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Capital, Savings, and Investment, Matching Borrowers and Lenders in Financial Markets
Bank failures, Federal Deposit Insurance Corporation, main way, Great Depression, wage earners
Households save money for several reasons: to provide a cushion against bad times, as when wage earners or others in the household become sick, injured, or disabled; to pay for large expenditures such as houses, cars, and vacations; to set aside money for retirement; or to invest. Banks and other financial institutions compete for households’ savings deposits by paying interest to the savers. Then banks lend those funds out to borrowers at a higher rate of interest than they pay to savers. The difference between the interest rates charged to borrowers and paid to savers is the main way that banks earn profits.
Of course banks must also be careful to lend the money to people and firms that are creditworthy—meaning they will be able to repay the loans. The creditworthiness of the borrower is one reason why some kinds of loans have higher rates of interest than others do. Short-term loans made to people or businesses with a long history of stable income and employment, and who have assets that can be pledged as collateral that will become the bank’s property if a loan is not repaid, will receive the lowest interest rates. For example, well-established firms such as AT&T often pay what is called the bank’s prime rate—the lowest available rate for business loans—when they borrow money. New, start-up companies pay higher rates because there is a greater risk they will default on the loan or even go out of business.
Other kinds of loans also have greater risks of default, so banks and other lenders charge different rates of interest. Mortgage loans are backed by the collateral of the property the loan was used to purchase. If someone does not pay his or her mortgage, the bank has the right to sell the property that was pledged as collateral and to collect the proceeds as payment for what it is owed. That means the bank’s risks are lower, so interest rates on these loans are typically lower, too. The money that is loaned to people who do not pay off the balances on their credit cards every month represents a greater risk to banks, because no collateral is provided. Because the bank does not hold any title to the consumer’s property for these loans, it charges a higher interest rate than it charges on mortgages. The higher rate allows the bank to collect enough money overall so that it can cover its losses when some of these riskier loans are not repaid.
If a bank makes too many loans that are not repaid, it will go out of business. The effects of bank failures on depositors and the overall economy can be very severe, especially if many banks fail at the same time and the deposits are not insured. In the United States, the most famous example of this kind of financial disaster occurred during the Great Depression of the 1930s, when a large number of banks failed. Many other businesses also closed and many people lost both their jobs and savings.
Bank failures are fairly rare events in the U.S. economy. Banks do not want to lose money or go out of business, and they try to avoid making loans to individuals and businesses who will be unable to repay them. In addition, a number of safeguards protect U.S. financial institutions and their customers against failures. The Federal Deposit Insurance Corporation (FDIC) insures most bank and savings and loan deposits up to $100,000. Government examiners conduct regular inspections of banks and other financial institutions to try to ensure that these firms are operating safely and responsibly.
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