managing assets (loans and investments) and liabilities (deposits) is a fundamental

challenge of banking. It is far more complex than just making sure the rates charged
for loans are higher than the rates paid for deposits.
A common misconception is that banks possess huge pools of money that belong
only to themselves, and that they can lend and invest these funds as they see fit, so a
bank would be risking only its own funds when it makes loans. In fact, the opposite is
true : Every bank loan represents an effort to put deposits to work safely, prudently,
and profitably, while meeting the legitimate credit needs of borrowers.
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BUSINESS RISKS IN BANKING
In banking, there are business risks that can affect income, capital, and bank safety
and soundness. Exhibit 10.4 defines major areas of risk that (OCC) the Office of the
Comptroller of the Currency has identified for national banks. These risks take on a
particular character depending on the area of banking, such as credit or investment.
Exhibit 10.4 Risk Areas in Banking
Generally, the major categories of risk are credit, market, and operational risks. The
Office of the Comptroller of the Currency (OCC) has identified nine risk management
areas for national banks.
Strategic risk A risk from adverse business decisions or improper implementation

of decisions
Reputation A risk from negative public opinion, affecting the bank’s ability to
risk retain or establish new relationships
Credit risk The risk to earnings or capital that comes from a borrower’s failure
to meet the terms of a loan contract
Interest rate A risk from movements in interest rates, because of the sensitivity of
risk interest rates to change, and the timings of changes
Liquidity risk A risk to earnings and capital dependent on the bank’s ability to
meet obligations as they come due, as well as unplanned decreases
or changes in funding sources
Price risk A risk arising from changes in the value of loans and investments
Foreign Risk due to the movement of foreign exchange rates (applicable, for
exchange risk example, to credit card advances or purchases in foreign countries)
Transaction The risk associated with service problems or product delivery
risk problems related to the major category of operational risk, regarding
internal controls, information systems, employee integrity, and
operating processes
Compliance A risk stemming from violations or nonconformance to laws and
risk regulations, which may expose banks to fines, civil money penalties,
payment of damages, and voided contracts.
ASSET AND LIABILITY MANAGEMENT
When crafting a strategy to manage its funds, every bank takes many variables into
account. Most banks use a funds management strategy that is applied simultaneously
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to assets and liabilities. Because this is so important, banks usually have an Asset and
Liability Management Committee (ALCO) that is responsible for this function.
The ALCO monitors the costs of deposits and the income from loans. Its goal is to
manage bank assets and liabilities, so that shareholders achieve the maximum
possible long-term gain. To accomplish this feat requires planning for liquidity and
controlling risk.
For years, management concentrated primarily on traditional assets such as loans.

Managers were not as concerned about the source of the funds – primarily customers’
deposits – that were used to purchase assets. Today, however, because customers
have a wide variety of options for depositing their money, managing the liability side
of banking has become equally important.
Banks work hard to attract new depositors and keep them. Periodically every bank
must decide how much it needs in working funds, where to acquire additional funds,
and how much it is willing to pay for funds in a competitive market.
One of the largest expenses for banks is the interest paid to depositors. A challenge
for bankers is to ensure that interest paid is less than the interest received on loans.
The difference between the two is net interest income (or loss). Each bank’s net
interest income is important to its efforts to meet payments, generate profits and grow.
Applying the principle of matched funding, short-term loans are funded with short-
term deposits; long-term loans with long-term deposits. A 15-year loan to buy a home
is funded by, for example, certificates of deposits. A short-term loan or an adjustable
rate loan that is repriced, as market rates change, is funded with demand deposits.
Matched funding is applied not to individual loans but to entire loan portfolios. Thus
banks are careful to maintain a balance in the types of deposits they attract and the
types of loans they make.
Matched funding An asset and liability management technique in which assets are
financed with liabilities of the same maturity or duration.
FUNDS MANAGEMENT OBJECTIVES
Because customers are entrusting their money to banks, a high priority for every
bank is a sound funds management program. Under the direction of the ALCO, the
president or CEO at smaller banks, and the funds management department at larger
banks are usually responsible for these programs. Such programs strive to balance 3
objectives : liquidity, safety, and income.
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LIQUIDITY
Liquidity is very important for banks. A bank that does not have money available
when depositors want to make withdrawals will fail. When it is suspected that a bank
is illiquid, depositors will rush to withdraw funds. Depositors who feared that money
would not be available for withdrawal have triggered panics and bank failures.
The need for liquidity is tied to both the deposit and the lending functions. Liquidity
enables a bank to meet customer loan demand, and respond to the credit needs of its
community, as mandated by the Community Reinvestment Act.
Every bank operates with the expectation that over time fund inflows will
approximate outflows. Normally, new deposits arrive at a bank each day as checks
and orders for withdrawals are being honored.
However, over time, if fund inflows and outflows do not match often enough,
liquidity problems can build up. High loan demand (because of low interest rates or
other market factors) and low deposits (because funds are being diverted to stock or
other investments, or people stop saving) can cause a “credit crunch”. In a credit
crunch, banks find it dificult to meet the legitimate borrowing needs of their
customers.
Reserves, classified usually as primary and secondary, help prevent liquidity

problems.
Primary reserves
Cash on hand, demand deposit balances at correspondent banks, and reserves kept
at the Federal Reserve. No interest is earned on these deposits. Because the funds
support daily operations, they are available immediately and thus highly liquid.
Secondary reserves
The highest-quality investments permitted by law, such as Treasury bills. They earn
interest but can be converted to cash quickly. They are a back-up source of liquidity
because they must be sold to be converted to cash.
Although a bank must stay liquid, it cannot afford to overemphasize liquidity by

keeping large amounts of currency in its vaults. Because excess reserves reduce the
percentage of deposits that are available for lending, they lower income from loans.
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Therefore, while recognizing the primary importance of liquidity, a bank recognizes 2
other obligations in its program of funds management : safety and income.
SAFETY
Depositors must be confident that their money is safe. Though deposits are insured to
$100 000 by the FDIC, banks must protect the deposits entrusted to them by avoiding
unnecessary risk. Prudent lending practices, appropriate loan loss reserves, and strong
corporate governance minimizing fraud and mismanagement help protect depositors.
Balancing liquidity, safety and income is essential. A bank that aimed at maximum
safety by avoiding all risk would make few loans, and invest only in low-yielding
instruments. Being overcautious, it would inevitably neglect the legitimate credit
needs of its customers and community, and would lose loan interest income.
Did you know ...... ? Corporate enterprise risk management looks at the portfolio of
risks the bank incurs and assesses how they interact. As a result, risk might be reduced
because two lines of business could counteract each other.
INCOME
The third objective of funds management is income. If liquidity and safety were the
only factors a bank had to consider, it could build the largest and strongest vault
imaginable, keep as much cash as possible on hand under maximum security, make
only those loans and investments that carry an absolute minimum of risk – and fail to
meet its income objective.
US banks are not owned or directly subsidized by the federal government. Because
banks are owned by their shareholders, earning a profit for those shareholders is of
primary importance. A bank that repeatedly operates at a loss, soon loses the
confidence of its depositors, its shareholders and the public.
Banks that chose to maximize short-term income at the expense of liquidity and
safety were forced out of business, because their practices were unsafe.
Although there may be a short-term gain in profits, unduly lowering credit standards
will in the long run be fatal to a bank when weak loans cannot be collected and must
be charged off for a loss. Income, liquidity and safety, never can be considered alone.
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MAXIMIZING ASSET RETURN
Recall that the main bank assets are loans and investments. Maximizing the profit
they earn is a fundamental objective.
LOAN VERSUS INVESTMENTS
There are 3 basic differences between loans and bank investments. First, for loans,
banks must by law give priority to the credit needs of customers and their
communities, lending money to individuals, businesses, government, and other banks.
Investments, on the other hand, are made chiefly for income purposes. The fact that
banks contribute to the general well-being of a community, by buying the
community’s notes or bonds, is secondary to the income objective. Investments are
made after the demand for loans has been met. When a bank encounters increased
demand for loans, it may choose to sell some of its investment holdings as well as
borrow Fed funds overnight to get additional funds to lend.
Second, banks negotiate directly on loans but only indirectly on investments. In

making loans, banks and borrowers agree on the amount, purpose, maturity, interest
rate, and other conditions, and banks investigate borrower creditworthiness. In
contrast, banks make investments indirectly through bond dealers or underwriters, and
the issuers may not know the purchasers. Banks rely on rating services to determine
investment quality and risk. Where issues of local securities are not rated, bank
investment portfolio officers evaluate the issues before investing.
Finally, banks invest in securities to diversify their risk, ensure that assets are
productive, and perhaps reduce taxes.
Diversifying holdings between loans and investments helps to keep income stable.
Securities can be converted to cash more easily than loans can be called or paid off,
and some investments, such as municipal bonds, provide tax relief, which increases
bank earnings.
Creditworthiness The ability and willingness to repay a debt, largely demonstrated by

credit history.
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CREDIT RISK VERSUS MARKET RISK
Whether lending or investing, a bank faces risks. How well a bank addresses its
risks significantly affects its profitability. Two of the major risks a bank must address
are credit risk and market risk.
Credit risk The risk that the borrower cannot or will not repay a loan with interest as
scheduled.
Market risk The risk that the market value of a security or other asset will decrease,
because of interest rates changes, and other market conditions.
The chief concern with loans is credit risk : Will the borrower repay the loan ? The
investments that banks are allowed to make have less credit risk than loans : Will the
government pay the interest due on the security ? With US government obligations
(Treasury bills and notes), there is no credit risk because the federal government
guarantees repayment.There is minimal credit risk when a state, or city guarantees
debt securities, because they can raise taxes to repay the obligation. The difference
between the credit risk of bank loans and investments is reflected in the rate of return,
or yield on investments. In general, investments produce less revenue than loans.
With investments, the chief concern is market risk. When a holder wishes to sell a
security, market conditions and the desirability of the security determine market value
– the seller cannot control it. The risk is that the market value at the time of sale may
be less than the price initially paid.Although US government obligations carry no
credit risk, like other investments, they do entail market risk. With loans, market risk
comes into play only for loans secured by collateral, such as stocks. If the value of the
stock decreases, the collateral securing the loan may not be sufficient to repay the
loan should the borrower default.
Collateral Specific property pledged by a borrower to secure a loan. If the borrower

defaults, the lender has the right to sell the collateral to liquidate the loan.
LOAN INTEREST
Because interest income is a primary source of bank revenue, choosing the interest
rate for each loan is important. The interest rates banks charge on loans reflect the
supply-and-demand value of money. The interest rate charged on a specific loan
usually represents a combination of the following factors :
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Cost of funds
The basic source of loanable funds is customer deposits. Deposits cost the bank the
interest paid on them, and the costs of providing services to depositors, such as teller
and check-clearing services. Banks monitor the cost of funds in terms of the interest
rate charged on loans.
Availability of funds
The Federal Reserve controls the nation’s supply of money and credit by raising or
lowering reserve requirements and the discount rate. In addition, purchases and sales
of government obligations , as directed by the Federal Open Market Committee,
directly affect the availability of loanable funds.
Risk factors
The interest rate charged on loans is affected by the bank’s perception of the risk of
loss. Banks evaluate risk according to the type of loan. Unsecured loans, such as credit
card loans, are higher risks than secured loans, such as mortgages or home equity
loans. If a borrower defaults on a secured loan, the collateral backing the loan can
provide an alternative source of repayment.
Term
The term or amount of time a loan will be outstanding affects the interest rate
charged. The longer the term, the higher the risk that the borrower’s credit standing
will deteriorate and jeopardize repayment. The cost of deposits also becomes less
certain over time. To offset these risks, banks usually charge higher rates for long-
term than for short-term loans.
MARKET INTEREST RATES AND LENDING
Another very important factor banks consider in setting interest rates for loans is the
interest rate prevailing in the financial markets.
Discount rate
The interest rate the Federal Reserve charges banks for short-term use of its funds.
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Prime rate
The base rate a bank will charge. It takes into account such factors as the cost of
funds, overhead, loan portfolio risk, profit objectives. Prime rate, or sometimes below
prime rate, loans are reserved for the bank’s most creditworthy customers. Rates on
other loans are set at a certain percentage above prime rate, such as prime plus 1.25%
The prime rate is variable; it is adjusted as the cost and availability of funds change.
Fed funds rate
The rate one bank charges another for overnight use of reserve funds to bring
reserves up to requirements.
LIBOR rate
The London Interbank Offered Rate. It is an international money market rate that
represents the average rate offered by banks for interbank placement of Eurodollars.
Banks add percentages above LIBOR to set the interest rate on a given loan.
INVESTMENT DIVERSIFICATION
Another important source of revenue is the profit banks earn on investments. To

achieve a balance of liquidity, safety, and income, banks diversify investments in a
variety of instruments that have different maturities.
INVESTMENT REQUIREMENTS
Although banks are prohibited from investing directly in any common stock, the
Gramm-Leach-Bliley Act permits nonbank affiliates of financial holding companies to
make controlling investments in any kind of company, including a nonfinancial firm.
This new authority is called merchant banking or equity investment.
Banks also are limited in the percentage of their capital and surplus they can invest
in the securities of any issuer, except for the US government.
Many states require banks to pledge US government obligations to ensure protection

for deposits in public funds accounts beyond the coverage provided by the FDIC.
Similarly, many states require bank trust departments to use as reserves, federal and
state debt issues to protect the pension, trust, and profit-sharing funds they manage.
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TYPES OF BANK INVESTMENTS
A typical bank investment portfolio consists almost exclusively of four types of

holdings : US Treasury (government) obligations, US government agency obligations,
municipal issues and miscellaneous investments that meet the highest credit
standards.
US Treasury obligations
Most acceptable collateral for Federal Reserve loans to banks. Backed by the full
faith and credit of the federal government.
Treasury bills
Maturities of less than one year. Immediately marketable and with limited market
risk.
Treasury notes
Maturities greater than one year but less than 5 years. Marketable but with more
market risk than Treasury bills.
Treasury Inflation Protected Securities (TIPS)
With 5, 10, 20-year maturities, these securities protect investors against inflation; the
principal increases with the Consumer Price Index. When a TIPS matures, the investor
is paid the inflation-adjusted principal or the original principal, whichever is greater.
US government agency obligations
Obligations issued by agencies such as the Export-Import Bank and by federally

sponsored agencies. Guaranteed or protected by the federal government. Yield higher
interest than US government obligations of the same maturity.
Municipal issues
Bonds issued by any government or government agency other than the federal
government – for example, state, city, county, town, or school district. Backed by the
taxing power of the issuer, they have both credit and market risk. Income is exempt
from federal income taxes, and sometimes state and local taxes. These investments
represent a bank’s commitment to the community.
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MISCELLANEOUS INVESTMENTS
Banker’s acceptances
Drafts or bills of exchange that banks accept as liabilities by pledging their credit on
behalf of customers.
Negotiable certificates of deposit
Certificates of deposit (CDs) that can be sold before maturity and have a $100 000
minimum denomination. Rates may be negotiated with depositors; to be attractive the
rates must be higher than Treasury bills & commercial paper with the same maturities.
Commercial paper
Short-term unsecured obligations of large, financially sound corporations. There is no

collateral except a firm’s good reputation. Used by companies instead of bank loans to
raise short-term funds.
Corporate bonds
Long-term debts owed to investors. May be unsecured or secured. Not used often as
bank investments because the after-tax return on other investments is usually greater.
FEE INCOME
The financial services marketplace is competitive. Although banks used to be the only
source of deposits and loans, today customers can choose from a variety of financial
service providers. As a result, banks must seek other income sources. Opportunities
for fee-based income are transforming many traditional commercial banks into
diversified financial asset service providers. Income from fees is an important
component of noninterest income. Exhibit 10.6 lists some sources of fee income.
Banks improve fee income in 3 ways :
Fee Income Method Examples
Increase fees to cover the Increase fees for processing checks to reflect the risk of
true cost of service paying checks returned for nonsufficient funds (NSF)
Charge for previously Charge for a copy of a statement
free services
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Enter into fee-based Offer credit cards, securities processing, international
services payments, private banking, investment management, and
fiduciary services.
Noninterest income Income a bank derives from sources other than interest, for
example, fees and service charges, trading income, and investment securities gains.
Exhibit 10.6 Sources of Fee Income
Deposit Account Fees
Monthly account fees, overdraft &NSF fees, early withdrawal fees, stop payment
fees.
Fiduciary Trust Services
Trust department revenues.
All other service fees
ATM fees, safe deposit boxes, money orders, cashier’s and traveler’s checks, renting
banking property.
Insurance and Securities
Insurance brokerage, providing insurance, securities brokerage and selling, handling

securities of others, securitization.
PERFORMANCE MEASURES
How well a bank manages its funds through its lending and investments is a major
determinant of its profitability. Net income alone is not the only measure of bank
performance. A bank with $1 billion in assets is expected to generate more net income
than a bank with $100 million in assets. For this reason, management investment,
investment analysts, state and federal regulators, and shareholders use measures such
as ratios to evaluate bank financial performance.
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Exhibit 10.7 Financial ratios for the banking industry, comparison of two years
XXX2 XXX1 Used to measure
Net interest margin 3.5% 3.5% Spread between the return on

and cost of funds
Net operating income to assets * 1.3% 1.2% Sustainable rate of earnings
Earning assets to assets 87.3% 87.1% Percentage of assets put to
productive use
Nonperforming assets to assets ** 0.5% 0.5% Loan problems
Loss allowance to loans 1.2% 1.3% Amount of protection against
nonpayment of loans
Loss allowance to noncurrent 155.0% 167.8% Amount of protection against
loans nonpayment of troubled loans
Loss provisions to assets 0.3% 0.3% Amount of protection against
nonpayment of loans or other
losses
Loss provisions to net charge-offs 93.8% 90.6% Amount of protection relative
to actual loan losses
Net charge-offs rate 0.5% 0.6% Losses from nonpayment per
dollar of loans
Noninterest income to assets 2.1% 2.1% Amount of fee earnings
Noninterest expenses to assets 3.0% 3.1% Operations overhead costs
Efficiency ratio *** 57.2% 58.0% Ability to control costs and
expenses
Equity capital to assets 10.3% 10.3% Total protection against
unforeseen losses
* Net interest income plus noninterest income / average total assets

** Loans 90 or more days past due plus repossessed assets / total assets
*** Noninterest expenses / (net interest income + noninterest income)
FINANCIAL RATIOS
Financial ratios are used to evaluate performance over time. The ratios are calculated
by dividing one line from a financial statement by another. For example, earnings and
other items from the income statement may be compared to assets, or capital on the
balance sheet. Analyzing these ratios can reveal much about bank profitability and
financial performance. Financial ratios also can be compared to those of previous
periods to determine whether or not performance is improving.
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But financial ratios offer only one perspective on a bank’s financial strength. To get
a thorough understanding of that, the local economy and the bank’s management
strategy also must be considered. For a more complete picture of financial
performance, management often compares the bank’s financial ratios to those of other
banks in similar circumstances, its peer group. The peer group might include a few
banks with similar amounts of assets that operate in the bank’s local market, or a
larger number of similar-sized banks in a broader region.
Peer group In banking, a statistical grouping of banks that have similar characteristics,
such as asset size. Each bank is compared to other banks in the group.
Return on assets, return on equity, capital ratio, net interest income, and earnings
per share are the most common financial ratios. Exhibit 10.7 compares financial ratios
for the banking industry as a whole for two consecutive years.
Performance Measure Definition
Return on assets : Measures how well a bank uses assets to

