Depository institutions

Definition & Types of Depository Institutions

Depository Institution: a financial firm in the US that accepts deposits from households and businesses. These deposits can be components from M1 and M2.

There are three types of depository institutions:

1. Commercial Banks: a firm that is licensed to take deposits and make loans.
   
   Deposits from commercial banks make 40% of M1 and 65% of M2.


2. Thrift Institutions: consists of savings bank, savings and loan association, and as well as credit unions.
   
   
   1. Savings bank: is a depository institution that accepts savings deposit and make home-purchase loans.
   
   
   2. Savings and loan association: is a depository institution that takes deposits and make commercial, personal, and home-purchase loans.
   
   
   3. Credit Union: is a depository institution that takes savings deposits and personal loans.
   
   Deposits from thrift institutions make 9% of M1 and 16% of M2.


3. Money Market Mutual Funds: A financial institution manages this fund, sells shares in the fund and hold assets like short-term commercial bills.
   
   Mutual funds shares act like a bank deposit, where shareholders can put money in or write checks. However, there are a lot of restrictions on these accounts.
   
   Money market mutual funds make 0% of M1 and 9% of M2.

Assets of Depository Institutions

Depository institutions make money from service fees of check clearing, account management, and credit cards. However, most of the income gained is from using the deposits to make loans and buy securities that earn higher interest rates than the ones paid to depositors.

To sustain the amount of depositor’s withdrawals, and loans and securities, the depository institution must perform a balancing act.

To see the balancing act clearly, we look at the assets of a commercial bank.

1. Bank Reserves: are coins and notes in the bank’s vault or deposit account at the Federal Reserve. These funds are used to meet depositor’s withdrawals of currency, and payments of other banks.
   
   Normally, the bank keeps 0.5% of deposits as reserves.


2. Liquid Assets: are cash, or assets that can be converted to cash easily and sold with little to no risk of loss. With liquid assets, banks can
   1. Meet reserve requirements (0.5% or higher)
   2. Use liquid assets to make overnight loans to other banks if their reserve requirements are not met. Since the risk is very low, overnight loan interest rates are very low as well.

Note: The interest rate on overnight loans to other banks are also known as the federal funds rate.


3. Securities: are government bonds and other types of bonds like mortgage-backed securities. These assets can be sold and converted to reserves like liquid assets. However, since the prices changes irregularly, the interest rate is high.


4. Loans: Loans are the riskiest assets, but they are also the highest earning assets. This is because loans can’t be converted to reserves unless they are repaid, and some borrowers never pay back.

Benefits & Regulation of Depository Institutions

Depository institutions give 4 benefits:

1. Create Liquidity: depository institutions take deposits and are ready to repay people with short notice, or if there is a high demand. In addition, they make loan commitments that run for many years (borrow short, lend long).


2. Pool Risk: There is also a risk that a loan may not be repaid, which we call a default.
   
   Loaning to one person who defaults means you lose the entire loan amount. However, loaning to 1000 people and having one default means you lost almost nothing.


3. Lowers the Cost of Borrowing: Suppose a firm needs a large sum of money, like 2 million. Without a depository institution, the firm would have to borrow from dozens of people to reach that amount. Depository institutions lowers the cost of searching by lending the entire 2 million to this firm.


4. Lowers the Cost of Monitoring Borrowers: When a lender monitors a borrower, the lender can suggest good decisions for the borrower to prevent defaults. However, monitoring is very costly, especially if they monitor every individual that borrows money. Depository institutions can do this at a way lower cost.

Regulation of Depository Institutions: Since depository institutions are dealing with a risky business and have the potential to damage the economy, they must minimize this risk. They do so by meeting reserve requirements.

If a depository institution fails, then each depository is guaranteed up to $250,000 per bank by the Federal Deposit Insurance Corporation (FDIC).