Principles of Banking

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\Principles of Banking

An Overview of the Financial Services Industry

Seventh Edition

G. Jay Francis

Susan M. Siegel

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AMERICANBANKERS

ASSOCIATION

This pubUcation is designed to provide accurate and authoritative information in regard to thesubject matter covered. It is sold with the understanding that the publisher is not engaged in ren-dering legal, accounting, or other professional service. If legal advice or other expert assistanceis required, the services of a competent professional person should be sought.

From a Declaration cf Principles jointly adopted by a Committee of the American Bar Association anda Committee of Publishers and Associations

The American Bankers Association is committed to providing innovative, high-qualityproducts and services that are responsive to its members' critical needs.

To comment about this product, or to learn more about the American BankersAssociation and the many products and services it offers, please call1-800-BANKERS or visit us at our website: www.aba.com.

2001 by the American Bankers AssociationSeventh Edition f

Cartoons on the following pages are reprinted with permission:Pages 35,53,79,97,121, and 145 are Frank and Ernest 1988,1994,1995,1996, and 1997

byThaves.Page 207 1996 Theodore Goff.Pages 183 and 227 1998 and 1997 Randy Glasbergen.Pages 1,13,165, and 247 1998 American Bankers Association by Sharon C. Lamberton.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system,or transmitted in any form or by any means-electronic, mechanical, photocopying, recording,or otherwise-without prior written permission from the American Bankers Association.

Catalog Number: 058600

ISBN: 0-89982-107-3

Printed in the United States of America10 987654321

Contents

Exhibit List xv

About the Authors xix

Acknowledgments xxa

Preface . xxiii

Chaptes y Banking and You 1LEARNING OBJECTIVES 1INTRODUCTION 2THE ROLE OF THE BANK EMPLOYEE 3

Bank Employees Serve Customers 3Bank Employees are Responsible 3Bank Employees Maintain Customer Confidence 3Bank Employees Are Professionals 4Bank Employees Have Career Opportunities 4

SERVICES BANKS PROVIDE 5Traditional Financial Services 5Non-traditional Financial Services 6Electronic Financial Services 6

Marketing and Cross-selling Services to Customers 7THE BANK IN YOUR COMMUNITY 7

Banks Provide Financial Services 7Banks Provide Customer Service 8

Banks Contribute to the Economy 8Banks Contribute to the Community 8

THE BANK AS A BUSINESS ORGANIZATION 8

Typical Bank Organization 8Financial Holding Companies 9

CONSOLIDATION OF THE BANKING COMPANIES 10

Mergers and Acquisitions 10Participating in the Global Economy 10Business Alliances in Banking Companies 11

SUMMARY 11

REVIEW AND DISCUSSION QUESTIONS ( 12

Hi

ADDITIONAL RESOURCES 12WEB RESOURCES 12

Chapter 2 The Evolution of Banking 13LEARNING OBJECTIVES 13INTRODUCTION 14THE EARLY BANKING SYSTEM AND ITS WEAKNESSES 14

Attempts to Form a Central Bank 16NATIONAL BANK ACT I7

National Banks 17Office of the Comptroller of the Currency 18National Banknotes 18Required Reserves 19

THE FEDERAL RESERVE ACT OF 1913 19Weaknesses after the National Bank Act 19How the Federal Reserve Act Addressed these Problems 21

THE GREAT DEPRESSION 22Impact of the Crash on Banks 22Factors Contributing to the Crash 23Resulting Legislation 23

A CHANGE IN PHILOSOPHY 24An Expanding Marketplace 25New Products to Challenge Non-bank Competitors 26New Rules to Strengthen Bank Lending 27New Opportunities to Compete 30

SUMMARY SI-

REVIEW AND DISCUSSION QUESTIONS 33NOTES 33ADDITIONAL RESOURCES 33WEB RESOURCES 33

Chapter 3 The Federal Reserve and its Regulatory Partners 85LEARNING OBJECTIVES 35INTRODUCTION 36CREATION AND DUTIES OF THE FEDERAL RESERVE SYSTEM 37

Creation of the Federal Reserve System 37Duties of the Federal Reserve 37

STRUCTURE OF THE FEDERAL RESERVE SYSTEM 37Board of Governors of the Federal Reserve System 38Federal Reserve Banks 38

FEDERAL RESERVE SERVICES 38

iv

Coin and Currency 40Check Processing 40Fed wire 41

Automated Clearing House 41Settlement 41U

.

S.

Government Services 42

ENFORCEMENT, SUPERVISION, AND EXAMINATION 42Regulations to Implement Laws 42Supervisory Agencies 43Other Enforcement Agencies 44Agency Examinations 44

MONETARY AND CREDIT POLICY AND THE TOOLS OF CONTROL 45

Role of Banks in Creating Money 45Tools of Monetary and Credit Policy 46

SUMMARY 50

REVIEW AND DISCUSSION QUESTIONS 51ADDITIONAL RESOURCES 51WEB RESOURCES 51

Chapter 4 The Deposit Fumetion 53ARJWG'DBJECTIVES 53

INTRODUCTION 54DEPOSIT FUNCTION 54

Deposit Safety and Customer Convenience 55Demand Deposits vs. Savings and Time Deposits 55

TYPE AND OWNERSHIP OF ACCOUNTS 57Consumer Owners 57Business Owners 60

AUTHORITY TO OPEN ACCOUNTS 64

Establishing Identity 64Capacity 67Authority 67

TYPES OF DEPOSIT ITEMS 67

Coin and Currency 68Cash Items 68Non-cash Items 70

HOW CUSTOMER DEPOSITS ARE MADE 71DEPOSIT REGULATIONS 72

Regulation CC 73Regulation DD 73Regulation E 76

v

Regulation D 76FDIC Insurance Protection 76

SUMMARY 76REVIEW AND DISCUSSION QUESTIONS 77ADDITIONAL RESOURCES 77WEB RESOURCES 78

Chapter 5 Checks as Negotiable Instruments 79LEARNING OBJECTIVES 79INTRODUCTION 80NEGOTIABLE INSTRUMENT DEFINED 80

Payable to Order or to Bearer 81Unconditional Order or Promise 82Fixed Amount of Money 82Payable on Demand or at a Definite Time 82Written and Signed 83

PARTIES TO NEGOTIABLE INSTRUMENTS AND THEIR LIABILITIES 83Parties to Drafts 83

Liability of the Parties 83TYPES OF CHECKS 85

Cashier's Check or Treasurer's Check 85Official's Check or Teller's Check 86Certified Check 86

NEGOTIATION AND TRANSFER 87Instruments Payable to an Identifiable Person 87Endorsements 88Checks Payable as "And" or "Or" 88Instruments Payable to Bearer 89

ENDORSEMENTS 89Blank Endorsement 90Special Endorsement 90Restrictive Endorsement 90Bank-provided Endorsement 91Regulation CC Endorsement Requirements 91

HOLDER IN DUE COURSE 91Value 92Good Faith 92Overdue and Dishonored Instrument 92Unauthorized Signature or Alteration 92Claim or Defense 92Facilitating Collection 93

vi

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SUMMARY 94

REVIEW AND DISCUSSION QUESTIONS 94ADDITIONAL RESOURCES 95WEB RE SOURCES 95

Chapter 6 Checks and the Payment Function 97LEARNING OBJECTIVES 97INTRODUCTION 98THE TELLER'S ROLE 98

Paying Checks 99Cashing Checks 101

PROPERLY PAYABLE ITEMS 102

Signatures 102Endorsements 102Alterations 103

Stop Payments 103Postdated Checks 104Stale-dated Checks 104

Death or Incompetence of a Customer 104Wrongful Dishonor 105

ENCODING AND PROOF 105

Item Preparation 105Encoding Function 107Proof Function 108

ITEM CAPTURE AND SORTING 109

Item Capture 109Other Capture Functions 112Sorting 113

CLEARING ALTERNATIVES - 114

Local Items C (pM 114Non-local or Transit Checks CT" f) QC flV t/T/ 115Electronic Check Presentment :~-f 117SUMMARY 9 M J

REVIEW AND DISCUSSION QUESTIONS 118ADDITIONAL RESOURCES 118

WEB RESOURCES

In-clearing Capture 123Posting 123Posting Rejects 124Reports 126

DOCUMENT EXAMINATION AND FILING 126

In-filing 127Bulk Filing 127

STATEMENTS 128Return of Checks 128

Check Truncation and Check Safekeeping 128Image Statements 130Combined Statements 130

Customer's Duty to Examine Statements 130DISHONORED ITEMS 131

Outgoing Return Items 131Incoming Return Items 132

FRAUD SCHEMES AND SECURITY ISSUES 132

Bank Robbery 133Teller Fraud Issues 134

Schemes Against Customers 138Bank Programs to Combat Check Fraud 140

SUMMARY 141

REVIEW AND DISCUSSION QUESTIONS 142ADDITIONAL RESOURCES 143WEB RESOURCES 143

Chapters / \ The Lending Function 145LEARNING OBJECTIVES 145INTRODUCTION 146THE LENDING FUNCTION . 147LEGAL REQUIREMENTS AND LENDING POLICY 148

