How do Banks Work? A Complete Beginner's Guide (2022)

How Do Banks Work: Complete Beginner’s Guide

Contents

  • 1 How Do Banks Work: Complete Beginner’s Guide
  • 2 The Origin of Banking
  • 3 How do Banks Work
  • 4 Banking Limitations
  • 5 Commercial vs Investment banking
  • 6 Conclusion

Banks and banking, have been a large topic of discussion in recent years. There are some things that are very wrong with banking, but they aren’t what most people normally think about.

Many people blame banks for being reckless, and there are people who associate this with capitalist greed or such nonsense.

In reality, banks are a necessary element in the economy. There is no real reason why people, or the economy, should be subject to how that particular element is behaving.

However, recent changes in the way banks work, have created a system where the activity of banks can affect us directly, and this had a lot to do with the proliferation of the financial crisis.

The Origin of Banking

The first banks originated from associations of merchants who would make loans to farmers and other merchants, normally against their crops and other merchandise. This was an important development for the economy. Because of this, farmers could sustain themselves while waiting for harvest season. Likewise, merchants and traders could fund voyages across the ocean to sell their goods elsewhere.

Merchant banking progressed from financing trade on one’s own behalf to settling trades for others and then to holding deposits for settlement of “billette” or notes written by the people who were still brokering the actual grain. And so the merchant’s “benches” (bank is derived from the Italian for bench, banca, as in a counter) in the great grain markets became centres for holding money against a bill (billette, a note, a letter of formal exchange, later a bill of exchange and later still a cheque).

These deposited funds were intended to be held for the settlement of grain trades, but often were used for the bench’s own trades in the meantime

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How do Banks Work

Over the next 1000 years, this practice would evolve into the global financial system we know and (don’t) love today. As banking became more prominent, it expanded its field of business. Insurance companies can also be seen as a form of banking. Banks soon became not only a place to get a loan but also a place for people to store their money. Eventually, banks would also settle transactions amongst their clients. Bank cheques came to be used as a form of money, though they really aren’t.

As the financial system has grown bigger it has become increasingly difficult for the common man to understand how this complex machinery works exactly. Especially when you hear people talking about derivatives, futures, and interest-rate swaps.

One can easily reach the conclusion that bankers are just somehow “taking advantage of the system”, by essentially gambling on the economy and making us pay the price. The truth, however, is a little bit more complex than that.

A regular bank should work like any other business. If we look at a bank’s balance sheet and break it down we can see there’s nothing too strange going on.

Like any company, a bank has assets and liabilities. The bank’s assets are the loans it has made, which it expects to get a return from. The liabilities are money that it owes, either to other banks or depositors. It’s important to understand that when you deposit money in a bank, you are essentially making a loan to the bank.

The bank receives income from its assets and makes interest payments to depositors and other people who have borrowed money from the bank. The difference between these is the profit.

I’d now like to invite you to have a look at the table below.

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This image was taken from Wells Fargo’s annual report for 2006. This is page 42 which is a summary of the interest payments received and given for the whole exercise.

As we can see, Wells Fargo gets an average of 7.79% from its loans (that’s your mortgage, credit cards, business loans, etc.) and pays out an average of 2.96% on its borrowings (that’s your savings accounts, current accounts, CDs etc.), producing a Net Interest Margin of 4.83%

This profit shows up in the income statement, the second most important item in the report.

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Here we see the interest received ($32 billion) minus the interest paid ($12 billion) producing net interest income of $20 billion. Then there is a provision for credit losses. Afterward, Wells Fargo declares $17.7 billion of net interest income. Then, there is about $16 billion of noninterest income (mostly fees and charges, and don’t we all know about those), followed by noninterest expenses of $20.7 billion, mostly salaries and other compensation. At the end of the day, Wells Fargo made $12.7 billion before taxes and $8.5 billion after taxes.