ROA = Net profit : Total assets x 100 produce income. An ROA of 1% is
considered good
Return on equity : Measures the rate of return achieved
ROE = Net profit : Total equity x 100 relative to funds invested (equity). An ROE
of 15% is the benchmark for good bank
performance
Capital ratio : Measures bank stability and strength. The
Capital ratio = Capital : Assets x 100 capital account absorbs losses not covered
by current earnings and loan loss reserves.
Banks are highly leveraged because their
capital ratios are normally 6% to 8%, higher
than other industries
Net interest income : Defines the difference between interest
Interest income = Interest earned – earned on loans and interest paid on
Interest paid deposits. The higher the amount, the greater
the profit if other expenses are constant
Earnings per share = Net income : Establishes income goals, such as $4 per
Average number of shares of stock share. This is compared with the market
outstanding price of a stock to determine value in the
market
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Leverage A measure of financial strength, showing the extent to which owners rather
than creditors finance a business. For banks, it demonstrates a bank’s use of debt
securities or borrowed funds to increase its return on equity.
OTHER PERFORMANCE MEASURES
In addition to financial performance measures, many banks establish performance

objectives for specific bank units or specific employees to measure productivity and
quality. For example, the proof department’s productivity measures may find that the
item encoding rate is 1 300 per hour this month, compared to 1 250 last month, and
1 150 in the same month last year – a notable increase.. The rate will be compared
with peer banks as well. (In general, technology and related process improvements
continue to increase productivity).
Another factor looked at is the quality of work. For example, the average proof
operator error rate of 1 per 1 000 items encoded is compared with previous error rates,
and with peer groups to identify department trends.
After obtaining measurements, management sets standards for the next budget year.
BUDGETING AND PLANNING
Good financial performance is not achieved automatically. Bank management must

plan carefully, set earnings objectives, structure the balance sheet to achieve its goals.
THE BUDGETING PROCESS
The budget is management’s financial plan for attaining its goals. Although budgeting
varies from one bank to another, the basic concept is the same : establishing a
financial plan at least for the coming year and perhaps for the next three to five years.
Most banks base their budgets on amounts spent the previous year. For example, a
bank may establish a goal that noninterest expense will not exceed the same item in
the previous year by more than 2%.
It is difficult to budget for interest income and expense because a bank must project
not only loan and deposit volumes but also interest rates and the effect rates will have
on interest income and expense.
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Budgeting is not an exact science, but a properly prepared budget offers a blueprint
for the future.
BUDGET VARIANCES
Unforeseen circumstances cause variances from the budget. An expenditure may be

incurred earlier than expected or business volume may be higher. Banks often do not
adjust the budget once it is in place. Instead, for example, they offer negative
variances in income with cost reductions.
Variances that cannot be offset, such as large loan charge-offs, are documented
because they will have a negative effect on profitability.
There are various sources and reasons for banks to create and report financial
performance to constituents, such as regulators, shareholders, board directors,
management and customers. Furthermore, like other businesses, banks must follow
standards acceptable to the government and accounting organizations when preparing
financial statements and other financial reports.
GAAP
Companies that sell stock to the public and those that apply for large loans have
their statements prepared by an independent certified public accountant (CPA), the
accountant is not an employee of the company being audited.
Certified Public Accountant (CPA) An accountant licensed to practise public

accounting. To earn this title, a person must pass examinations and meet requirements
established by each state for age, education, experience, and moral character.
Audit An official examination and verification of accounts and internal controls,

usually by an independent accountant, to determine whether financial information is
accurate, prepared in conformity with generally accepted accounting principles
GAAP.
The accountants base their work on generally accepted accounting principles (GAAP).
GAAP ensure that the information accountants report in different financial statements
meets similar requirements to ensure comparability. GAAP are continuously being
refined to accommodate :
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- innovations in the ways credit is extended and debt financed
- innovations in the ways accountants calculate and present financial information
- legal considerations, such as changes in tax laws
Among the organizations that influence GAAP, the most prominent are the
Financial Accounting Standards Board (FASB), the Securities and Exchange
Commission (SEC), American Institute of Certified Public Accountants (AICPA).
REGULATORY REPORTING
National banks and state nonmember banks must prepare annual financial disclosure
statements consisting of selected schedules from bank reports of income and condition
(call reports) for the previous two calendar years. By March 31 of each year they must
prepare the disclosure statement and make it available to the public upon request.
They must post a notice in the lobbies that the statements are available, and give
notice to shareholders at annual shareholder meetings. The FDIC also posts bank call
report information on its website.
Other financing reporting
In addition to reporting to their primary regulator, banks must report to the Internal
Revenue Service (IRS), the SEC, other federal and state agencies on a whole range of
issues relating to loans, investments, and fee-based transactions that affect line items
on balance sheets and income statements. The following are just some of the laws or
regulations that require financial reports to be sent to federal agencies.
Financial Institutions Regulatory and Interest Rate Control Act of 1978 (FIRA)
FIRA governs lending limits in insider transactions, overdrafts, and preferential

treatment (Title I); correspondent relationships between institutions (Title II), and the
disclosure of loans to insiders (Title III). FRS Regulation O implements the law for
member banks. The intent is to limit abusive insider relationships.
Tax Reform Act of 1984
Banks must report to the IRS the names of borrowers who have paid $600 or more
in interest during the year on any real estate loans. This helps the IRS find overstated
interest deductions on individual or business income tax filings. Banks also must
report to the IRS information on property foreclosed or abandoned during the year that
secures a loan.
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Omnibus Budget Reconciliation Act of 1993
The Internal Revenue Code requires banks to report any discharge of indebtedness
of $ 600 or more, including those in bankruptcy, cancellation of debt by agreement
with the bank and cancellation of debt by law. A bookkeeping entry, such as a charge-
off for book, tax, or regulatory reasons, is not by itself reportable.
Tax Reform Act of 1986
Banks must report to the IRS information on real estate loan transactions for one-to-
four-family dwellings when they conduct the settlement, or when there is no
identifiable settlement agent for the transaction.
Securities and Exchange Act of 1934
A provision of this act is enforced by FRS Regulation U, Credit by Banks for the
Purpose of Purchasing or Carrying Margin Stock. Banks and borrowers must complete
Form U-1, whenever a loan of more than $100 000 is secured by margin stock. The
borrower must disclose the purpose of the loan, if it is to purchase or carry margin
stock, the loan becomes a regulated loan with limits and reporting requirements.
SUMMARY
1. A bank’s annual report typically contains two key financial statements : the
statement of condition (balance sheet) and the profit-and-loss (income) statement.
These statements convey the essential information about a bank’s current financial
condition and results. An important financial statement is the statement of cash flows.
2. The statement of condition, or balance sheet, lists all of a bank’s assets, liabilities,
and shareholder equity (net worth or capital) as of a specific date. An asset is anything
of value a bank owns or is owed; a liability is anything the bank owes. The profit-and-
loss statement covers bank operations over a certain length of time such as the
quarter, the fiscal year, or the calendar year. It shows all revenues and expenses and
the resulting profit or loss. The statement of cash flows illustrates changes in financial
position. It presents a detailed account of the bank’s financing, investing, and
operating activities over time, by comparing line items on both the balance sheet and
the income statement.
3. Financial information is used by shareholders, investors, regulators, other banks,

customers, and employees in pursuit of their own goals. For example, financial reports
give management insight on how to improve bank performance.
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4. A bank’s primary assets are its loans and investments. Its principal liability is its
deposits. Managing assets and liabilities is the fundamental challenge of banking and
the major determinant of whether a bank operates profitably. The Asset and Liability
Committee (ALCO) monitors the cost of deposits and income from loans. Its goal is to
manage bank assets and liabilities, so that shareholders receive maximum long-term
gain.
5. A funds management program strives to balance 3 objectives : liquidity, safety and

income. The need for liquidity is tied to both the deposit and the lending function.
Banks must have funds on hand to meet customer demands for withdrawals. Such
liquidity enables a bank to meet the loan demands of its customers, and helps it to
respond to the credit needs of its communities, as mandated by the Community
Reinvestment Act. Prudent lending practices, adequate loan loss reserves, and strong
corporate governance that minimizes fraud and mismanagement help protect
depositors against loss of funds, supporting the safety objective. Income is the third
objective : because banks are owned by their shareholders, earning a profit for those
shareholders is of primary importance.
6. To maximize its return on loans and investments, a bank must manage both credit
and market risk. Because interest income is a primary source of bank revenue,
choosing the right interest rate to charge for loans is important. Factors influencing
interest rates are the cost of funds, funds availability, risk factors, and the loan term.
As a starting point for setting rates, banks look at market interest rates, such as the
discount, prime, and Fed funds rates and LIBOR.
7. Banks also seek to diversify their investments. The investment portfolio of a typical
bank consists of US Treasury & government agency obligations, municipal bonds, and
miscellaneous investments that meet the highest credit standards, such as negotiable
CDs, commercial paper, or corporate bonds issued by financially sound companies.
8. Besides loan and investment revenue, banks accrue noninterest income from fees
provided for traditional services, such as printing additional account statements or
transferring funds, and by offering fee-based services, such as international payments,
insurance, investments, and other fiduciary services.
9. A bank’s financial performance can be measured on the basis of its return on assets,
return on equity, capital ratio, net interest income (or loss), and earnings per share,
Each of these measures reflects a different aspect of a bank’s strength over a given
period. Using ratios, a bank can compare its performance with its own past
performance or with peer group banks. In addition to financial performance measures,
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many banks establish other types of performance objectives to measure the
productivity and quality of specific bank units or specific employees.
10. Good financial performance is not achieved automatically. Bank management

must plan carefully, set realistic earnings objectives, and structure the balance sheet
appropriately. The budget is the financial plan for attaining goals set by management.
11. There are laws and regulations that govern the financial accounting and financial
reports required of banks. Use of generally accepted accounting principles (GAAP)
ensures that the information accountants report in financial statements is comparable.
Banks must prepare annual financial disclosure statements for their regulators that
consist of selected schedules from bank reports of income and condition (call reports),
usually for the previous 2 calendar years. Most banks must make the information
available to the public upon request. In addition to their primary regulators, banks
must report data to other government agencies on many transactions that affect line
items on balance sheets and income statements.
1. What is a bank’s largest asset ? Its largest income and expense items ?
2. Why is accurate financial data so important to bank shareholders and investors ?
To federal and state regulators ? To customers ?
3. What would be the consequences if a bank overemphasized liquidity to the
detriment of other factors in funds management ? What would be the consequence of
overemphasizing safety at the expense of liquidity and income ?
4. What is the difference between the discount rate and the prime rate ?
5. What are at least 3 measures of bank performance other than net income ?
6. What is the net worth of a bank that has the following assets and liabilities ?
(thousands of dollars)
Cash on hand $45 400 Investments $ 76 600 Fed funds sold $35 800
Loans (net of reserve for loan losses) $ 224 300 Fixed assets $18 900
Other assets $12 200 Deposits $ 312 700 Funds purchased $ 68 600
Other liabilities $ 4 300
7. What is the net profit or loss of a bank reporting the following revenues and
expenses ?
Interest & fees on loans $ 253 700 Interest & dividends on investments $ 22 100
Interest paid on deposits $ 158 800 Salaries, wages, and benefits $ 70 300
Taxes $ 11 000
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8. What are the earnings per share for a bank with an average of 5 360 000 shares
outstanding and net income of $12 450 000 ?
9. In what three ways are banks improving fee income ?
10. Why is it important for a bank to have a financial plan (a budget) ?
11. Why are GAAP necessary ?
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CHAPTER 11
BUILDING RELATIONSHIPS : SALES, MARKETING, CUSTOMER SERVICE
LEARNING OBJECTIVES
- discuss how sales, marketing, and service help build customer relationships
- explain the components of a market-driven strategy
- identify what customers expect from bankers
- discuss the nature and importance of cross-selling and referrals
- explain how a customer makes a purchase decision
- identify the components of effective product development
- describe the laws governing telemarketing by phone, fax, and email
INTRODUCTION
Like other businesses today, banks want to build relationships with customers, provide
excellent customer service, create and sell services that meet customer needs and
expectations. They also honor their fiduciary relationship to customers. Every day banks
must demonstrate that the money held in their care is safe, well-managed, and accessible,
and that caring for the customer is paramount.
Sales, marketing, and customer service are important in today’s financial services
environment, and building long-term relationships with customers is vital to bank
profitability and success. Every bank employee has a role in relationship building.
Customers have specific expectations for service, and all employees can help to meet
these expectations. In creating and selling products and services, banks incorporate their
understanding of customer needs and expectations, and how customers make purchase
decisions.
SELLING TODAY
A customer in a long-term relationship with a bank may regard the bank as the
primary, even lifelong, source of financial services. For good customer relationships to be
sustained, all employees need to practice a customer-centered philosophy.
SALES, MARKETING, AND CUSTOMER SERVICE
Many banks have a marketing department or officer responsible for promoting

products and services, and projecting an image of the bank’s strength and trust to the
community. Some smaller banks may outsource the marketing function.
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Marketing is fundamental to building relationships. Through advertising, the marketing
department ensures that both current and prospective customers are aware of bank
products and services that will help them meet their personal financial goals. Typically,
employees engaged in the marketing function also have public relations responsibilities,
such as charitable and sponsorship activities that help a bank be recognized as a
community partner.
Banks also engage in sales and business development. The bank president often has a
prominent role in selling products and services to community leaders. Members of the
board may bring in new customers through their ties in the business community.
Although larger banks often employ business development officers whose job is
specifically to find a place for the bank’s financial services in the marketplace, most
banks require all their officers to seek such opportunities. Officers in lending, trust,
commercial services, and retail banking employ sales strategies to ensure that the bank
captures and retains market share.
Market share One seller’s portion of the total sales of a product, usually measured as a
percentage.
If a customer’s everyday experience with a bank is unsatisfactory, its marketing and

sales efforts are wasted. Every employee’s most important job is to help the bank build
long-term customer relationships, something employees keep in mind as they work with
each customer. Because every transaction is important to the customer; care, accuracy,
and professionalism ensure that the customer will want to return to the bank. Smiling,
remembering the customer’s name, taking time to understand and answer a question, and
expressing genuine appreciation for the customer’s business may seem like small
gestures, but they are powerful incentives for customers to continue their relationship
with the bank.
Even employees whose jobs do not involve face-to-face contact with customers are
important in the relationship building process. A bank will have difficulty convincing
customers that it cares about their business, for example, if it regularly makes errors in
posting transactions. A loan approval that takes too long is not likely to please a potential
borrower.
To be a successful salesperson :
- Know your customer
- Know your bank’s products and services
- Match your bank’s products and services to your customer’s needs
- Demonstrate the benefits
- Anticipate questions and be prepared to answer
- Ask for the business
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THE MARKET - DRIVEN STRATEGY
A market-driven strategy is broader than the advertising and promotional activities

most often associated with the marketing function. It holds that a business can best reach
its objectives by first identifying customer needs and wants, and fulfilling them through
an efficient total company-and-management-supported effort. The four pillars of the
market-driven strategy are total company effort, customer satisfaction, profitability, and
social responsibility.
Market-driven strategy A customer-focused strategy that involves determining customer

needs, and then creating and delivering products and services to satisfy those needs. Its
elements are a total company effort, customer satisfaction, profitability, and social
responsibility.
Total company effort
To customers, bank employees are the bank. Every time a customer interacts with an
employee, the bank markets (sells) itself. If a teller or call center employee is rude to a
customer, then as far as the customer is concerned, the bank is rude. If a proof operator
habitually makes mistakes, as far as the customer is concerned, the bank is careless and
untrustworthy. No matter what an employee’s job is, marketing is an inherent part of it.
By doing the job well, the employee is selling the bank and its products, services, and
customer service standards.
In an organization with a market-driven strategy, every department sees itself as

serving customers in some way. Employees understand that if they are not serving the
customer directly, they are serving someone in the bank who is serving the customer. For
that reason, employees regard other employees as their internal customers. They treat
each other like professionals, all working toward the same goal of serving customers with
care and distinction.
Customer satisfaction
A market-driven strategy requires bankers to recognize that satisfying customers is the

core business of banking. If they are not satisfied, the bank will not only lose those
customers, it will prove incapable of building strong relationships with the customers
who remain. Customer retention and relationship-building depend on customers
perceiving that the bank values their business.
So customer satisfaction is good business. Retaining customers costs less than

attracting new ones. More marketing dollars are needed to advertise in newspapers,
television, and the radio than to convey targeted messages to current customers.
The best & least costly way to promote banks is to provide excellent customer service.
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Customer satisfaction is achievable only when the bank organizes its processes to best
serve the interests and convenience of its customers. Although certain forms, disclosures,
and account opening procedures are required by law, how they are processed, and how
the customer is treated during the transaction makes a difference. Banks strive to put the
customer, not the paperwork, at the center of each transaction.
One example is the universal account agreement in which information about the
customer is kept on file. Later, a customer who decides to open another account has less
paperwork to complete. To make banking more convenient, banks have changed their
hours and locations. Lobby and drive-in hours have been extended, for example, to
weekends and evenings.
Electronic banking services, including Internet banking, offer the ultimate in customer
convenience. They allow customers to handle bank transactions from the comfort of their
home, their work place, or a remote computer.
Bank employees are taught to be discreet when addressing a customer’s private

banking needs. Within bank procedures or with management approval, employees are
encouraged to take the initiative in finding solutions to a customer’s banking
requirements.
Profitability
Profitability is an important part of the market-driven strategy. Without profits, the

bank will not have the capital, resources to retain and grow its business. Profitability and
customer satisfaction are not mutually exclusive. Indeed, the market-driven strategy holds
that profit objectives can best be met by keeping customers satisfied.
Customer satisfaction has a direct bearing on pricing for services. Satisfied customers
are less price-sensitive than unhappy ones. This is important, because banks must charge
fees that reflect the true cost of services. A satisfied customer accepts a reasonable fee for
high-quality, attentive service. A displeased customer, on the other hand, is likely to shop
around for competitive pricing on products & services.
Consistent with customer needs, a successful organization seeks ways to use resources
efficiently. It prices products & services to both provide value to customers and earn a
profit for the bank. For example, banks set loan interest rates that are attractive to
borrowers and contribute to earnings, while covering costs and risks. Banks that build
value into products and services attract more customers at higher prices than competitors
who charge less but also offer less value. Value leads to customer satisfaction, which in
turn improves bank earnings, by enlarging the customer base, increasing deposit
balances, and raising interest and fee income.
Value The worth of a product or service that is expressed in money (price) or a quantity
of another product or service. It is also the quality that makes something desirable or
important.
4
Social responsibility
Although they are private businesses, banks are not only expected but required to
promote the well-being of their communities, especially low-to-moderate-income
customers. The vast majority of banks have built their success by assuming a prominent
role in their community’s economy, providing financial resources so individuals,
families, and businesses, and others can prosper.
Banks also serve the nation. They act as fiscal agents of the federal government,
collecting tax deposits from businesses. They work with the government to help
implement the nation’s monetary policies and keep the economy strong.
Bankers are involved in civic affairs and local service organizations. Many banks give
their employees time off for volunteer and civic activities, and they often recruit
employees to help in disaster relief efforts, public events, and other community activities.
Through their community relations programs; banks support the arts, philanthropic
causes, scholastic achievement, school programs, and amateur sports. Some banks
assume an educational role by, for example, participating in the ABA Educational
Foundation National Teach Children How to Save program, so that young people can
learn how to handle their personal finances.
MEETING CUSTOMER EXPECTATIONS
In building customer relationships, bankers must be mindful of customer expectations.

These are the standards by which bankers hone their skills for effective customer service
and sales. Asked what they want in a bank, customers usually respond with requests for :
- responsive service
- competent staff
- a customer perspective
- courteous treatment
- reliable service
- viable products and services
- professional appearance
- financial privacy
- access to funds and staff
RESPONSIVE SERVICE
Customers want their bankers to be ready to serve them. Responsive service makes it
clear that the bank values the customer’s business. Responsiveness involves :
- acknowledging customers as they approach

- being ready to help customers
- listening carefully to understand customer needs
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- taking responsibility for resolving the problems customers present
- functioning as a team member with other bank employees to solve problems and
serve customers
- solving problems promptly and accurately
- being friendly and caring when problems are particularly complicated
COMPETENT STAFF
Customers expect employees to have the skills and knowledge necessary to explain
bank products and services, and answer questions clearly. They expect to be directed to
the products and services that will be most useful to them. Demonstrated competence
reassures customers that their money is in good hands.
CUSTOMER PERSPECTIVE
In all interactions with customers, it is important to understand their perspective. Both

written and spoken communication should be clear, concise language articulated from the
customer’s, not the bank’s point of view. “Preauthorized automatic transfers are available
with this account” may be operationally correct but a customer perspective would phrase
the same thought as “You may arrange to have funds automatically transferred from your
checking account to your money market savings account, making regular saving easier
for you”.
Similarly, bank employees should avoid bank jargon when dealing with customers.
Terms may be familiar to bank employees, but they are not familiar to the average bank
customer. Acronyms such as PMI, APY, and even CD may draw blank stares. Unless
using them is absolutely necessary to comply with regulations, technical terms and
acronyms should be avoided when a simple explanation suffices. When technical terms
are required, they should be explained in language the customer can understand.
COURTEOUS TREATMENT
Customers want to be treated in a friendly, thoughtful, efficient, respectful manner.

When customers believe they have been treated discourteously, they conclude that they
and their business are not important to the bank. They may feel uncomfortable interacting
with bank employees, and ultimately take their business elsewhere. In contrast, satisfied
customers feel valued, and believe the bank wants their business.
Making eye contact Looking customers in the eye as they approach lets them know you
are interested in their business.
Smiling A smile communicates warmth. When employees smile, they give customers the
impression that the bank is happy to serve them.
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Acknowledging and greeting the customer Customers expect to be acknowledged and
greeted promptly when they approach. Bankers should stand, shake hands, and initiate
introductions. This makes customers feel welcome, comfortable stating their business.
Using the customer’s name Calling customers by name makes them feel at home. It
raises the interaction to a more personal level.
Using expressions of courtesy “Please”, “Thank you” and “Excuse me” should be used
liberally in all customer contact situations.
Having a positive attitude Employees always should be helpful, cheerful, and interested
when they respond to customers. Even when customers are upset or angry, bank
employees should show that they are willing to listen calmly.
RELIABLE SERVICES
Customers understandably expect excellent service from banks. They expect

statements to arrive on time and to be accurate, they expect renewal notices for
certificates of deposit, they expect electronic banking services available when needed,
and they expect problems to be resolved quickly. Reliable service means not just meeting
but exceeding customer expectations.
VIABLE PRODUCTS AND SERVICES
Customers expect banks to have a variety of banking products, and they expect each to
have specific benefits that address different financial needs. The following are examples
of appropriate bank products and services to address 4 basic financial needs .
Financial need Product or service
Save money Savings account, money market deposit account, certificate of deposit,
investment advisory services
Borrow money Auto loan, mortgage, home equity loan or line of credit, credit cards
Move money Checking account, automatic transfer, direct deposit, Internet banking,
telephone banking, ATMs, wire transfers
Protect assets Trust services, insurance services, FDIC insurance
PROFESSIONAL APPEARANCE
Customers expect the place where they bank to look like a safe place to put their
money. Customer attitudes are shaped in part by the appearance of the bank facility and
its employees. Drab or disorganized facilities and sloppily or too casually dressed staff
erode confidence. Banks have long designed their facilities to project trust and strength.
Today many bank lobbies are being redesigned to also project a more modern, retail-
oriented atmosphere.
7
When employees dress professionally, customers feel more confident about the bank.
Most banks require employees who interact with the public to dress in business attire;
business casual may be allowed in areas that do not have direct customer contact. Many
banks also issue policy expectations about other aspects of personal appearance, as long
as the guidelines do not discriminate against a protected group of employees.
Professional appearance conveys the impression that employees respect themselves and
their customers, and in turn deserve respect from customers.
ACCESS TO FUNDS AND STAFF
Customers expect services and employees to be available when and where they meet
them. Interest banking, automated teller machines, and telephone banking are examples
of how banks use technology to deliver bank products and services to customers at any
hour of the day, so they have access to their funds whenever they need them. Banks also
have extended branch banking hours to meet customer needs for services that require
direct employee interaction. This “customer first” attitude also is reflected by employees
who are accessible, and demonstrate a willingness to help. Accessibility applies not only
to employees with customer contact responsibilities. Every employee has an obligation to
be of assistance to coworkers.
FINANCIAL PRIVACY
Bank customers expect their accounts to be handled in complete privacy. As the

amount of personal information stored and transmitted electronically grows, so does
consumer anxiety about confidentiality. Because banks have in their databases far more
confidential information about their customers than most other businesses, their
employees must honor the bank’s privacy policies and never discuss accounts or
transactions with friends or neighbors.
The Gramm-Leach-Bliley Act (GLBA) requires financial institutions to protect the

privacy of personal customer information. Banks must tell customers whether they share
customer information with third parties, and refrain from doing so if the customer
objects. Banks have always made protecting customer account information a priority, but
the GLBA privacy provisions provide additional assurance that the banking industry is
committed to protecting private financial information.
CROSS - SELLING AND REFERRALS
On average the more products and services a customer uses, the more likely the
customer will remain loyal to the bank – and the more profitable the customer
relationship will be.
The best way for bank employees to extend the relationship with customers is through
cross-selling and referrals. Cross-selling is the practice of recommending the benefits of
additional products or services to current customers. Referrals usually are made when a
bank employee does not have the expertise or authority to sell a product or service, or the
8
product or service is offered by another department or a bank affiliate. They are
suggestions to customers that they speak to someone in the bank or bank affiliate who
can explain a product or service that would be appropriate for them. In both cases,
listening to customers to recognize their needs is the crucial first step.
Referral Directing a potential customer from one area of the bank, such as consumer
lending, to another area, such as insurance, to help the customer obtain information
about, or purchase another product or service.
A bank that effectively cross-sells additional products and refers business to other
departments or affiliates, expands its customer relationships, helps customers meet their
financial goals, and sells more products, both immediately and over the long term.
Furthermore, when employees cross-sell and make referrals, customers feel appreciated
and realize that the bank values their business, and has their financial interests in mind.
To cross-sell and make referrals, bankers must be aware of marketing and sales
opportunities. For example :
- A teller who notices that a customer has a large balance in a savings account should
suggest a money market account, or a certificate of deposit (cross-selling) or the bank’s
investment services (referral).
- A loan officer who helps a customer finance a new car should suggest opening a
checking account, and arranging for the automatic loan payment service (cross-sell) and
an insurance review with the bank’s insurance subsidiary (referral).
- A call center employee should suggest Internet banking or telephone banking to a

customer who inquires about an account statement or current history (cross-sell).
- A commercial loan officer should recommend cash management services for a small
business (cross-sell) and private banking services (referral) for the owner who has an
established credit relationship with the bank.
THE PURCHASING PROCESS
Understanding what is involved when a customer decides to make a purchase is

essential to building customer relationships. The customer purchasing process is
influenced by every transaction, communication, and experience with the bank. Knowing
the steps in the process helps bankers facilitate customer decisions to obtain a product or
service. The purchasing process usually happens in 4 phases : needs identification,
prepurchase searching, purchase decision, and postpurchase assesment.
9
Exbibit 11.1 The Purchasing Process
Identify needs
Postpurchase assessment Prepurchase searching

