Quiz 12: Inflation: How to Gain and Lose at the Same Time
At any given time, there are some individuals who have more money than they immediately require for purchases, leaving them with a certain amount that they would save. At the same time, there are other individuals who need money for various purposes, meaning that there is an amount that they would borrow. Commercial banks are called financial intermediaries because they act as a mediator between savers and borrowers to meet the needs of both groups. Savers make deposits in a bank with the expectation of receiving an interest payment in exchange for allowing the bank to hold on to the money. At the same time, the bank lends a portion of that deposit to borrowers, who repay the loan with interest. The bank earns a profit by bringing in more interest from borrowers than it pays to savers.
Commercial banks receive deposits from and offers loans to consumers. An example of a commercial banking activity would be an individual opening a checking account, making deposits into that account, and writing checks based on that balance. Another example would be of a consumer taking a loan from a bank to purchase a car or a house. Investment banks do not receive deposits, but instead has the brokerage functions of selling stock and bonds on behalf of corporations. An example of an investment banking activity would be a corporation making an initial public offering of its stock using an investment bank as the agent to facilitate the sale to the public. Another example would be of an investor using the bank as a broker to purchase stocks. In the United States, commercial banking and investment banking could not be undertaken by the same institution, because of the Glass-Steagall Act of 1933 that prohibited commercial banks from investment banking activities and vice versa. Glass-Steagall was repealed in 1999. Afterward, commercial and investment banks could begin performing a variety of additional financial functions. Many large institutions were created through mergers in this time, concentrating a great deal of assets in a relatively small number of banks. The financial crisis of 2008, which was spurred by the collapse of the housing market, affected investment banks because many of these owned the mortgage debts that many homeowners were unable to pay during the rate increases occurring at the time. The crisis meant that many investment banks were close to failing. The Federal Reserved intervened in the case of some banks, while another large bank collapsed. In response to the 2008 financial crisis and the damage caused to the economy, the Dodd-Frank Act was passed in 2010, which had the objectives of protecting consumers and making the financial system more open and accountable. The Act created the Financial Stability Oversight Council, which provides oversight over federal agencies that regulate the financial system and organizes regulatory activity. Under this legislation, investment banking became subject to a new set of regulations and requirements.
Bonds are loans that individuals and businesses make to corporations, state and local governments, and the US treasury, which are paid back with interest over time. Bond holders receive incremental payments from the recipient of the loan until it has been paid back in full, with interest. The bondholder does not "own" a part of the company, unlike in the case of stocks. Stocks are shares of ownership in a company that the buyer continues to possess as long as the company exists, or until the stockholder decides to sell it. Stockholders make money from stocks by receiving dividends from the company. A dividend is a share of the profit earned by the company. Stockholders also earn money when the value of their stock appreciates, and they are able to sell shares for more than they paid for them. Unlike bondholders, stockholders are not "paid back" their original investment directly, but rather they own a stake in the company.