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Chapter 5
Banking and Interest Rates

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36 Madura • Personal Finance, Fifth Edition

 Chapter Overview
Given the failures and subsequent collapse of several financial institutions in 2008 and 2009, the topic of
financial institutions should be viewed with more scrutiny than ever before. Financial institutions provide
services for those who wish to invest or borrow funds. Chapter 5 discusses the various types of depository
institutions that offer these services: commercial banks, savings institutions, and credit unions. Also,
services offered by nondepository institutions such as finance companies, securities firms, insurance
companies, and investment companies, are explained. In addition to offering investment opportunities and
loans, some financial institutions offer services such as credit card financing, debit cards, safety deposit
boxes, automated teller machines, cashier’s checks, money orders, and traveler’s checks.

Choosing a financial institution today can be more challenging than ever. The ongoing changes in the
structure of financial institutions can cause consumers to reevaluate their choices. Today, consumers can
even choose to use a virtual financial institution, one where there is no physical location. Regardless of the
type of financial institution chosen, the consumer needs to evaluate the services offered (including online),
convenience, interest rates on deposits, deposit insurance, and the various fees that may be charged.
Interest rates, paid on deposits and charged on loans, may vary among institutions. The relationship of
interest rate to risk is discussed in the chapter, as well as the relationship of interest rate to the maturity of
the investment. Interest rates play a large role in deciding which banking services a customer would use,
but the fees charged for services may play an even bigger role.

Any change in savings behaviors by investors will affect the money supply. When investors save more,
the money supply increases, and when they save less, the money supply decreases. Monetary policy also
affects the money supply. The Federal Reserve directs monetary policy and can control interest rates by
changing the reserve requirements for banks, setting the discount rate, or through open market operations.

Shifts in the demand for money can also affect interest rates. The U.S. government often borrows
substantial amounts of money. Shifts in government borrowing affect the demand for money. The more
money the government borrows, the less money there is left for others to borrow, and interest rates
increase. In the same manner, shifts in borrowing for businesses and for households have the same effect.

 Chapter Objectives
The objectives of this chapter are to:
 Describe the types and functions of financial institutions
 Describe the banking services offered by financial institutions
 Identify the components of interest rates
 Explain why interest rates change over time

 Teaching Tips
1. Survey students as to their choices of financial institutions. Many times it is the same financial
institution their parents used, or it is where a friend does business. Discuss the idea that there are two
ways to look at financial institutions: as a place to keep money safe or as a business out to make
money. Stress that shopping around for a bank is like shopping around for a pair of shoes: You want
the best fit for the lowest price.

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2. Describe the kinds of services a financial institution might offer. Have the students prepare a banking
profile describing the kind of customer they might be. How many checks would they write a month?
What minimum balance could they maintain? How often do they actually visit their financial
institution? How important are the online services that are offered? How often would they use ATMs
or debit cards? Would they use other banking services such as traveler’s checks, cashier’s checks, or
money orders? Help them make their profiles as complete as possible.

3. Team/online exercise—have students complete a financial institution survey composed of questions.

(What is the NSF charge at your financial institution? What is the interest rate on savings? What are
U.S. Savings Bonds, and how are they purchased? What is the current rate on CDs? How many times a
month do you go to your financial institution? How many times do you use online services?) The
discussion that follows allows more-informed students to share their knowledge and usually generates
questions about other services a financial institution may offer.

4. Open a discussion asking if students know the main difference between a credit union and a bank. As
members of credit unions, they are owners, but at banks they are only customers unless they own
stock in that bank. Many times the service provided is more personal and the rates on loans may be
lower while the rates on savings may be higher than comparable financial institutions. It is not
uncommon that a student opens an account at a financial institution that is advertising on campus
(offering “free” stuff). Urge students to shop around for an institution that best suits their needs.

5. Have students gather information from local financial institutions and online institutions about the
services they offer. Include the services that are offered online. The information may be found online
or through brochures at local banks. Using the banking profile prepared previously, have students
determine which bank would offer them the best deal for the lowest cost.