 
Purchase decision
NEEDS IDENTIFICATION
The starting point for purchase is an unsatisfied need. There are 2 basic types of needs.
Recognized needs
The customer is aware of them. For example, a young college graduate who has found a
job recognizes the need to establish credit. A regular savings account customer realizes
that more interest can be earned by investing in a certificate of deposit.
Unrecognized needs
The customer is unaware of these. The college graduate turned professional may not
know the credit options, and financial planning services available. The savings account
customer may not realize that savings can grow faster, if they are invested in the equities
market, or may be used more effectively for purchasing an annuity.
Bank employees can be very helpful in the needs identification process. Most
customers welcome advice on how their bank can serve them better. For employees to
offer advice, they must both know their customers and thoroughly understand their
bank’s products and services. In short, bank employees should be alert for opportunities
to recommend a product to a customer.
PREPURCHASE SEARCHING
Once a need is identified, the customer begins to search for the best way to satisfy it.
How much effort is expended depends on the cost, durability, and complexity of the
product or service sought. The customer buying a saving product may look through
newspaper ads to compare the rates offered by competing financial institutions. The
customer shopping for a mortgage loan or a home equity line of credit, may search longer
and more carefully, because mortgage products are complicated, and require an
understanding of a variety of conditions that can be attached to such products.
Although prepurchase searching often includes talking to other people, reading

pamphlets, or requesting a loan application, the most important source of information
is a bank’s employees. Often a prospective customer will call the bank, or approach an
employee in person to solicit information, offering an opportunity to sell a bank product
or service. An employee who shows interest in the customer’s needs, conveys enthusiasm
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about the bank’s products, and demonstrates knowledge and capability, is more effective
in selling than any promotional material.
Features and benefits
Much of the customer’s prepurchase activity consists of gathering information about

features and benefits of possible product solutions. Features are characteristics of the
product or service, such as interest rate or term. Product benefits address the 4 basic
financial needs : save money, borrow money, move money, and protect assets.
Feature A characteristic of the product or service, such as the interest rate or the term
Benefit The value the product or service features give to customers to meet their needs :
earn money, save money, save time, provide convenience, or provide security.
The following shows common bank products and corresponding features and benefits.
Product Feature Benefit
Home equity Revolving line of Customers can use funds as needed, pay interest only
line of credit credit on the outstanding balance, save time and money,
and perhaps qualify for a tax benefit.
Money A higher yield than Customers earn more money than with statement
market statement savings savings accounts, and can move money more freely
deposit accounts, no fixed than with time deposits.
account maturity date
In discussing products with a customer, bankers translate product features into benefits
the customer will appreciate. For example, “With Internet banking you can pay bills
online. What that means to you is time saved writing out payment checks and money
saved in postage. You are also assured the bill will be paid on time”.
PURCHASE DECISION
In deciding to make a purchase, the customer uses information gathered in the previous
phase to weigh the advantages and disadvantages of the product or service, compare the
relative merits of alternatives, and choose particular features. In financial decisions, this
may mean choosing the most appropriate type of individual retirement account, or
applying for a fixed rate, rather than an adjustable rate mortgage. The purchase decision
is often the result of an informed choice, the choice becomes more complex as the
product or service becomes more complex. Bankers play an important sales and service
role, by answering any questions the customer may have, and either moving to close a
sale, if possible, or referring the customer to other bank personnel who are more familiar
with the product or service.
Purchase decision In the buying process, the culmination of prepurchase activity, in

which a customer first assesses information gathered to reduce the risk associated with a
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decision about a product, and then makes the purchase.
POST PURCHASE ASSESMENT
After customers make a purchase, they invariably reassess their decision. Customers
want assurance that they made the right choice. Many customers experience anxiety,
especially if the purchase decision was difficult, or attractive alternatives were rejected.
Was the decision the right one ? Were the features chosen the best ones ? Most customers
ask themselves questions like this, as they reevaluate a product or service they have just
bought.
Bankers, aware of this stage in the purchasing process, take steps to ease customer
anxiety and offer evidence that the decision was good. They know that a customer
generally needs continuing support after a purchase. In the banking world, reassuring new
customers may entail :
- sending them letters reaffirming the benefits of the decision

- calling to thank them for their business, and offer further assistance
- answering questions after they deposit their money, or sign loan papers
Exhibit 11.2 New Product Development
Conduct Market Research. Get current information on customers, market, competitors
Profile customers, market, and competitors. Aggregate data for meaningful analysis
Getting new product ideas. What is the need in the marketplace ?
Screening new products. What is the initial reaction against the bank’s objectives, other
products, and company resources ? Are there regulatory constraints ?
Testing the concept. What do the small focus groups say ?
Business analysis. Is there sufficient demand for the product ? Does it fit with the bank’s
goals and objectives ?
Developing the product. What will the features be ? How will the bank promote,
distribute and price the new product ?
Test marketing the product. What target markets will the bank test the product in ?
How will the bank promote the product in those markets ?
Introducing the product. How will the bank introduce the product ? What impact will this
product have on the exising product line ?
Evaluating the product. How does the progress of the new product meet the company’s
goals ? What adjustments are necessary ?
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PRODUCT DEVELOPMENT
Banks not only market and sell current products, they also evaluate and introduce new
ones. The GLBA financial modernization reforms expanded the types of products and
services banks may offer, and today many customers demand more products to meet their
financial goals.
Developing new products is a multiphase process : conducting market research,

profiling the market, soliciting new product ideas, testing the concept, and conducting a
business analysis. The product is then test-marketed before it is rolled out to the entire
market. Finally, the product is evaluated to see it it is meeting its objectives.
In most banks, product development is a joint effort of the marketing officer,

department managers, and senior managers. Compliance or risk management officers are
often part of the team, because many new products have regulatory or risk implications.
Product development includes many of the following activities :
Conducting market research
Up-to-date information about customers, the market, and competitors is drawn from
internal records, such as the marketing customer information file; location contacts,
such as the chamber of commerce; regulatory agency reports; the Internet, such as other
bank websites; surveys, such as those about customer preferences, and secondary sources,
such as lists of new home development sites.
Profiling customers, the market, and competitors
The bank profile of its consumer customers may include information about age
distribution, occupation, educational level, income, and geographic location. A market
profile may describe the number and value of housing units, population data, other
demographic information about the area. A competitive profile includes information on
competitors’ market shares, and the types and prices of services they offer.
Marketing customer information file (MCIF) A software program that can sort and
analyze customer information, and serves as a customer information database.
Profiling Identifying relevant characteristics to gain insight about the need for a product
in the marketplace.
Soliciting new ideas
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Ideas for new products come from many sources : market research, management or
employees, or authorization by laws and regulators; such as health savings accounts,
insurance, and investments.
Screening the product
New product ideas are screened against the bank’s objectives, policies, resources, and the
probable effect on current products. The bank then decides whether to continue
developing the product or start over.
Testing the concept
A promising product idea is tested in the marketplace through customer focus groups or
customer surveys.
Performing a business analysis
Market and business analysis techniques determine market share, product demand, and
compatibility with bank goals. Then, product objectives, target market, and strategy are
defined.
Developing the product
The product is defined in terms of features and benefits, pricing, processes, the
procedures necessary to support the product, and distribution and promotion strategies.
Testing and marketing the product
The product is tested in one or more of the bank’s geographic markets, using different
features, distribution methods, and promotion strategies.
Introducing the product
Rolling out a new banking product requires a substantial investment in advertising, sales
promotions, and employee training. Customer-contact employees in particular must
understand product features and consumer benefits.
Monitoring the product
Monitoring product performance helps identify any adjustments needed, the effect on
other product lines, and other product development opportunities.
Like other commercial enterprises, banks must abide by laws and regulations intended
to protect other businesses and consumers. Because advertising and sales promotions
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may mislead customers or invade their privacy, both federal and state governments
supervise bank marketing practices. For marketing activities, banks must abide by the
rules of their regulators, the Federal Communications Commission (FCC), and the state
in which they operate, as well as their bank regulators’ directives on Federal Trade
Commission (FTC) and Department of Justice rules.
Advertising Any form of communication paid for by a sponsor for the purpose of
informing and persuading customers to buy goods, ideas, or services. By using
advertising, an organization can control what is said about its products, and when and
where the information appears.
Sales promotion Any activity other than advertising, publicity, and personal selling, that
provides incentive to the consumer to purchase goods or services; for example, offering
premiums and having-in branch displays.
UNFAIR OR DECEPTIVE ACTS OR PRACTICES
Virtually all states have regulating deceptive trade practices, but the principal stature
governing business marketing practices in the USA is the Federal Trade Commission
(FTC) Act. Enacted ín 1914 to regulate industrial policy and commercial trade practices,
it created the Federal Trade Commission, whose first enforcement efforts were directed
to price-fixing, monopolies, and unfair practices in commercial competition. The FTC
has since taken on consumer protection as well.
While the FTC has authority strictly over nonbank businesses, the federal banking
regulators have the authority to enforce the FTC Act, Section 5 of which details the unfair
and deceptive practices that are forbidden in the financial industry.
Deceptive acts or practices are those that are likely to mislead the reasonable consumer
and constitute a material practice.
Likely to mislead
A representation, omission, act, or practice can mislead. Examples are false oral or
written representations, misleading claims about costs, bait-and-switch tactics, and
failure to provide the service or product.
Bait-and-switch Advertising a product or service at an attractive price (bait), and then

informing a consumer who is ready to purchase that the product or service is not
available, or is of lesser quality, and encouraging the consumer to purchase (switch)
to a higher-priced product or service.
Reasonable customer
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The act or practice would be deceptive to a person of average intelligence exercising an
average amount of judgment. Omitting material information from an otherwise truthful
advertisement could mislead a reasonable customer and thus be deceptive.
Material practice
The misrepresentation, omission, act, or practice affects the customer’s choice or

conduct, as when misleading information about costs leads the customer to decide to buy
the product.
The FTC Act, Section 5, defines the elements of unfair acts or practices as those
causing substantial injury or injuries that are not overweighed by the benefits and could
not be reasonably avoided.
Substantial injury
This occurs when a customer suffers, for example, monetary harm, such as paying an
unnecessary fee, or interest charge due to an unfair practice. The injury may be small, but
affect many people, or be significant for a single customer. For example, claiming there
are no fees in the promotion, and mentioning the fees only in the small print.
Benefit less than the injury
For this element, the net effect of the practice is analyzed to see if the overall benefits are
greater than the harm caused by incomplete or misleading communication.
Not a reasonably avoidable injury
The consumer could not avoid the injury. This can occur when information is withheld or
distorted to impede the customer’s reasonable choice.
DO NOT CALL, DO NOT FAX
Telemarketing involves lines (phone or fax) to promote products and services. Because
it seeks out customers in their own homes or offices, telemarketing raises questions of
privacy, full disclosure, and where marketers should be off limits.
In November 2005 the Federal Financial Institutions Examination Council (FFIEC)

approved interagency examination procedures for consumer compliance with the
Telephone Consumer Protection Act of 1991 and the Junk Fax Prevention Act of 1994
and its 2005 update.
Essentially the interagency procedures allowed the FCC to expand coverage of the
FTC’s national “Do-Not-Call” registry to banks, insurance companies, credit unions, and
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savings associations. The regulations give consumers options to avoid unwanted
telephone solicitations. For example :
- No seller, or entity telemarketing on behalf of a seller, can initiate a telephone

solicitation to residential telephone subscribers who have registered their numbers on the
Do-Not-Call registry.
- Calls are permitted, however, to those with whom the seller has an established business
relationship.
- Banks must maintain bank specific do-not-call lists with the names of people with
whom they have a business relationship who have asked to be excluded from
telemarketing.
- Telemarketing calls can be made between 8.00 a.m and 9.00 pm only.
- Telemarketers must comply with limits on abandoned calls.

- Consumer-friendly practices must be used when calls are made with automated
telephone-dialing equipment.
- Prerecorded messages must identify the name and telephone number of the entity
responsible for the call.
- Telemarketers must transmit caller ID information, when available, and refrain from
blocking such transmissions to the consumer.
- The advertiser must first obtain the written permission and signature of the intended
recipient before sending unsolicited advertising fax transmissions, unless there is an
established business relationship that includes the specific fax number.
Established business relationship A commercial relationship in which the consumer has

purchased, rented, or leased the seller’s goods or services, or conducted a financial
transaction with the seller within the 18 months immediately preceding a telemarketing
call, or has inquired about, or applied for, a product or service offered by the seller within
3 months immediately preceding the call.
Abandoned call A telemarketing call that is not connected to a sales person within two
seconds after the recipient answers the telephone and completes a greeting.
CAN - SPAM Act
The Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003,
the CAN-SPAM Act, sets rules for commercial use of electronic mail. The law covers
email the primary purpose of which is advertising, or promoting a commercial product or
service. It does not cover email facilitating a transaction, or providing information to a
customer with whom there is an established business relationship. Both the FTC and the
Department of Justice enforce the CAN-SPAM Act. It prohibits, for example, false or
misleading header information and deceptive subject lines, and requires senders to give
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recipients an opt-out method, respond to opt-out requests, and identify commercial email
as advertising.
False or misleading header information
The email address must be accurate and identify the person who initiated the email.
Deceptive subject lines
The subject line cannot mislead the recipient about the message’s contents.
Opt-out methods
The message must contain a return email address or other Internet-based response
mechanism allowing recipients to opt out future email messages.
Response to opt-out requests
Senders must process opt-out requests for at least 30 days after the original commercial
email. Upon receipt of an opt-out request, the sender has 10 business days to stop sending
the emails.
Identifying commercial email as advertising
The email must clearly state that the message is an advertisement or solicitation, and that
the recipient can opt out of future emails. A valid postal address is required.
SUMMARY
1. The most successful banks build long-term relationships with their customers. To form
and sustain good customer relationships, the entire bank – systems, procedures, and
people – must adopt a customer-centered philosophy for doing business. Every employee,
including those who do not have daily contact with customers, can build customer
relationships. Sales, marketing, and customer service are all part of building customer
relationships and fulfilling a market-driven sales strategy.
2. The market-driven sales strategy is fundamental to a customer relationship orientation.

The broad concept of marketing holds that the objectives of a business are best reached
by identifying the needs and wants of its customers and meeting them through an
integrated, efficient, organization-wide effort supported by management. The pillars of
the market-driven sales strategy are total company effort, customer satisfaction,
profitability, and social responsibility.
3. To succeed in today’s sales-oriented banking environment, employees must be

personally and professionally skilled. Customers have a right to expect responsive
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service, competence, courteous treatment, reliable service, professional demeanour, and
privacy in their interactions with employees. They have a right to expect the employee to
understand their perspective and identify products and services that will meet their needs.
4. The best prospects for new sales are current customers. This is the underlying principle
behind cross-selling : getting users of one or more services to buy additional services. To
cross-sell, bankers must constantly be aware of sales opportunities, and provide the best
service at all times, so that customers want to buy other products. Referrals involve
listening for customer needs, and then arranging for the customer to talk to another
knowledgeable staff member, or employee of a bank affiliate for more information about
a particular product or service.
5. In keeping with a customer-oriented philosophy, bank employees should understand

the 4 stages a customer goes through in purchasing a product : needs identification,
prepurchase searching, purchase decision, and postpurchase assessment. As they interact
with customers during these stages, bank employees have opportunities to build customer
relationships.
6. Banks must not only succesfully market and sell current products, they also must
introduce new ones. Developing a new product begins with conducting market research,
and drawing up a market profile. New product ideas can come from many sources,
including employees. Product ideas are screened and tested. If a business analysis
indicates that consumer acceptance is likely, the product is refined and test-marketed
before being introduced to the entire market.
7. Because advertising and sales promotions may mislead customers or invade their
privacy, both federal and state governments supervise bank marketing practices. For
marketing activities, banks must answer to their federal and state regulators and to the
Federal Communications Commission (FCC). They must abide by their bank regulators’
directives that implement Federal Trade Commission (FTC), Department of Justice rules.
The Unfair or Deceptive Practices Act, laws and guidance covering telemarketing, and
the CAN-SPAM Act are examples of federal rules that apply in marketing.
1. Do employees who rarely interact with bank customers have a role in building
customer relationships ? Why or why not?
2. What are some of the ways a bank employee can demonstrate responsiveness to
customer needs ?
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3. What are the benefits of cross-selling and referrals ?
4. What are some of the things customers do in anticipation of making a purchase ?
5. What is the difference between a product feature and a product benefit ?
6. What steps are involved in bringing a new product to market ?
7. Jennifer opened a certificate of deposit with First Trust and Savings Bank on July 3,
2007, and she redeemed it on January 3, 2008. It is her only account with the bank.
According to Do-Not-Call, Do-Not-Fax, and CAN-SPAM rules, for how long and
why may the bank send her commercial marketing messages ? If Jennifer wishes,
what may she do to stop them ?
CHAPTER 12 - SAFEGUARDING CUSTOMER INFORMATION
Learning Objectives
After studying this chapter you should be able to

- describe methods by which banks secure data
- describe how banks identify customers
- describe the types of fraud perpetrated against bank customers
- explain how customers can protect their privacy
- discuss some laws and regulations that address financial privacy and security
INTRODUCTION
Banks are considered safe repositories for people’s money. Just as important, banks
must be safe repositories for customers’ financial and personal information, which in this
electronic age can be more valuable than money, and if misused, can cause customers
great harm.
Bank employees have an obligation to safeguard customers’ information and ensure

customers are not victimized by financial fraud resulting from information security
breaches. Banks, recognizing that customers trust them to protect their financial and
personal information, have implemented security programs to safeguard customers’
information. Unfortunately, criminals’ ingenuity knows no bounds. Therefore, to meet
their fiduciary responsibilities, banks also are educating customers on how to use
available resources to protect their financial information.
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PROTECTING CUSTOMER INFORMATION
Protecting customers’ financial and personal information is at the forefront of today’s

banking concerns. The increased use of technology and the passage of the Gramm-Leach-
Bliley Act (GLBA) have raised the bar even higher. Banks not only must have a reliable
information security program in place, but must communicate clearly the protective
steps they are taking, so customers understand and feel comfortable with what their bank
is doing to keep their information secure. Banks also must demonstrate to regulators that
they have assessed the risks to customer information, and have controls in place to
manage those risks.
Information security program A plan for ensuring that data and technology systems are
not accessed by unauthorized uses.
To give banks credit, “When you look at the number of data breaches that occurred in
2006, you’ll see a very small percentage happened at financial institutions. And that’s no
accident. Banks and their regulators work very hard to protect sensitive information and
help customers avoid identity theft”. Indeed, unlike many other industries, banks have a
strict regulatory system designed to prevent data breaches and to notify customers, if a
breach occurs that could put their identity at risk.
By protecting customers’ information and privacy, banks provide peace of mind. This
service becomes ever more important each time banks undertake a new PC banking and
web initiative. Even when banks outsource information technology services, they cannot
outsource the liability. Information security may be an emotional and financial issue for
customers; for banks it is a business priority.
DATA SECURITY
Although most financial institutions have multiple layers of physical and electronic
security, keeping up with the latest technologies and criminal attacks takes constant
vigilance. To enhance employee productivity, bank employees may use personal
computers and company-issued PDAs to connect to the bank’s financial programs.
Although the connections may be secure, data security systems employees constantly
must protect and monitor the security programs, so viruses don’t enter through these
devices. Once a mobile device is connected, it becomes part of the bank’s network.
GENERAL SECURITY FEATURES
Banks protect customers’ information in ways that go beyond the banking relationship.
Automatic session expiration
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A security feature that closes an online banking session after a certain period of
inactivity, often 5 or 10 minutes. This protects the data when a customer steps away from
a computer, or fails to sign out properly, leaving account information displayed on a
monitor.
Automatic account lockout
This measure registers failed login attempts and, after a certain number of failures, shuts
down further efforts to gain access, informing the true (often forgetful) customer how to
open the account again. Activity considered suspicious is relayed to the bank security
team to alert them to potential problems.
Direct deposit
Electronically depositing salary, government, and other benefit payments to customers’

deposit accounts makes it more difficult for criminals to steal the payments and customer
information.
E-alerts
These short messages that confirm activity, such as electronic debits and credits, also
may be used to remind customers of things such as loan payment due dates. This is
usually an opt-in service that allows customers to receive notifications via email-capable
devices, such as PDAs.
Online bill payment
Whether free or for a fee, this service allows customers to manage monthly bills and
regularly scheduled payments from a single location. The customer no longer needs to
deal with utility, credit card, or other paper statements that contain confidential personal
information. This protects customers from having the information stolen from a mailbox,
or the postal delivery services.
Online statements
These statements are another way to avoid paper documentation of confidential personal
information. Customers are notified by email that the most recent statement is available.
Customers also can access their accounts between billing dates to see whether certain
checks have cleared, or if there has been any suspicious activity.
Unique security numbers and passphrases
Both of these security measures are used to access online statements & other services.
Usually banks issue the security number and customers choose their paraphrase.
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EMERGENCY PREPAREDNESS
To protect consumer and other bank data, federal regulators and sound business
practices require that banks be prepared to respond to any security breach. Recognizing
that every bank is susceptible to improperly configured systems and sotfware
vulnerabilities, regulators have mandated that financial institutions put in place incident
response programs (IRPs) that follow certain standard procedures. Moreover, laws in
most states now require that individuals be notified if there is a breach in the security of
electronically held customer information.
Password An arbitrary string of 6 to 10 characters chosen by, or assigned to a user to

authenticate the user attempting to log on to a computer system, such as “treebumper”.
Passphrase An arbitrary string of up to 100 characters similar to, and used like a
password that provides more security, for example *bumping!trees963$$.
Incident response programs (IRP) A comprehensive plan for reacting to threats to the
security of bank’s data, systems, employees or facilities.
Because IRPs guide the decisive actions banks take to contain the damage from a security
breach, they serve to limit harm to consumer and bank financial data. Most banks,
however, go beyond the minimum IRP requirements and implement best practices such
as :
- including personnel from different functional areas on the incident response team
- defining clearly what constitutes an incident requiring an IRP
- identifying processes to assess risks and their potential effect
- specifying procedures for notifying customers, overseeing & coordinating with third-
party service providers, and coordinating with law enforcement representatives and
federal regulators.
- planning for a comprehensive program of communications, both internal and
external, in the event of a security breach
CUSTOMER IDENTIFICATION
Identity verification is not always easy because the USA does not have a standard form
of identification. A driver’s license is the most common means of verifying identity, but
it can be altered. Many businesses with fiduciary responsibilities, such as banks, use
document verification programs that analyze various security features, such as holograms
and state seals. These systems can detect subtle ink shifts and slight color changes that
are not visible to the naked eye.
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To protect customers’ information, banks must ensure customers are properly
identified during all banking services – from opening accounts to accessing accounts
online, in person, or over the telephone.
NEW ACCOUNT IDENTIFICATION REQUIREMENTS
The USA PATRIOT Act requires banks to implement a customer identification

program (CIP) for new accounts. Although the intent was to stop terrorists from the US
financial system to launder money and finance crimes, the CIP provides another layer of
security for customers’ financial and personal information. A bank’s written CIP
incorporates reasonable procedures to :
- collect identifying information about an individual opening an account, such as

name, date of birth, address, and Social Security or tax payer identification number
- verify the customer’s identification
- determine if the customer appears on any government list of suspected terrorists
- maintains records of the information used to verify the customer’s identity
ACCOUNT ACCESS IDENTIFICATION METHODS
Whether servicing customers in person, over the telephone, or online, bankers follow
procedures to ensure they know with whom they are communicating. That is why
customers using a drive-through banking window may be asked to present a driver’s
license, and customers accessing bank accounts by telephone may be asked to enter a PIN
or respond to a question, such as “What is your grandmother’s maiden name ?” when
making transactions through a bank call center. In each case, the request seeks to ensure
privacy is preserved.
Banks that engage in any form of electronic banking must follow regulatory guidelines
for customer authentification, including regular risk assessments and authentification
procedures reviews to ensure they are current. For high-risk transactions, authentification
methods have three facets:
- something the user knows, such as a PIN

