How Does a Bank Work?

If you are like most Americans you probably have a bank account and you may even have received a loan from a bank whether it be a mortgage, a car loan, school loan, etc. You may wonder why a bank pays you interest or where they get all of the money that they lent to you. Before we answer those questions let's cover a few basics. First let's answer what a bank is. A bank is a financial intermediary, which means they are an intermediate between savers and borrowers that accepts deposits and offers loans (for an official definition of a bank check this out, although it doesn't actually tell you what a bank really is Bank, Investor Words). This probably means nothing to you but essentially what a bank does is that it takes your money in the form of deposits and gives out this money as a loan. It is basically that simple (with a few more complications). But the question that may arise is, why does a bank exist, why wouldn't you just loan out money directly rather than giving it to a bank so they can loan it?

The answer to the question is because generally a saver will want to put their money into a safe location that pays interest and have the ability to withdraw immediately (think of a savings account, it pays you interest and you can withdraw the money from your bank's branch anytime you wish during their business hours Savings Account, Wikipedia). Conversely, for loans borrowers typically want to borrow the money over a long period of time and do not want to have to pay back the loan on demand (meaning they don't want to borrow money for a 5 year project and have to pay back the money a month later because someone wants their money back now Loan, Investor Words). Because of this problem where savers want to earn interest and have immediate access to their money, coupled with borrowers who want the ability to pay back a loan over several years, a gap in the economy exist. Savers have a difficult time finding short term savings options that pay interest and keep their money safe, whereas borrowers have a difficult time finding sources that are willing to loan them large amounts of money over long periods of time. This is where a bank steps in as the "financial intermediary," which is to say that they act as the intermediate between savers and borrowers Financial Intermediary, Investopedia. Nice of the banks to do that, right? Well before you thank them, you should know that a bank does this because they make money from acting as a financial intermediary.

Essentially, they take your money and pay you a small interest rate for a savings account say 0.25% (less for checking accounts and more for certificates of deposit, also known as time deposits Certificate of Deposit, Investor Words). What they do next is take the money you deposited and loan it out at a higher interest rate, say 5.00% for a 30 year mortgage (they keep a small amount of the money you deposit and keep it as cash, this is federally mandated as a reserve ratio. Look for a future article of mine which will discuss more about reserve ratios in much more detail Reserve Ratio Investopedia). Let's say that 300 depositors put $10,000 each into a savings account that pays 0.25% interest (this is a total of $300,000). Now let's suppose that the bank loans out the $300,000 to a family buying a home at 5.00% interest over a period of 30 years. This is a great investment for the bank where essentially they take your and your fellow depositors' money and pay 0.25% on the deposits and loan it out at 5.00% (they are making a net 4.75% rate of return on the $300,000 someone else gave them, which is a total of $14,250 a year!) Must be nice to make $14,250 on money that isn't yours! Well it isn't quite this simple as the bank encounters a few problems.

First, the money in the savings accounts can be withdrawn at any time and the bank must provide the depositor the money upon making a withdraw request, whereas the bank cannot immediately recoup the money they have already lent out. This is a problem that banks regularly face and ultimately because they are so large and have so many customers they can handle this problem. The way it works out is that they have so many depositors that as one depositor takes money out another depositor will put money back in. This leads to a predictable and steady money supply for the banks which enables them to make long term loans without having to worry about running out of money for depositors making withdraws from their accounts.

Secondly, another problem for the banks is time risk (NY Times Time Risk). Think of interest rates at your bank. They are not constant and they change regularly. In fact the last few years interest rates have rapidly fallen. If a bank made a loan at 5.00% and is now only paying 0.10% that is a great deal for them, but what if interest rates spike? The bank would now be on the hook of having a fixed loan at 5.00% and maybe the interest rate they pay out spikes to 3.00% or even above 5.00% (above 5.00% would mean a loss)! This is a major problem and a major risk that banks take. This risk is ultimately the reason why banks are able to make a large profits by using your money and loaning it to someone else. In practice this is what a bank is and how they operate. There of course more complications and intricacies but this beginner's guide will allow you to understand why a bank exists, what it is, and what it does.