Quite a lot of work to make $8.5 billion, no? They had to carry a ginormous $481 billion dollars of assets to make that relatively puny $8.5 billion in profit. That’s a ratio of 1.77% (return on assets). Which is sort of low, you could say.

However, the shareholders did pretty well. The total amount of capital invested in the company (crudely speaking) was $45.9 billion, the shareholders’ equity or book value. So, if you had a $45.9 billion investment and got paid $8.5 billion in profit for just one year, that’s a Return on Equity of 18.5%. Sort of like a bond that pays 18.5%. Juicy! That’s why there are so many banks out there.

You can look at it this way: You start with $46 billion dollars. You borrow $436 billion dollars and lend $481 billion dollars (approximately). You make a profit of $8.5 billion dollars.

The difference between the rather mediocre yield on loans (7.79%) low return on assets (1.77%) and the splendid return on equity (18.5%) is due to leverage.

The bank is leveraged at about 10:1, This means for every dollar the shareholders have invested, the bank carries 10 of in assets. This is akin to the homeowner with a 10% downpayment, who carries $500,000 of assets (the house) on a $50,000 down payment and a $450,000 mortgage.

Banking Limitations

Some of you may be wondering at this point how exactly banks can lend out all their money, while always having cash available for their depositors. This is a very good question and the answer lies at the heart of banking.

To better understand this topic, let’s first define two terms which can sometimes be confused.

A bank, or business, is liquid if it has enough available cash to meet its short-term payments. On the other hand. Solvency is the ability of a company to meet its long-term financial obligations. Banks have to keep enough money in their reserves to be liquid, so that they can make payments on their short-term debts, or simply to allow people to access their deposits. Calculating and changing the bank’s liquidity is somewhat simple. It’s a matter of changing the form of their assets.

If a bank is short on cash all it has to do is call in some of its short term-debts or it can even borrow the money from another bank. In general, however, banks want to loan out all their money, since this is how they profit. This careful act of balancing liquidity is one of the most important things a banker has to do.

Solvency is a little bit harder to measure. It comes down to the quality of the loans the bank has made. At this point rating agencies become involved, but of course, we know they can’t always be trusted. In general, something like a government bond would be considered a secure investment. But things like mortgages or credit card debt have a higher probability of default.

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A bank may be illiquid but still be solvent. Liquidity used to be a big problem when banks first appeared. A crisis in confidence may push depositors to withdraw their funds from a bank. Before the age of instant transfers and central banks, this could have meant the end of a bank.

Central banks such as the Federal Reserve and Bank of England were in fact first created with this purpose in mind. The central bank would be a “lender of last resort”. Granting banks emergency funding if they so required. This can work if the problem is of liquidity.

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However, there isn’t in reality much a central bank can do if the banks are insolvent. In 2008, the crash in the housing market meant a default on many loans. This did, in fact, make some banks insolvent. They had simply lost too much money to bad investments, therefore making it physically impossible for them to repay their debts.

Commercial vs Investment banking

Since banks are loaning out money, it stands to reason that there should be more and less risky banks. These banks should make different investments, both in risk and in time-frame. This was the case for a long time.

Commercial banks used to be clearly separated from investment banks.

A commercial bank is where you’d have your basic CDs and savings accounts. It’s a regular folks bank. The idea is that, more than anything, they are managing liquidity. With a CD, you are giving the money to the bank under the pretense that you can withdraw it at any time. Therefore, the investments of a commercial bank should be low-risk and easy to liquidate, government bonds, or even monetary funds.

An investment bank, on the other hand, would hold your funds for longer and make riskier investments. It would buy stocks, corporate bonds, and might use some of the more modern financial instruments such as derivatives to bet in the forex market.

Intuitively, this separation makes sense. In 1933 a piece of legislation was introduced in the U.S. known as the Glass-Steagall act which officially separated these two forms of banking. As recently as 1999 this legislation was repealed.

This remains a serious point of discussion in the U.K.

