How Banks Work

Banks are private, for-profit businesses that offer a variety of services to the public with the intent of making a profit. Credit unions operate as not for profit entities, but play the same basic role in providing services to the general public and the economy. Though banks are driven by a profit motive, they also provide a place to safely store your money in FDIC insured checking and savings accounts until you need to take the money out ac or for credit unions in National Credit Union Administration insured. Banks enable customers to write checks, pay bills or send money to other people with their basic service and enable customers to accumulate savings at fixed and variable rates of interest for long term investments. They also make a wide selection of loans to people and businesses. As a key component of the financial system, banks allocate funds from savers to borrowers in an efficient manner.

When you put money into a bank with a checking account, savings account, money market deposit account or certificate of deposit, the bank pays you interest or provides a service for use of those funds. The deposits of money into a bank account allow the bank to use the money. The customer deposits are a liability of the bank since these are funds the bank owes to it depositors. The bank then loans the money out and makes investments that provide a greater rate of return than what they pay to you the depositor. Interest on loans is the principal source of revenue for most banks. The spread is the difference between what a bank makes lending money and the rate at which it borrows money. Fortunately, with large base of deposits from checking, savings, and CDs, banks have a fairly stable source of funds on which they pay a low rate of interest. Banks most constantly manage the of the money that customers have deposited into checking and savings accounts while ensuring that those depositors can still get their money back when they want it.

By lending money to businesses and making investments, banks keep the economy liquid with available credit. When banks lend money to individuals for mortgages, auto loans and other consumer loans banks help provide liquidity and credit to individuals. Banks are not the only source of funds for consumers and businesses but are an essential source of funding for communities and the economy as a whole.

The tools of the banker has changed little over the years with regards to that underlying formula of lending out the funds that were first placed with them by some patient money holders. Making money the old fashioned way, by charging more interest on loans than they pay for deposits. Through the process of taking deposits, making loans, and responding to interest rate signals, the banking system helps channel funds from savers to borrowers in an efficient manner.

Lending money is one of the ways that a bank earns money. Banks are constantly adapting to a slow changing environment and diversify their services to become more competitive. Interest income on loans and fess paid on deposits are the primary tools used by banks to make money but many banks are also offering their customers financial planning and asset management services, as well as brokerage and insurance services, often through a subsidiary or third party. Others are beginning to provide investment banking services, usually through well identified subsidiaries, that help companies and governments raise money through the issuance of stocks and bonds. As banks respond to deregulation and as competition in this sector grows, the nature of the banking industry will continue to undergo significant change.

Banks are appreciably different from other industries and other financial institutions because they offer transaction accounts and make loans by lending deposits. The money that individuals and businesses deposit in bank accounts is the capital the banks use to make these loans and investments. These deposits and additional lending based on these deposits lead to yet additional deposit creation activity, essentially creating money. This creation affects interest rates because these deposits are part of savings, the source of the supply of credit to the economic demand supply equilibrium for funds. Banks create deposits by making loans. Rather than handing cash to borrowers, banks simply increase balances in borrowers’ checking accounts. Borrowers can then draw checks to pay for goods and services.

The money that comes from the customers who have deposited funds into checking and savings accounts are borrowed funds of the bank. Banks borrow from individuals, businesses, and financial institution. The bank will hold a portion of the funds held as reserves while the majority of the funds are loaned to businesses and individuals. The banks loans to businesses, other financial institutions, individuals or even purchased securities are all assets of the bank.

By transferring the ownership of deposits from one party to another, they can replace physical cash as a method of payment. In fact, deposits account for most of the money supply in use today. If a bank in the United States makes a loan to a customer by depositing the loan proceeds in the customer’s checking account, the bank typically records this event by debiting an asset account on the bank’s books credits the deposit liability or checking account of the customer on the bank’s books. From an economic standpoint, the bank has essentially created economic money. The customer’s checking account balance has no “dollar bills” in it, as a demand deposit account is simply a liability owed by the bank to its customer. In this way, commercial banks are allowed to increase the money supply (without printing currency, or legal tender).

The process our banking system employs of not holding the entire sum of deposits in reserve, but of loaning the money at interest to other clients, is a process known as fractional-reserve banking. It is this process which allows providers to pay out interest on deposits and expand the money supply and credit. All depository institutions ,commercial banks, savings institutions, credit unions, and foreign banking entities, are required to hold reserves against certain types of deposits that they report as liabilities on their balance sheets.

The Federal Reserve sets the amount of money a bank must hold as reserves. The Fed has the responsibility of monitoring and influencing the total supply of money including bank reserves.

This entry was posted on Sunday, October 12th, 2008 at 11:59 am and is filed under Banking and CD Guide. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.