- something the user has, such as an ATM card
- something the user is – a biometric characteristic, such as a fingerprint or voice scan.
BIOMETRIC IDENTIFICATION METHODS
Another authentication method is biometrics. Biometric customer authentification is

becoming a convenient and considerably more accurate security measure than
passphrases or PINs, because biometrics link a particular event to a definite individual.
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Authentication
1/ Determination that a message comes from a source authorized to

originate the message.
2/ a measure designed to protect against a fraudulent transmission by establishing the

validity of a transmission, message, station, or person.
Biometrics Automated methods of identifying a person based on a physiological or

behaviorial characteristic, such as a voice or fingerprint pattern.
Not only are biometric security methods convenient and more accurate, they also
provide an audit trail.
A variety of biometric options are now available and more are being tested. The public
gradually is becoming more comfortable using the most common biometric methods –
voice identification, keystroke dynamics, and digital fingerprinting.
Voice identification
The voice identification method stores a voice print, called a voice reference template,
of a customer speaking a specific phrase. The template, constructed while the customer
speaks the phrase several times, is built from dozens of measurements that record pitch,
dynamics and wave forms for physiological and behavioral distinctions. The result is a
unique digital representation of the customer’s voice.
A voice print is not a recording, it cannot be used for any purpose other than to
compare the measurements to those “heard” when the customer speaks the same phrase
to gain access to his or her account. The voice print security system compares the spoken
phrase with the template to authenticate the customer before allowing account access.
More sophisticated voice identification systems work no matter what kind of telephone
the customer uses, from cell phone to Internet.
Did you know ..... ? In the USA, more than 3 million customers pay for goods at the
supermarket, drug store, or convenience store by scanning their fingers, and entering a
PIN rather than using credit or debit cards. In Japan, more than 2 million people now use
contactless palm-scanners when withdrawing cash from an ATM.
Keystroke dynamics
The keystroke dynamics method identifies customers by the way they type, measuring
dwell time – the amount of time a particular key is held down – and flight time – the
amount of time a person takes to move from key to key. These systems can measure
keyboard input up to a thousand times a second. Keyboard dynamics require a reference
template that is created from customers typing the same characters several times. This is
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a behavioral rather than a physiological measurement that works best with customers who
can touch-type.
Digital fingerprinting
The most popular and successful biometric device in recent years is fingerprint
imaging. Credit card companies have begun to use this method to identify cardholders at
the point of purchase. The technology captures unique fingertip line patterns (usually just
one), such as the loop, whorl, and arch patterns in the skin ridges. The most common
device scans the “minutiae points”, where ridges come together or end, and assigns
locations (points) to the minutiae. The Federal Bureau of Investigation (FBI) has found
that no two individuals have more than eight points in common; the typical scanner looks
at 30 to 40 points for each fingerprint it evaluates. Two electronic methods are used to
capture the needed information.
Optical device
Users put their finger on a glass that has an internal light source that captures the
fingerprint image.
Capacitative imaging
The fingerprint is analyzed by detecting the electrical field around the print. Then a
print template is built and stored in a database, so it can be compared to the customer’s
scanned fingerprint during a transaction.
FRAUD AND PREVENTION METHODS
Bank’s efforts to ensure customers are properly identified, and their financial and
personal information secured are part of the continuing battle against criminals who
perpetrate fraud against consumers. The list of fraud schemes, most aimed ultimately at
identity theft, continues to grow. The Federal Trade Commission (FTC) website features
a scam alert to keep consumers and businesses current on the latest scheme. The
following sections describe the most common schemes and prevention steps banks take.
CALLER-ID MANIPULATION
Many consumers and businesses invest in caller-ID to screen calls. The technology can
be manipulated, however, to make the identification number or name of an incoming call
appear, as if is coming from a reliable party, such as a bank. This practice is known as
caller-ID manipulation or spoofing.
Criminals pay a small fee to an online software provider to get instructions on how to
make a caller-ID number appear other than the one used to make the call, and to change
the caller’s voice pattern so it seems to be either male or female. These online services
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are legal, and used for legitimate law enforcement reasons, but they also can be used by
criminals attempting identity theft or other types of fraud.
Spoofing is also used with email. The “from” line is modified to appear as if it is from a
known or legitimate sender, or from an agency’s or corporation’s internal address.
Did you know .....? A Dutch bank, ABN AMRO, which has 4 million customers
generating 35 million calls a year, is rolling out a system that uses voice analysis to
identify customers using telephone banking. A typical ABN-AMRO customer only visits
a branch about once a year.
Credit card protection fraud
A variation on caller-ID manipulation involves offers of credit card protection. Illicit

telemarketers claim they are calling on behalf of a credit card issuer or government
agency. The caller claims criminals are using the Internet to steal credit card numbers,
and that consumers are liable for any unsubstantiated charges made by online thieves.
The sales pitch concludes with an offer of a credit card “protection” package that covers
unsubstantiated charges, along with an unconditional money-back guarantee.
During the call, the telemarketers obtains the consumer’s credit card number and other
information and charges for the “protection” package, whether or not the consumer
agreed to purchase it. Bank employees should advise cardholders that, under federal law,
they are liable only for up to $50 of properly reported unauthorized charges made to their
credit cards. Thus, there is little need for credit card fraud protection insurance.
Pretext calling
In a scam known as pretext calling, bank employees are taken in by callers who pose as
customers and ask for personal and account information over the telephone, making up a
story about losing or forgetting account numbers and other sensitive information.
Trusting bank employees divulge the information to help the “unfortunate” customers,
not realizing the callers are thieves.
Pretext calling Attempt to use phones to gain access to another’s account information by
pretending to be the account holder or an authorized signer on the account.
ONLINE FRAUD SCHEMES
Schemes perpetrated in person, by direect mail, and by telephone have been adapted for
the worldwide web. Using Internet technology, criminals continually create new methods
to defraud consumers and businesses. Three of the more common schemes are advance
fee fraud, phishing, and pharming.
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Advance fee fraud
Advance fee fraud victimizes banks and their customers. The average loss per person is
more than $6 000. The scam often begins with the intended victim receiving an
unsolicited letter, fax, or email allegedly from a foreign national who claims to be a high-
level civil servant. The “official” requests assistance depositing millions of dollars that
his or her government overpaid on a contract. Other fraudulent requests may involve
disbursements from wills, proceeds from real estate sales, conversion of hard currency, or
sales of crude oil below-market prices.
In return for assisting with the funds transfer, the recipient of the correspondence (the
fraud victim) is promised a large commission. The victim is instructed to provide
documentation on company letterhead and pro forma invoicing to show completion of
the contract, after receipt of which a bank in the official’s country will remit the funds to
the victim’s account. Inevitably, something arises to threaten the deal, such as an
unforeseen tax or fee that must be paid, which the victim is asked to advance with
reimbursement promised when the funds are remitted.
Bank employees should be alert to questions from customers who have been contacted
about such financial ventures. Banks must contact law enforcement representatives and
bank regulators, whenever they have information suggesting advance fee, or any other
type of bank fraud.
Phishing
Phishing (pronounced fishing) involves sending customers seemingly legitimate email

requests that direct them to a phony customer service site asking them to provide personal
account information. Basically, this common type of fraud tricks customers into
providing account numbers, Social Security numbers, or passwords. The illegally
obtained confidential information then is used in identity theft and credit card and
Internet-based frauds. Like all frauds of this type, the most effective remedies are
educated customers and alert, helpful bank employees.
Customer service tip : Phishing protection
- Never give out your personal financial information in response to an unsolicited phone
call, fax, or email, no matter how official it may seem.
- Do not respond to emails that may warn of dire consequences unless you immediately
validate your information.
- Check your credit card and bank account statements regularly, and look for
unauthorized transactions, even small ones. Immediately report discrepancies to your
bank.
- Secure your Internet transactions. When submitting financial information to a website,
look for the padlock or key icon at the bottom of the browser window and make sure the
Internet address begins with https.
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- Report suspicious activity to the Internet Fraud Complaint Center, a partnership
between the FBI and the National White Collar Crime Center.
- If you have responded to an email, contact your bank immediately so it can protect
your account and your identity.
Pharming
Pharming fools consumers into entering sensitive data, such as a passphrase or credit
card number, on a malicious website that impersonates a legitimate website. Unlike
phishing, the thief does not have to rely on the victim performing an action, such as
clicking a link in an email. Even if the consumer enters a correct URL (web address) in
the browser’s address bar, pharming redirects the victim to a different website.
Sometimes this is accomplished by changing a file on the victim’s computer, more often
it is done by exploiting a vulnerability in DNS server software. DNS servers are
computers responsible for translating Internet names into their real addresses.
Online Fraud Prevention
Banks combat online fraud in many ways, including:
- providing notices on websites and printed materials reminding customers the bank never
uses emails to request confidential information and asking them to report any such
requests to the bank.
- restricting electronic customer communications to an email system available through
the bank’s secure Internet banking application.
- using authentication methods.

- explaining how consumers can authenticate the bank’s web pages.
- introducing methods by which customers can be sure they actually are on the bank’s
website by, for example, displaying an illustration or a phrase customers have chosen
after they log in.
- assigning dedicated staff to monitor online transactions for fraud.
Customer service tip : Ways to avoid internet scams
- Don’t email personal information or give it to someone who has called you
- Know with whom you’re dealing
- Use antivirus and anti-spyware software and a firewall, and update them regularly
- Make sure your operating system and web browser are set up properly and update
them regularly
- Protect your passwords
- Back up important files
- Learn who to contact if something goes wrong
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Virus A software program capable of reproducing itself that usually causes great harm to
files, or other programs on the same computer.
Spam (n) Unsolicited junk emails sent to large numbers or people to promote products or
services or to spread computer viruses.
(v) sending such junk email or email containing computer viruses.
COMPUTER ATTACKS
Because banks store sensitive consumer financial information on computers, illegal

attempts to gain access to private accounts are a special concern for banks’ data systems
specialists. Computer attacks can come from inside the bank, perpetrated by disgruntled
employees who are knowledgeable about the bank’s computer security systems, or
outside the bank, perpetrated by hackers. Because the inventiveness of criminal software
programmers is unlimited, data security systems employees must be well-informed
about the latest technology developments and fraud schemes.
Malicious software threatens banks as well as customers. Banks, which can lose
critical customer information to these types of attacks, incur the cost of restoring data.
Most banks have central virus protection software, and require employees who use PCs
and PDAs to install security software on their home systems as well. As directed by the
bank, employees maintain backup files, practice safe Internet and email usage habits, and
otherwise follow bank policy regarding the secure use of computers. The stakes are high,
so all bank employees are trained on safe computer usage for their computers, not just at
work but also at home.
Basically, malicious software falls into 3 categories – viruses, worms, and Trojan
horses. See Exhibit 12.1 for examples.
Exhibit 12.1 Famous Malicious Software Programs
Melissa : A virus you did not want to meet
Melissa made her attack in March 1999, infecting computers through a Word document
attachment. Unwitting users of Outlook Express forwarded the virus to 50 people in their
address books. Over a million users were affected, causing $80 million in damage. Melisa
was the first virus to spread by email.
The Love Bug : Not a VW but a worm
The Love Bug traveled independently through networks, as worms will do. In May 2000
it swarmed the Internet with emails with the subject line, ILOVEYOU. The body of the
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email read :”Kindly check the attached love letter coming from me”. When the letter was
opened, the emailed worm attached itself, replicated automatically, sent copies to those in
the computer’s address book, and damaged computer files. Not satisfied with a few
million computers, it spread across the world, infecting even US government computers.
Cult of the Dead Cow “Horse” breeders
The most famous Trojan horse to date was developed by, Count Zero, a hacker in a group
known as Cult of the Dead Cow. Once installed, the program gave the hacker access and
control over any computer running a Windows 95/98 operating system or later.
According to the hacker, the program allowed someone at one computer to control the
activity at another computer across the Internet. The backer had complete control over the
other computer, able to upload and download files like the actual user.
Viruses
Viruses attach themselves to a program or file, spreading from one computer to

another, infecting each as it goes, or to email messages, sending duplicates across the
Internet using the infected computer’s address book.
Most viruses are created to cause destruction and launched as an attack. The virus
waits for a trigger event, and then opens a small program that performs a disruptive task.
Like biological viruses, some computer viruses are annoying while others can destroy a
hard drive.
Worms
Worms are a subclass of a virus that spread from one computer to another. They take
advantage of computer conveniences and security defects, scanning networks for
computers with similar features and defects. Infected computers spam the Internet, often
requesting information similar to a database inquiry from other servers. A worm can
replicate quickly, creating requests that overwhelm Internet servers and halting Internet
access for millions in just hours.
Trojan horses
Trojan horses are destructive programs that seem to be benign. Unlike viruses and
worms, Trojan horses do not replicate themselves. Those who receive a Trojan horse
usually are tricked into opening it, because it seems to be legitimate software, or a file
from a legitimate source.
Some Trojan horses are more annoying than malicious, others can cause serious
damage by deleting files, and destroying information on a computer or network system.
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Trojan horses can open a backdoor to a computer, thereby allowing malicious users to
access stored confidential or personal information.
BANK CARD FRAUD
Criminals who commit bank card fraud steal a credit or debit card or number and then
fraudently purchase goods or services. The potential for loss is high because criminals
often make purchases before victims know their card is missing. Criminals obtain bank
card information in a number of ways, such as :
- taking a card from a stolen wallet or handbag.

- stealing a card or statement from a mailbox or from the postal delivery service.
- copying information from a card presented for a legitimate transaction, usually by a
salesperson or server.
- paying dishonest employees of card issuers who seek to sell account information.
- stealing statements from files or trash cans.
Bank Card Fraud Safeguards
Banks employ these safeguards to counter unauthorized bank card transactions.
Toll free number to activate card
To thwart mailbox theft, customers call a toll-free number to confirm they are the
legitimate cardholder and not a thief in possession of the card. Card issuers may send an
advance notice that the card was sent, and needs to be activated before use. If the card is
not received, the intended recipient can alert the issuer.
Data for transaction approval
For transaction approval, a customer’s card must have a current expiration date, account
number, and special digital code.
Card signatures
Merchants can compare the signature on the receipt with the signature on the back of the
card at the point of purchase.
Holograms and embossed data
Cards feature a gold or silver hologram showing clear, three-dimensional images that
appear to move when the card is tilted. The account number, expiration date, and
cardholder’s name are embossed across the face of the card.
Cash limits
Most banks set limits on the amount of cash customers can receive from ATMs.
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Account monitoring
Sophisticated software monitors accounts for unusual increases in activity,

uncharacteristically high spending volume, increases in mail orders, or use in atypical
parts of the country or world, all of which initiate a warning on the account. Until
transactions are verified, the issuer may freeze or flag the account. Some card issuers also
contact the cardholder.
ELDER FINANCIAL ABUSE
As the baby boomer generation ages and life spans lengthen, the incidences of elder
financial abuse are increasing. Legislatures, law enforcement agencies, social service
agencies, and businesses with fiduciary responsibilities, such as banks, therefore have
added elder financial abuse to their watch lists and drawn up related policies, procedures,
and employee training.
Elder financial abuse perpetrators may be strangers or persons who have a relationship
with the senior citizen. Types of fraud by strangers include many of those discussed
earlier, as well as home repair and sales schemes, mortgage fraud, investment or
securities fraud, insurance fraud, and Medicare fraud. People who have a relationship
with a senior citizen – family members, caregivers, neighbors, and strangers who
“befriend” seniors – tend to perpetrate scams such as depleting joint checking accounts,
misusing ATM cards and powers of attorney, and neglecting fiduciary obligations in trust
relationships.
Senior citizens are targeted for many reasons. For example, seniors are less likely to
report the abuse, because they might not realize it is happening, they might be
embarrassed and ashamed, or they might be afraid they will not be believed.
Senior citizen protections
Banks increasingly are coordinating with local law enforcement and social services to
prevent or stop elder financial abuse. Among the signs banks watch for are :
- unusual recent withdrawals or changes in seniors’ accounts.

- new persons added to seniors’ accounts.
- new persons coming to the bank with senior account holders.
- use of an ATM when the seniors have not previously used ATMs.
- seniors who appear confused, unkempt, or afraid.
Because banks have regular contact with most seniors, they are in a good position to
notice changes. Taking steps to protect senior customers promotes good will, in some
states, it is mandated by law.
IDENTITY THEFT
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The public, government, and banks recognize identity theft – the theft of a person’s
personal and financial information – as one of the more vicious financial crimes. Identity
theft has a detrimental effect on a bank and a devastating effect on the bank’s customers.
The consequences range from the misuse of of a person’s information to the general
takeover of the victim’s identity, wherein the thief gains access to bank accounts, and
applies for loans and credit cards in the victim’s name.
The personal information stolen and used to commit identity theft is : name, address, date
of birth, mother’s maiden name, Social Security number, bank names, financial account
numbers, place of employment, children’s names, driver’s license number...
Criminals use both low-and-high-tech methods to exploit a person’s assets and credit.
They divert financial information by simply filing a change of address form with the US
Postal Service, rummage through trash looking for papers with personal information
(dumpster diving), and steal wallets and purses, pre-approved credit card offers, new
checks, and employer personnel records. Many of the fraud schemes, including the high-
tech methods, also are used to steal customer identities.
As trusted advisers, bankers must be prepared to inform customers about how to avoid
identity theft and help them recover if they are victimized. The best deterrents against
identity theft are vigilant bank employees and informed customers.
Identity theft prevention
All employees have a role to play in curbing identity theft, especially front-line tellers
and customer service representatives who receive, or are asked to provide account
information, or who accept applications. Bank employees also can remind customers how
to safeguard their information.
By law, every bank is required to have comprehensive security procedures that outline
appropriate employee conduct for handling customer information. Banks also have strict
guidelines about how to communicate with customers seeking information about their
account or with a third party, such as another bank, seeking to verify the authenticity of a
customer’s account. Employees never should provide customer information without the
caller first providing a PIN, passphrase, or another identifier known only to the customer,
for example, answers to questions such as ? “What is the name of your first pet ?” or
“Where were you born ?”. Such secure identifiers often are established when an account
is opened.
When another financial institution or merchant calls seeking information, banks use
caller-CD, verify the phone number, and then call back the institution or merchant to
verify the caller’s identity before releasing information. Banks may prohibit releasing
some customer information over the telephone under any circumstances.
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WHAT CUSTOMERS CAN DO
Customers can deter the theft of their information in a number of ways, as shown in the
customer service tips in this chapter. Besides following protective habits, customers can
make their mailboxes and electronic devices as secure as possible, and should report
problems as soon as they are detected.
Bankers have numerous channels through which they give customers tips on how to
protect their identity, including brochures and other mailings, information on their
websites, and personal contact with customers. Many banks also have customer education
programs such as workshops that explain how the bank protects customer information,
and how customers can protect their own information.
COMMUNICATION DEVICES
Cordless and cell phones are not as secure as landline phones. Beause wireless
communications are transmitted by radio signal, conversations can be intercepted on
radio scanners. Newer-model digital phones are less vulnerable to eavesdropping, but
their very convenience tends to make people forget that cell phones are not private. In
public places, customers should never provide sensitive information, such as credit card
numbers, using their cell phones.
Cell phones’ camera capabilities add another dimension to risk. A thief standing near a
customer at a merchant location, for example, may be able to take a picture of the
customer’s credit card, obtaining the name, number, and expiration date.
Customers can have their phone numbers blocked so they cannot be read by another
party’s caller-ID phone system. This service automatically prevents customers’ phone
numbers from being transmitted each time they make a call. Customers also can sign up
for the FTC’s National Do Not Call Registry to prevent calls from telemarketers with
whom they do not have an established business relationship.
COMPUTERS
Firewalls, virus protection software, anti-spyware software can be installed on home

computers to prevent hackers from obtaining information from the hard drive, and
viruses, worms, and Trojan horses from damaging files. Files particularly sensitive, such
as financial account information, can be passphrase-protected or encrypted.
Spyware Computer software that collects personal information about users without their
informed consent. Anti-spyware is computer software that prevents the use of spyware to
invade a personal computer, computer server, data-processing system.
Such computer protections are especially important for customers who enjoy swapping
and sharing files, because they are more vulnerable than most to illegitimate access by
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hackers. Customers should be reminded that even if they do not swap files, their children
may be doing so on the same computer.
When shopping online, customers should conduct business only with companies that
have effective privacy & security policies, and provide transaction security protection.
Before a computer is disposed of, all data should be removed using a disk wipe utility
– the delete function is not effective for removing all data.
PERSONAL DATA
Annually, customers should request copies of their credit reports from the major credit
reporting agencies (Equifax, Experian, Transunion). Customers now can order a report
from all 3 three agencies at the same time so the information can be compared.
Customers should look for debts they did not incur, inquiries from companies they did
not contact, and accounts they did not open. Unusual actions, such as an unexpected
credit denial, should be cleared up immediately to protect their credit rating.
If customers suspect their personal information is being misused, they may put a 90-
day fraud alert on their credit reports. The alert tells creditors they have to follow certain
procedures before opening a new account in a customer’s name or changing an existing
account. A fraud alert entitles customers to free copies of their credit reports.
To close accounts that have been established fraudulently or tampered with, customers
should immediately call the security department of each company with the relevant
information and follow up in writing. They also should ask for verification that the
disputed account has been closed and the debts discharged, and kept copies of documents
and records of all conversations about the theft.
Whenever personal data are compromised, the credit reporting agencies, police, FTC,
and companies with which the victim has a financial relationship should be informed.
FTC has an ID Theft Affidavit form that can be filed with these entities. The affidavit
also enters Internet, telemarketing, identity theft, and other fraud-related complaints into
Consumer Sentinel, a secure online database that is available to hundreds of law
enforcement agencies in the USA and abroad.
The Truth in Lending Act, the Fair Credit Reporting Act, the Fair Debt Collection
Practices Act, the Equal Credit Opportunity Act, the Electronic Fund Transfer Act, and
the Unfair or Deceptive Acts or Practices Act, all bear on aspects of consumer protection.
Several other laws, however, are more directly related to customers’ financial privacy and
identity protection.
PRIVACY OF CONSUMER FINANCIAL INFORMATION
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FRS Regulation P, Privacy of Consumer Financial Information, implements the GLBA
financial privacy provisions. Through GLBA, Congress restricted the way banks disclose
customer information to third parties. The law and the regulation also require banks to
provide customers with their privacy policy disclosures when the banking relationship is
established and annually thereafter. (See Exhibit 12.2). Customers can opt out of certain
disclosures of personal financial information.
INTERAGENCY GUIDELINES ON INFORMATION SECURITY
GLBA requires financial institutions to ensure the security and confidentiality of

customer records and information, protect against any anticipated threats or hazards to
the security or integrity of such records, and protect against unauthorized access to, or use
of such records or information that would result in substantial harm or inconvenience to
any customer.
The law also requires bank regulators to set standards for systems and controls that
implement the law. The Interagency Guidelines Establishing Standards for Safeguarding
Customer Information requires banks to have a written security program with internal
controls, monitoring and reporting procedures to the board of directors, and arrangements
for disposing of consumer records.
Exhibit 12.2 Sample Bank Privacy Notice
Information Categories Collected
We collect nonpublic personal information about you, including information:
- we receive from you on applications or other forms.

