VII. Depository Institutions

• A firm that takes deposits from households and firms and makes loans to other households and firms is called a depository institution. There are three types of depository institutions whose deposits are money: commercial banks, thrift institutions, and money market mutual funds.

Commercial Banks

• A commercial bank is a firm that is licensed to receive deposits and make loans. In 2008 there are about 7,000 commercial banks but that number has been trending downward. The deposits of commercial banks account for 37 percent of M1 and 61 percent of M2.

• Banks accept deposits and then divide these funds into reserves (cash in the vault plus its deposits at the Federal Reserve), liquid assets (such as Treasury bills and commercial bills), securities (such as U.S. government bonds and mortgage-backed securities), and loans (made primarily to corporations for purchases of capital equipment and to households to finance homes, consumer durable goods, and credit cards). Loans are the riskiest of a bank’s assets. As a percentage of deposits, on June 30, 2010 reserves were 14.3 percent, liquid assets were 1.3 percent, securities and other assets were 39.5 percent, and loans were 89.2 percent. (The percentages sum to more than 100 percent because deposits are just one source of funds; borrowing and the banks’ own capital are other sources of funds and are equal to about 50 percent of deposits.)

Thrift Institutions

The thrift institutions are savings and loan associations, savings banks, and credit unions.

Money Market Mutual Funds

A money market mutual fund is a fund operated by a financial institution that sells shares in the fund and holds liquid assets such as U.S. Treasury bills and short-term commercial bills.

The Economic Functions of Depository Institutions

• Depository institutions make a profit from the spread on the interest rate at which they lend over the interest rate they pay on deposits. The spread reflects four services provided by depository institutions:

· Create Liquidity: Most assets are less liquid than liabilities, so depository institutions turn less-liquid funds into more liquid funds.

· Lower the Cost of Borrowing Obtaining Funds: Depository institutions lower transaction costs of matching borrowers and lenders.

· Lower the Cost of Monitoring Borrowers: Depository institutions lower transaction costs by specializing in monitoring risky loans.

· Pool Risk: The costs of defaults on loans are spread across all depositors, instead of being borne by individual lenders.

Financial Innovation

• The development of new financial products is called financial innovation. Some innovation has been a response to economic circumstances such as high inflation and high interest rates in the 1970s. Others, such communications networks which have spread the use of credit cards, are the result of advances in technology. Still others, such as sub-prime mortgages, were developed during the 2000s.

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