Legal Requirements 148Lending Policy 150

THE LENDING PROCESS 150

The Application and Interview 151The Investigation 151Loan Documentation 153

Loan Management 155Asset Recovery and Loan Review 155

LOAN CATEGORIES 155Real Estate Loans 156

IConsumer Loans

Business Loans

Government Loans

SUMMARY

REVIEW AND DISCUSSION QUESTIONSADDITIONAL RESOURCES

WEB RESOURCES

s> Conducts the nation's monetary policy by

influencing money and credit conditions

> Supervises and regulates banking institutionsto ensure safety and soundness

> Maintains the stability of the financial systemand contains risk in financial markets

> Provides certain financial services to the U.S.government, the public, financial institutions,aind foreign official institutions

Exercises=generalsupervision

JL

Federal Reserve banks (12 districts)> Propose discount rates

> Hold reserve balances for depositoryinstitutions and lend to them at thediscount window

> Furnish currency

> Collect and clear checks and transferfunds for depository institutions

> Handle U.S. government debt and cashbalances

: Composer

vConsumer AdvisoryCouncil

Federal AdvisoryCouncil

Thrift InstitutionsAdvisory Council

Federal Open Market Committee(Board of Governors and 5 Federal

Reserve bank presidents)Directs open market operations (buy-ing and selling of U.S. governmentsecurities), which are the primaryinstrument of monetary policy

>

Chapter 3 - The Federal Reserve and its Regulatory Partners 39

Exhibit 3.3 Major Responsibilities of the Federal Reserve Board of Governors. Supervise the operations of the Federal Reserve System. Set reserve requirements. Approve discount rates set by the 12 Reserve banks. Appoint three of the nine directors of each Reserve bank. Approve the presidents of the Reserve banks. Direct the supervision and regulation of member banks and bank holding companies. Examine the operations of the Reserve banks. Represent the Federal Reserve System in its relations with the president and Congress. Maintain formal relations with international economic and financial organizations

services to member banks. From its inceptionuntil 1980, the Fed provided almost all its ser-vices free of charge (lending money was theexception) but only to its member banks. In1980, Congress, through the Monetary ControlAct of 1980, mandated that the Fed charge forits services, including float. Fed services thatcarry a fee are. coin and currency. check processing. Fedwire

. automated clearing house

. settlement

. securities safekeepingThe act further provided that the fees be

priced explicitly, that they cover all direct andindirect expenses incurred by the Fed

,

and that

the Fed offer non-member banks all the servicesit offers member institutions for the same fees.

Coin and Currency

The Fed supplies banks with coin and curren-cy to meet customers' withdrawal demand.Because many retail businesses, as well asindividuals, rely on their banks to providecoin and currency, banks have to keep a suffi-cient supply of coin and currency on hand.Most banks store this money in their vaults orsafes. Vault cash, along with correspondentbank balances and teller cash, is a form of

reserves that banks use to meet their reserve

requirement. The Fed also accepts shipmentsof coin and currency from banks and ensuresthat mutilated currency is destroyed. Thebanker's response to the customer in situation1 would be that new $50 bills are ordered

from their branch of the district's Federal

Reserve Bank.

Exhibit 3.4 Functions of the FederalReserve District Banks

. Propose discount rates

. Hold reserve balances for depository in-stitutions

. Lend at the discount rate to memberbanks

. Furnish currency and coinB Collect and clear checks*

Transfer funds for depository institutions9 Handle U

.

S.

government debit and creditbalances

Check Processing

The Fed offers check clearing services, col-lection services, and return items services to

banks. The rules governing these services areestablished under Regulation J and RegulationCC. Approximately 40 percent of the nation'sinterbank checks are currently processed bythe Fed, and an even larger percentage ofreturn items are processed by the Fed. TheFed also offers other check-related services

40 Principles of Banking

referred to as payer bank services (chapter 13)that assist banks in offering services such ascontrolled disbursement accounts to corporatecustomers. A controlled disbursement account

(chapter 13) is a demand deposit account onwhich the corporate customer writes checksand the bank advises the customer of the dol-

lar amount of the checks that will be posted tothe customer's account that night. The cus-tomer then wires money into this account tocover the checks being paid. This serviceallows customers to manage their fundsinstead of leaving them in a checking accountthat does not pay interest.

Fed wire

Fedwire services are also provided by theFed to many U.S. banks. Fedwire services aregoverned by Regulation J and are also subjectto Article 4A of the Uniform CommercialCode. Banks that do not maintain an account

with the Fed typically use the services of acorrespondent bank that does maintain a Fedaccount. A customer who wants to transfer

funds from his or her account to a beneficiarywith an account at another bank issues a

funds transfer at his or her bank. The bank

initiates a funds transfer instruction to the

Fed through the use of the Fed's Fedwire sys-tem. The Fed then initiates a funds transfer

instruction to the beneficiary's bank or toanother Federal Reserve bank. In the end, the

funds are paid to the intended beneficiary.Large corporate customers and other finan-cial institutions are the largest users of thisservice. Most wire transfers are initiated

through the Fed, but banks may also issuewires through the Clearing House Inter-bank Payments System (CHIPS), operatedby the New York Clearing House.

.A

Banks price their services in a financial servicesmarketplace that includes nearly 40,000providers, from banks and S&Ls to credit unions,securities firms, mutual funds, and insurance

companies.(American Bankers Association)

Automated Clearing House

Some banks use the services of private sectorprocessors, but the Federal Reserve is the pri-mary provider of automated clearing house(ACH) services. ACH transactions (chapter13) are paperless electronic debit and credittransactions. Just like checks, ACH transac-

tions are presented to the paying bank or thereceiving bank. The Fed maintains the soft-ware to sort the transactions and present themto the paying or receiving bank.

Settlement

In addition to actually performing the ser-vices described above, the Fed also offers set-

tlement services. When a bank sends checks

to the paying bank or sends a Fedwire, pay-ment is made by one bank to the other. TheFed provides this settlement service, or pay-ment, through Federal Reserve accounts. TheFed charges and credits these accounts at dif-ferent times. For example, if a bank transfersfunds to another bank, the Fed charges thesending bank's account and credits thereceiving bank's account simultaneously.Check transactions are settled at different

times, based on when the Fed receives pay-ment for the checks it presents to the payingbank. The Fed monitors these transactions


ML: D,d You Know?The average life of a Federal Reserve note rangesfrom 18 months for a $1 bill to nine years for $50and $100 bills.(Bureau of Engraving and Printing)

Regu'at'ons to 'mp'ement Laws

The Federal Reserve Act gave the Board ofGovernors of the Federal Reserve the authori-

ty to issue rules, regulations, and guidelinesthat apply to both national banks and statemember banks. The various regulations pro-vide the Fed with the means to carry out con-

and discourages banks from creating gressional policies and to control the flow ofintra-day overdrafts, referred to as daylight money and credit.overdrafts. These overdrafts occur when When Congress passes banking-relateditems posted to a bank reserve account bring regulatory legislation, it directs the Fed to for-the account into a negative balance. mulate regulatory requirements to implement

the provisions of the act or law. An example isU

.

S. Government Services Regulation E, titled Electronic Funds Trans-

fer, that was issued to implement the provi-Fed services are extremely important not sions of the Electronic Funds Transfer Act ofonly to banks but also to the U.S. govern- 1978. Typically, the Fed publishes a proposedment: the Fed serves as its bank. An individ- regulation for comment, allowing all interest-ual who receives an income tax refund or ed parties the opportunity to react to it. If theother disbursement of funds from the gov- Fed is convinced that the comments are valid,eminent is actually receiving a check drawn it typically modifies the regulation, unlesson the Fed. If the disbursement of govern- doing so is prohibited by the act the regulationment funds is made through an electronic is meant to implement. In addition to issuingtransfer of funds, as in the case of Social regulations, the Fed also issues comments toSecurity payments, the appropriate govern- the regulations. The official comments on ament account with the Fed is reduced. The regulation are interpretations issued by theinflow of all funds to the federal government staff of the Board. Good-faith compliancealso goes through the Fed. As the fiscal agent with the official staff commentary generallyfor the U.S. Treasury, the Fed is responsible affords the bank protection from violating thefor issuing and redeeming all federal govern- regulation.ment obligations.

and Emmmmmmtmrn

As of March 2000, 31 Federal Reserve

regulations had been implemented. Each reg-ulation is assigned a letter of the alphabet.Having used letters A to Z, the regulationsstarted over at AA, and now extend through

Among the Fed's many roles is the enforce- EE. A summary of the Federal Reserve regu-ment of banking law through implementing lations is presented in the appendix of thisregulations and the supervision and examina- book.tion of banks to ensure their safety and Regulations address relationships betweensoundness. the Fed and member banks for such items as


!loans to depository institutions, reserverequirements, member stock in the Fed, andcheck collections. The regulations also addressloans by members to directors and executiveofficers, assessment of risk, and interlockingrelationships with securities dealers.Consumer protection and disclosure regula-tions apply to areas such as truth in lending,truth in savings, expedited funds availability,and electronic funds transfers.