- about your transactions with us, our affiliates, or others.
- we receive from consumer-reporting agencies.
Information Categories Disclosed
We may disclose nonpublic personal information about you to third parties, including:
- financial service providers, such as mortgage bankers, securities broker-dealers, and

insurance agents.
- nonfinancial services companies : retailers, direct marketers, airlines, publishers.
- others, such as nonprofit organizations.
- nonaffiliated third parties as permitted by law.
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We may disclose nonpublic information to companies that perform marketing services on
our behalf, or to other financial services companies with whom we have joint marketing
agreements, including information.
- we receive from you on applications or other forms, such as your name, address, Social
Security number, assets, and income.
- about your transactions with us, our affiliates, or others, such as your account balance,
payment history, parties to transactions, and credit card usage.
- we receive from a consumer reporting agency, such as your creditworthiness and credit
history.
Your Opt-Out Rights
If you prefer that we not disclose nonpublic personal information about you to
nonaffiliated parties, you may opt out of those disclosures; that is, you may direct us not
to make such disclosures (other than disclosures permitted by law). If you wish to opt out
of disclosures to nonaffiliated third parties, you may call toll-free number 1-886-555-
5555.
Information Confidentiality and Security

We restrict access to nonpublic personal information about you to those employees who
need to know such information to provide you with products or services. We maintain
physical, electronic, and procedural safeguards that comply with federal standards to
guard your nonpublic personal information.
GUIDANCE ON INTERNET AUTHENTIFICATION
In 2001 federal banking regulators issued an interagency guidance on bank methods

for identifying customers using electronic banking services. Titled “Authentication in an
Internet Banking Environment”, the guidance provides direction for evaluating and
implementing authentication systems and practices. Although the guidance, updated in
2005, focuses on Internet banking delivery channels, it also applies to all types of
electronic banking.
The guidance’s purposes are to safeguard customer information, prevent money

laundering and terrorist financing, reduce fraud, inhibit identity theft, and promote the
enforceability of electronic agreements and transactions.
PROTECTING CHILDREN ONLINE
In 1998 Congress enacted the Children’s Online Privacy Protection Act to prohibit
unfair or deceptive acts or practices in the collection, use, or disclosure of personal
information from, and about children on the Internet. The act protects the privacy of
children, and requires operators of websites directed toward children to obtain consent
from parents, before collecting data from their children.
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RIGHTS TO FINANCIAL PRIVACY
One of the older privacy laws, the Right to Financy Privacy Act was passed in 1978 to
protect the financial records of individuals from unwarranted access by the federal
government. The act establishes criteria under which federal government agencies may
obtain financial records, and imposes a duty on financial institutions to screen requests
for information, to ensure they meet the requirements of the law before releasing the
requested records.
SUMMARY
1. By law and practice, banks have a fiduciary responsibility to protect customers from
invasion of their financial privacy, whether intentional or inadvertent. Therefore, banks
must have a comprehensive information security program, not only to reassure customers
but also to demonstrate to regulators that they have assessed the risks and are prepared to
manage them.
2. Banks protect customer transactions in various ways : automatic session expiration,

automatic account lockout, direct deposit, e-alerts, unique numbers and passphrases, and
online statement access and bill payment. Although banks do their best to prevent attacks
on customer data, they also are aware that they must be ready in case an attack occurs.
Federal regulators have mandated that banks and other financial institutions implement
incident response programs that follow certain standard procedures. Taking decisive
action to contain damage from a security breach protects customers, and preserves the
bank’s reputation.
3. The USA PATRIOT Act requires banks to have and follow a customer identification
program (CIP) when opening accounts. When banks deal with customers in person, over
the telephone, and online they need ways to ensure the customers are who they claim to
be. Questions, PINs, and a variety of other means are used to authenticate the customer’s
identity. Biometrics is an emerging security method for ensuring only customers are able
to access their accounts. The most common biometric methods are voice identification,
keystroke dynamics, and digital fingerprinting.
4. Authenticating a customer’s identification is not enough, however. Banks also must be

ready to help customers avoid an ever-expanding list of frauds. Common fraud schemes
today are caller-ID manipulation, including credit card protection fraud and pretext
calling; advance fee fraud, phishing, pharming; computer attacks such as viruses, worms,
and Trojan horses; elder financial abuse. The most comprehensive and damaging fraud is
identity theft, which can occur through low-tech thievery, such as stealing purses and
wallets as well as high-tech methods. Banks have policies, procedures, and systems in
place to help protect customers from, and assist them in responding to fraud situations.
5. Bank regulations have issued guidelines calling on banks to institute safeguards against
identity theft. The best deterrents are vigilant bank employees and informed customers.
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Employees must stay alert to avoid compromising customer financial information, by
following bank policies and procedures at all times. They also must do all they can to
keep customers informed about how they can protect their data, and when data breaches
occur. Many banks provide customers information about fraud schemes and security
measures they can take, such as installing protective software on personal computers.
6. Most general consumer protection laws and regulations protect bank customers and
transactions. Some laws specifically address the security measures that must be taken to
protect customers’ personal and financial information. Among these are FRS Regulation
P, Privacy of Consumer Financial Information, Interagency Guidelines Establishing
Information Security Standards, Guidance on Authentication in an Internet Banking
Environment, the Children’s Online Privacy Protection Act, and the Right to Financial
Privacy Act.
1. What are the three components of authentification for high-risk transactions ?

2. What are some security features banks use to protect customers ?
3. What are some best practices implemented in incident response programs ?
4. What are the three most common biometric methods ? Describe each.
5. What is pharming ?
6. What are some methods of identity theft ?
7. What risks do cell phones represent, and what can customers do to protect
themselves ?
8. What regulatory protection does FRS Regulation P provide ?
CHAPTER 13 - SAFEGUARDING THE BANK, THE ECONOMY, THE NATION
LEARNING OBJECTIVES
- explain the bank examination rating systems used by regulators

- describe the roles of the board of directors, bank committees, officers and employees
in safeguarding bank assets
- explain some processes for employee hiring and vendor management
- describe typical crimes against banks
- describe how banks help safeguard the economy and the nation
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INTRODUCTION
Banks have a special commitment to customers, because they must be stewards of their
customers’ wealth, and also must assume a pivotal role in fostering the health and growth
of the nation’s economy. Banks are expected to safeguard the assets customers entrust to
them. At the same time, bank shareholders and the public assume that banks will protect
their own financial assets, so that loan and investment funds will be available to keep
local economies strong.
Banks occupy a unique position in the nation’s economic life, because they provide
fiscal and agency services to the government, helping to carry out the nation’s monetary
policies and financing economic development. Furthermore, they contribute to our
country’s foreign policy and national security goals. They are vital to the nation’s
economic system. Managing risk in banking is therefore very important, and banking
regulators work to ensure that banks manage risk well.
With all these critical roles to fulfill, banks have a special duty to safeguard customer
and bank assets, deter financial crimes, and help protect the nation’s financial system
against misuse, corruption, and disruption. That is why banking has been called a “public
trust”, and bank employees have a responsibility to protect that trust.
MANAGING RISK
Ensuring the safety and soundness of their banks is a core function of bank directors
and management as well as bank regulators. The hard lessons of the 1980s savings and
loan crisis and bank closures spurred regulators to concern themselves with management
of risks in all areas of banking.
RATINGS SYSTEMS
In evaluating bank soundness, examiners use the Uniform Financial Institutions Rating
System (UFIRS) adopted by the Federal Financial Institutions Examination Council
(FFIEC) in 1979. The system applies uniform standards to identify financial institutions
that need attention. It takes into consideration financial, managerial and compliance
factors that are assigned composite ratings.
The composite rating incorporates individual ratings for the following factors, referred
to as CAMELS, capital adequacy, asset quality, management, earnings, liquidity, and
sensitivity to market risk. A rating of 1 goes to a sound bank, a rating of 5 signals
unsatisfactory performance and a need for regulatory intervention.
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Impinging on these safety and soundness areas are risk categories & subcategories that
affect different banking activities, such as market, credit, reputation, interest rate,
liquidity, price, transaction, information technology systems, crime, compliance risks.
Since the early 1990s, bank regulators have focused on bank risk probabilities. The
goal is to uncover risk problems and fix them before banks and the economy suffer. It is
now expected that each bank will manage its own risks.
Uniform Financial Institutions Rating System
An internal supervisory tool for evaluating the soundness of financial institutions on a

uniform basis, and for identifying institutions that require special attention. It is used to
evaluate certain financial, managerial, and compliance factors that are common to all
institutions. Its composite rating is based on an evaluation and rating of 6 essential
components of an institution’s financial condition and operations : CAMELS.
CAMELS Factors considered by regulatory authorities in bank examinations : capital

adequacy, asset quality, management, earnings, liquidity, sensitivity to market risk.
Numerical ratings applied to each factor are combined into a single composite rating.
The MOECA Rating System
The trust area’s MOECA rating system is similar to the CAMELS rating system for
banking; it measures :
M = management
O = operations, internal controls, and auditing
E = earnings
C = compliance
A = asset management
TECHNOLOGY AND RISK MANAGEMENT
Technological advances have brought new products and services to bank customers and
made it possible for banks to fine-tune operational and funds management. Yet every new
operational process carries its own set of risks.
Technology and market risk
The time to complete transactions in most banking areas has been greatly reduced, even
down to seconds. Today’s information systems can quickly factor in a complete range of
analytical formulas to, for example, determine interest rate risks for specific transactions,
asset categories, or entire companies. Bank regulators regularly review systems used to
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manage market risk. Furthermore, behind every system’s use and outcome is an
employee operator and a management decision.
Technology and Credit Risk
Technology has helped banks diversify the products they offer, fine-tune their market
segmentation, and take more advantage of secondary markets. Data systems can
determine default probabilities for individual loans and market segments, and the effects
of changes in the economic environment. Yet behind the systems are bankers who,
working in highly competitive markets, may feel compelled to make decisions that are
too risky for safety, soundness, or regulatory compliance.
Elements of risk management
With the rapid rise of technology, the rapid expansion of markets and bank products and
services, and the diversification of the industry, bank regulators now focus their
examinations, and encourage banks to do the same, on the basic elements of risk
management : corporate governance, policies, procedures, and limits; use of risk
management techniques and reports; and internal controls.
SAFEGUARDING BANK ASSETS
A bank must safeguard itself as a corporate entity. Occasionally banks are victimized
from within. An inattentive board or audit committee, senior managers who reward
harmful employee practices, an employee who embezzles, or a dishonest vendor poses a
threat to a bank’s safety and soundness. The best antidotes to these kinds of behavior are
high standards of corporate governance, a strong code of ethics, vigilant oversight of
hiring and contracting procedures, consistent and persistent monitoring. Other threats to
banks & their assets are fraud, bank robbery, currency counterfeiting.
Banks are obliged to their shareholders, employees, and customers to safeguard assets
by adopting good corporate governance controls, deterring financial crimes, and
maintaining quality hiring and vendor due diligence procedures.
CORPORATE GOVERNANCE AND ETHICAL BEHAVIOR
Corporate governance is the manner in which a company is managed and its assets are
accounted for and reported to the public. It is the responsibility of a company’s directors
and senior managers.
Lax or dishonest corporate governance practices have caused the failures of several
major corporations. Although the banking industry was not implicated directly in any of
the scandals of the 1990s, the governance crisis eroded public confidence in the
accounting and reporting practices of all businesses.
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In 2002 Congress enacted the Sarbanes-Oxley Act to improve corporate governance.
The act imposes significant new responsibilities on boards of directors, corporate
executives, audit committees, external auditors of public companies. For example,
corporate executives are required to attest to the completeness and the accuracy of the
information in their company financial reports. Also, to ensure that the board of directors
exercises its oversight responsibility independently, members of the audit committee
cannot be members of management.
Banks are subject to federal laws that impose high standards of corporate
accountability and ethical behavior, and the Sarbanes-Oxley Act parallels some
requirements that were already in place for banks. After the act became law, bank
regulatory agencies issued guidelines that clarified how the law applied to banks.
Board of Directors and Management Responsibilities
All bank employees must observe the highest ethical standards and be committed to
doing the right thing when a choice presents itself. The conduct and practices of several
parties, however, are especially important to good corporate governance.
Board of directors
Responsible for setting bank policies and directives, and ensuring that management
carries them out. Primarily responsible for establishing and maintaining policies and
procedures for controlling risks. Ultimately responsible for ensuring that depositor funds
are protected, and public confidence in the bank remains high.
Audit committee
Monitors management and staff compliance with board policies and with all laws and
regulations. Selects internal and external auditors; oversees internal audit function,
reviews and approves audit scope and frequency; receives audit reports and reviews the
conclusions with management, and ensures that management takes necessary corrective
actions.
Other board committees
Play an important role in safeguarding the bank and its assets : the loan committee
approves major loans, reviews problem loans, and helps with internal loan examinations;
the trust committee oversees trust activities; and the compensation committee
recommends salary and benefit packages for management.
Senior management
By words, attitudes, and actions, define and reinforce ethical behavior among all
employees. They must avoid policies and practices that encourage inappropriate
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behavior, such as undue emphasis on short-term performance, performance-dependent
compensation, ineffective segregation of duties that may tempt misuse of resources, or
conceal poor performance, and insignificant or overly onerous penalties for improper
bevavior.
Employee responsibilities
The bank’s expectations for employee conduct, both professionally and personally, are
communicated in a code of conduct, or code of ethics. The code helps employees decide
what is in the best interests of the bank, rather than their own personal interests.
Employees should review the bank’s code of conduct periodically.
Code of conduct address personal conduct, conflicts of interest, compliance, accepting

gifts, outside activities, confidentiality, purchasing defaulted property, notification of
violations.
Exhibit 13.1 Contents of a Typical Bank Code of Conduct
Corporate creed or letter from the Senior Executive

Organization principles and values
General statement of compliance with laws and regulations
Equal Employment Opportunity Statement
Fair Lending or Community Reinvestment
Environmental laws
Conflict of interest
Criminal activity
Confidential information
Insider trading
Purchasing defaulted property
Relationship with the investment community
Financial accountability and internal controls
Integrity of accounting and financial information
Money laundering and transaction structuring
Embezzlement, theft, and misapplication of funds
Use of corporate name and letterhead
Relationships with the media
Things offered to employees
Things offered by employees
Estate matters
Outside activities
Sound personal finances
Employment of relatives or persons having close relationships
Safety
Disclosure and record keeping
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Acknowledgement
Code of conduct violations
EMPLOYEE HIRING AND VENDOR MANAGEMENT
Recognizing risks (insider theft, identity theft, data breaches, terrorism...) more banks,
with the encouragement of regulators, are focusing on pre-employment screening and
vendor management to protect bank assets, and fulfill their fiduciary responsibilities.
Pre-employment screening
In 2005 FDIC issued guidance recommending that banks draw up written risk-based
screening procedures for hiring employees, bank officers and third-party contractors.
Besides reducing risk, pre-employment background screening may reduce turnover costs
because the potential employee’s skills, certification, license, or degrees are
verified.
At minimum pre-employment screening verifies references, experience, education,

professional qualifications, and the applicant’s identity. Additional screening depends on
the risks of a given job. Similar screening may be continuous, or scheduled periodically
for all employees.
Banks also check for any criminal record an applicant may have. Most banks have
applicants fingerprinted and send the prints to the Federal Bureau of Investigation (FBI)
to be checked against FBI records.
The FDIC recommends that banks check the applicant’s name against each federal
banking agency’s list of individuals who have been assessed civil money penalties
(CMPs) or have been prohibited from taking bank employment.
Civil money penalty (CMP) A fine imposed by a civil court on an individual, business,
or organization that has profited from illegal or unethical activity or has violated a law or
regulation.
The bank screening process must comply with the Fair Credit Reporting Act (FCRA)
because it covers information about the prospect’s credit, character, mode of living,
general reputation, and personal characteristics. The bank must have the applicant’s
written consent, before obtaining a credit report for employment purposes. If the
applicant is denied employment due to credit report information, the bank must provide
contact information for the credit reporting agency and any third party screening
company used. Applicants have the right to correct credit report information and to
review their application files.
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Vendor management
Banks now outsource a variety of services, from customer service response to

marketing to technology. While outsourcing, whether to affiliated or nonaffiliated
entities, helps banks manage costs, obtain necessary expertise, expand customer product
offerings, and improve services, it also introduces risks that banks and bank regulators
are concerned about managing.
As with pre-employment screening, managing outsourced relationships is important to

safeguarding bank assets. A case in point within the last decade has been the focus on
vendor management of technology services.
In a 2000 guidance, the FFIEC discussed identifying, measuring, monitoring, and

controlling the risks associated with outsourcing technology services. Many services
outsourced, such as bill paying, ACH transfers, or Internet communications, have their
own inherent risks, even if the bank handles them directly. Having them outsourced adds
risks, such as geographic scope and access to data systems. Besides performing due
diligence before executing contracts, banks must monitor continuously vendor
performance as well, including the service provider’s.
- financial condition and operations

- quality of service and support
- contract compliance and any emerging need to revise the contract
- business continuity contingency or emergency preparedness plans
Exhibit 13.2 outlines some guidelines for banks on vendor management. Just as banks
apply strict standards to their own operations in fulfillment of their fiduciary and legal
compliance duties, they also must do so with vendors.
Exhibit 13.2 Outsourcing Services - Vendor Management
Policies & Boards of Directors and management establish policies for monitoring
procedures service providers.
Risk Vendor relationships carry risks, such as strategy, transaction, market,
assessment compliance, reputation and country risk. Banks assess the risks and those
managing the relationship help determine specific risks, such as the
sensitivity of data or the transaction volume.
Due A “pre-employment screening” for the vendor, including its financial
diligence condition, reliability, security, growth capacity, and its third party service
providers. All references are checked, as well as the vendor’s expertise,
reliability, and capabilities.
Contract Contracts define rights and responsibilities of bank and vendor, service-
points level agreements, disaster recovery and business continuity plans, detailed
pricing terms, data ownership, compliance with regulations, audit reports,
the dispute resolution process, allowed subcontracting relationships, and
termination and continuation conditions.
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Monitoring Management reviews compliance with service-level agreements, the
the financial condition of the provider, audit reports, and business continuity
relationship plans, especially with regard to changes in regulation or the economy
Providers Management assesses the risk of the relationship with regard to the bank’s
in foreign strategy. It ensures the choice-of-law and jurisdiction monitoring
countries procedures are reviewed before any contracts are finalized. It assesses the
country-risk factor in the relationship, such as the potential for changes in
government, the economy or social environment.The vendors must be in
compliance with US laws and their operations may be examined by a US
bank regulator.
CRIMES AGAINST BANKS
Crimes against bank customers affect bank assets. Incidents of identity theft, phishing,
and credit and check fraud affect banks monetarily and can harm their reputation.
Because reputation is important to the financial service system, reputation risk is an
important risk category bank regulators monitor. Criminal threats against banks occur
both from within and outside the organization. Insider fraud, bank robbery, currency
counterfeiting, check fraud, are crimes for which banks always have to be prepared.
Fraud An intentional misrepresentation made by one person to another who, believing

the misrepresentation, takes some action and suffers a loss of property or a right to the
first person. The elements of common law fraud are therefore :
1/ a false representation
2/ with respect to a material fact
3/ made with knowledge of its falsity
4/ with intent to deceive
5/ with action taken in reliance on that representation
Insider fraud
Employee theft, embezzlement, and other forms of insider fraud annually cause more
losses than bank robberies. Banks are particularly vulnerable to insider fraud, because so
many of their employees work with large sums of money, securities, and other financial
assets. Insider fraud can cause significant financial losses as well as loss of confidential
information. If it goes undetected for a prolonged period, insider fraud can threaten the
bank’s safety and soundness.
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Embezzlement A crime involving the fraudulent use or keeping of money or other
property that has been entrusted to one’s care. Known as misappropriation of funds.
The most common type of employee fraud is asset misappropriation : embezzling money,
stealing blank cashier’s or treasurer’s checks. Employees also may overcome informarion
security controls to access accounts and move money electronically.
Banks try to minimize insider fraud by carefully screening prospective employees.