6. A good discussion as a class or in groups focusing on the types of financial institutions the students
are using would be helpful. Why are they using a particular institution? Is anyone using virtual
financial institutions? What are important factors that were used in choosing a given financial
institution?

7. Develop a practice bank reconciliation with the data to support it. Have the students actually
reconcile the account.

8. Many students will have problems calculating interest for different time periods. A good group
exercise would be to have 10–15 problems focusing on the math in different interest rate calculations
and the difference in cost and savings the rates do make.

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 Answers to End-of-Chapter Review Questions

1. Commercial banks accept deposits in checking and savings accounts and make loans to both
commercial and personal clients. Savings institutions accept deposits but focus on providing
mortgage and personal loans to individuals rather than commercial clients. Credit unions are
nonprofit organizations that accept deposits and provide personal and mortgage loans only to their
members. Credit unions serve members who have a common affiliation (such as the same employer
or the same community).

2. Finance companies provide personal loans to individuals. These loans are usually at higher rates to
individuals at a higher risk of defaulting on the loan. Securities companies facilitate the purchase
or sale of securities by firms or individuals by (1) finding investors to purchase a firm’s securities;
(2) providing advice to firms selling securities, such as the amount and price of securities to be sold;
and (3) providing firms with advice for mergers, such as valuation and potential benefits. Securities
firms also provide brokerage services, helping to make a market for stocks and bonds by matching
buyers and sellers. Insurance companies sell insurance to protect individuals and companies against
perils (adverse events). Insurance companies include life insurance companies, property and casualty
insurance companies, and health insurance companies. Investment companies use money provided by
individuals to invest in securities to create mutual funds. Mutual funds provide a means by which
investors with only a small amount of money can invest in a portfolio of securities.

3. Financial conglomerates are financial institutions that offer a diverse set of financial services to
individuals or firms. Financial conglomerates offer a diverse set of financial services such as
accepting deposits, providing loans, offering credit cards, providing brokerage services, providing
insurance services, etc. Examples of financial conglomerates include Citigroup, Bank of America,
and Merrill Lynch.

4. Some of the more important banking services offered to individuals by financial institutions are
checking services that include debit cards and ATMs that monitor your account balance, reconciling
your account balance, accessing your account balance through an automated phone service or online,
electronic checking, depository (savings) accounts, and personal loans.

5. A credit card allows you to purchase goods and services on credit, within your credit limits. If you do
not pay off your entire balance each month, you will incur a finance charge. When you use a debit
card, payment comes directly from your checking account

6. Safety deposit boxes are used to store important documents, jewelry, etc. ATMs offer convenient
access to cash. Cashier’s checks are checks written on behalf of a person to a specific payee and will
be charged against a financial institution’s account. They are useful when the payee is concerned that
a personal check may bounce. Money orders are checks written on behalf of a person and will be
charged against a nonfinancial institution’s account. Money orders are a safe way to send money.
Traveler’s checks are a safe way to carry money when you travel as they can be replaced if lost or
stolen. However, the use of traveler’s checks has diminished with the increasing use of ATMs.

7. Steve should consider the convenience of making deposits and withdrawals, including ATM locations
and the availability of Web-based access. He should also consider interest rates paid to depositors and
minimum balance requirements. Finally, Steve should consider fees such as service charges, per
check charges, and ATM use charges.

8. Current interest rates affect the amount of interest you would receive on deposits as well as the
amount of interest you would pay on borrowing. Therefore, current interest rates could affect both
your cash inflows and cash outflows.

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 Chapter 5 Banking and Interest Rates 39

9. A risk-free rate is an interest rate guaranteed on an investment for a specified period. A certificate of
deposit issued by a financial institution insured by the federal government is an example of a risk-free
rate because it could not default. Even if the financial institution were to go into bankruptcy, the
investors would receive what was owed them by the bank.

