The banking system is a huge part of our everyday lives. It helps us with everything from depositing our paychecks to buying our first home or a new car. How are banks able to help us with such a wide range of our needs and goals? Part of it relates to the underlying structure of how banks work.
When you deposit money into your account, the bank uses those funds to lend to other customers for a small fee. In a way, you become a lender to the bank, which borrows money from you to lend it to other borrowers. But don't worry—your money always remains your own, and you're not on the hook if those borrowers default.
What happens to your money in a bank
This system of lending and borrowing is just one way that banks make money. When they lend out their customers' money to someone who wants a house or a personal loan, they charge interest. When the borrower repays the loan, the bank receives the money they lent out, plus the amount set by their interest rate.
In general, banks are only allowed to lend 90% of their customers' money. The other 10% must be kept in the bank's vaults or the closest Federal Reserve bank. This is known as fractional reserve banking, and it ensures banks have enough funds on hand to cover any possible withdrawals by customers.
The banking industry also acts as a financial intermediary between people. When you buy something at a store with a debit card, your bank and the store's bank make a transaction on your behalf. Even if you pay with cash, that money will eventually be deposited into the store's bank account. The bank charges a small fee to conduct that transaction, usually by charging a small monthly fee for a checking account.
The money doesn't go into the store's account right away though. Banks keep track of transactions on a ledger and settle with each other in bulk, crediting or debiting accounts that the different banks have between themselves. This keeps the transaction costs for banks down and makes the process as efficient as possible.
Securing your money
So, with all the transactions that banks conduct in a day, how does your money stay secure?
Today, banks are required to be insured by the Federal Deposit Insurance Corporation, or FDIC. The FDIC insures up to $250,000 per person, per account. This is an insurance policy for customer deposits. In the unlikely case that the bank doesn't have enough cash to pay customers, they'll still receive their money through the FDIC.
Since the 2008 financial crisis, regulators have also restricted how much money a bank can lend relative to how much they have in assets, which includes customer bank accounts. If a bank is highly leveraged, that means it has to use its own capital to make loans or investments. These guidelines reduce the chance of default if the economy has a downturn and borrowers can't pay back their loans.
Types of banking services
Borrowing and lending are just some of the services that banks provide. They also help people save and grow their money through checking and savings accounts. They provide advice on different investment options. You can also get a credit card from banks. And of course, the bank is the best place to go for a personal loan, a mortgage or a car loan.
Banks also help small businesses by offering business accounts, including debit and credit cards. They service business loans and can help a company with merchant services, like processing credit card transactions or maintaining their payroll accounts.
These days, more and more banks offer extensive digital services, too. You can deposit your checks and pay bills through your smartphone or computer. You can even opt for online bank statements instead of paper documents sent to you in the mail. Banks also offer extra layers of digital security—you can receive text messages and alerts about your accounts on your phone.
No matter what your financial goals are, or where you are in your life, the banking system is there to help you meet your target.
FAQs
Although banks do many things, their primary role is to take in funds—called deposits—from those with money, pool them, and lend them to those who need funds. Banks are intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money).
How does the banking system really work? ›
People deposit their money in banks; the bank lends the money out in car loans, credit cards, mortgages, and business loans. The loan recipients spend the money they borrow, the bank earns interest on the loans, and the process keeps money moving through the system.
How does the banking process work? ›
Banks perform a myriad of functions, including deposits and withdrawals, currency exchange, forex trading, and wealth management. Also, they act as a link between depositors and borrowers, and they use the funds deposited by their customers to provide credit facilities to people who want to borrow.
How does a bank work in simple terms? ›
Banks are privately-owned institutions that, generally, accept deposits and make loans. Deposits are money people leave in an institution with the understanding that they can get it back at any time or at an agreed-upon future time. A loan is money let out to a borrower to be generally paid back with interest.
What are 3 key functions of the banking system? ›
There are three main functions for a bank:
- Receiving money: Deposits are the sums of money that a consumer gives to the bank. ...
- Keeping money: Reserves can be kept in two ways by banks. ...
- Lending money: People are given money by the bank on the basis of time and interest.
They earn interest on the securities they hold. They earn fees for customer services, such as checking accounts, financial counseling, loan servicing and the sales of other financial products (e.g., insurance and mutual funds).
What stops banks from creating money? ›
Required reserves are to give the Federal Reserve control over the amount of lending or deposits that banks can create. In other words, required reserves help the Fed control credit and money creation. Banks cannot loan beyond their excess reserves.
What is the basic knowledge of banking? ›
A bank is known as a financial institution responsible for accepting deposits from the public and creates a demand deposit while simultaneously providing loans to its borrowers. Banks can perform these lending activities either directly or through capital markets.
How does the bank get paid? ›
Commercial banks make money by providing and earning interest from loans such as mortgages, auto loans, business loans, and personal loans. Customer deposits provide banks with the capital to make these loans.
Where do banks borrow money from? ›
Commercial banks borrow from the Federal Reserve System (FRS) to meet reserve requirements or to address a temporary funding problem. The Fed provides loans through the discount window with a discount rate, the interest rate that applies when the Federal Reserve lends to banks.
Browse online banking courses
- Essential Career Skills for. Investment Banking and Finance. New York Institute of Finance. Course.
- Foundations of Central Bank Law. The International Monetary Fund. Course.
- Capital Markets. New York Institute of Finance. Professional Certificate. ...
- Corporate Finance. Professional Certificate. 3 Courses.
Although banks do many things, their primary role is to take in funds—called deposits—from those with money, pool them, and lend them to those who need funds. Banks are intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money).
How is money created in the banking system? ›
Money is created within the banking system when banks issue loans; it is destroyed when the loans are repaid. An increase (decrease) in reserves in the banking system can increase (decrease) the money supply.
What are the three C's of banking? ›
Students classify those characteristics based on the three C's of credit (capacity, character, and collateral), assess the riskiness of lending to that individual based on these characteristics, and then decide whether or not to approve or deny the loan request.
How does the US banking system work? ›
When you deposit your money at a bank, that money goes into a large pool of money, and the amount of money that you deposited is credited to your account. Money is subtracted from your account when you write checks or make withdrawals. Money is also added to your account as you accrue interest.
Which machine is used to withdraw money? ›
ATM stands for Automated Teller Machine which is a self-service banking outlet. You can withdraw money, check your balance, or even transfer funds at an ATM. Different banks provide their ATM services by installing cash machines in different parts of the country.
How does the banking system function? ›
Although banks do many things, their primary role is to take in funds—called deposits—from those with money, pool them, and lend them to those who need funds. Banks are intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money).
How is money created by the banking system? ›
Money is created within the banking system when banks issue loans; it is destroyed when the loans are repaid. An increase (decrease) in reserves in the banking system can increase (decrease) the money supply.
How does the federal banking system work? ›
The Federal Reserve System is composed of a board of seven members, 12 regional Federal Reserve Banks, and the Federal Open Market Committee. The Fed's main duties include conducting national monetary policy, supervising and regulating banks, maintaining financial stability, and providing banking services.
How is money really made? ›
Banks create money by lending excess reserves to consumers and businesses. This, in turn, ultimately adds more to money in circulation as funds are deposited and loaned again. The Fed does not actually print money. This is handled by the Treasury Department's Bureau of Engraving and Printing.