They also have systems and procedures in place to prevent, or identify insider fraud
including dual custody, transaction balancing, and reconciliation procedures, internal
audits; and insider hotlines to report illegal activity. The best defense against insider
fraud is a corporate culture in which high standards of ethical behavior are expected and
reinforced by a clearly articulated and enforced employee code of conduct.
Bank robbery
Although banks as a whole suffer more losses from other crimes, bank robbery is a
serious concern because of its potential for personal trauma, injury, and loss of life.
According to FBI statistics, thousands of bank robberies occur in the USA each year. In
half of them, tellers or other bank employees are physically threatened or attacked.
Although in general banks have a basic responsibility to protect depositor funds, their
primary objective during a robbery is to ensure the safety of employees, customers, and
law enforcement officers. Limiting losses and helping to identify and prosecute offenders
are secondary objectives.
During a holdup, tellers and other bank employees should not resist, because that
would place not only their own safety but also the safety of others at risk. FBI statistics
show that, in nearly 2/3 of robberies, weapons were observed, usually handguns.
While all bank robberies may not be preventable, their number can be reduced. Some
banks equip their premises with cameras and alarms. Those in high-crime areas limit
access to the lobby and put bullet-resistant glass in front of teller’s stations.
During robberies, banks employ a variety of measures to help catch or identify robbers.
By using an alert button or device in the cash drawer, tellers can activate silent alarms.
Also tellers may give the robber decoy or marked money. Some banks prepare special
bundles of money that contain an exploding device filled with dye.
The best security measure is still attentive employees who know and follow bank
procedures. To help prevent a robbery or reduce the effect, if one occurs, bank employees
should :
- strictly abide by bank procedures for opening and closing the bank.
- keep on the alert for suspicious vehicles, people, and circumstances.
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- jot down the license number of suspicious vehicles in the parking lot or near the
Building.
- greet customers by looking directly into their eyes.
- take notice of whom they are serving and note who are customers and who are non-
Customers.
- keep information about bank procedures and operations confidential.
Currency counterfeiting
Banks also must be on the alert for counterfeit money. High-resolution scanners and
printers are used to forge paper currency as well as counterfeit checks.
To combat use of digital imaging technology to counterfeit currency, the US

government in 1996 began introducing currency that has counterfeit-resistant features.
These features help tellers authenticate notes and make it difficult for criminals to
produce counterfeits. The government in 2003 took its anti-counterfeiting further when
the Federal Reserve began issuing redesigned notes. New designs circulate along with
older notes until the older notes gradually become worn and are removed from
circulation.
Hand examination, which most tellers do, is the most effective way to detect
counterfeit notes. The new currency contains security features that can help bank
employees quickly determine whether a note is real or fake. All bank employees should
be familiar with these characteristics. The following details security features of the new
$20 bill illustrated in Exhibit 13.3
Exhibit 13.3 : The $ 20 Bill
Security features watermark, security thread, color-shifting ink, microprinting, color,

low-vision feature, Federal Reserve indicators, serial numbers, symbols of freedom,
updated portrait and vignette
Crimes against banks Larceny, robbery, forgery, embezzlement, mail fraud, wire fraud,
bankruptcy fraud, bribery, insider trading, money laundering, identity theft, cyber theft.
Feature Description
Watermark A faint image, similar to the large portrait, is part of the paper and can be
seen from both sides of the note
Security A plastic strip embedded in the paper runs vertically up one side of the
thread note. On both sides of the note, the words “USA TWENTY” and a small
flag are visible along the thread. Under ultraviolet light, the thread glows
green
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Color - When tilted, the number “20” in the lower right corner on the face of the
shifting ink bill shifts color from copper to green
Micro- Microprinting is on the face of the note in two new areas. Bordering the
printing first three letters of the “TWENTY USA” ribbon to the right of the
portrait, the inscription “USA 20” is printed in blue. “THE UNITED
STATES OF AMERICA 20 USA 20” appears in black on the border
below the Treasurer’s signature.
Low-vision The large numeral “20” in the lower right corner on the back of the bill is
feature easy to read
Federal A universal seal to the left of the portrait represents the entire Federal
Reserve Reserve System. A letter and number beneath the left serial number
indicators identifies the issuing Federal Reserve bank
Serial A unique combination of eleven numbers and letters appears twice on the
numbers front of the note
Color Subtle background colors of green, peach, and blue are on both sides of
the note. The words “TWENTY USA” are printed in blue in the
background to the right of the portrait, and small yellow numeral 20s are
printed in the background on the back of the bill
Symbols of On the front are two American eagle symbols. The large blue eagle is in
freedom the background to the left of President Andrew Jackson’s image and the
smaller green metallic eagle to the lower right of the portrait
Updated The oval borders and fine lines surrounding the portrait on the front and
portrait and the White House vignette on the back of the previous note were removed.
vignette The portrait has been moved up and shoulders extended into the border.
Additional engraving details were added to the vignette background.
Another form of counterfeit currency is altered or “raised” currency. One or two ends or
the corners of a smaller denomination bill, such as a $1 or a $5, are replaced with the
ends or corners of a larger bill, such as $10, $20, or $50. The bill is redeemed for the
value of the “raised” currency.
Cashier’s Check Scams
Cashier’s checks are direct obligations of banks. Bank customers may receive them in the
course of conducting business, whether in person or over the Internet. Fraudulent
cashier’s checks pose a reputation risk to banks, because questioning checks can affect
consumer and business transactions. Among the fraudulent cashier’d checks schemes
now in practice are :
Unexpected windfall
Customers are told they have won a lottery or are beneficiaries of an estate, and the
proceeds will be sent to them when taxes or fees are paid. Fraudulent cashier’s checks are
provided to cover the charges, and customers are asked to deposit the checks, and then
wire the funds when the checks clear.
Purchase price differential
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As part of a sales transaction on the Internet, customers receive cashier’s checks for
amounts greater than the purchase price. Buyers tell sellers to deposit the fraudulent
checks and wire the excess amounts when the checks clear.
Money transfer agent
Customers are solicited to act as money transfer agents and are told that they will receive
cashier’s checks to deposit into their accounts. They are told to wire sums to other
persons or accounts in other countries.
Fraudulent checks are difficult to detect and may take weeks to return to the
customer’s bank. Checks may be drawn on banks located in different check processing
regions from the depositor’s bank. Checks can be made to look genuine by, for example,
altering genuine checks, they may list the name of one bank, but use the routing number
for another bank, or parts of the check may be illegible so that manual processing is
necessary. When the check is returned, the bank reverses the deposit and withdraws the
funds from the customer’s account.
Fraudulent cashier’s checks pose risks to depositary banks, including :
Customer dissatisfaction
Customers may believe that the bank should take responsibility for their loss, because the
check amount should not have been credited until the check cleared, there should have
been protective procedures in place, or a bank employee accepted the check.
Reputation risk
Customers could sue the bank for their loss, resulting in negative publicity for the bank in
the community generally, and among customers and prospective customers.
Credit risk
Reversing credited amounts could cause customer accounts to be overdrawn, creating
loans to customers, who may not be able, or may not want to repay the amount.
Paying banks also have risks. If they do not detect fraudulent cashier’s checks, they
pay them in error. If they detect them but fail to return them within the legally required
time, they may be liable for the amounts.
To guard against fraudulent cashier’s checks, the Office of the Comptroller of the
Currency (OCC) recommends that banks:
- have procedures for identifying suspicious items and hold policies for them, and train
employees in these policies and procedures.
- have information and procedures in place to help customers who have been victims
of such scams and train employees to help them.
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- provide information to customers about fraudulent cashier’s checks, explaining bank
practice in the handling of these deposits.
- receive and communicate to employees regulatory agency alerts on counterfeit and
stolen cashier’s checks.
- notify regulatory agency and law enforcement authorities of such suspicious
transactions by filing a Suspicious Activity Report (SAR).
SAFEGUARDING THE ECONOMY AND THE NATION
Occasionally events remind everyone of the critical importance of banks to the

economic vitality of the USA. The terrorist attacks of September 11, 2001 on the World
Trade Center and the devastation of hurricanes Katrina, Rita, and Wilma in 2005 were
such events, one man-made and the others acts of nature.
New York City is home to the New York Stock Exchanke and many of the largest and
most influential banks, securities firms, clearing and settlement organizations, and
payment system operators in the country. Despite the terrible loss of life and the enormity
of the damage on September 11, the nation’s financial markets and payment systems
continued to function almost without pause.
Hurricane Katrina was a deadly hurricane that hit the Gulf Coast of the US in 2005. It
had catastrophic effects on New Orleans and coastal Mississippi. Hundreds of people lost
their lives, and billions of dollars in damage made this hurricane the costliest natural
disaster in US history.
Today most banks are prepared for terrorist acts and natural catastrophes. They have
disaster recovery programs and business contingency plans for resuming critical
functions. These plans are reviewed continually by bankers and regulators.
Depositary Versus Paying Banks
- Depositary bank : The bank in which a check is first deposited

- Paying bank : The bank of the customer who wrote the check
A depositary bank may be a paying bank, if the check is drawn on, payable at, or
payable through the bank.
Business contigency plan (Business continuity plan)
A plan for maintaining or resuming business operations if unexpected events occur.
TERRORISM
The events of September 11, 2001, gave terrorism a new meaning for all Americans.
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Terrorism kills and destroys innocent lives. It has a wider purpose, however, and that is to
spread fear and disrupt economic and financial activity.
Because banks play a central and very visible role in the US economy, they are targets
for terrorist groups, domestic or foreign. The risk arises because they are active in
curbing money laundering, identifying and cutting off sources of funds for terrorist
groups.
Tactics used to cause terror and wide-ranging and unpredictable. Bomb threats are
among the most common techniques used against banks. Fully aware of the
consequences, banks take such threats seriously. Maintaining adequate security systems
and training employees is a high priority. Keeping employees apprised of the risk of
terrorist acts, and how to respond is an important part of contingency planning.
Employees need to know how to protect themselves, their coworkers and customers.
Terrorist activity often requires vast sums of money. These funds can be gained from
supporters, but more commonly arise from illicit activity. Banks are thefore in the front
line in combating the financing of terrorist organizations.
Bank Security Systems
Banks are required by law to have security procedures that discourage crime and
physical damage to bank structures. Under the Bank Protection Act of 1968, banks must
select, test, operate, and maintain security devices, including :
- vaults to protect cash and other liquid assets.

- lighting systems to make areas such as the vault visible from within and outside
the building.
- an alarm or similar system to notify the nearest law enforcement officers of an
attempted robbery or burglary.
- tamper-resistant locks on exterior doors and windows that could be opened.
Combating Money Laundering
Money laundering is associated with many crimes, from racketeering and drug dealing to
terrorism. Banks are the first line of defense in the battle against the illegal flow of
money. They report financial transactions that may be associated with criminal
fundraising and funds transfer. They are obligated to exercise due diligence to know who
their customers are, and judge whether transactions are legitimate. Banks also assist the
federal government by freezing the assets of organizations or individuals suspected of
terrorist activities.
Money laundering Moving large amounts of illegally obtained cash through many bank
accounts or to other legal investments or assets in order to hide the source of the money.
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Band Secrecy Act
The Bank Secrecy Act (BSA) requires banks to record and report certain financial
transactions to curb illicit activities. Banks must file Currency Transaction Reports
(CTRs) on all deposits, withdrawals, and exchanges of currency that exceed $10 000.
Since its passage 35 years ago, BSA has been amended often to expand its scope. In
1986, Congress made money laundering a federal crime, allowed laundered funds to be
seized and forfeited, required banks to have a formal BSA compliance program. In 1990,
Congress created the Financial Crimes Enforcement Network (FinCEN) to detect
financial crimes, and in 1994 FinCEN took over responsibility for BSA.
In the late 1990s regulatory agencies shifted their emphasis from the technicalities of
reporting large currency transactions to monitoring and reporting suspicious activities.
Banks are required to file a SAR whenever they detect or suspect a crime has been
committed within or through the bank.
USA PATRIOT Act
After the 11.9.2001 terrorist attacks, detecting and reporting supicious activities
became a national imperative, especially because of the close link between money
laundering and the funding of terrorist activities. In 2001 Congress enacted the Uniting
and Strengthening America by Providing Appropriate Tools Required to Intercept and
Obstruct Terrorism Act (USA PATRIOT Act). Its antimoney-laundering provisions
include a requirement that banks provide reports on their compliance with those
provisions. New customer identification program requirements imposed significant
mandatory procedures for identifying both loan and deposit customers.
As of 2004 banks must use a new SAR form that includes check boxes for identifying
suspicious activity as terrorist financing or identity theft. Some of the warning signs of
possible terrorist financing activity are :
- using a business account to collect funds that are sent to a small number of foreign
beneficiaries in a country associated with terrorism.
- an unusually high volume of wire transfers from a business account.
- multiple individuals structuring transactions that are under the currency transaction
reporting threshold.
- large currency withdrawals from a business account not normally associated with cash
transactions.
- same-day transactions at the same bank using different tellers.
- addresses, which are also business locations, shared by persons involved in currency
transactions.
- circumventing identification requirements by purchasing money orders in small
amounts.
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Freezing Assets
As part of foreign policy the federal government uses economic sanctions against
individuals, terrorist organizations, and countries hostile to the USA. The Office of
Foreign Assets Control (OFAC) in the Department of the Treasury posts a list on its
website of individuals and entities subject to sanctions, such as blocking accounts and
freezing assets. Banks must regularly check their records to identify assets owned by
individuals or organizations that appear on the OFAC list.
When a match is found, the bank must take action to prevent the funds being
withdrawn and used for illegal activities. Specified procedures govern the handling of
frozen assets and blocked accounts.
EMERGENCY PREPAREDNESS
After Hurricane Katrina, the federal and state governments and the banking industry
quickly assessed the lessons to be learned. FFIEC, its member regulatory agencies, and
the Conference of State Bank Supervisors analyzed bank experience and found :
- Banks reported that communications outages made it difficult to locate missing

personnel.
- Access to and reliable transportation into restricted areas were not always available.
- Lack of electrical power or fuel for generators rendered computer system inoperable.
- Many facilities were destroyed outright or sustained significant damage.
- Some branches and ATMs were underwater for weeks.
- Mail service in some areas was interrupted for months.
In response, the banking industry and the government formulated planning tools and
guidelines to help banks prepare and respond to emergencies. There were
recommendations for restoring communications, emergency management processes, plan
development and review, financial assistance, anticipating the needed response, assessing
the economic impact, preparing for unique emergencies, such as pandemics.
Effective Communications
Restoring communications in an emergency is vital to retaining confidence in the

banking system. It is important that customers know their banks are prepared, their
deposits are safe, and they can access their funds. To be prepared, banks should :
- identify alternate communication channels for use during a disaster.

- provide emergency telephone numbers, email addresses, and a physical address list to
employees and substitutes if employees are not able to work.
- provide employees and substitutes with numbers for vendors, emergency services,
transportation, and regulatory agencies.
- provide contact information for employees on wallet cards and Internet postings, and set
up calling trees.
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- have reporting locations, so employees can call in and be accounted for.
For Effective Crisis Communications
- Appoint a crisis communications response team.

- Conduct a brief communications audit.
- Coordinate communications channels.
- Prepare a crisis communications plan.
- Establish on-site and off-site command centers.
Local Emergency Management
In times of emergency, banks need to work together to share cash reserves, facilities and
communication systems. They also need to partner with other local industries and local,
state, and federal emergency management agencies to understand who does what in an
emergency in their community. They can join or start a private organization focused on
emergency management and partnering with the first responders. Banks also can join
their local Community Emergency Response Team (CERT) program.
Emergency Preparedness and Disaster Recovery Plans
All banks have disaster recovery or business contingency plans. Changes in

technology, world events, and recent national emergencies have underscored the
importance of these plans. Banks are constantly updating the plans, expanding
procedures, and testing the plans to ensure that they meet current needs, and incorporate
service providers and other partners.
Part of the plan should be a strategy for emergency power during a disaster. The use of
mobile branches and ATMs are also options as well as coordinating with other banks to
share facilities and services. Employees are trained to handle contaminated currency and
checks, and water-soaked contents of safe deposit boxes. Banks also are expanding their
use of electronic services such as ACH and check conversion to handle transactions more
efficiently and with fewer employees.
The FBIIC and the FSSCC were formed to help the financial services industry prepare for
and recover from disasters.
FBIIC The Financial and Banking Information Infrastructure Committee – comprises

representatives of the financial services regulatory agencies, the Department of the
Treasury, and the Homeland Security Council.
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FSSCC The Financial Service Sector Coordinating Council comprises representatives of
national trade associations across the financial services industry, such as the American
Bankers Association.
Disaster Financial Assistance
Government relief agencies may distribute financial assistance after a disaster as checks
or vouchers, through direct deposits, as debit or prepaid cards. Assistance also comes as
loans, to help local businesses repair their facilities, prepare to reopen, etc.
Providing and coordinating financial assistance is an important role for banks during
disaster recovery. Steps banks can take are to :
- limit cashing for relief checks by encouraging customers to participate in the US

Treasury “Go Direct” program.
- encourage Red Cross chapters to issue client assistance cards.
- train employees to recognize fraudulent items and red flags in relief transactions .
- use terms such as “Red Cross”, “hurricane” or other disaster-specific terms in SARs that
involve disaster-related fraud.
- become an approved SBA lender to help process loans under the Disaster Loan
Partners Initiative.
Limiting Fraud
During the 2005 hurricane relief efforts, there were unfortunate instances of fraud.
Banks and government agencies identified red flags for bank employees to watch for
during recovery operations. Banks train employees on disaster relief procedures,
including the filing of SARs with local offices of the FBI, or the US Secret Service when
transactions seem suspicious.
Although during emergencies, the US Treasury may issue temporary rules to remove
bank liability for cashing checks, banks still are required to try to record identifying
information for relief recipients. In some cases, employees can call the issuing agency for
identification assistance. When this is not possible, other prudent identification effort
must be made and documented.
Anticipating Regulatory Response
Although there are different kinds of natural disasters, certain kinds of disasters are more
probable in some regions. Florida has a long history of hurricane threats, and California
has a history of widespread fires. In anticipating threats, coordinating with local, state,
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federal agencies, bank regulators, with private industry organizations can prepate banks
for what may happen and the likely regulatory response.
After Hurricane Katrina, FFIEC issued guidance encouraging financial institutions to

take reasonable and prudent actions to meet the critical financial needs of their customers
and communities. Areas where banks can expect regulatory examinations are risk
assessment, particularly for bank capital, earnings, asset quality; procedures for
documenting credit, such as modifications in policies or procedures; and revisions to
budget and asset and liability plans, such as disaster-related cash flows.
The Effects of a Disaster
Normal business is disrupted after a disaster. Understanding and preparing to mitigate the
effects is a part of emergency preparedness. Although most recent natural disasters have
not been like Hurricane Katrina, the economic lessons are part of a bank business
continuity plan, including the effects on loan quality, deposit growth. capital and income
for the first 6 months after most disasters, and the first few years after a major flood.
Standard ratios, such as return on assets (ROA) drop; industries recover at varying rates,
which affects loan and deposit portfolios; credit quality declines; and personal
bankruptcy filings increase significantly.
Preparing for Pandemics
Bank business continuity programs have traditionally focused on maintaining or

recovering operations after a natural disaster; in the last few years they have added plans
for events such as terrorist attacks or financial systems disruptions. But the advent of
pandemic threats such as the avian flu virus brings new challenges to bank operations.
Vital pandemics present special challenges :
- An outbreak could erupt in waves over weeks or even months, with different levels of
severity.
- During an outbreak, absenteeism may be prevalent for weeks, at a time due to
employee illness, family demandsm or fear of contagion.
- An outbreak may affect several regions simultaneously.
- Disruptions could affect other market sectors : transportation, telecommunications,
power, water systems, health services. All of these affect bank operations, especially
employee ability to get to work and to work effectively.
The 1994 Northridge Earthquake
Before the earthquake, banks headquartered in the affected area had suffered from an
economic downturn, they had higher loan loss provision and nonperforming loan ratios
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than state or national averages. After the earthquake, bank lending performance did not
noticeably worsen.
Before the earthquake, capital ratios were slightly below state and national levels and
ROA ratios were negative, well below the state and national averages. It took years after
the earthquake before capital ratios and ROA ratios improved significantly.
Although banks headquartered in the affected areas struggled after the disaster, it was
not necessarily all due to the disaster.
Economic Losses and Disaster Assistance, Northridge Earthquake

