How the Banking Sector Impacts Our Economy

Banks help keep the economy running smoothly—and can also send it crashing

What Is the Banking Sector?

The banking sector is a major segment of the U.S. and world economies. While some might define it more broadly, the U.S. Department of Commerce considers it a subsector of the larger financial services industry, which also includes subsectors focusing on asset management, insurance, venture capital, and private equity.

The U.S. banking system alone had $17.9 trillion in assets and a net income of $236.8 billion as of the end of 2018, the Commerce Department notes, and “supports the world’s largest economy with the greatest diversity in banking institutions and concentration of private credit anywhere in the world.”

The principal economic functions of the banking sector are to take deposits and make loans.

Key Takeaways

  • The banking sector is vital to the U.S. and world economies.
  • Its primary function is to safeguard depositors’ assets and make loans to individuals and businesses.
  • Banks are regulated by the federal government, and sometimes state governments, to try to keep them from taking on too much risk and imperiling the economy.

How Banking Works

Holding financial assets is at the core of all banking, and where it began in ancient times—though it has expanded far beyond the days of storing gold coins for wealthy patrons.

At the most basic level, a bank takes deposits from individuals or businesses, with the promise that the money can be withdrawn when the depositor wants it (though sometimes with a penalty for early withdrawal). Depending on the type of account, the bank also may pay interest on the depositor’s money.

The bank then lends the money it has on deposit to other individuals and businesses and receives interest payments from the borrower in return. Banks make a profit on the difference between the interest rate that they pay depositors for the use of their money and the higher interest rate that they charge borrowers.

By law, banks cannot lend out all of the money in their possession, but are required by regulators to keep a certain amount of capital in reserve to cover withdrawals and other needs. The rules change from time to time and vary by the size of the bank, but many large U.S. banks recently were required to keep 8% of their capital in reserve.

In addition to making loans, banks can invest their own money in other kinds of assets, such as government securities.

How Do Banks Drive the Economy?

The banking sector is crucial to the modern economy. As the primary supplier of credit, it provides money for people to buy cars and homes and for businesses to buy equipment, expand their operations, and meet their payrolls.

Banks also provide depositors with a safe place to keep their money (particularly since the advent of the Federal Deposit Insurance Corp. (FDIC), which insures many accounts up to certain limits) as well as to earn some interest on it.

The credit cards, debit cards, and checking accounts that banks make available facilitate all kinds of everyday transactions. They also help drive ecommerce, where cash is of little use.

The banking sector is also a major employer. In 2020, for example, FDIC-insured commercial banks alone employed nearly 2 million people in the United States.

On the negative side, the banking sector also has the capability of doing enormous harm to the economy. In the subprime mortgage meltdown that began in 2007, for example, reckless lending on the part of some banks sent the economy into a tailspin and triggered the Great Recession of 2007–2009. Regulatory reforms enacted since that time may help avert a similar crisis in the future.

How Banks Are Regulated

Because of the vital role that banks play in the economy, governments around the world have laws in place to try to prevent them from engaging in excessively risky behavior. In the United States, for example, banks are regulated by an assortment of federal and state agencies, depending on the type of bank.

The federal regulators include the Federal Reserve System, the Office of the Comptroller of the Currency, and the FDIC. Credit unions, which also may be considered part of the banking sector, are regulated by the National Credit Union Administration.

State-chartered banks fall under the jurisdiction of state banking regulators and supervisors. Some banks are regulated on both state and federal levels.

Major Companies in the Banking Sector

Banks range dramatically in size, from the small-town corner bank to international behemoths, sometimes referred to “global systemically important banks” or banks considered “too big to fail” because of the havoc that their failure could supposedly cause to the world economy.

In the United States today, the five largest banks are JPMorgan Chase, Bank of America, Wells Fargo, Citibank, and US Bank. All but the last hold assets in excess of $1 trillion.

Why are banks called banks?

Some believe the word “bank” comes from banca, the Italian word for bench. Merriam-Webster says banca also referred to “the benchlike counter at which an early money changer transacted business.”

What are the different types of banks?

The common types of banks include central banks, commercial banks, and investment banks. Central banks are government institutions, like the U.S. Federal Reserve, whose role is to regulate their nation’s money supply. Commercial banks are what most of us think of as banks, taking in deposits and issuing loans. Investment banks generally work with companies to help them issue stock or find financing. Large banks often have divisions for both commercial and investment banking.

How many banks are there in the United States?

There were 4,301 Federal Deposit Insurance Corp. (FDIC)-insured commercial banks in the United States as of September 2021. That number is dramatically down from previous decades, due to mergers, consolidations, and bank failures. In 1984, the U.S. had more than 14,000 commercial banks.

The Bottom Line

The banking sector has been important to nations’ economies since ancient times, particularly in safeguarding wealth and providing credit to individuals and businesses. Countries, including the United States, have regulations aimed at keeping banks from getting into financial trouble and dragging down the entire economy. Those regulations have met with mixed success over the years but continue to be refined.

Article Sources

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