Certain Federal Reserve regulations alsoapply to entities other than member banks.Examples of regulations that go beyond memberbanks are those governing corporations engagedin foreign banking, margin requirements, con-sumer protection, and non-bank activities of for-eign banks that have branches in the UnitedStates. The Fed also has regulatory authorityover the activities of bank holding companies.

Supervisory Agencies

The Fed is one of four agencies with theauthority to supervise banking activities. Theother agencies are the Office of theComptroller of the Currency, the FederalDeposit Insurance Corporation, and eachstate's banking authorities.

Office of the Comptroller of the Currency

The Office of the Comptroller of the Currencyhas jurisdiction over all national banks and isresponsible for chartering, examining, andsupervising them. All applications for nation-al bank charters, all requests by any nationalbank for opening new domestic or foreignbranches or for offering new services

,

and all

mergers or acquisitions involving nationalbanks must have OCC approval. Thisagency

'

s many functions are carried out

' Did You Know? .

The annual net profit generated by the FederalReserve is paid to the U.S. Treasury.

through regional administrative officesthroughout the country.

Federal Deposit Insurance Corporation

The Federal Deposit Insurance Corporation(FDIC) is responsible for supervising andexamining all federally insured commercialbanks and savings banks (through the BankInsurance Fund) and savings and loan associ-ations (through the Savings AssociationInsurance Fund). It sets enforceable standardsfor its members, can examine anyFDIC-insured financial institution at anytime, and may act to prevent the failure of aninsured bank by bringing about a merger withor acquisition by a stronger insured institu-tion. It may also take other positive action toprevent an insured institution from failing-for example, by buying the troubled bank'sassets or providing an infusion of capitalfunds.

Sfafe Banking Departments

Each state has its own banking departmentresponsible for chartering, supervising, andexamining the state-chartered non-memberbanks within the boundaries of the state.

Banks' applications for state charters are sub-mitted to the banking departments of the indi-vidual states and must pass qualifying tests. Ifthe proposed new bank desires membership inthe Federal Reserve System or the FDIC

,

its

application must be reviewed and approvedby those agencies.


Other Enforcement Agencies condition. Examinations also provide comfort

and confidence to depositors.Other government agencies have an impact Periodic bank examinations have becomeon banks. For example, the FBI is charged an accepted part of our banking system. Everywith investigating bank robberies

, employee commercial bank receives at least one suchtheft, embezzlement, and criminal acts. The examination each year. More frequent exami-Secret Service investigates counterfeit cur- nations are conducted if they seem warrantedrency. The IRS enforces tax law on banks and by conditions in a particular bank. All nationaluses the banking system to freeze bank banks must be members of the Federalaccounts for tax evaders. The IRS also Reserve System

,

and all Fed member banks

reviews currency transaction reports for must be insured by the FDIC. Therefore,money laundering activity. The influence of national banks are subject to examination bygovernment agencies will increase as banks the OCC, the Fed, and the FDIC. It is impossi-and bank holding companies expand services ble, however, for each regulatory agency toas allowed under the 1999 Gramm-Leach- examine every bank under its jurisdiction.Bliley Act. Because of that, banks and bank To avoid duplication and waste, federal reg-holding companies will come under increased ulatory agencies have agreed on an examina-scrutiny by the Securities and Exchange tion format. The primary examiningCommission and the individual state depart- responsibility is assigned to one agency, whichments of insurance. then transmits the results of its findings to all

other interested agencies and to the bank'sAgency Examinations board of directors (exhibit 3.5):

This system does not inhibit any agencyExaminations by the Fed and the other agen- from conducting its own

, separate examinationcies are intended to ensure that banks are oper- of a particular bank when justified by concili-ating prudently, obeying all regulations and tions. For example, if the OCC identified alaws, and accurately reporting their financial problem at a national bank, the Fed and the

Exhibit 3 5 Bank Regulatory Authorities

Type of BankNational bank

State member bank

Regulatory AuthorityAnnua! ExaminationConducted by

Comptroller of the CurrencyFederal ReserveFDIC

Federal ReserveFDICState banking departmentFDICState banking departmentState banking department

Comptroller of the Currency

Federal Reserve*

FDICState non-memberinsured bank

State non-membernonlnsured bank*

Examinations of state-chartered member banks are often conducted jointly by Federal Reserve and statebanking department examiners.

State banking department


FDIC could, on the basis of the OCC's report, Similarly, the Federal Reserve has theimmediately examine that bank if they felt responsibility to ensure that the money supplydoing so was appropriate. does not outpace the needs of the economy.

Too many dollars for too few goods couldllonetarif afii Credit Policy result in a rise in the price of those goods

,

or

and the Tools off Control inflation.The Fed influences the entire economic

The National Bank Act did not address the environment by taking specific actions toissue of the nation's money supply. (The basic influence the flow of money and credit.money supply, termed Ml, includes the coin However, the Fed always takes into considera-and currency in circulation, demand deposits, tion fiscal policy-the activities of Congressand traveler's checks.) As the agent of mone- and the president in the areas of taxation andtary policy, the Federal Reserve was given this government spending. Fiscal policy deter-responsibility. Prior to the establishment of the mines how much revenue the governmentFederal Reserve, the money supply was not expects to collect and bow much it will spend.controlled or managed, and the results were Monetary policy works to control the flow ofdevastating to the economy. No mechanism money and credit without political concerns.existed to provide the money and the credit The impact of monetary policy also can beneeded to support an expanding economy, yet realized faster than changes in fiscal policy asfor economic growth to occur, business need- shown by the immediate reaction to Alaned a source of credit and banks needed money Greenspan's comment in situation 2, becauseto lend. the Fed can act quickly to implement changes.

There was also no mechanism to control Changes in fiscal policy require an act ofinflation, which occurs when too many dollars Congress.are chasing too few goods. A non-monetaryexample is used here to explain the concept of Role of Banks in Creating Moneyinflation. The case of Beanie Babies, while not

inflation in the true sense, shows how prices The Fed establishes ranges for the growth ratecan rise (inflate) under certain circumstances. of the money supply on the basis of a number

Beanie Baby toys were a purchasing phe- of economic factors. The Fed then uses itsnomenon in the 1990s. If every parent who tools for monetary control to keep the moneywanted one of the rarer, and therefore harder- supply within those ranges. Banks play anto-find Beanie Babies, had had the purchase important role in the growth of the money sup-price to spend, and if there had been enough ply because of their abihty to create demandtoys for everyone, the price would have deposits.remained constant. As it happened, the supply Banks create money for demand depositsof some Beanie Babies was Umited and the through a combination of the deposit and thedemand was high. Parents were willing to loan functions. When banks make loans, theyspend double or triple the purchase price to also increase the volume of demand deposits.secure one of these toys, which artificially Here is an example of how demand deposits arepushed up, or inflated, the price. increased: ABC Bank has $10,000 in cash


assets-part of the stockholders' originalinvestment-and $0 in demand deposits. A con-sumer borrows the $10,000 in cash from ABCto buy a car and pays the $10,000 cash to the cardealership. The dealership deposits the $10,000to its checking account, also at ABC. Now ABCBank's demand deposits are increased by$10,000, and its money supply is also increased.After the transaction, the bank has $10,000 inloans, $10,000 in cash (the dealer's deposit) and$10,000 in demand deposits; the stockholders'investment does not change. Exhibit 3.6 uses aT-account to show how this transaction would

be shown in the bank's books (bank accountingis discussed in chapter 10).

If the bank has a reserve requirement of 10percent, the bank must keep 10 percent of itsdemand deposits in cash or balances at theFederal Reserve. In this example the bankmust keep $1,000 as reserves (10 percent of$10,000), so it has only $9,000 available tolend to other customers ($10,000 minus

$1,000). If the bank lends out its available$9,000, that $9,000 will be deposited in thesame or another bank in a demand depositaccount. The result of this transaction is that

demand deposits are created and increased by$9,000, as is the money supply. The fact thatthe deposits may not be made to the same bankis irrelevant. The point is that money loaned bybanks ends up in demand deposits that can beloaned out again after reserves are kept, caus-ing a recycling of funds.

Tools of Monetary and Credit Policy

The Federal Reserve exercises its monetaryand credit policy through three tools: (1)reserve requirements, (2) discount operations,and (3) open market operations. These instru-ments of monetary policy can be used by theFed to increase or decrease the growth rate ofthe money supply by encouraging or discour-aging borrowing.