10. When an investment is not insured by the federal government, there is a risk of default. That is, you
may receive a lower return than you expected if the firm goes bankrupt. An investor is compensated
for the additional risk by receiving a higher rate of return. The difference between the risk-free rate
and the higher rate an investor might receive is called the risk premium. Due to the risk of losing part
or all of their investment, only those with substantial savings would want to invest in riskier deposits
and certificates.

11. The risk premium offered on a risky deposit is the return on the risky deposit less the risk-free rate:
RP  R  Rf
12. Financial institutions obtain funds for loans by accepting deposits from individuals. Investors
essentially provide credit to financial markets. The interest rate for loans is determined by adding
varying percentage points to the rate paid on deposits. Interest rates will vary among loans. Higher
rates of interest are charged on loans that are exposed to higher default risk.

13. As current interest rates rise, depositors can expect to receive a higher interest rate for their deposits
and borrowers can expect to pay a higher interest rate for their loans. Should interest rates fall,
depositors can expect to receive less for their deposits and borrowers can expect to pay less for
their loans.

14. The two factors that will influence investment decisions are the individual’s risk tolerance and
financial situation. An appropriate investment for an investor who needs funds in a short period of
time for necessities is a risk-free investment because other investments could be worth less in a short
time period than they are worth today.

15. The term structure of interest rates refers to the differing annualized interest rates of investments with
different maturities. The longer the time to maturity, the higher the interest rates will be. The term
structure is often based on rates of return offered by Treasury securities with different maturities. The
structure provides the investor with risk-free rates at varying maturities to help in making decisions
on various investments depending on when the investor will need the money.

16. Monetary policy is the act of controlling the money supply. The Federal Reserve System, the central
bank of the United States, oversees monetary policy.

17. The three key factors include a shift in government demand for money, a shift in business demand for
money, and a shift in household demand for money. The U.S. government frequently borrows
substantial amounts of funds. Thus, any change in the government’s borrowing behavior can affect
the aggregate demand for funds. As economic conditions change, businesses adjust their plans and
their demand for funds, thus affecting the aggregate demand for money. The amount that households
wish to borrow can change in response to economic conditions.

18. When the economy is weak, the potential loss on risky investments increases. Therefore, investors
will only invest in risky assets under these conditions if the risk premium is relatively high. The risk
premium increases as the economy weakens to reflect the higher rate of return required above the
risk-free rate when investing in corporations.

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40 Madura • Personal Finance, Fifth Edition

19. A high risk premium is an advantage for the investor because it represents a higher rate of return
beyond the risk-free rate. However, the high risk premium is offered because the risk at that time is
high, meaning that the value of the investment has a relatively high chance of experiencing a large
loss.

During more favorable economic conditions, the risk premium would be lower, which represents a
relatively low rate of return beyond the risk-free rate. However, the low risk premium is offered
under these conditions because the risk at that time is low, meaning that the value of the investment
has a relatively low chance of experiencing a large loss.

 Answers to Financial Planning Problems

1. Jason should choose Hillsboro:

Hillsboro First National South Trust Sun Coast

ATM $ 4.00 $10.00 $10.00 $10.00
Monthly fee 6.00 7.00 11.00 2.50
Per check 3.00 8.00 0 7.50
Total $13.00 $25.00 $21.00 $20.00

ATM computations:
Hillsboro (8  4)  1.00 4.00
First National, South Trust, Sun Coast 8  1.25 10.00
Per check computations:
Hillsboro (15  12)  1.00  3.00
First National (15  7)  1.00  8.00
Sun Coast 15  0.50  7.50

2. Julie should choose South Trust

Hillsboro First National South Trust Sun Coast

ATM * 0 0 0
Monthly fee $ 7.00 $11.00 $ 2.50
Per check 13.00 0 10.00
Total $20.00 $11.00 $12.50

Per check computations:

First National (20  7)  1.00  13.00
Sun Coast (20  0.50)  10.00
*Could not meet Hillsboro’s minimum deposit amount.
3. Veronica should choose Hillsboro:

Hillsboro First National South Trust Sun Coast

ATM $11.00 $18.75 $18.75 $18.75
Monthly fee 6.00 7.00 0 $ 2.50

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 Chapter 5 Banking and Interest Rates 41

Per check 0 3.00 0 5.00

Total $17.00 $28.75 $18.75 $26.25

ATM computations:
Hillsboro (15  4)  1  11.00
First National, South Trust, Sun Coast 15  1.25  18.75

Per check computations:

First National (10  7)  1.00  3.00
Sun Coast 10  0.50  5.00

4. Randy has to write 18 checks or more to prefer South Trust over Sun Coast.
Because he will not maintain a minimum balance, Randy will have to pay either $11 per month for
unlimited writing at South Trust or a $2.50 per month fee plus a per check charge at Sun Coast.
($11.00  $2.50)  8.50. $8.50/ 0.50  17 checks. If he wrote exactly 17 checks, he would pay $11
per month at both Sun Coast and South Trust. If he writes 18 checks or more, Randy would pay
exactly $11 at South Trust but a higher amount at Sun Coast.

5. One of Paul’s checks will bounce if he doesn’t make another deposit. Although the balance currently
shown is $568.40, this balance does not include the two checks he has written, totaling $395.60.
Paul’s actual balance is only $568.40  $395.60  $172.80. This amount is insufficient to cover the
$241 check he just wrote. It is not possible to say exactly which check will bounce, since this depends
on the order in which the checks reach his bank.

6. The worksheet to reconcile Mary’s bank statement is shown below.

Beginning balance $168.51

Deposits 600.00
Withdrawals 239.00
Checks written 143.00
Bank fees 0.00
Balance shown on bank statement $386.51
Checks that have not yet cleared 106.09
Adjusted bank balance $280.42

7. The risk premium is 5.2%  2.5%  2.7%. Casey must also consider when she will need the money.
If she may need access to the money in a short period of time, the nonfinancial institution’s CD might
be too risky. She must also consider her risk tolerance and whether an additional 2.7% return is
sufficient compensation considering her risk tolerance.

Ethical Dilemma
8. a. Students may be divided in their answer. Some may believe that you need to make sure to read
the fine print, while others may be concerned that the bank is failing to make a best-effort
attempt to inform their customers.

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42 Madura • Personal Finance, Fifth Edition

b. One lesson is to pay close attention to what accompanies bank or credit card statements as some
of it may be important. Another lesson might be to inquire of the bank about fees before entering
into “new types” of transactions.

 Answers to Questions in The Sampsons—A Continuing Case

1. The longer-term maturities offer a higher interest rate than the shorter-term maturities. However, the
Sampsons will need the funds within the next year, so each month that they invest money, they
should use a maturity that is no longer than the time at which they will need the funds. Assuming that
the Sampsons will purchase the car in less than a year’s time, they should consider six-month CDs for
the first few months, creating a new CD every month. However, their later monthly savings should be
used to purchase three-month or one-month CDs, depending on the exact point in time they plan to
purchase the new car. All the CDs must mature by the time they need the funds.

2. The longer-term maturities (like the 10-year CD) may be appropriate when investing in a college
education that is 12 years in the future. After two years, their monthly savings should then be
invested in seven-year CDs, as they would not have the money available 12 years from now if they
continued to invest in 10-year CDs two years from now. Again, the Sampsons need to invest their
funds to ensure that all the savings will be accessible for their children’s college education. The use
of the long-term maturity also prevents them from using the money for any other purpose, thereby
ensuring that the savings will be there when the college expenses occur. However, longer maturities
prevent the Sampsons from using the funds for some emergency purpose without incurring penalties
on the interest. Furthermore, interest rates could increase in the future, and long-term maturities
would lock the Sampsons into relatively low current interest rates.

3. If interest rates are expected to rise in the next few months, you might advise the Sampsons to invest
in short-term CDs so that they can reinvest their money at a higher rate once interest rates increase.

©2014 Pearson Education, Inc.