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Bank Accounts

Bank Accounts

An intermediary is one who stands between two other parties; for example, a person who arranges a blind date between two other people is one kind of intermediary. In financial capital markets, banks are an example of a financial intermediary—that is, an institution that operates between a saver who deposits funds in a bank and a borrower who receives a loan from that bank. When a bank serves as a financial intermediary, unlike the situation with a couple on a blind date, the saver and the borrower never meet. In fact, it is not even possible to make direct connections between those who deposit funds in banks and those who borrow from banks, because all funds deposited end up in one big pool, which is then loaned out.

This figure illustrates the position of banks as a financial intermediary, with a pattern of deposits flowing into a bank and loans flowing out, and then repayment of the loans flowing back to the bank, with interest payments for the original savers.

Banks as Financial Intermediaries

The illustration shows the circular transactions between savers, banks, and borrowers. Savers give deposits to banks, and the bank provides them with withdrawals and interest payments. Borrowers give repayment of loans and interest payments to banks, and the banks provide them with loans.

Banks are a financial intermediary because they stand between savers and borrowers. Savers place deposits with banks, and then receive interest payments and withdraw money. Borrowers receive loans from banks, and repay the loans with interest.

Banks offer a range of accounts to serve different needs. A checking account typically pays little or no interest, but it facilitates transactions by giving you easy access to your money, either by writing a check or by using a debit card (that is, a card which works like a credit card, except that purchases are immediately deducted from your checking account rather than being billed separately through a credit card company). A savings account typically pays some interest rate, but getting the money typically requires you to make a trip to the bank or an automatic teller machine (or you can access the funds electronically). The lines between checking and savings accounts have blurred in the last couple of decades, as many banks offer checking accounts that will pay an interest rate similar to a savings account if you keep a certain minimum amount in the account, or conversely, offer savings accounts that allow you to write at least a few checks per month.

Another way to deposit savings at a bank is to use a certificate of deposit (CD). With a CD, as it is commonly called, you agree to deposit a certain amount of money, often measured in thousands of dollars, in the account for a stated period of time, typically ranging from a few months to several years. In exchange, the bank agrees to pay a higher interest rate than for a regular savings account. While you can withdraw the money before the allotted time, as the advertisements for CDs always warn, there is “a substantial penalty for early withdrawal.”

This figure shows the annual rate of interest paid on a six-month, one-year, and five-year CD since 1984, as reported by Bankrate.com. The interest rates paid by savings accounts are typically a little lower than the CD rate, because financial investors need to receive a slightly higher rate of interest as compensation for promising to leave deposits untouched for a period of time in a CD, and thus giving up some liquidity.

Interest Rates on Six-Month, One-Year, and Five-Year Certificates of Deposit

The graph shows that interest rates for 6-month, 1-year, and 5-year CDs were highest between 1984 and 1986 with rates exceeding 9%. Today, they each have interest rates below 1.8%.

The interest rates on certificates of deposit have fluctuated over time. The high interest rates of the early 1980s are indicative of the relatively high inflation rate in the United States at that time. Interest rates fluctuate with the business cycle, typically increasing during expansions and decreasing during a recession. Note the steep decline in CD rates since 2008, the beginning of the Great Recession.

The great advantages of bank accounts are that financial investors have very easy access to their money, and also money in bank accounts is extremely safe. In part, this safety arises because a bank account offers more security than keeping a few thousand dollars in the toe of a sock in your underwear drawer. In addition, the Federal Deposit Insurance Corporation (FDIC) protects the savings of the average person. Every bank is required by law to pay a fee to the FDIC, based on the size of its deposits. Then, if a bank should happen to go bankrupt and not be able to repay depositors, the FDIC guarantees that all customers will receive their deposits back up to $250,000.

The bottom line on bank accounts looks like this: low risk means low rate of return but high liquidity.

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