Exhibit 3.6 How Banks Create Money

BANK BALANCE SHEET BEFORE LOAN

Assets Liabilities

Cash

TotalAssets

$10,000

$10,000

Deposits

Total liabilities &stockholder equity

BANK BALANCE SHEET AFTER LOAN

Cash

Loans

TotalAssets

$10,000

$10,000

$20.000

Deposits

Total liabilities &stockholder equity

$ 0

Stockholder equity $10,000

$10,000

$10,000

Stockholder equity $10,000

$20,000


Reserve Requirements Reserve Services section in this chapter).Non-member banks maintained their

The Federal Reserve requires banks to set reserves with other financial institutionsaside a portion of their deposits in a non- according to the laws of their individual states.interest-bearing reserve account at the Since implementation of the Monetary ControlFederal Reserve as a means of safeguarding Act, all banks that have transaction accountscustomer deposits. The Fed uses changes in (specifically, accounts that make payments tothe reserve requirement to decrease or third parties) must keep reserves at the Fed.increase the amount of money a bank has Please note that we are using a $10,000 fig-available to lend. If the Fed decides to stimu- ure here for the sake of illustration. In the real

late the economy by increasing the money economy, the change would be measured insupply, it decreases the reserve requirement, billions of,dollars!Conversely, a decrease in the reserve require- A decrease in the reserve requirement alsoment increases the amount of money banks ought to improve banks' profitability. Bankshave available to lend. are not paid interest on reserves, but a bank

For example, a decrease in the reserve can lend or invest the additional funds maderequirement from 15 percent to 10 percent available by the reduction in the reservewould make 5 percent more funds available requirement. Banks, however, manage theirfor lending purposes. If the reserve require- loans and investments to ensure that these fment were 15 percent, a bank would be additional funds are put to work.required to hold $1,500 in reserve on demand Banks whose reserves at the Fed are tem-deposits of $10,000 (15 percent of $10,000), porarily larger thaqi required may lend thesethereby limiting to $8,500 the amount avail- excess reserves, called Fed funds, to anotherable for loans. If the reserve requirement were bank whose reserves are temporarily short.reduced to 10 percent, that same $10,000 Since these transactions take place by adjust-would make $9,000 available for loans. In this ing the reserves of the two institutions on theexample, reducing the reserve requirement Fed's account books, no money actuallyfrom 15 percent to 10 percent increases the changes hands. The funds typically are sold tomoney supply by an additional $500. the other institution overnight. The institution

Conversely, if the Fed were concerned selling the Fed funds charges the other institu-about inflation and wanted to decrease the tion interest for the use of the funds. The rate

money supply, it could increase the reserve charged, called the Fed funds rate, is set byrequirement. If the reserve requirement were the banks rather than the Fed. Although theincreased from 15 percent to 20 percent, the Federal Reserve does not set the Fed fundsamount of the $10,000 in demand deposits rate, it establishes the rate's range and influ-available for loans would be reduced from ences it by increasing or decreasing the$8,500 to $8,000 and growth in the money amount of reserves available. If the rate risessupply would be reduced by $500. too rapidly and remains high because the

Until the Monetary Control Act of 1980, demand for funds exceeds the supply, the Fedonly Fed member banks were affected by the makes additional funds available to meet theFed's reserve requirements (see the Federal demand and thereby reduces the rate.


Like any other commodity, money is sub-ject to the law of supply and demand. Theinterest rate is the price of money, and if thedemand for money is high and the supply islow, the price (interest rate) rises.

Discount Operations

The Fed influences loan demand and the eas-

ing or tightening of credit through the discountrate. The discount rate is the rate charged bythe Fed on loans it makes to financial institu-

tions. Unlike the Fed funds rate, the discount

rate is set by each of the 12 Federal Reservebanks. Each Reserve bank can change the ratewhenever appropriate, subject to review by theBoard of Governors. In general, the discountrate is uniform throughout the Federal ReserveSystem. As a result of the Monetary ControlAct, all financial institutions offering transac-tion accounts have the privilege of applying tothe Fed for short-term credit.

The Fed uses the discount rate to encourageor discourage borrowing, depending on theimpact it is trying to make on the money sup-ply. If the Fed wants to increase the moneysupply, it reduces the discount rate to encour-age borrowing. During an economic recovery,the Fed wants to expand business growth andactivity (exhibit 3.7). By reducing the discountrate, the Fed is attempting to make credit avail-able, to encourage borrowing for businessexpansion, and to increase the money supply.The Kowalskis in situation 3 saw the interest

rate on their mortgage loan change severaltimes while they waited for approval. If therate had gone too high, they might not havepurchased the house and the Fed's attempt todiscourage borrowing would have been suc-cessful. Banks create money through thedeposit and credit functions. As businesses andconsumers borrow money, those dollars endup in demand deposit accounts, therebyincreasing the money supply. On the other

Exhibit 3.7 Discount Rates Charged by Federal Reserve Banks

15 i-

0

10

0)

EL

J*5

I I I I J

I

L J

I

I

L

I

I

I

I

f N# f J f f N# N# f f f N# f f f /Year

Source: Federal Reserve Economic Data, St. Louis. Month-end for December of each year.


hand, if the Fed wants to discourage borrow- decides to make more credit available bying to reduce the growth of the money supply, increasing the money supply, it issues a direc-it increases the discount rate. The increase in tive to the New York Fed to purchase govem-the discount rate often signals an increase in ment securities from banks and the public.the cost of funds for banks, which in turn When the securities are sold by banks, busi-increases the rates banks charge to customers, nesses, or consumers, the Fed credits theThe increase in rates discourages borrowing reserve accounts of banks. Banks in turn cred-and results in a decrease in the growth of the it the demand deposit accounts of the sellers,money supply. thereby increasing demand deposits.

For example, the Fed purchases $5 billionOpen Market Operations in government securities, and pays for the

securities, by crediting the banks' reserveBy far the most powerful tool available to the accounts. If the banks owned the securities,Fed in its role as the agent of monetary policy they will use the money to make loans, and theis the open market operations of the Federal proceeds will be deposited to demand depositOpen Market Committee (FOMC). The accounts. If the securities were owned by otherFOMC consists of the seven members of the investors (individual or business), the banksBoard of Governors plus the president of the will directly credit the sellers' checkingNew York Federal Reserve Bank and four accounts. Either way, the proceeds issued byother Reserve bank presidents. They meet the Fed for the securities end up in demandevery six weeks to project levels of economic deposits and thereby increase the money sup-activity-three-to-six months in the future, ply by $5 billion.Their actions to increase or decrease the On the other hand, if the FOMC decides to

growth rate of the money supply is based on tighten credit by reducing the growth rate ofthese projections. the money supply, it issues a directive to the

The FOMC is responsible for system-wide New York Fed to sell government securitiesadministration of monetary policy. One of the held by the Fed. When the securities are pur-basic functions of the FOMC is to determine chased by banks and the general public, thethe amount of government obligations (bills, Fed charges banks' reserve accounts for thenotes, and bonds) to be sold and redeemed amount of the securities. The banks theneach week. After each meeting of the FOMC, charge their customers' demand depositwhere short-term and long-term monetary accounts, thereby reducing the money supply.needs are determined, a directive is issued to As this example shows, the operations ofthe New York Fed, which has been designated the FOMC can have an immediate impact onas the agent to buy and sell government obli- the money supply and the availability of cred-gations for the accounts of all Federal Reserve it, whereas the changes in reserve require-district banks. ments and the discount rate usually have a

The purchase or sale of government securi- delayed impact. However, because of mediaties by the Fed immediately increases or coverage and comments by financial experts, adecreases the money supply and affects the change in the reserve requirement or the dis-availability of short-term credit. If the FOMC count rate can have an instant impact on the


Exhibit 3.8 Fed Tools and Their Effects

Reserve Requirements Increase

Decrease

Slow, lagging effects on banks and theeconomy. It decreases the money supplyand availability of loanable funds if infla-tion needs to be checked.

It stimulates the economy by increasingthe supply of loanable finds.

Discount Operations Increase DiscountRate

Decrease Rate

Moderately fast effect on banks and econ-omy. It discourages borrowing and themoney supply shrinks when inflation isbecoming a problem.Has opposite effect during economicrecovery when the Fed wants to expandbusiness activity.

Open Market Operations Purchase Securities Immediate, powerful effect on banks and

economy. Increases money supply inpaying for purchases by crediting thereserve accounts of banks.

Sales Tightens credit by reducing money sup-ply in times of rising inflation.

Source: Amaury Betancourt, Loan Review Examiner, Hamilton Bank, NX

economy-specifically, on the stock market-because the change signals the Fed's direction.An increase in the discount rate signals a tight-ening of the money supply and an increase ininterest rates, which could have an immediateeffect on the stock market. Exhibit 3.8 sum-marizes the effect of the basic Federal Reserve

monetary and credit tools on the economy.

The Federal Reserve plays a major role in boththe national and international economies. The

Federal Reserve System was created by theFederal Reserve Act of 1913 to eliminate

many of the problems not solved by theNational Bank Act. Through the establishmentof the 12 Federal Reserve districts, a nation-

wide check collection system was created,

and

the problem of pyramided reserves wasresolved. In its role as the agent of monetarypolicy, the Fed was made responsible for man-aging the money supply.

