May
5/29
1

The Banking System Explained

in Accounting

BanksSo, I always know when it’s time to talk about a specific subject on here. Usually, several (ie. more than 2 or 3) of our customers have the same question, around the same time. So here we go… This isn’t going to be a fun topic, but, if you get to the bottom of the post, there will be a nice reward for you. Read this though, and you’ll never have to question it again… You’ll just remember!

In my opinion, the banking business is in the top 10 most confusing systems in the world. It’s so hard to understand, yet we trust these people with ALL of our money, ALL of our credit and ALL of our investments. We take cash to this building, hand it to a person behind a desk and miraculously it shows up as a number on our bank statement. Most of the time, we never see that cash again, but we trust that when we write a check, the numbers show up on someone else’s bank statement and not ours anymore. CRAZY… REALLY, we trust that it just all works, but most of us have no idea what goes on behind the scenes. So, let me give you a 30 thousand foot overview of what’s going on here.

First, when you write a check to someone, you’re basically giving them an “IOU” and promising that your bank will transfer the money to them… Somehow. Now, if that person takes that check to YOUR bank to cash it, then your bank will take the cash directly out of your bank account and give it to them. Simple, right? But, if that person takes that check to THEIR bank (or any other place that will cash the check) then several things need to happen. First, THEIR bank will usually want to know that they have enough money in their own bank account to cover the amount of the check. So, if the check is written for $200 and they have $500 in their bank account, then the bank will typically cash the check. However, if there the check is written for $200 but they only have $100 in their bank account, then the bank may put a “HOLD” on a portion of that money until the check clears the system. So, the bank may “HOLD” $100 of the $200 check.

What happens next? Well, the processing time actually depends on the time you make the deposit at the bank. Typically, if you make a deposit before 2:00pm, then the check will be processed that day. If you deposit it after 2:00pm, then it may not be processed until the next BUSINESS day. Remember, if you make a deposit at 3:00pm on Friday, that check usually won’t be processed until MONDAY. Then, you have to consider the next step in the process.

Each day, after the “Cut-off” time, the bank sends a listing of all the checks that they’ve cashed for the day to what’s called an “Intermediary Bank”. There are really 3 types of intermediary banks, but the Federal Reserve Bank handles about 60% of all these transactions, so let’s just talk about that one. The Fed is really the link between all financial institutions. Money that you deposit at your bank, is ultimately taken to the Federal Reserve and then distributed from there. If everyone who banks at your branch, came in on one day and tried to withdrawal all of their money, the branch wouldn’t have enough cash to give them. That’s because, most of the money is sitting in the Federal Reserve bank (or, other places that we can talk about later. Hence our current financial crisis!) So, the federal reserve looks at the routing # (ABA#) on your check and finds the bank that the check was written off of. They then send a request to your bank, asking them to send the Federal Reserve the $200 that the check was written for. If there is enough money in your bank account, then your bank debits your account and sends the money to the Federal Reserve. The Federal Reserve then sends the money to the bank the person made the deposit at and everyone is happy.

Now, what if there isn’t enough money in your bank account, but you write the check anyway? Well, when the Federal Reserve requests that money from your bank, your bank says “Sorry, “Insufficient Funds”. The federal reserve then sends a message back to the depositing bank saying, “Insufficient Funds – Don’t cash that check!” If the bank had already given the person the money, then they’re stuck and you’ve run off with their money! This is why banks won’t cash a check unless you have an account with them. They want to make sure that you’re going to be responsible for that money, just in case the federal reserve comes back saying “Insufficient Funds”.

So, it takes time for all of this to happen. Years ago, it used to take longer, but now that Check 21 is in effect, everything is done electronically and it’s a much quicker process. BUT, it still takes 24 to 48 hours (sometimes longer) for all of this to take place. This time frame makes up PART of the term “FLOAT”. The float is really the time between when the check is printed to the time the funds are available. You can figure mail time, how long it takes someone to open the mail and actually get it to the bank to make the deposit and then how long it takes for the banks to negotiate the funds. ALL this time makes up the float and there are literally 50 different things you can do with that “Float Time” to actually make money before the checks clear. (ie. Zero Balance Accounts, Funds sweep, etc. Again, different topics for a different day BUT, if you want more info now, just ask!)

This float time can work in your favor (sometimes) OR it could kill you! For example, if you know that payroll is hitting tomorrow and you make a deposit today, then the bank might put a hold on that deposit to wait for the Federal Reserve to do their thing… This hold could take 2 days, in which case, your payroll won’t go through and checks would likely bounce! Just because you make a deposit today, doesn’t mean that the money will be available tomorrow! This is very important!

So, in a nutshell, the Federal Reserve Bank is the middle man between all the other banks. All the money supposedly goes in and out of the Federal Reserve. So, A couple questions…

1. What if your bank decides to take your $200 and invest it rather than sending it to the Federal Reserve? What if your BANK plays the “Float”?

2. What happens if a bunch of people withdrawal all (or a lot) of their cash out of their bank accounts at one time and the Federal Reserve doesn’t have enough cash to distribute to everyone because the BANK played the float?

3. What if the bank barrows money (from another bank) to send to the Federal Reserve and then invests YOUR money, trying to make a profit?

4. What if the stock market sucks and the bank loses your money and can’t pay back the loan they took out to send to the Federal Reserve?

hummmm…

Comments

One Response to “The Banking System Explained”
  1. Sanford Levings says:

    Ben,

    Not sure if i can answer your questions but here’s my stab at it:

    1) What if your bank decides to take your $200 and invest it rather than sending it to the Federal Reserve?

    I believe banks take a percentage of their deposits and do invest by making loans and buying fixed income securities. I remember hearing years ago, that banks try to make a 4% “spread” between the cost of borrowing (interest on checking accounts and cd’s) and investing (via extending loans and buying bonds). I’m pretty sure banks are prohibited from buying stocks, due to stocks inherent volitility. And i believe banks can lend out 10 to 1 and evn much higher than that. (like 45 to 1 with some banks) which to me, is scary high leverage.

    Federal regulators are supposed to make sure that all banks are sound, which makes me wonder why so many banks are failing and/or struggling. Where were the “feds”?

    2. What happens if a bunch of people withdrawal all (or a lot) of their cash out of their bank accounts at one time and the Federal Reserve doesn’t have enough cash to distribute to everyone because the BANK played the float?

    FDIC insures up to $250,000 per depositer now, right?

    3. What if the bank barrows money (from another bank) to send to the Federal Reserve and then invests YOUR money, trying to make a profit?

    I think this is called “fed funds” and is heavily practiced among the banks.

    4. What if the stock market sucks and the bank loses your money and can’t pay back the loan they took out to send to the Federal Reserve?

    i don’t think banks can invest in stocks. FDIC insurance kicks in, right?