Retail Banking, Its Types and Economic Impact

How It Works and How It Affects the U.S. Economy

couple at bank
••• Photo by omgimages/Getty Images

Retail banking provides financial services for individuals and families. The three most important functions are credit, deposit, and money management.

First, retail banks offer consumers credit to purchase homes, cars, and furniture. These include mortgages, auto loans, and credit cards. The resulting consumer spending drives almost 70% of the U.S. economy. They provide extra liquidity to the economy this way. Credit allows people to spend future earnings now.

Second, retail banks provide a safe place for people to deposit their money. Savings accounts, certificates of deposit, and other financial products offer a better rate of return compared to stuffing their money under a mattress. Banks base their interest rates on the fed funds rate and Treasury bond interest rates. These rise and fall over time. The Federal Deposit Insurance Corporation insures most of these deposits.

Third, retail banks allow you, the customer, to manage your money with checking accounts and debit cards. You don't have to do all your transactions with dollar bills and coins. All of this can be done online, making banking an added convenience.

Types of Retail Banks

Most of America's largest banks have retail banking divisions. These include Bank of America, JP Morgan Chase, Wells Fargo, and Citigroup. Retail banking makes up 50% to 60% of these banks' total revenue.

There are many smaller community banks as well. They focus on building relationships with the people in their local towns, cities, and regions. They have less than $1 billion in total assets.

Credit unions are another type of retail bank. They restrict services to employees of companies or schools. They operate as non-profits. They offer better terms to savers and borrowers because they aren't as focused on profitability as the bigger banks.

Savings and loans are retail banks that target mortgages. They've almost disappeared since the 1989 savings and loans crisis

Lastly, Sharia banking conforms to Islamic prohibition against interest rates. So borrowers share their profits with the bank instead of paying interest. This policy helped Islamic banks avoid the 2008 financial crisis. They didn't invest in risky derivatives. These banks cannot invest in alcohol, tobacco, and gambling businesses. 

How Retail Banks Work

Retail banks use the depositors' funds to make loans. To make a profit, banks charge higher interest rates on loans than they pay on deposits. 

The Federal Reserve, the nation's central bank, regulates most retail banks. Except for the smallest banks, it requires all other banks to keep around 10% of their deposits in reserve each night. They are free to lend out the rest. At the end of each day, banks that are short of the Fed's reserve requirement borrow from other banks to make up for the shortfall. The amount borrowed is called the fed funds

How They Affect the U.S. Economy and You

Retail banks create the supply of money in the economy. Since the Fed only requires them to keep 10% of deposits on hand, they loan out the remaining 90%. Each dollar lent out goes to the borrower's bank account. That bank then lends 90% of this money, which goes into another bank account. That's how a bank creates $9 for every dollar you deposit.

As you can imagine, this is a powerful tool for economic expansion. To ensure proper conduct, the Fed controls this as well. It sets the interest rate banks use to lend fed funds to each other. That's called the fed funds rate. That's the most important interest rate in the world. Why? Banks set all other interest rates against it. If the fed funds rate moves higher, so do all other rates.

Most retail banks sell their mortgages to large banks in the secondary market. They retain their large deposits. As a result, they were spared from the worst of the 2007 banking crisis.

Retail Banking History

In the Roaring 20s, banks were unregulated. Many of them invested their depositors' savings in the stock market without telling them. After the 1929 stock market crash, people demanded their money. Banks didn't have enough to honor depositors' withdrawals. That helped cause the Great Depression.

In response, President Franklin D. Roosevelt created the FDIC. It guaranteed depositors' savings as part of the New Deal.

The Federal Home Loan Bank Act of 1932 created the savings and loans banking system to promote homeownership for the working class. They offered low mortgage rates in return for low interest rates on deposits. They couldn't lend for commercial real estate, business expansion, or education. They didn't even provide checking accounts. 

In 1933, Congress imposed the Glass-Steagall Act. It prohibited retail banks from using deposits to fund risky investments. They could only use their depositors' funds for lending. Banks could not operate across state lines. They often could not raise interest rates.

In the 1970s, stagflation created double-digit inflation. Retail banks' paltry interest rates weren't enough of a reward for people to save. They lost business as customers withdrew deposits. Banks cried out to Congress for deregulation.

The 1980 Depository Institutions Deregulation and Monetary Control Act allowed banks to operate across state lines. In 1982, President Ronald Reagan signed the Garn-St. Germain Depository Institutions Act. It removed restrictions on loan-to-value ratios for savings and loan banks. It also allowed these banks to invest in risky real estate ventures. 

The Fed lowered its reserve requirements. That gave banks more money to lend, but it also increased risk. To compensate depositors, the FDIC raised its limit from $40,000 to $100,000 of savings.

Deregulation allowed banks to raise interest rates on deposits and loans. In fact, it overrode state limits on interest rates. Banks no longer had to direct a portion of their funds toward specific industries, such as home mortgages. They could instead use their funds in a wide range of loans, including commercial investments.

By 1985, savings and loans assets increased by 56%. But many of their investments were bad. By 1989, more than 1,000 had failed. The resultant S&L crisis cost $160 billion.

Large banks began gobbling up small ones. In 1998, Nations Bank bought Bank of America to become the first nationwide bank. The other banks soon followed. That consolidation created the national banking giants in operation today.

In 1999, the Gramm-Leach-Bliley Act repealed Glass-Steagall. It allowed banks to invest in even riskier ventures. They promised to restrict themselves to low-risk securities. That would diversify their portfolios and lower risk. But as competition increased, even traditional banks invested in risky derivatives to increase profit and shareholder value.

That risk destroyed many banks during the 2008 financial crisis. That changed retail banking again. Losses from derivatives forced many banks out of business.

In 2010, President Barack Obama signed the Dodd-Frank Wall Street Reform Act. It prevented banks from using depositor funds for their own investments. They had to sell any hedge funds they owned. It also required banks to verify borrowers' income to make sure they could afford loans. 

All these extra factors forced banks to cut costs. They closed rural branch banks. They relied more on ATMs and less on tellers. They focused on personal services to high net worth clients and began charging more fees to everyone else.