(in billions of 2005 dollars)
Economic Loss Economic Aid
Damage Lost output Total loss Insurance Government Total aid

payments assistance
20.1 12.5 32.7 3.3 15.5 18.8
As a part of the international effort to understand and plan for such events, banks and
other emergency planners are examining their current contingency plans and enhancing
them to prepare for such outbreaks. Some areas banks are addressing are :
Coordination teams Medical, communication, information, telecommunications, and

security teams have defined responsibilities for preparedness and responsive planning.
Critical operations Current busines continuity programs, including services provided by

third parties, are adjusted for the implications of a vital or biologicical outbreak.
Office quarantines Public health decisions to quarantine certain offices or the bank call
for targeted communications to customers.
Telecommuting Telecommuting plans can be made available to more employees.
Other continuity planning considerations include suspended operations, video

conferencing, teleconferencing, travel restrictions, local transportation, security, crisis
information systems, coordinating plans, and phasing in the plan.
SUMMARY
1. Ensuring the safety and soundness of banks is a priority for the directors, managers,
and regulators. The hard lessons of the 1980s savings and loan crisis and bank closures
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spurred regulators to look at management of risks in all areas of banking. In reviewing a
bank’s asset portfolio, examiners use the Uniform Financial Institutions Rating System,
and assign asset-quality ratings. Examiners use the CAMELS factors, assigning ratings
for capital adequacy, asset quality, management, earnings, liquidity and sensibility to
market risk.
2. Technological advances have contributed greatly to banking, making it possible to

offer customers new products and services, and to fine-tune operational processes and
funds management. Yet every new process carries its own set of risks, such as market and
credit risks. Bank regulators now focus their examinations, and encourage banks to do the
same, on the key elements of risk management : corporate governance, policies,
procedures and limits; use of risk-management techniques and reports; and bank internal
controls.
3. A bank must safeguard itself as a corporate entity. Sometimes banks are victimized
from within – unethical or irresponsible behavior can occur anywhere in a bank. An
inattentive board or audit committee, senior managers who reward bad employee
practices, an employee who embezzles, or a dishonest vendor each poses a threat to bank
safety and soundness. The best antidotes to these kinds of behavior are high standards of
corporate governance, a strong code of ethics, quality hiring, contracting procedures and
vigilant oversight. Criminal threats to banks and their assets are fraud, robbery, and
currency counterfeiting.
4. Banks are essential to safeguarding the economy and the nation. They help federal and
state law enforcement agencies fight criminal activities, especially terrorism and money
laundering. By filing Currency Transaction Reports (CTRs), and Suspicious Activity
Reports (SARs), and by freezing the assets of suspected terrorist individuals,
organizations, and states subject to sanctions; banks help protect the USA against .
terrorism, money laundering, and other financial crimes. They also draw up business
contingency plans, so they can readily resume critical functions if a natural disaster or a
terrorist act occurs. Being prepared for emergencies allows banks to respond to special
needs of their customers, their communities, and the nation’s financial system.
1. What are CAMELS ? What are some risk categories that can affect a CAMELS
rating ? What are the basic elements of risk management ?
2. What is the bank employee’s role in safeguarding bank assets ?
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3. What is the most basic form of pre-employment screening ?
4. What does FFIEC recommend that banks do, to manage vendors beyond
due diligence in executing contracts ?
5. What can a bank employee do to prevent robberies ?
6. What are some risks to the bank from fraudulent cashier’s checks ?
7. What are some ways banks help federal authorities protect the country against
terrorism ?
8. Why should banks become involved in local emergency management processes ?
ANSWERS TO SELF – CHECK AND REVIEW
CHAPTER 1 BANKING AND YOU
1. If all bankers are expected to sell products and services as part of their job, why is
sales and business development a separate career path for bankers ?
While all bankers are salespeople for the bank, most also have other duties. Banks must
give special attention to the sale of their products and services, if they are to be
competitive. In larger banks, sales teams specialize according to product. Retail banking,
business banking, insurance sales, investment products, and trust services are all
examples of sales avenues open to bankers.
2. Over several years, a bank has experienced losses while other banks have been
profitable. Who ultimately is accountable for the bank’s poor financial performance ?
Although executive management, led by the bank president and CEO, makes the day-to-
day operating decisions, the board of directors ultimately is responsible for financial
performance and must answer to the shareholders. The board of directors has the power
to appoint the bank’s senior officers.
3. What are nontraditional bank services and why do banks want to provide them ?
Nontraditional bank services include insurance and securities. Because of the Gramm-
Leach-Bliley Act; banks, insurance companies, and brokerage firms may now offer each
other’s products and services. Banks want to offer nontraditional products so they can
compete on an equal basis with the other providers, and provide a full range of
services to their customers.
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4. How do banks contribute to their communities ?
In addition to providing deposit and credit services to individuals and businesses in the
community, banks contribute time, effort, and funds to build, restore, and enrich their
communities. Bank employees have a history of service to charitable organizations, and
banks sponsor many community events.
5. What are the benefits of banking partner and oursourcing relationships ?
These alliances can provide significant cost savings, greater choice for consumers, and
better customer service.
6. Why might a bank consider acquiring or merging with another bank ?
Through mergers and acquisitions, some banks are eliminating duplication of effort and
becoming more profitable. Banks can combine forces as a way of entering new
geographic areas to expand their market share.
7. What are some trends in banking today ?
Trends in banking include deregulation of restrictions on the financial services bank can
offer; continued expansion of the financial services offered to customers; innovations in
technology for product delivery and operations; more intense competition in financial
services; narrowing margins between interest earnings and costs; and ever-wider
geographic expansion into the world as a whole.
1. What is the role of banks in the US economy ?
Banks fund loans, offer financial services to consumers and businesses, provide access to
the payment system, create money, help expand and contract the money supply, and are a
force for economic and social change.
2. What is inflation ?
A continuing increase in prices in an economy caused by too much currency and too few
goods available to be purchased.
3. Why is the National Bank Act of 1983 important ?
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The National Bank Act founded the dual banking system. Its four major provisions
created national banks, established the Office of the Comptroller of the Currency,
introduced the national banknote, and established a system of required reserves.
4. What is meant by the dual banking system ? Does it still exist ?
The dual banking system is the banking system in the USA today, in which a bank may
be chartered by a state or the federal government. National banks are chartered through
the Office of the Comptroller of the Currency, a federal banking agency.
5. What was the singular achievement of the Federal Reserve Act ?
The singular achievement of the Federal Reserve Act was the creation of a central bank –
the Federal Reserve system, also called the Fed.
6. What federal agency was created by the Banking Act of 1933 and why ?
The Federal Deposit Insurance Corporation (FDIC) was created to insure depositors’
funds at FDIC-insured banks.
7. What are the four basic duties of the Federal Reserve ?
The Federal Reserve main duties are to :
- Conduct the nation’s monetary policy by influencing money and credit conditions in
the economy, in pursuit of full employment, stable prices and economic growth.
- Supervise and regulate banking institutions to ensure the safety and soundness of the
nation’s banking and financial system, and protect the credit rights of consumers.
- Keep the financial system stable and minimize systemic risk in financial markets.
- Provide certain financial services to the US government, financial institutions, and

foreign official institutions, including operating the nation’s payment system.
8. What events contributed to bank failures in the late 1980s and early 1990s ?
Poor loans were a major contributing factor to bank failures during this period. Banks
that loaned heavily to less developed countries suffered large losses when many of those
countries defaulted on their loans. The USA also went through a prolonged economic
slowdown in the late 1980s and early 1990s. Real estate sales in many parts of the
country plummeted, and large amounts of office space in major cities were unoccupied.
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As a consequence, real estate developers started defaulting on loans. Bankruptcies in
other industries, such as the oil and gas industries, also undermined bank loan portfolios.
9. What legislation stipulates that a bank customer’s financial records will be kept
private ? What are the basic privacy provisions ?
The privacy provisions in the Gramm-Leach-Bliley Act give customers the right to
instruct banks not to share their personal information with nonaffiliated third parties. It
also requires financial institutions to establish a privacy policy, and disclose the policy to
customers when they open an account and annually thereafter. The law also requires
financial institutions to implement technical, physical, and administrative safeguards to
protect the security and confidentiality of customer information.
10. What five regulatory groups have the authority to supervise bank activities ?
- Federal Reserve System

- Office of the Comptroller of the Currency (OCC)
- Federal Deposit Insurance Corporation (FDIC)
- Office of Thrift Supervision (OTS)
- State banking departments
1. How do the properties of money reinforce the basic functions of money ?
Money’s most basic function is to serve as a medium of exchange generally accepted for
goods and services and for settling debts. Money also serves as a unit of account, a
standard for determining the value of goods and services, and a store of value – a means
of accumulating the power to purchase goods and services in the future.
These functions are reinforced by the properties of money : an item must be accepted
generally as a mediumof exchange, divisible without loss of value, relatively scarce and
in controlled supply, stable in value, and portable.
2. What is the difference between a money economy and a barter economy ?
In a barter economy, certain goods and services are accepted in exchange for other goods
and services based on the mutual needs of the parties to the transaction. Finding goods
and services of equal value to both parties can take considerable negotiation.
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In a money economy, coins and currency the government has declared to be legal
tender acceptable for use as a medium of exchange are used to buy goods and services.
Because legal tender has a generally accepted value that can be stored, it can be used at a
future date without the need for negotiation.
3. If there were no reserve requirements, could banks create an infinite amount of

demand deposits ?
In theory, if a bank was not subject to reserve requirements, it could make new loans and
create new demand deposits using every dollar it held. But when the proceeds of these
new loans were disbursed and the loan funds transferred through the check collection
process, the bank would lose a dollar in cash for every dollar it created.
Apart from the legal requirement to hold reserves, banks need to hold a percentage of
their assets as cash, or on deposit with other banks to meet cash withdrawals, and pay the
claims of other banks presenting depositors’ checks for collection.
4. How does money flow in an economy ?
Consumers, businesses, and governments supply each other with factors of production in
the form of land, labor, capital, and talent. In turn they receive wages, rent, interest,
profits, and, for the government, taxes. These forms of income are spent to buy the goods
and services they helped produce. Consumer spending depends on the wants and needs of
individuals and families such as food, health, and education. Business spending is
directed toward a return of profit, for example, by investing in more employees, training
them or replacing old machines with ones that are more efficient. Governments have a
variety of social and other public objectives, such as defense.
In many ways, savings represent a leakage from the circular flow of economic activity,
because they are not used immediately to buy goods and services, or to generate income.
If savings were kept out of circulation, the economic consequences could be devastating,
perhaps even leading to a recession. Because savings usually are deposited in financial
institutions, however, they are pumped back into the economy in the form of loans.
5. What is the difference between M1 and M2 ?
M1 is the narrowest measure of money. It counts all mediums of exchange, principally

cash, demand deposits, and interest-earning checkable deposits at banks and savings
institutions. M2 incorporates all the items counted in M1 and adds near-monies that are
close substitutes for money, most notably time and savings deposits at banks and savings
institutions.
As of March 2006, the Fed no longer uses M3, a measure that once incorporated M1
and M2 plus other financial instruments. The Fed does, however, monitor money market
mutual funds separately.
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6. How does the Fed manage the money supply ?
The Fed manages the quantity of money circulating to ensure credit is available in the
amounts, and at interest rates consistent with specific economic objectives. The methods
the Fed uses to manage the money supply include reserve requirements, discount
operations, and most important, open-market operations managed on behalf of the Fed by
FOMC, and implemented by the Federal Reserve Bank of New York.
7. Why does the Fed need to manage the money supply ?
A nation’s money supply is the sum of all the funds individuals and businesses have
immediately available for spending in the domestic economy. Careful management is
necessary to ensure the money supply doesn’t grow too fast and result in inflation, or too
slowly and result in a recession.
To ensure the deposits banks create are not too much or too little for the needs of the
economy, the Fed controls the amount and cost of reserves available to banks. It buys and
sells government securities in the open market, raises and lowers the amount of reserve
banks must hold, and sets the target Fed funds rate banks use when they lend to each
other. These actions in turn become the basis for the interest rates banks offer their
customers on both loans and deposits.
CHAPTER 4 DEPOSIT ACCOUNTS
1. Why are deposits so important to banks ?
Deposits from checking, savings, and money market deposit accounts and certificates of
deposit provide a majority of the funds banks use to lend and invest.
2. What are the basic differences and similarities between a checking account and a
savings account ?
Checking accounts are transaction accounts. Deposits made to noninterest-earning

checking accounts are payable on demand. Usually the customer intends to withdraw
checking account funds in the near future to pay bills and meet expenses. Checking
accounts also may pay interest. Such accounts are known as negotiable order of
withdrawal or NOW accounts.
Customers generally place funds in savings accounts to set aside money for future
needs and to earn interest. Technically speaking, savings account funds are not
immediately available to the depositor. Although banks rarely do so, they can require 7
days notice before a withdrawal from a savings account.
Checking accounts and savings accounts do not have maturity dates. Deposits and
withdrawals can be made on any day. Thus, unlike a time deposit account, such as
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certificates of deposit, no interest penalty is imposed for withdrawal from a checking or
savings account. Also, under Federal Reserve Regulation D, transaction account deposits
are subject to reserve requirements. Savings account deposits are not.
3. How do automatic transfer services benefit a customer ?
With automatic transfer service (ATS), customers can write checks that exceed their
checking account balances, and the bank by prior arrangement (preauthorization) will
move funds automatically from their savings accounts to cover the checks.
4. What deposit account would you recommend to a customer who wants to earn interest
and would like the option of writing a small number of checks (< 3) every month ?
A money market deposit account (MMDA) offers higher annual percentage yields than
savings accounts. This account also allows a limited number of monthly transfers (6 per
month : 3 per check and 3 per preauthorization)
5. How can customers make deposits into their accounts without going to the bank ?
Electronic funds transfer (EFT), automatic transfer service (ATS), remote deposit
capture, automated teller machine (ATM), wire transfer, Internet banking, direct deposit,
and deposit by mail.
6. How do account transactions differ from joint accounts held in joint tenancy versus
those held as tenants-in-common ?
With a joint tenancy account, each account holder may make transactions and only one
signature is required. When one account holder dies, the funds in the account typically
pass to the surviving account holders in accordance with state law and without need to
establish an estate.
Tenants-in-common accounts require the signatures of all account holders for

transactions. From the bank’s perspectives, tenants-in-common accounts need more
monitoring. If the bank pays checks with only one signature when it has agreed to require
the signatures of all the account holders, it could be liable to those account holders who
did not sign.
7. When a deposit account is opened, why is it important for a bank to establish the
authority of the customer to use the account ? What 3 steps does the bank take to
accomplish this ?
When an account is opened, the bank enters into a contractual relationship that gives
customers the ability to extend credit themselves, gives them a vehicle to convert checks
and other instruments into cash, and creates other situations that could result in a loss to
the bank. Three steps the bank takes to open an account are to :
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- establish the identity of the person opening the account.
- determine that the person has the legal capacity to open the account.
- ensure that the person has the authority to open the account.
8. What types of deposit transactions are covered by FRS Regulation E ?
FRS Regulation E covers electronic funds transfers, ATM transactions, point-of-sale

debit transactions, online banking transactions through the Internet, payroll cards, and
most consumer-initiated telephone transfers.
9. Constance Gardner has a single checking account for $10 000, a single savings
account for $30 000, and a single certificate of deposit for $35 000. She also has three
joint accounts for $125 000, $75 000 and $50 000. Because there are two owners for
each account, her interest is half of the balances or $125 000 of the $250 000 total. Her
insured interest in the joint accounts is $100 000. Is the remaining $25 000 uninsured ?
The remaining $25 000 is insured. It will be treated as being owned by Constance as an
individual and added to the total of her other single-ownership-accounts, which is $75
000. Thus, the $25 000 that is uninsured under the joint account rules will be insured
under the single account ownership rules. Constance is insured for $200 000.
1. What five things make a check negotiable ?
Negotiable checks are (a) payable to bearer or to order

(b) an unconditional order to pay
(c) payable for a specific (fixed) amount of money
(d) payable on demand or at a definite date
(e) in writing and signed by the drawer
2. Who are the parties to a check ?
The parties to a check are the drawer, the payee and the drawee. The drawer writes the
check. The payee is the one to whom the check is written. The drawee is the bank that
holds the drawer’s account and pays the check.
3. What is the difference between a blank endorsement and a special endorsement ?

Discuss when each is used.
A blank endorsement consists simply of the signature of the payee or other holder of the
instrument. A blank endorsement can be used for any purpose & allows flexibility and
ease of transfer. In a special endorsement, the holder both signs the instrument and names
the party to whom rights to the instrument are being transferred.
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4. What are the differences between cashier’s checks, teller’s checks, certified checks ?
Cashier’s checks are issued by a national bank and drawn on that bank. The bank is both
drawer and drawee. Teller’s checks are issued by one bank but drawn on another bank.
The issuing bank has the same obligation for teller’s checks as for cashier’s checks.
A certified check is a customer’s check previously accepted by the bank on which it is

drawn. The drawee sets funds aside from the customer’s account to a “certified checks
outstanding” account, and places an official stamp or signature on the check. The
original order to pay becomes the bank’s promise to pay.
5. In check preparation, proofing and encoding, the depositary bank performs what
functions ?
Check (item) preparation includes removing staples, paper clips, and rubber bands. All
items are arranged to face forward and right side up. Only items that are to be captured
are sent through the proofing and encoding function. During proofing, each transaction is
reviewed to see that the dollar amount of the debits equals the dollar amount of the
credits. This is where errors in addition, extra items not reflected on the deposit ticket,
and items listed but not included are found. During encoding, MICR data are imprinted
on checks. High-speed reader-sorters can then read the MICR data and capture
information, such as the amount, account numbers, and check numbers, which expedites
transaction posting and disposition of check clearings. Today, banks have changed or are
changing this process, to include check imaging technology and electronic transmission
of check data, a process begun with Check 21.
6. What are some examples of checks that might be rejected from the normal posting
process and require handling as exception items ?
Checks may require special handling as exception items because, for example, the funds
available in the account may be insufficient to pay the check, an uncollected balance may
not leave a sufficient balance in the account to pay the check, there may be a stop
payment on the check, or there may be a hold placed on the account.
7. What is dual custody ? Provide an example of where it is used.
Dual custody (dual control) is a security technique that uses two or more individual
parties operating together to protect sensitive functions, information or assets. Both
parties are equally responsible for physically protecting materials in vulnerable
transactions. Currency is prepared for shipment and received using dual custody.
8. What are at least three signs of a fraudulent check ?
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Any of the following may apply :
- Check lacks perforations, is stained or discolored, or has an odd “feel”. Most check
paper has the same weight and texture.
- Check number is either missing, does not change, or is low, between 100 and 500.
90% of returned checks have low check numbers. Low check numbers indicate a
recently opened account and, therefore, a potentially riskier check.
- The font used to print the customer’s name looks visibly different from the font used to
print the address.
- Additions to the check are hand written.
- Customer’s address or bank’s address is missing.
- There is evidence of erasures or alterations.
- MICR numbers are missing or are shiny. Fraudulent checks often substitute regular
tones or ink for magnetic ink.
- MICR encoding does not match the check number, the bank district, or the routing
symbol in the upper right-hand corner of the check.
- The name of the payee appears to have been printed by a typewriter. Most payroll,
expense, and dividend checks are printed by computer.
- The word VOID appears across the check.
- The check lacks an authorized signature.
1. How are electronic funds transfers (EFTs) and Automatic Clearing House (ACH)
services related ?
Banks use EFTs to borrow from each other, invest surplus funds, settle clearing balances
in the check collection process, and provide fast and efficient transfer services for
depositors. ACH services are the channel through which banks perform these services,
forwarding information from theur own customers in batches to either the Fed or the
privately owned ACH, which processes, distributes, and settles the transactions
electronically.
2. How do contactless payment devices work ?
RFID technology transmits information a few inches from a card carried by a customer to
a card reader at a retailer. The customer does not have to swipe the card (although most
contactless cards also can be swiped), let go of it, sign a receipt, or input a personal
identification number. Because of their convenience, they are used for small-ticket items
such as fast food purchases.
3. How is check imaging used ?
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Technology now can scan a paper check and create an electronic image, which then is
transferred as an electronic file for collection. Many businesses now make deposits using
check imaging, also called remote deposit capture (RDC) or check truncation, using
scanners that capture both sides of the check.
4. How do Fedwire and CHIPS work ?
Fedwire Funds Service is an EFT settlement system used mainly to settle participants’
accounts. It is used to transfer time-critical third-party payments to bank customers, and
U.S government and federal agency securities, almost all of which exist only in electronic
form. The Fedwire Securities Service provides safekeeping, transfer, and settlement
services for certain government, government-sponsored, and international organizations
for which the Federal Reserve banks act as fiscal agents. CHIPS handles funds transfers
in the international dollar market for its member institutions.
5. What Fed regulations apply directly to electronic banking ?
FRS Regulation E covers EFTs, FRS Regulation CC implements the Expedited Funds
Availability Act, and FRS Regulation J applies to check collection and funds transfers.
Other regulations that apply to traditional banking methods also apply to electronic
banking, as do the federal privacy laws.
6. How do virtual banks operate ?
Virtual banks operate only online, they have no physical branches. Customers make
deposits primarily through direct deposit and automatic transfers from accounts at brick-
and-mortar banks. Withdrawals are made online or by phone.
CHAPTER 7 LENDING
1. Why is the lending function so important to banks ?
The lending function is important to banks because :
- Of the 3 cornerstones of banking - the deposit, payment, and lending functions – the
lending function represents the most significant source of income.
- Lending is one of the most traditional elements in the relationship between a bank and
its customers.
- Under the Community Reinvestment Act, banks are evaluated and given a public
rating on their record of helping to meet the credit needs of their communities :
individuals, small businesses, small farms, low-to-moderate-income consumers.
- The quality of a bank’s loan portfolio often is critical to its survival.
- Lending is essential to the functioning of a healthy growing economy.
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2. What is the difference between open-end and closed-end credit ? Give some examples
of each type of consumer loan
Open-end credit is a revolving line of credit on which a customer may draw for a
specified period. The balance may fluctuate from zero to a set maximum.Two examples
of open-end credit are home equity lines of credit and credit cards. Closed-end loans
involve an agreement with the customer specifying the total amount of the loan, the
maturity date, the number of payments, and the dates payments are due. Automobile and
home equity loans are examples of closed-end loans.
3. Why are home equity loans and lines of credit popular ?
Interest paid on these loans may be tax-deductible. The interest charged is lower than for
other loan products, because the loan is secured by the customer’s residence.
4. If a business wants to purchase a piece of equipment, what loan type is appropriate –

working capital or term loan ? Why ?
A long-term loan is appropriate, because the funds are for long-term use of the
equipment. These loans have maturities of up to 5 years. Working capital loans are short-
term (typically 90 days) and generally are used to purchase raw materials or finance other
immediate needs.
4. Name the Five Cs of credit. Is collateral the most important C ? Why or why not ?
The Five Cs of credit are : character, capacity, collateral, capital, and conditions. A loan
request should not be approved solely on the basis of the value of collateral. Collateral
should be viewed as a secondary source of repayment.
6. What kinds of payment protection are available to consumers ?
Payment protection may be an insurance or a fee-based product. Credit insurance is

issued by an insurance company and may cover life, disability, and loss of income. Fee-
based credit protection and bank products include debit cancellation (DCA) and debt
suspension agreement (DSA).
7. What are some activities involved in loan administration ?
Loan administration activities include :
- mailing regular statements.

- receiving and posting specific payments.
- keeping address information current.
- ensuring that the bank’s security interest is recorded, filed, and returned to the bank.
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- answering customer inquiries.
- reporting the loan to credit reporting agencies.
- maintaining documentation by internal and external auditors and regulators.
- taking the loan off the books when the final payment is received.
8. What is the function of loan review ?
The loan review area examines loan documents to ensure accuracy, completeness, and
conformity with bank loan policy and state and federal laws and regulations. It gives
bank management and directors assurance that :
- lending officers are staying within their authority.

- lending policy, procedures, laws and regulations are being followed.
- investigation and analysis are adequate.
- all necessary documentation on each loan has been properly obtained and filed.
9. What roles does the bank’s board of directors play in the lending function ?
The bank’s board of directors represents the highest authority on lending policy. The
directors’ responsibilities include :
- determining the types of loans to be made.

