How Does a Bank Work?

We use banks almost every day of our lives – yet we rarely (if ever) think about how they operate. I thought it would be fun to take a brief, “banking 101” view of how the banking system works.

Types of banks

When I was younger, my father took me into a bank near our home so that I could open up my first checking account. It was an exciting moment for me because I would have the opportunity to write checks like dad for different things. I knew I was making my way into the “real world.”

Since my first checking account, our economy has been through a few rocky moments. In 2008, a small number of banks received large bailouts at the taxpayers expense to help stabilize a weakened financial system due to the subprime mortgage crisis. Since then, I think banks have been fighting a PR battle to gain back the goodwill of its customers before the crisis began.

And banking has certainly changed since I was a wee one. Now, many of us can access our funds online and with a couple key strokes, transfer money to one account to another. We can also use our smartphones for different transactions. And many of us rarely write checks (I still do!).

There are a couple types of banks today:

  • Commercial banks. These are the big guys that have traditionally serviced businesses – but have now moved into personal banking as well.
  • Thrift institutions. These are your credit unions, cooperatives, savings/loans, and savings banks. Often smaller in size, they were established to service the everyday man/woman.

how a bank works

How they operate and make money

Banks largely exist on trust. Customers trust their bank to hold and protect their money when they deposit it AND they'll be able to access it whenever they want. We also expect that we'll get a little return on allowing the bank to hold / use our money

bank interest
Banks pay you interest for the privilege of using your money

Since most of us realize that banks are a business, we know they are making money off our money. Banks don't “make” anything. Their products are money. So how does this process work?

Let's say I were to deposit $100 into my bank account. My bank would turn around and make that money work for them. Of that $100, they might keep $10 of it in their vaults and then loan the remaining $90 out to someone else at a certain interest rate. They may be paying you 1% in interest for the privilege of using your money – but they will charge someone else 2x or more that in interest when loaning it out.

banks make money through loans
Banks make money by loaning out your money

Because banks are highly leveraged, they are also highly regulated by the government. After the Depression, customers also wanted a further guarantee their money would always be there if something catastrophic were to happen. This is why many banks need to be members of the FDIC (Federal Deposit Insurance Corporation). This tells customers they can trust the bank and their deposits will be guaranteed up to a certain amount (today it is $250k).

Regulations also require that banks keep a certain percentage of reserves based on their deposits.

This is good protection for customers and fosters trust. If everyone were to ask for their money from the bank at the same time, there wouldn't be enough to satisfy the demand. So, it's crucial the system of trust is strong and has some oversight.

So, here are the three main ways banks make their money these days:

  1. Net interest margin. As discussed, banks keep the difference between what they are paying the depositor to hold their money vs. what they are charging the loanee. Because the current federal interest rate policy is so low, depositors get almost nothing for their savings, while banks are receiving high margins on their loans.
  2. Interchange. Whenever you swipe your bank credit card or debit card, banks are getting a little something off the transaction. One estimate says it is about 1.7% for credit cards and 1.1% for debit cards. Since Americans spend more than we save – this can be a huge money-maker for banks.
  3. Fees. ATM, overdraft, late penalties, etc all make the banks more money. It's estimated that an average customer pays about $200 in fees per year to their institutions. Fees have become a large percentage of their profits.

Do we need the banks?

Banks are no different than other businesses in that they need to make a profit to survive. We could put our money under the mattress, or stuff it in the walls (like some of our Depression-era elders did) – but we won't get some of the benefits that a bank can provide:

  • Convenience. Write a check or swipe your car – there is a convenience factor in the fact we don't need to carry around wads of cash to make purchases. There is a central place were our accounts can be debited and credited.
  • Safety. Banks offer security that your money will be there when you need it – come hell or high water. This offers great peace of mind for customers. There's also the backing of the government should something else bad happen to the bank itself or otherwise.
  • Interest. While you aren't going to get rich off most bank savings accounts these days – I've always thought that something is better than nothing. Banks provide that extra incentive to put your hard-earned money into their hands.

Where do you bank and how has your experience been?

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  1. Banks do even more with deposits. They can leverage their deposits 10-1. So to your point they keep 10% of their deposits in savings and lend the rest. But when for example, if a bank has $1M in deposits the Fed will loan them $10M; they keep there $1M as collateral, then lend the rest. It’s Arbitrage on Arbitrage. This is why when they tank, they really tank.

    Thanks for the article, it’s a good read.

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