The Fed provides many services to memberbanks, including supplying coin and currency,check processing, Fedwire, automated clearinghouse, settlement, and securities safe-keeping.

The Fed operates as both a competitor and aregulator by offering services in competitionwith correspondent banks. The Fed issues reg-ulations to perform its duties as the agent ofmonetary policy and to implement the provi-sions of various laws created by Congress; it isalso the primary federal supervisor ofstate-chartered member banks. The Fed helpsthe government maintain a sound banking sys-tem and assists in reinforcing public confi-dence.


The Fed controls the ability of banks to ere- The Federal Reserve System: Purposes andate money through three primary tools of mon- Functions, Washington, D.C.: Board ofetary control: (1) changes in the reserve Governors of the Federal Reserve System,requirement, (2) discount operations, and (3) 1994.open market operations. Banks create moneythrough the deposit and credit functions, and Mfelb Resourcesthe Fed uses reserve requirements and the dis-count rate to encourage or discourage the use American Bankers Association www.aba.comof credit. The Fed's most powerful tool is the Code of Federal Regulationsoperations of the Federal Open Market www.access.gpo.gov/nara/cfr/Committee, which the Fed uses to influence Federal Deposit Insurance Corporationthe money supply through the purchase and www.fdic.govsale of government securities. Federal Reserve Bank

www.federdreserve.govRewlew and Oiseussion House Committee on Banking and FinancialHuestSons Services www.house.gov/banking/

National Credit Union Association1

.

List the four basic duties of the Federal www.ncua.govReserve. Office of the Comptroller of the Currency

2.

How is the Federal Reserve structured? www.occ.treas.gov3

.

What services are offered to banks by theFederal Reserve?

4.

How is the Fed used to implement regu-latory legislation?

5.

Describe how banks create money.6

.

Briefly describe the tools of monetarycontrol, and explain how the Fed uses them.

Law and Banking: Applications. Washington,D

.

C.

: American Bankers Association,

2000.

Money and Banking. Washington, D.C.:American Bankers Association, 1998.

Reference Guide to Regulatory Compliance.Washington, D.C.: American BankersAssociation, 2000.


The Deposit Function

bankmm

.

..

Th v/Hj

Learning Objectives

After completing this chapter, you will be able to do the following:

. define the deposit function and distinguish among the various types of deposit accounts0 describe various types of individual and business account owners, noting considerations for

banks in dealing with each type of account*

explain the difference between identity, authority, and capacity when opening an account andlist acceptable forms of identification

0 differentiate among coin and currency, cash items, and noncash items9 describe several ways customers can make depositse give an overview of the requirements of four deposit regulations, including Regulations DD,

CC, E, and D, and the coverage of FDICc define the bolded terms that appear in the text

53

inf roduCltiCIH of the corporation, but he has no documenta-tion to substantiate his claim. He says he will

The following situations demonstrate different obtain the proper documentation at an upcom-customer needs for opening, managing, and ing meeting of the board of directors, but hedepositing to accounts. While customer- must open the account today. He adds that if hefocused banking usually means helping cus- is unable to open the account immediately attomers find the right solutions to their this bank, he will take his business elsewhere.problems, this has to be balanced with protect- Opening the account could result in a substan-ing the bank against loss. tial customer and a long-lasting, mutually ben-

eficial relationship, or it could result in aSituation 1 $250,000 loss to the bank. What course of

action should you take regarding his request?A retired couple comes to you with the follow-ing problem: they are planning to travel exten- Situation 4sively in their new RV. They have arranged tohave their pension checks automatically A customer of yours owns a retail store anddeposited into their checking account and want cannot make deposits during the day when theto give their daughter the ability to pay bills bank is open. The store owner calls you andand otherwise manage the account while they says he wants to deposit $2,000 into a generalare away. However, they also want access to account. He has $800 in coin and currency,cash from the account while they travel across $900 in checks drawn on this bank, and $300the country. What arrangements can you sug- in checks drawn on other banks. The ownergest to cover these needs? does not want to leave the money in the store

overnight, but will get to the bank too late toSituation 2 make a deposit at the teller window. What cash

management service will you recommend toA man asks you to help him open a joint your customer?account for himself and his wife, who is not

present. He wants to open the account by Each of the above situations provides chal-depositing checks from an out-of-state compa- lenges for a bank in accepting deposits, pro-ny. He is very polite and friendly and is hoping viding deposit services, and limiting fraud.to withdraw several thousand dollars right This chapter discusses the deposit function,away to help him get settled; What steps can the documentation required to open anyou take to help him and to protect your bank? account, and the risks faced by banks in offer-

ing accounts and accepting deposits.Situations

Deposit'FunctionYou are the new accounts representative atyour bank. A potential customer approaches The deposit function is the traditional bank-you with a check for $250,000 payable to a ing function of accepting funds for credit tocorporation. He claims that he is the president checking, savings, and other types of deposit


accounts. If there were no deposits, there tomers are-in grocery stores, for example.would be no need for the other two principal Banks make their offices and facihties readilybanking functions-payments and lending, available while simplifying banking transac-Banks would have no need to pay instruments tions. Extra banking hours, drive-in windowsdrawn on deposits and, because most funding or teller stations, and automated tellerfor loans and investments is generated by machines (ATMs) have also become common-deposits, banks would have no funds to lend, place. Banks are also becoming active playersThe deposit function also provides customers a in the electronic realm with such services assafe place to keep their coin and currency. online banking, electronic bill payment, and

Through the deposit function, customers web-based loan application and approval.can simply deposit checks or other items in Bank cardholders can now access theirtheir accounts and receive credit. Hundreds of accounts for cash withdrawals worldwide

billions of dollars are deposited in and with- through linked ATM networks. ATM machinesdrawn from commercial banks each year. The not only meet customer needs and providebulk of a bank's daily deposit activity consists greater convenience, but also reduce a bank'sof checks rather than coin and currency. Since transaction costs and allow banks to offerchecks are so widely used, the total dollar around-the-clock banking servicesvalue of all the checks deposited each day is Many banks now offer the convenience offar greater than the daily deposits of coin and PC banking. Customers can issue bill paymentcurrency. As technology develops and instructions and conduct other banking busi-becomes more accepted, more money will ness over the Internet.flow in and out of accounts electronicallythrough such means as direct deposit, automat- Demand Deposits vs. Savings anded clearing houses (ACHs), wire transfers, and Time DepositsInternet operations.

Deposits at banks may be placed in a checkingDeposit Safety and Customer or savings account, or used to establish someConvenience form of time deposit. The depositor's intention

is different in each case. Checking accountDepositors believe that the bank is responsible deposits (demand deposits) are made becausefor safeguarding their deposits at all times the customer intends to withdraw the funds inwhile making them available for withdrawal at the very near future to pay bills and meetsome future date. If a bank robbery or other expenses. Basic checking accounts do not earnloss of funds takes place, the depositor is pro- interest. However, banks offer other types oftected against loss. Banks, always conscious of accounts that allow customers to earn interestthis need for safety, protect and use depositors' on funds they plan to withdraw in the veryfunds prudently for loans and investments. A near future. In today's economy, customersbank should always be able to honor a legiti- tend to leave minimum amounts in non-inter-mate request for payment from an account. est-bearing accounts, while placing most of

Convenience is also extremely important to their funds in accounts that will generate inter-bank customers. Banks go where their cus- est. Savings and time deposit accounts earn

Chapter 4 - The Deposit Function 55

Fifty-nine percent of bank customers report thatthey do not save money on a regular basis.(American Bankers Association)

withdrawal from savings accounts. Therefore,while in practice few banks actually requiresuch notice, these accounts cannot be consid-

ered demand deposit accounts. Savingsaccounts do have one thing in common withdemand deposit accounts-they have no matu-

interest and are generally used to deposit funds rity date. Deposits and withdrawals can benot immediately needed by the customer. made at any time over a period of days, weeks,

or years. By contrast, time deposit accountsDemand Deposits have specific maturity dates, at least seven

days from the date of deposit. Whenever aThe largest single element in the nation's time deposit is withdrawn before maturity,money supply are the demand deposit bal- there usually is a penalty for early (premature)ances, against which checks are issued, withdrawal. Banks pay interest on both sav-Demand deposits are so named because the ings and time deposit accounts.total amount on deposit, or any part of it, is In addition to certificates of deposit (CDs),payable "on demand" and can be converted other time deposits include Christmas,into coin and currency after the deposited Hanukkah, and Vacation Club accounts.funds are collected and available. If you have Deposits are generally made weekly to thesean available balance of $100 in your checking accounts in small amounts to help customersaccount, you can write a check for that amount accumulate funds for these annual events.and present it to a teller for immediate pay- The ratio of demand deposits to savings andment of $100 in cash. time deposits is important for two reasons. One,

Traditionally, checking accounts existed the bank pays interest on savings and timeonly at commercial banks. Today, thrift institu- deposits as well as on some demand deposits,tions compete aggressively for these accounts, and the turnover rate for demand deposits isand members of credit unions can participate in extremely high. Two, every deposit accepteda similar arrangement using share drafts (which from a customer is a liability-not an asset-are like checks) as payment vehicles. for the bank that accepts it. It is an obligation

Federal laws also allow banks to offer auto- that must be repaid at some future date.matic transfer services (ATS). With ATS, a Deposits represent the largest percentage of lia-customer can write checks that exceed existing bilities on almost all bank balance sheets. At thebalances and the bank, by prior arrangement, same time, as the bank's raw material, thesewill automatically move funds from the cus- deposits are the primary and most importanttomer's savings account to the checking source of funds to be put to profitable use asaccount to cover the checks. loans and investments. Because time deposits

with stated maturities remain with the bank for

Savings and Time Deposits longer periods of time than demand deposits do,these funds are generally used for longer-term

Savings accounts differ from demand deposits bank loans and investments. High-turnoverin that banks can require a seven-day notice of demand deposit funds are put to short-term use.


