Chapter 5

Banking and
Interest Rates

Copyright 2004 Pearson Education, Inc. All rights reserved.

Chapter Objectives
Describe the functions of financial
institutions
Identify the components of interest
rates
Clarify the relationship between the
maturity and interest rate of an
investment
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-2

Types of Financial Institutions

Depository institutions: Financial
institutions that accept deposits
from individuals and provide loans
Commercial banks: financial institutions that
accept deposits and use the funds to
provide commercial and personal loans
Deposits insured by Federal Deposit Insurance
Corporation (FDIC) up to $100,000 per
depositor
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-3

Types of Financial Institutions

Savings institutions (or thrift institutions):
financial institutions that accept deposits
and provide mortgage and personal loans
to individuals
Credit unions: nonprofit depository
institutions that serve members who have
a common affiliation

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-4

Types of Financial Institutions

Focus on Ethics: Special Rates on
Deposits
Check the fine print before making any
deposit
Ask important questions
How long is an advertised rate good for?
What will it be lowered to?
How long must your maintain the deposit?
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-5

Types of Financial Institutions

Nondepository institutions: financial
institutions that do not offer federally
insured deposit accounts, but provide
various other financial services
Finance companies: nondepository
institutions that specialize in providing
personal loans

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-6

Types of Financial Institutions

Securities firms: nondepository institutions
that facilitate the purchase or sale of
securities by providing investment banking
and brokerage services
Insurance companies: nondepository
institutions that provide insurance to
protect individuals or firms against possible
adverse events
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-7

Types of Financial Institutions

Investment companies: nondepository
institutions that sell shares to individuals
and use the proceeds to invest in securities
to create mutual funds

Financial conglomerates: financial

institutions that offer a diverse set of
financial services to individuals or firms
Examples include Bank of America, Merrill
Lynch, and Citigroup
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-8

Types of Financial Institutions

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-9

Banking Services Offered by

Financial Institutions
Checking services
Checking accounts allow you to draw on
funds by writing checks
Monitor your account balance by recording
checks as you write them
Banks charge fees for bounced checks

You should reconcile your account balance

with your monthly statement
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-10

Banking Services Offered by

Financial Institutions

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-11

Banking Services Offered by

Financial Institutions
You can often access your account
balance by calling an automated phone
service or online
Electronic checking reduces fraud by
clearing checks immediately

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-12

Banking Services Offered by

Financial Institutions
Credit card financing such as Visa
and Mastercard
Debit card: a card that is used to make
purchases that are charged against an
existing checking account
Safety deposit box: a box at a financial
institution where a customer stores
valuables such as documents or jewelry
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-13

Additional Services
Financial Institutions Offer
Automated teller machines (ATMs):
machines where individuals can deposit
and withdraw funds any time of the day
Money order: a check that is written
on behalf of a person and will be
charged against a nonfinancial
institutions account
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-14

Additional Services
Financial Institutions Offer
Travelers check: a check that is written
on behalf of an individual and will be charged
against a large well-known financial institution
or credit card sponsors account
Cashiers check: a check that is written on
behalf of a person to a specific payee and will
be charged against a financial institutions
account
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-15

Selecting a Financial Institution

Convenience
Close to where you live or work, convenient
ATM locations, Internet banking

Deposit rates and insurance

Comparison shop for best interest rates

Fees
Comparison shop for best fees on the services
you need
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-16

Financial Planning Online:

Internet Banking
Go to: http://www.chicagofed.org
Click on: Project Money $mart, then
What You Should Know About Internet
Banking
This Web site provides information that
can help you decide whether an
Internet bank suits your needs.
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-17

Financial Planning Online: Financial

Institutions That Can Serve Your Needs
Go to:
http://dir.yahoo.com/business_and_eco
nomy/finance_and_investment/banking/
This Web site provides information
about individual financial institutions
such as the services they offer and the
interest rates they pay on deposits or
charge on loans.
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-18

Interest Rates on Deposits and

Loans
Interest rates on deposits and loans affect
your cash inflows and outflows
Certificate of deposit: an instrument
that is issued by a depository institution
and specifies a minimum investment,
an interest rate, and a maturity
Risk-free rate: a return on an investment that
is guaranteed for a specified period
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-19

Interest Rates on Deposits and

Loans
Risk premium: an additional return beyond
the risk-free rate that can be earned from a
deposit guaranteed by the government
Loan rate financial institutions loan money
at a rate higher than they pay depositors
Individuals with a poor credit history pay higher
rates

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-20

Financial Planning Online:

Current Interest Rate Quotations
Go to:
http://www.bloomberg.com/markets/rates.html

This Web site provides updated

quotations on key interest rates and
charts showing recent movements in
these rates.