- tightening credit standards when warranted.
- establishing and monitoring legal lending limits and minimum loan amounts.
- setting loan policy.
- assigning credit authority.
- authorizing all loans above a stipulated amount.
- reviewing the loan portfolio to ensure that the bank is meeting local credit needs and
complying with CRA.
- conducting periodic reviews and audits.
10. What are some laws with which loan officers must comply when making a mortgage
loan ?
The Equal Credit Opportunity Act, Truth in Lending Act, Community Reinvestment Act,
Home Mortgage Disclosure Act, and Real Estate Settlement Procedures Act are among
the laws that affect home mortgage lending
CHAPTER 8 PERSONAL FINANCIAL PLANNING
1. Are Americans spending more than they save, and who is concerned ?
Yes. In 2005, for the first time in decades Americans began spending more than they
saved. This “dis-saving” trend is a concern to federal and state governments, employees,
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and the general public. Efforts are now underway to educate Americans of all ages and
income levels on the value of saving.
2. What factors and effects must be taken into account in financial planning ?
Financial planning must take into account the customer’s age and risk tolerance level, and
recognize the potential effects of inflation, appreciation, interest, and the time value of
money. When selecting investment options, the risk / return tradeoff also must be taken
into account.
3. What are a financial planner’s ethical responsibilities ?
Financial planners must behave ethically by providing objective information

uncontaminated by the knowledge that certain financial products offer greater income for
the bank. Bankers must be careful not to stray into areas beyond their professional
expertise and licensed qualifications, such as giving specific legal advice that is more
appropriate coming from a lawyer, or tax advice that is more appropriate coming from a
certified public accountant.
4. What are the preliminary steps in financial planning ?
The financial planning process begins with an analysis of the customers’s current
position, or net worth, and then his or her financial needs and goals. With this
information, cash flow and investment strategies are developed and incorporated into the
plan. The customer and required experts put the plan into action. The plan should be
reassessed, usually annually, for needed modifications.
5. What is the purpose of life insurance and who needs it ?
Life insurance replaces the income the policy holder contributed to the family before he
or she died. Single people with no dependents usually need only enough insurance to
cover funeral expenses, unpaid debts. Adults with dependents may need more to ensure
that their dependents’ future living expenses including caregiving, are covered.
6. What are the 3 investment strategies & motivations that influence investment choice ?
The 3 basic investment strategies are conservative, aggressive and speculative. The
customer’s risk tolerance level, defined by life stage, personal circumstances and
financial plan goals, determines the investment strategy. Common motivations are to
safeguard or increase principal, produce income, or pursue high returns.
7. What are the 2 basic types of personal trust ?
Testamentary and living trusts are the 2 basic types of personal trusts. Testamentary trusts
are created under the terms of a decedent’s will. As trustee, the bank is responsible for
managing assets turned over to it by the executor or administrator, and for payouts to the
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beneficiaries as specified in the will. Living trusts are trusts created by living individuals
who execute a trust agreement and transfer property to the trust. Individuals who set up
living trusts want to avoid the details of probate or keep transfers private.
8. How do banks deliver investment products ?
Bank subsidiaries or financial holding company affiliates may offer investment and
brokerage services through third parties, joint ventures and in-house organizational
structures. If the delivery is through a third party, a licensed brokerage firm operates on
the bank’s premises, paying the bank a fee. With a joint venture, the bank arranges with a
broker-dealer to sell securities, with employees working for either the bank or the broker-
dealer. Employees working for a broker-dealer generally are licensed and registered
representatives who have taken qualifying exams. A licensed broker-dealer must
supervise brokerage functions performed by bank employees. If operated as an in-house
function, the bank sells brokerage products through its own discount or full-service
brokerage, formed either as bank subsidiary, or as a holding company affiliate .
9. What are the requirements for the sale of retail nondeposit investment products ?
Banks selling investment products must take a number of precautions, including :
- marketing nondeposit investments in a way that does not mislead or confuse customers
about the products or the risks, including separating retail deposit-taking and retail
nondeposit sales functions.
- prohibiting bank employees, such as tellers, from offering investment advice.
- refraining from offering uninsured retail investment products with a product name
identical to the bank’s name.
- conspicuously disclosing that investment products are not FDIC-insured, are not
obligations of, or guaranteed by the bank & carry the risk of possible loss of principal.
CHAPTER 9 BUSINESS AND INTERNATIONAL BANKING SERVICES
1. What types of cash management services help a corporate customer optimize the
interest earned by deposits, or reduce the interest expense of loans ?
Controlled disbursement and zero balance accounts help businesses optimize day-to-day
cash management, by establishing an automated link between different disbursements, or
zero balance accounts and a cash concentration account or a line of credit. When there are
more funds than needed in the disbursement or zero balance accounts, they are
automatically transferred to a concentration account, usually an interest-earning or
investment account, or are used to reduce the balance on a line of credit. Cash
concentration services allow a business that has accounts at many banks to pool surplus
balances in a concentration account that can be invested at a higher rate of return than
the business could otherwise earn on separate smaller accounts.
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2. What check imaging advance is rapidly gaining acceptance in the business community
and changing the way banks deliver cash management services ?
Remote deposit capture, known as point of purchase (POP), account reconciliation entry
(ARE), and bank office conversion (BOC). is changing the way banks provide cash
management services.With this service, a business can convert payments into check
images or ACH data, at either the point of purchase or off-site locations such as an
accounts receivable office in company headquarters, or a third-party processing center,
including those run by banks. The check data proceeds through the ACH system for
collection and payment. The service reduces collection time, expedites deposits, and
reduces processing costs for businesses and banks.
3. What is the purpose of key person insurance ?
A company purchases key person insurance on employees whose loss, by death or from
disability, would financially hurt the company. Executives and other employees with
managerial or technical expertise usually are insured. Proceeds from a key person policy
can be used to recruit and train replacements, help replace lost profits, and reassure
creditors and suppliers about the continuity of the business.
4. What types of customers need capital market services ? What are some examples of
capital market services that banks provide ?
Capital market services are useful to corporate customers who need money to finance
operations and growth. Banks help such companies to access public and private equity
and debt markets. Capital market services range from specialized lending to
underwriting, structuring, and distributing corporate debt.
5. What corporate trust services do banks typically provide ?
Banks offer corporate agency services (safekeeping, transfer, registrar, paying agent
services), employee benefit services, such as employee welfare (insurance and payments
for sick leave, vacation, disability, training), and pension programs (defined benefit and
defined contribution plans).
6. What organizational structures can banks use to facilitate delivery of international

banking services ?
Organizational structures banks use for international banking include :
- Edge Act corporations – subsidiaries of national banks used for either foreign trade-
related banking or foreign investment.
- Foreign branch – a branch in another country that is approved by both the Federal
Reserve and the host country, and abides by the laws of both the host country and U.S
banking authorities.
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- Shell branch – a special-purpose overseas branch without a physical location, used for
investment purposes such as Eurodollar deposits.
- International banking facility (IBF) – set up to allow a domestic bank to accept deposits
and offer loans to foreign customers. The accounts of the IBF are separate from the
parent bank’s accounts. Federal Reserve approval is not required but the Fed must be
informed, and the banking facility must abide by its regulations.
- Foreign representative office – an office located in another national capital that does not
provide as many services as a foreign branch. Representatives build business that is
handled by a foreign branch of the bank.
- Foreign subsidiary – a foreign company in which the U.S bank has a majority
ownership interest, or another form of control. It is used when foreign branches are not
allowed.
- Foreign joint venture- a foreign company in which the U.S. bank shares ownership and
management with other banks.
7. How does a letter of credit protect the interests of the buyer and the seller of goods ?
A credit of letter guarantees that the exporter (seller) will be paid, if all the terms of the
contract are met, and that payment on behalf of the importer (buyer) will not be made
until the contract has been fulfilled.
8. Your company is importing widgets from Europe. Each widget costs 100 euros. The
current exchange rate is € 1,00 = $1.15. How much does each widget cost in US
dollars ?
€100 (euros) x $1.15 (US dollar exchange rate) = $ 115.
9. What does UCC Article 5 govern ? What are some sample rules ? Is there an
international law similar to UCC Article 5 ?
UCC Article 5 sets out rules governing letter of credit transactions, including the
agreement of the parties to the transaction, rules on its enforcement, the issuer’s payment
responsibility, and what happens if there is wrongful dishonor. The international rules for
letters of credit that support and supplement Article 5 are the ICC’s UCP 500, Uniform
Customs and Practices for Documentary Credits.
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CHAPTER 10 BANK INVESTMENTS AND PERFORMANCE
1. What is a bank’s largest asset? Its largest liability ? Its largest income and expense
item ?
A bank’s largest asset is loans, which generate the majority of revenues. The largest
liability is deposits, which provide funds for making loans. The largest income item is the
interest received on loans, and the largest expense is the interest paid on deposits. An
increasingly important income item is noninterest fee income. Another large expense
item is salaries and employee benefits.
2. Why is accurate financial data so important to shareholders and investors ? To federal

and state regulators ? To customers ?
Shareholders and investors consider accurate financial data a predictor of growth

potential. Federal and state bank examiners evaluate financial reports to determine a
bank’s true financial condition, and ascertain whether it has sufficient capital. Customers
are concerned about the financial stability of their bank.
3. What would be the consequences if a bank overemphasized liquidity to the detriment of

other factors in funds management ? What would be the consequences of overemphasing
safety at the expense of liquidity and income ?
If a bank emphasized liquidity only, keeping large supplies of currency in its vaults in
case of increasing customer demands for funds, the percentage of deposits available for
lending would shrink. The drop in loanable funds would impair the credit function and
reduce income. If a bank tried to achieve ultimate safety, it would never assume any risk
in putting deposits to profitable use, and the potential to maximize loans would not be
reached. The situation would result in lost income opportunities, and failure to serve the
credit needs of the community.
4. What is the difference between the discount rate and the prime rate ?
The discount rate applies to short-term credit extended by the Federal Reserve to banks.
The prime rate is a base rate that reflects how a bank evaluates such factors as cost of
funds, overhead, loan portfolio risk, and profit objectives.
5. What are at least 3 measures of bank performance other than net income ?
Possible choices are the return on assets ratio, return on equity ratio, capital ratio, net
interest income, and earnings per share.
6. What is the net worth of a bank that has the following assets and liabilities ?
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Cash on hand $ 45 400

Investments $ 76 600
Loans (net of reserve for loan losses) $ 224 300
Fed funds sold $ 35 800
Fixed assets $ 18 900
Other assets $ 12 200
Deposits $ 312 700
Fund funds purchased $ 68 600
Other liabilities $ 4 300
Assets = Liabilities + Net worth or Assets – Liabilities = Net worth

Assets = $413 200 (45 400 + 76 600 + 224 300 + 35 800 + 18 900 + 12 200)
Liabilities = $ 385 600 (312 700 + 68 600 + 4 300)
Net worth = $ 27 600 (413 200 – 385 600)
7. What is the net profit or loss of a bank reporting the following revenues & expenses ?
Interest and fees on loans $ 253 700

Interest and dividends on investments $ 21 100
Interest paid on deposits $ 158 800
Salaries, wages, and benefits $ 70 300
Taxes $ 11 000
Net profit = Revenue – Expenses
Revenue = $ 275 800 (253 700 + 22 100)
Expenses = $ 240 100 (158 800 + 70 300 + 11 000)
Net profit = $ 35 700 (275 800 – 240 100)
8. What are the earnings per share for a bank with an average of 5 360 000 shares
outstanding and net income of $ 21 450 000 ?
Earnings per share = Net income : Average number of shares of stock outstanding
during the period
Earnings per share = 12 450 000 : 5 360 000 shares
Earnings per share = $ 2.32 per share
9. In what three ways are banks improving fee income ?
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They are increasing existing fees, charging for previously free services, and entering fee-
based lines of business.
10. Why is it important for a bank to have a financial plan (a budget) ?
A financial plan or budget allows a bank to plan expenditures carefully and set earning
objectives. A budget is a vehicle planners use to forecast future conditions and achieve
their goals.
11. Why are GAAP necessary ?
GAAP generally accepted accounted principles, have been prepared to ensure that the
information accountants report in financial statements, meets similar accounting
requirements. These rules are for accountants and companies that analyze and summarize
records to make financial statements.
CHAPTER 11 Building relationships : Sales, Marketing and Customer Service
1. Do employees who rarely interact with bank customers have a role in buiding
customer relationship ? Why or why not ?
Employees who perform jobs where there is little direct contact with customers still have
an important role in the relationship-building process. Bank employees who are
responsive to requests from coworkers are providing customer service and supporting
relationship building. Meeting delivery standards is providing customer service and
building relationships. A bank will have difficulty convincing customers that it cares
about their business when back-office personnel regularly make errors.
2. What are some of the ways a bank employee can demonstrate responsiveness to
customer needs ?
Demonstrating responsiveness includes acknowledging customers as they approach,

being ready to help them, listening carefully to understand their needs, taking
responsibility for the problems they present, working as a team member with coworkers
to solve problems promptly and accurately, and resolving special problems in a friendly
and caring manner.
3. What are the benefits of cross-selling and referrals ?
A bank that effectively cross-sells additional products and refers business to other
departments or affiliates, expands its customer relationships, helps customers meet their
financial goals, and sells more products, both immediately and over the long term. When
employees cross-sell and make referrals, customers are given the impression the bank
values their business, and has their financial interests in mind.
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4. What are some of the things customers do in anticipation of making a purchase ?
In anticipation of purchasing a product, customers often look through newspaper

advertisements and Internet websites, talk to other people, and read information
pamphlets and promotional brochures. When contemplating a loan, a customer may
request a loan application. Often a prospective customer will call the bank or approach an
employee in person to solicit information about particular financial products.
5. What is the difference between a product feature and a product benefit ?
A product feature is a characteristic of the product; a product benefit describes how the
product will meet customer needs.
6. What steps are involved in bringing a new product to market ?
Bringing a new product to market entails multiple steps under the direction of a product
development team. The process begins with market research and the profiling of
customers, the market, and the bank’s competitors. The product development team
solicits and screens new product ideas, tests the concept, performs a business analysis,
creates the product, test-markets it, introduces it to the market, and monitors its
performance.
7. Jennifer opened a certificate of deposit with First Trust and Savings Bank on July 3,
2007 and she redeemed it on January 3, 2008. It is her only account with the bank.
According to Do-Not Call, Do-Not-Fax and CAN-SPAM rules, for how long and why
may the bank send her commercial marketing messages ? If Jennifer wishes, what may
she do to stop them ?
By opening an account, Jennifer has established a business relationship with the bank.
The bank may send her telemarketing messages through January 3, 2009. If she wishes to
stop them, she may ask that her name be placed on the bank’s own Do-Not-Call list for
phone and fax solicitations. She also may use the opt-out option that must be made
available to her to stop commercial email solicitations from the bank.
CHAPTER 12 SAFEGUARDING CUSTOMER INFORMATION
1. What are the three components of authentication for high-risk transactions ?
The three components are:
- something the user knows, such as PIN.

- something the user has, such as an ATM card.
- something the user is, such as a biometric characteristic.
82
2. What are some security features banks use to protect customers ?
The most common security features banks use to protect customers are :
- automatic session expiration - automatic account lockout

- direct deposit - e-alerts
- unique security numbers and passphrases - online bill payment and statements
3. What are some best practices implemented in incident response programs ?
Among the best practices implemented in incident response programs are :
- including personnel from various functional areas on the incident response team.
- defining clearly what constitutes an incident requiring an IRP.
- identifying processes to assess risks and the potential impacts.
- specifying procedures for notifying customers, overseeing and coordinating with
third-party service providers, coordinating with law enforcement representatives and
federal regulators.
- planning for a comprehensive program of communications, both internal and external,
in case of a security breach.
4. What are the three most common biometric methods ? Describe each.
The most common biometric methods are :
- voice identification, which compares how a customer speaks a phrase with a

previously recorded template of the customer speaking that phrase.
- keystroke dynamics, which identifies customers by the way they type.
- digital fingerprinting, which captures unique patterns of lines on a fingertip and
compares them with a pattern already stored in a database.
5. What is pharming ?
Pharming is an online fraud scheme in which a consumer can be fooled into entering
sensitive data, such as a passphrase, or credit card number, on a malicious website that
impersonates a legitimate website.
6. What are some methods of identity theft ?
Criminals use both low-and-high-tech methods to exploit a person’s assets and credit.
They divert financial information by simply filing a change of address form with the U.S.
Postal Service, rummage through trash looking for papers with personal information
(dumpster diving), and steal wallets and purses, pre-approved credit card offers, new
checks, and employer personnel records. Many of the fraud schemes, including the high-
83
tech methods, also are used to steal customer identities, such as phishing, pharming,
pretext calling, credit card protection fraud, caller-ID manipulation, bank card fraud.
7. What risk do cell phones represent and what can customers do to protect themselves ?
Because wireless communications are transmitted using radio signals, cell phone
conversations can be intercepted on radio scanners. Newer-model digital phones are less
vulnerable to eavesdropping, but their very convenience tends to make people forget that
cell phone calls are not private. In public places, customers should never provide
sensitive information, such as credit card numbers, using a cell phone. Customers also
should be careful when entering a PIN or handling their credit card, when standing next
to someone using a cell phone, because a thief may use the cell phone’s photographic
capabilities to record the information on the credit card. Customers also can add their cell
phone number to the FTC’s National Do Not Call Registry to prevent calls from
telemarketers.
8. What regulatory protection does FRS Regulation P provide ?
FRS Regulation P, Privacy of Consumer Financial Information, implements the GLBA

financial privacy provisions. Banks are restricted in the ways they may disclose customer
information to third parties. Banks may also must provide privacy policy disclosures to
customers, when the banking relationship is established and annually thereafter.
Customers must be able to opt out of certain disclosures of personal financial
information.
CHAPTER 13 Safeguarding the Bank, the Economy, and the Nation
1. What are CAMELS ? What are some risk categories that can affect CAMELS rating ?
What are the basic elements of risk management ?
CAMELS stand for the factors federal and state bank examiners use to evaluate a bank’s
safety and soundness; they are capital adequacy, asset quality, management quality,
liquidity, and sensitivity to market risk. Numerical ratings for each factor are combined
into a single composite rating.
Factors that can affect a CAMELS analysis are market risk, credit risk, reputation risk,
interest rate risk, liquidity risk, price risk, transaction risk, the risk of crime against the
bank, risks in information technology and other systems, compliance risks.
Key elements of bank risk management are corporate governance; policies, limits,
procedures; use of risk-management techniques and reports, and internal controls.
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2. What is the bank employee’s role in safeguarding bank assets ?
The bank’s expectations for employee conduct, both professionally and personally, are
usually communicated in a code of ethics. The code helps employees decide what is in
the best interests of the bank, rather than their personal interests. Employees should abide
by the policies and procedures established by the board of directors and management to
implement laws, regulations, and other bank-specific safeguards.
3. What is the most basic form of pre-employment screening ?
At minimum, the pre-employment screening verifies references, experience, education,

professional qualifications, and the applicant’s identity. Additional screening processes
are based on the risk factors of a specific job. Similar screening may be continuous, or
scheduled periodically for all employees.
4. What does the FFIEC recommend that banks do to manage vendors beyond due
diligence in executing contracts ?
The FFIEC recommends that banks continuously monitor the vendor’s financial
condition and operations, quality of service and support, contract compliance, and any
emerging needs to revise the contract, and the vendor’s business continuity contingency,
and emergency preparedness plans.
5. What can a bank employee do to prevent robberies ?
To help prevent bank robberies, employees can :
- abide by the bank’s procedures for opening and closing the bank.
- stay alert for suspicious vehicles, people, and circumstances.
- jot down the license number of suspicious vehicles in the parking lot or near the
building.
- greet customers by looking directly into their eyes.
- keep bank procedures and operations confidential.
6. What are some risks to the bank from fraudulent cashier’s checks ?
Risks posed by fraudulent cashier’s check include customer dissatisfaction, reputation

risk, and credit risk.
7. What are some ways banks help federal authorities protect the country against
terrorism ?
Among the many ways banks assist federal authorities, they :
85
- implement policies and procedures against money laundering, in compliance with the
Bank Secrecy Act, such as filing CTRs on transactions exceeding $10 000.
- file SARs on suspicious transactions with FinCEN, in compliance with the USA
PATRIOT Act .
- freeze accounts of sanctioned individuals, organizations, and countries that appear on
the list posted on the OFAC website.
8. Why should banks become involved in local emergency management processes ?
In times of emergency, banks need to work together to share cash reserves, facilities, and
communications systems. They also need to partner as united response forces with other
local industries and local, state, and federal emergency management agencies. The more
banks and other entities plan in advance, the more likely it is that recovery periods can be
shortened. Currently within the first six months of a natural disaster such as a hurricane,
banks experience adverse effects on loan quality, deposit growth, equity capital, and
income. With floods these effects could last for several years.
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PRINCIPLES OF BANKING

CHAPTER 1 : BANKING AND YOU

THE BANK AS AN ORGANIZATION

• Typical bank structure

BANK PRODUCTS AND SERVICES

• Traditional products and services

THE BANK AND THE COMMUNITY

PARTNERSHIPS AND OUTSOURCING

CHAPTER 2 THE U.S. BANKING SYSTEM

BANKING AND THE ECONOMY

US BANKING SYSTEM 1700s-1913

BANKING IN THE 20th CENTURY

• The Great Depression and Bank Protections

BANKING IN THE 21st CENTURY

• Opportunity : Gramm-Leach-Bliley Act

FEDERAL RESERVE SYSTEM

• The Fed’s Structure

SELF-CHECK AND REVIEW

CHAPTER 3 MONEY AND BANKING

THE EVOLUTION OF MONEY

• Coin and currency

THE FUNCTIONS AND PROPERTIES OF MONEY

THE MONEY SUPPLY AND THE ECONOMY

• How the money supply is measured

BANKS AND MONEY CREATION

THE FEDERAL RESERVE AND MONETARY POLICY

SELF-CHECK AND REVIEW

CHAPTER 4 DEPOSIT ACCOUNTS

THE DEPOSIT FUNCTION

DEPOSIT ACCOUNT PRODUCTS

• Types of deposit accounts

• Options for depositing funds

OWNERSHIP OF DEPOSIT ACCOUNTS

• Consumer account ownership

OPENING A DEPOSIT ACCOUNT

SELF-CHECK AND REVIEW

CHAPTER 5 PAYMENTS : CASH AND CHECKS

CASH AS A PAYMENT SYSTEM

• United States legal tender

CHECKS AS A PAYMENT SYSTEM

• Elements of negotiable instruments

THE CHECK PAYMENT PROCESS

ELECTRONIC CHECK PROCESSING

LAWS AND REGULATIONS

• Collection of checks and funds transfers

SELF-CHECK AND REVIEW

CHAPTER 6 ELECTRONIC BANKING

ELECTRONING BANKING – WHAT AND WHO

• The roots of electronic banking

• Card access to funds

• Electronic Bill Presentment and Payment (EBPP)

LAWS AND REGULATIONS

• Electronic funds transfers

SELF-CHECK AND REVIEW

THE LENDING FUNCTION

THE LENDING PROCESS

• The application and the interview

LAWS AND REGULATIONS

• Equal Opportunity Act

SELF-CHECK AND REVIEW

CHAPTER 8 - PERSONAL FINANCING PLANNING

FINANCIAL HEALTH EQUALS PERSONAL WEALTH

• Banks and financial planning

• Customer life stages