Tf P@ and wifiersiiip @f

The type of account opened by a customer,whether individual, joint, partnership, corpo-rate, or other, determines the ownership of theaccount, what identification is required, andwhat documentation is necessary to establishthe capacity and the authority of the personopening the account. The type of account alsodetermines the rights, obligations, and liabili-ties of the parties to the account. The implica-tions of ownership are discussed in thefollowing sections. Exhibit 4.1 shows thetypes of consumer and business account own-ers to be discussed.

Consumer Owners

Individual Accounts

An individual account is an account openedfor and owned by an individual. The individualis the sole owner of the account, and no other

person has any rights concerning it. When theaccount owner dies, the account normallybecomes part of his or her estate.

When opening individual accounts, banksare mostly concerned with estabhshing theaccount owner's identity. Banks have policiesand procedures that dictate the forms of iden-tification required to open an individual

account and the types of documentation or ref-erences needed.

At a minimum, banks require at least oneform of primary identification, typically some-thing with a photograph such as a driver'slicense or passport, and a piece of secondaryidentification like an automobile registrationor social security card. (Appropriate types ofidentification will be covered more fully laterin this chapter.) In addition, banks requireother banking references and will usuallycheck the databases available from credit

reporting services.Individuals are properly identified to ensure

that they are the persons they represent them-selves to be. Proper identification substantiallyreduces the risk that the person opening theaccount will use the account for fraudulent

purposes.

Sometimes a customer might want to givesomeone else the authority to sign checks ormake other decisions for his or her account.

This can be accomplished through a power ofattorney. A power of attorney (exhibit 4.2) isa legal document that authorizes a person (theattorney-in-fact) to act on behalf of anotherperson (the principal).

Powers of attorney vary depending on thewishes of the account owner. He or she can

grant a general power of attorney, which givesthe attorney-in-fact unlimited authority overthe account, or a special power of attorney

Exhibit 4.1 Type and Ownership of Accounts

Consumer Business

-Individual-

-Joint-Fiduciary

-Sole Proprietorship-Partnership-Corporate-Public Funds-Unincorporated Organizations


Exhibit 4.2 Power of Attorney Form

DEMAND ACCOUNT

SAVINGS ACCOUNT1

ACCEPTED BY OFFICE

SCnoui all Mm inj tljzzt IfreaattsThat

.

do make, constitute and appoint

name:

.

trae and lawful attorney for and in .

1.

To withdraw all or any part of the balance in ,

account number

in

THE INSTITUTE NATIONAL BANK

by drawing checks, if a demand account; or, by giving the required priornotice and by executing the proper withdrawal order or receipt if a savingsaccount.

2. To endorse notes, checks, drafts or bills of exchange which may

.

endorsement for deposit as cash in, or for collection byrequire said bank.

3.

To do all lawful acts requisite for effecting any of the above premises;-hereby ratifying and confirming all that the said attorney shall do therein byvirtue of these presents.

This power of attorney shall continue in force until due notice of therevocation thereof shall be given in writing.

In witness whereof

seal this '

day of.

two thousand and

.

have hereunto set..

hand and

SIGNED, SEALED AND DELIVEREDIN THE PRESENCE OF }

which limits the authority to a specific duty orfunction and to a limited period of time.Powers of attorney cease at the death of theperson who grants the power of attorney. Forexample, a customer may place a power ofattorney on a checking account but not on a

savings account or certificate of deposit, deny-ing access to these other accounts. The retiredcouple in situation 1 wants their daughter to beable to pay their bills while they are away. Thedaughter can be given power of attorney overthe couple's checking account only, and the


power of attorney could be revoked when thecouple returns from their trip.

Just as they do with identification, bankshave policies and procedures to follow whenaccepting a power of attorney. It is importantto follow these procedures, which ensure that,among other things, the power of attorney wasauthorized by the principal.

Joint Accounts

A joint account is an account opened in thenames of and owned by two or more deposi-tors. Joint accounts can be held either in jointtenancy with full right of survivorship or astenants in common (exhibit 4.3).

A typical joint tenancy account with fullright of survivorship has the word "or" sepa-rating the names of the account owners (BillWiltshire or Peggy Wiltshire). In an accountlike this, either one of the account holders maymake deposits, write checks, make with-drawals, transfer funds, access the account

electronically, stop payment on checks, closethe account, or otherwise treat the account as

his or her own. Only one signature is required.When one of the account holders dies, the

funds in the account typically pass to the sur-viving account holder(s) in accordance withstate law and without need to establish an

estate.

Joint tenants in common accounts usuallyhave the word "and" separating the names ofthe holders (Mike Harris and Jackie Harris).These account holders must act together. Forexample, both Mike's and Jackie's signatures

would be required to make a deposit or with-drawal from the account. Roommates mightfind a tenants in common account to be the

most convenient way to share expenses. Sinceall of their signatures are required on checksdrawn on the household account, none of the

roommates can use the funds without the oth-

ers'

knowledge. Joint tenants-in-common ac-counts need greater monitoring, requiring thebank to verify that all account holders signchecks or withdrawal slips. If the bank payschecks with only one signature when it hasagreed to require the signatures of all theaccount holders, the bank could be liable to the

account holders who did not sign the checks orwithdrawals.

Establishing identification is just as impor-tant in opening joint accounts as it is in open-ing individual accounts. Bank procedures vary.Some require that all the joint account holdersbe present to sign the signature card, while oth-ers might allow a signature card to be mailedfrom one or more of the joint account holders.

In most circumstances, the account agree-ment holds each account holder responsiblefor the transactions on a joint account, includ-ing overdrafts.

Fiduciary Accounts

The term fiduciary means one who acts for thebenefit of another. A fiduciary account is anaccount opened by a representative for thebenefit of another. Some examples of fiduciaryaccounts are guardianships, conservatorships,trust accounts, and estate accounts. In all

Exhibit 4.3 Joint Accounts

Right of survivorshipTenants in common

"

or"

husband and wife act independently"and" roommates act together


cases, each account has a representative (such documentation that banks should obtain. Theas a guardian) and a beneficiary (such as a act also outlines the steps in maintaining andminor child) or person for whose benefit the policing fiduciary accounts.account is held. The accounts take many dif-ferent forms and require several different types Business Ownersof documentation, depending on the type ofaccount opened. Sole Proprietorship Accounts

An example of a simple fiduciary account isan account opened "in trust for" a minor child. A sole proprietorship is a business owned byIn this example, a mother and father open a an individual called a proprietor. The business

fiduciary account for their newborn child. This may be in the name of the proprietor or in asimple account usually involves only a basic trade name ("trading as" or "t/a"), or thedocument and may not involve large balances, phrase "doing business as (dba)" may be used.When opening the account, the bank will Examples are Winston's, or Winston's Coffeeobtain identification from the representative House, or James Winston doing business as(the parents), just as if opening an account for Winston's Coffee House. In each example,an individual. Winston is the owner of the business, and he

An account established for the executor or alone has the right to open an account oradministrator of a substantial estate is far more authorize someone to open an account for him.complicated, requires extensive doeumenta- When a proprietorship is operated under thetion, and may carry large balances until the individual's own name, a bank requires identi-estate is finally settled. Before opening an fication, references, and signature cards toestate account, the executor or the administra- open the account, much as it does in the casetor provides the bank with court-issued docu- of an individual. However, when any namements establishing the estate of the deceased other than the individual's is used, the connec-and appointing the administrator or executor tion between the owner and the fictitious tradeof the estate. name should also be established legally. The

Guardianship accounts can also be compli- proprietor provides the bank with the legalcated, and they require substantial documen- registration form required by the state. Thistation. The laws governing guardianships might be a business certificate, a fictitiousmay vary from state to state, but in.general a name registration, or a certificate of registra-guardianship account may be opened only tion of trade name.with court documentation. In many cases, A sole proprietor has the right to open anwithdrawals may be made only by a court account, make deposits, stop payment, andorder. Policing these accounts usually conduct his or her account in any manner he orrequires special handling by experienced she wishes. Checks payable to the proprietorbanking officers. or to the proprietorship may be deposited to

Many states have adopted the Uniform the sole proprietorship account. The proprietorFiduciaries Act, which contains provisions that can authorize another individual as a signer onapply to fiduciary accounts and provides the account, but this person would not have theguidelines for banks on the type and extent of same rights to the account as the owner.