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-21

Interest Rates on Deposits and

Loans

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-22

Interest Rates on Deposits and

Loans

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-23

Interest Rates on Deposits and

Loans
Impact of changes in interest rates
Rising interest rates increase the amount
of interest paid on deposits but also increases
the amount of interest charged on loans

Comparing interest rates and banks

Choice is dependent on your risk tolerance
and your financial situation

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-24

Term Structure of Interest Rates

Term structure of interest rates:
the relationship between the maturities
of risk-free debt securities and the
annualized yields offered on those
securities
Often based on rates of return offered by
U.S. Treasury securities with different
maturities
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-25

Term Structure of Interest Rates

Exhibit 5.4: Annualized Deposit Rates Offered on Deposits with Various Maturities
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-26

Term Structure of Interest Rates

Exhibit 5.5: Comparison of Interest Rates among Deposits

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-27

Term Structure of Interest Rates

Shifts in the yield curve
Graphs such as the one on the previous
slide can be found in financial publications
such as the Wall Street Journal and
illustrate how returns change over time

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-28

Term Structure of Interest Rates

Exhibit 5.6: Treasury Security Yields

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-29

Financial Planning Online:

Updated Treasury Yields
Go to: http://www.bloomberg.com
Click on: U.S. Treasuries
This Web site provides yields of
Treasury securities with various
maturities.

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-30

How Banking Services Fit within

Your Financial Plan
The key banking decisions for your
financial plan are:
What banking service characteristics are
most important to you?
What financial institution provides the best
banking service characteristic for you?

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-31

Integrating the Key Concepts

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-32

Integrating the Key Concepts

Part 1: Financial Planning Tools
Part 2: Liquidity Management
In Chapter 5 we learned about banking and interest rates
Chapter 6 teaches about managing your money
Chapter 7 teaches about managing your credit

Part 3: Financing
Part 4: Protecting Your Wealth
Part 5: Investing
Part 6: Retirement and Estate Planning
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-33

How the Risk-Free Interest Rate

Is Determined
Determined by total supply of funds
provided by all investors and the total
demand for funds by all borrowers
Interest rate represents cost of debt
to borrowers and reward for providing
credit to creditors
Intersection between supply curve and
demand curve results in equilibrium rate
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-34

How the Risk-Free Interest Rate

Is Determined

Exhibit 5A.1: How an Equilibrium Interest Rate Is Determined

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-35

Why Interest Rates Change

Shift in the supply curve
Increase in saving causes supply curve to shift
outward, lowering equilibrium interest rate
Shift in monetary policy: the actions taken
by the Federal Reserve to control the
money supply
Money supply: demand deposits and currency held by
the public
Open market operations: the Feds buying and selling of
Treasury securities
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-36

Why Interest Rates Change

Exhibit 5A.2 Impact of an Inward Shift in the Supply Schedule

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-37

Why Interest Rates Change

Shift in the demand curve
Any factors that cause a change in the demand
for funds
Shift in the government demand for funds
Shift in the business demand for funds
Shift in the household demand for funds

Combining the factors changes often occur

as the result of a combination of factors
Copyright 2004 Pearson Education, Inc. All rights reserved.

5-38

Why Interest Rates Change

Exhibit 5.A3: Impact of an Outward Shift in the Demand Schedule

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-39

Financial Planning Online:

Feds Upcoming Meetings
Go to:
http://www.bloomberg.com/bbn/fedwatch.html

This Web site provides updated

information about the Feds recent
actions and upcoming meetings.

Copyright 2004 Pearson Education, Inc. All rights reserved.

5-40