Partnership Accounts the partnership. When a partner dies or newpartners are added to the firm, the bank obtains

When two or more individuals enter into a new documents that reflect the changes.business together, they may form a partner-ship. The business may operate under the Corporate Accountsnames of the individual partners (for example,Harris, Wink, and Harris), or it may use a trade A corporation is a legal entity or an artificialname. Partnerships are widely used in real person created by state or national law. A cor-estate ownership and in many law firms, poration has the right and capacity to enter intoaccounting firms, and brokerage houses. Most contracts. A corporate account is opened in thestates have adopted laws pertaining to the con- name of the corporation, and the corporation isduct of this type of business and the rights and the owner of the account. Anytime a bankobligations of each partner. These laws direct- interacts with the corporation-lending money,ly relate to the bank's handling of the account, for example-it interacts with the corporation,

A legal document called a partnership not its stockholders, directors, or officers.agreement is usually drawn up at the time the A corporation can be identified by its legalpartnership is established. The agreement name, which includes "Inc.," "Corporation,"states the contributions each partner has made "Incorporated," or "Limited." For example, ifto the business, the nature of the business, and Winston incorporated his coffee house, hethe proportions in which each partner will would have to change the name from

*! share in profits or losses. Any one member of Winston's Coffee House to, say, Winston'sthe partnership may be empowered to act for Coffee House, Inc.all the others, so that his or her actions are Corporations are the same as individualslegally binding on all the other partners. and partnerships in that the corporation is a

In opening an account for a partnership, a legal entity, but the similarity ends there. Thebank obtains signatures from all the partners corporation cannot act on its own; it must actwho will be authorized to issue checks, apply through representatives. The stockholders,for loans for the partnership, and otherwise who own the corporation, elect the board ofdeal with the bank. This form is normally directors, who are the governing body of thecalled a partnership resolution. The bank also corporation and are responsible for conductingobtains a copy of the partnership agreement, its business. Only the directors can establisheither on the bank's own standard form or on the legal right to open and operate a bankanother legally acceptable form. If the partner- account.ship operates under a trade name, the bank also To verify the authority to open an account,keeps a copy of the business certificate on the bank reviews the corporate resolution

file--the same as was required of the sole pro- (exhibit 4.4)-a document prepared by theprietor discussed earlier. board of directors when it resolves to open an

Partnership law generally states that the account. When the account is opened, a certi-death of any one partner automatically termi- fied copy of the resolution is filed with thenates the partnership; however, provisions are bank. In addition to other information, the cor-made for the surviving partners to reorganize porate resolution authorizes certain officers to


Exhibit 4.4 Corporate Resolution Formr

CORPORATE RESOLUTION

(account tide)

ACCOUNT NUMBER

OFFICE

ACCEPTED BY

DATE

"RESOLVED, that an account in the name of this Corporation beestablished or maintained with the INSTITUTE NATIONAL BANK and thatall checks, drafts, notes, or other orders for the payment of money drawn on orpayable against said account shall be signed by any (indicate number) person or persons from time to time holding the followingoffices of this Corporation.

Indicate title only; not individual's name.FURTHER RESOLVED, that said INSTITUTE NATIONAL BANK is

hereby authorized and directed to pay all checks, drafts, notes and orders sosigned whether payable to bearer, or to the order of any person, firm orcorporation, or to the order of any person signing the same.

The undersigned Secretary of

(name of corporation) hereby certifiesthat the above is a true and correct copy of a resolution regularly adopted by theBoard of Directors of the Corporation at a duly called meeting of the Board heldon (dateV at which a quorum was present andvoting throughout; and that said resolution is presently in full force and effect.

I further certify that the persons named below are those duly elected orappointed to the Corporate Office or capacity set forth opposite their respectivenames.

NAME TITLE

iIn Witness Whereof, I have hereunto set my hand and affixed hereto the

Corporate Seal of this Corporation."

CorporateSeal

Secretary

Dated:

sign checks or otherwise issue instructions to separate resolution will cover the corporation'sthe bank concerning the account. The resolu- borrowing needs.tion may also authorize the corporation to bor- The question of authority is important in arow money from the bank or, more likely, a bank's relationship with a corporation. Only

c


individuals authorized by the directors can do funds involved are collected and used for thebusiness with the bank on behalf of the corpo- public's benefit; the general term public fundsration. Therefore, when the corporate resolu- account is used to describe all relationshipstion mentions official titles (such as vice opened for any department, agency, authority,president or treasurer), the bank keeps on file or other component of any federal, state, orthe names and signatures of the persons who local government or political subdivision.hold those titles and who are authorized to The unit of government officially appointstransact business on the corporation's behalf, the banks with which it wishes to openThis file is updated constantly with new signa- accounts. State and local laws usually pre-ture cards as new people are given authority or scribe the procedures that estabhsh publicauthority is lost through death, retirement, or funds accounts at banks.other means. While banks are careful to iden- Documentation of public funds accountstify those authorized to transact business, the usually consists of signature cards listing thecorporation may bear some liability for unau- authorized signers and some form of officialthorized transactions if it is shown that the cor- letter or notice appointing the bank as a depos-poration's neghgence contributed to the loss. itory. The letter or notice is typically issued by

In addition to knowing who can transact the head of the unit of government.business for the corporation, banks keep In general, all such accounts are secured byrecords on the limits to the authority of each segregated, specific assets in the bank's pos-signer. The president, for example, may have session; that is, the bank sets aside U.S. gov-unlimited authority, while the vice president of emment obligations or other assets of

finance can sign checks up to only $100,000. It unquestioned value as collateral to protect theis also possible that several people will need to deposited funds. This collateral provides, ancombine their signatures to be acceptable additional guarantee that public funds willunder the resolution, as shown below. never be lost. If a bank does not possess or

cannot obtain enough government securities orIndividually Combined (any two) other satisfactory assets to be pledged for thisVP $5,000 $25,000 purpose, it must decline a new public fundsComptroller $5,000 account.Secretary $5,000

Unincorporated OrganizationsUnlike an individual or a partnership

account, neither a corporate account nor the Banks are asked to open deposit accounts for

operation of a business is affected by the death all sorts of unincorporated organizations suchof a stockholder. as churches, bowling leagues, soccer teams,

class reunions, and disaster relief funds. While

Public Funds Accounts these are not "businesses" in the traditional

sense, many banks tend to treat them as busi-Thousands of governments receive and dis- ness accounts. Accounts established for socialburse funds on behalf of the communities and or fraternal groups, not-for-profit and unincor-citizens they serve. In most instances, the porated associations and societies, and other


informal types of entities can create interesting tomer the abiUty to extend credit to himself orsituations for banks. herself, provides the customer with the vehicle

Important issues with unincorporated to convert checks and other instruments intoorganizations are (1) establishing the authority cash, and creates a number of other situationsto open the account and (2) authorizing the that could result in a loss to the bank. Theperson or persons who will sign checks, same principle that applies to making a loanUnlike a corporation that has a board of direc- applies to opening an account: Know as muchtors, an unincorporated organization may not as you can about your customer!have an established governing body. Becausesuch organizations usually are not listed in Establishing identitystate or local government records, the bankrelies largely on its knowledge of the parties it The bank establishes the identity of the personwill be dealing with when it establishes such opening the account in order to protect theaccounts. Signature cards always are required, bank from loss. But how can a bank determineEach situation dictates what additional letters, that the individual who wishes to open anforms, agreements, or special documents account is the person he or she claims to beshould be obtained. The bank's attorneys are and is someone with whom the bank wouldoften consulted when dealing with these types want to do business? Unfortunately, there is noof organizations. foolproof way. Forgers can counterfeit driver's

After the account is opened, unincorporated licenses, auto registrations, credit cards, andorganizations frequendy send letters changing other forms of identification. A passport isthe authorized signers. The organization occa- often regarded as ideal identification, yet fewsionally documents the meeting where the new people have them, and most people who doofficers were elected and provides the bank have one rarely carry it with them. Bank staffwith the minutes of the meeting. members, then, must evaluate the identifica-

tion that is offered according to bank policyAuthority to pen A&euntS and procedures

, and employ an element ofjudgment.

A customer must open an account before the New Accounts representatives are thebank can accept items for deposit. The bank's first line of defense against all types ofaccount-opening process entails niuch more new account fraud. Bankers who openthan filling out forms at the new accounts accounts walk a fine line between keepingdesk. In opening the account, the bank undesirable customers from opening accounts. establishes the identity of the person open- and not discouraging potentially valued cus-

ing the account tomers. Bank policies and procedures vary, but. determines that the person has the legal generally, bankers:

capacity to open the account . Require at least one form of primary identi-. ensures that the person is authorized to fication (driver's license, passport, U.S.

open the account Armed Forces ID, state- or bank-issued ID,By opening an account, a bank enters into a or a work ID with a photo) and at least one

contractual relationship that gives the cus- form of secondary identification (automo-


!, J

bile registration, birth certificate, union fraud. A customer opened an account in thecard, local credit card, voter registration name of a pest exterminator company. Becausecard, government ID, Social Security card, he had convincing identification-even a busi-and so forth). ness card with a picture of a bug on it-the

. Check to see if the customer's home or new accounts clerk did not question whetherplace of work is close to the bank. If not, the man was actually the person he represent-inquire as to why the customer wants to ed himself to be. After opening the accountopen an account at that bank. with cash, this con artist made legitimate

. Check that the customer's employment deposits to his account with cash and checksinformation is valid after the account is for about three weeks. During that time he alsoopened by calling the customer at the work- cashed checks at various branches aroundplace to thank him or her for opening an town and got to know a number of tellers byaccount. name. After three weeks, he put his scheme

. Consider the source of funds used to open into action. He deposited to the account a num-an account. Be wary of large cash deposits ber of checks drawn on closed accountsand large checks from out of state. around the country, and before the bank

. Consider using prior bank references or received notification of return, he withdrewcredit bureau reports. the funds from the account. He absconded

. Search databases for undesirable cus- with the money and was never seen again.tomers-those who have had problems at Remember the man in Situation 2 whoother banks, including insufficient funds, wanted to open a joint account for himself andfraud, bankruptcy, or other judgments his wife? The out-of-state checks and theIn addition to establishing the identity of the absence of his wife should be red flags to any

customer, IRS regulations in most instances, new accounts representative. Bank policyrequire that banks verify a customer's Taxpayer most likely dictates that, in this case, starterIdentification Number (TIN) through TIN checks would be denied until the initial depositCertification. TIN Certification is the process has cleared, thereby preventing loss.of confirming that a customer's tax identifica- The bank must establish the identity of thetion number is correct, and that he or she is not person opening the account, even if the personsubject to back-up withholding (requiring the opens an account with cash. There are strictbank to withhold and pay to the IRS 31 percent reporting requirements to help detect potentialof interest, dividends, and other payments) or money laundering (the practice of movingexempt from withholding. For TIN large amounts of cash received fromCertification, the customer completes IRS cash-based illegal business-like sellingForm W-9 (see exhibit 4.5). For tax reporting drugs-through many accounts or banks topurposes, the W-9 is one of most important hide the source of the money). Forged checks,documents for a financial institution to receive identity theft, kiting (chapter 7), stolen checks,and retain. Banks generally require these for all and other instances of fraud are all compellingentities that are required to file a return. reasons to establish the customer's identity. In

An incident that actually occurred at a bank many situations, the bank is liable for lossesillustrates how difficult it may be to discover due to new accounts fraud.


Exhibit 4.5 IRS Form W-9

Form \A/3(Rev. December 2000)Department of the TreasuryInternal Revenue Service

a

o

|a

o0}a

a.

Request for TaxpayerIdentification Number and Certification

Give form to therequester. Do notsend to the IRS.

Name (See Specific Instructions on page 2.)Susan E. Smith

Business name, if different from above. (See Specific Instructions on page 2.)

Check appropriate box: jESfr Individual/Sole proprietor Q Corporation Q Partnership Q OtherAddress (number, street, and apt. or suite no.)

456 Cherry StreetCity, state, and ZIP code

Portsmouth, RI 02871

Requester's name and address (optional)

Taxpayer Identification Number (TIN)PartEnter your TIN in the appropriate box. Forindividuals, this is your social security number(SSN). However, for a resident alien, soleproprietor, or disregarded entity, see the Part Iinstructions on page 2. For other entities, it is youremployer identification number (EIN). If you do nothave a number, see How to get a TIN on page 2.Note: // the account is in more than one name, seethe chart on page 2 for guidelines on whose numberto enter.

Social security number1|2|34415|6|7|8|9

List account number(s) here (optional)

42-1234567

orPart II

Employer identification number

III I 1 i 1

For U.S. Payees Exempt FromBackup Withholding (See theinstructions on page 2.)

CertificationPart III

Under penalties of perjury, I certify that:1

. The number shown on this form is my correct taxpayer identification number (or I am waiting for a number to be issued to me), and

2. I am not subject to backup withholding because: (a) I am exempt from backup withholding, or (b) I have not been notified by the Internal

Revenue Service (IRS) that I am subject to backup withholding as a result of a failure to report all interest or dividends, or (c) the IRS hasnotified me that I am no longer subject to backup withholding, and

3.

I am a U.S. person (including a U.S. resident alien).Certification instructions. You must cross out item 2 above if you have been notified by the IRS that you are currently subject to backupwithholding because you have failed to report all interest and dividends on your tax return: For real estate transactions, item 2 does not apply.For mortgage interest paid, acquisition or abandonment of secured property, cancellation of debt, contributions to an individual retirementarrangement (IRA), and generally, payments other than interest and dividends, you are not required to sign the Certification, tut you mustprovide your correct TIN. (See the instructions on page 2.)Sign Signature of

U.

S.

person Date

Purpose of FormA person who is required to file an informationreturn with the IRS must get your correcttaxpayer identification number (TIN) to report, forexample, income paid to you, real estatetransactions, mortgage interest you paid,acquisition or abandonment of secured property,cancellation of debt, or contributions you madeto an IRA.

Use Form W-9 only if you are a U.S. person(including a resident alien), to give your correctTIN to the person requesting it (the requester)and, when applicable, to:

1.

Certify the TIN you are giving is correct (oryou are waiting for a number to be issued),

2.

Certify you are not subject to backupwithholding, or

3.

Claim exemption from backup withholding ifyou are a U.S. exempt payee.

if you are a foreign person, use theappropriate Form W-8. See Pub. 515,Withholding of Tax on Nonresident Aliens andForeign Corporations.Note: tf a requester gives you a form other thanForm W-9 to request your TIN, you must use the

What is backup withholding? Persons makingcertain payments to you must withhold and payto the IRS 31% of such payments under certainconditions. This is called "backup withholding."Payments that may be subject to backupwithholding include interest, dividends, brokerand barter exchange transactions, rents,royalties, nonemployee pay, and certainpayments from fishing boat operators. Real"estate, transactions are not subject to backupwithholding.

If you give the requester your correct TIN,make the proper certifications, and report allyour taxable interest and dividends on your taxreturn, payments you receive will not be subjectto backup withholding. Payments you receivewill be subject to backup withholding if:

1. You do not furnish your TIN to the

requester, or2

. You do not certify your TIN when required

(see the Part III instructions on page 2 fordetails), or

3.

The IRS tells the requester that youfurnished an incorrect TIN, or

4. The IRS tells you that you are subject to

backup withholding because you did not reportrequesters form if it is substantially similar to this all your interest and dividends on your tax returnForm W-9. (for reportable interest and dividends only), or

5.

You do not certify to the requester that youare not subject to backup withholding under 4above (for reportable interest and dividendaccounts opened after 1983 only).

Certain payees and payments are exemptfrom backup withholding. See the Part IIinstructions and the separate Instructions forthe Requester of Form W-9.

PenaltiesFailure to furnish TIN. If you fail to furnish yourcorrect TIN to a requester, you are subject to apenalty of $50 for each such failure unless yourfailure is due to reasonable cause and not towillful neglect.Civil penalty for false information with respectto withholding. If you make a false statementwith no reasonable basis that results in nobackup withholding, you are subject to a $500penalty.Criminal penalty for falsifying information.Willfully falsifying certifications or affirmationsmay subject you to criminal penalties includingfines and/or imprisonment.Misuse of TINs. If the requester discloses oruses TINs in violation of Federal law, therequester may be subject to civil and criminalpenalties.

Cat. No. 10231X Form W-9 (Rev. 12-2000)


Despite their desire to attract new business, and use the account. An individual opening anbanks must be selective in opening accounts, account in his or her name need only produceThe bank has no obligation to open an account proper identification. On the other hand, anif the potential customer fails to meet the individual opening an account on behalf ofrequirements estabhshed by the bank. another person will be asked to produce proof

Recendy, there has been growing concern that he or she has the authority to act on behalfover a new type of fraud referred to as identity of that other person. For example, a man rep-theft (see chapter 7). Criminals obtain one or resenting himself as an executor of an estate ismore pieces of identification and social securi- asked to produce the court-approved docu-ty numbers from their victims, either through mentation appointing him as the executor. Amail theft or other means. The pictures and sig- person opening an account in the name of anatures on these pieces of identification can be corporation or a partnership will want to bringaltered using graphic software, and used to the proper documents issued by the board ofopen fraudulent accounts in the victim's name, directors or the partnership authorizing that

person to open the account. The "corporateCapacity president" in situation 3

Principles of Banking

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