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Conclusion

As far as I’m concerned, banking in itself is a necessary institution. I don’t think it is immoral or should be viewed with any more contempt than other businesses.

However, modern banking has a lot of problems which have been discussed a lot, especially since the 2008 meltdown.

For starters, we have the problem of moral hazard, meaning that, due to the protection and privileges that States have granted banks, this has incentivized them to act more recklessly. Thanks to government bailouts banks can privatize their profits while socializing their losses.

Secondly, we have a problem with central banks around the world, using their power to help bankers increase their profits. By systematically lowering interest rates and offering cheap credit, central banks are just making it easier for the financial sector to acquire funds. There used to be a time when banks would have to actually offer their clients a return on their money, and checking accounts would offer returns of 5%. But it has been a long time since those days, and the consequences can be felt.

Finally, there is a problem with the increasing amount of derivatives. The derivatives markets triple every year, and its growth outpaces that of any other market, having reached recently a total estimated value of 100 trillion dollars. Speculation has a place in banking, but gambling does not, and it’s important to understand the difference

Speculation is trying to predict future outcomes, based on forces of nature which may or may not push things one way or another. This means that we try to guess and insure ourselves against the risks created by nature.

Gambling, on the other hand, means betting on risks created by man. When you go to a casino and you spin a wheel and try to guess on which number the ball will land, that is gambling. It is a game of chance and the uncertainty in it is a human creation.

In those two simple definitions, we can find the hidden truth behind derivatives markets. We can understand why derivatives have grown to over 100 trillion, having been virtually nonexistent before the 1930s.

The way in which monetary policy has evolved in the last century has given place to what we have today. Through this dogma of “money supply” manipulation, we have created, us humans, a world of uncertainty in terms of interest rates, exchange rates, and the gold price.

Back in the age of the gold standard, interest rates were stable, and also, notably low and exchange rates were fixed.

Now banks stand to make millions on small changes between currencies, especially due to incredible amounts of leverage. This, I believe, is not a natural or necessary part of banking.

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I hope this article has helped shed some light on the issue at hand.

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FAQs

How do banks work simplified? ›

More specifically, banks offer deposit accounts that are secure places for people to keep their money. Banks use the money in deposit accounts to make loans to other people or businesses. In return, the bank receives interest payments on those loans from borrowers.

What is bank small answer? ›

A bank is a financial institution that is licensed to accept checking and savings deposits and make loans. Banks also provide related services such as individual retirement accounts (IRAs), certificates of deposit (CDs), currency exchange, and safe deposit boxes.

How does a bank account work? ›

You open a savings account at the bank. The bank pays you interest on the money that you deposit and leave in that account. The bank then loans that money out to other people, only they charge a slightly higher interest rate on the loan than what they pay you for your account.

What are two most important things for you to consider when choosing a bank? ›

The two factors we've considered so far—the type of institution you choose and the amount it will cost you in fees or lost interest—are the most fundamental aspects of choosing a bank. However, most banks will also offer a range of other services, discounts, or features that may be crucial for you.

Why do banks work? ›

Banks accept deposits and make loans and make a profit from the difference in the interest rates paid on deposits and charged for loans. Banks work because of our trust. We give a bank our money to keep it safe for us, and then the bank lends it to someone else in order to make money for itself.

What is basic banking knowledge? ›

Banking fundamentals refer to the concepts and principles relating to the practice of banking. Banking is an industry that deals with credit facilities, storage for cash, investments, and other financial transactions.

What is type of bank? ›

How many types of banking sectors are there? Commercial banks are of three types i.e., Public sector banks, Private sector banks and Foreign banks.

Why are they called banks? ›

The word bank comes from an Italian word banco, meaning a bench, since Italian merchants in the Renaissance made deals to borrow and lend money beside a bench. They placed the money on that bench. Elementary financial records are known from the beginning of history.

How do banks make money? ›

They make money from what they call the spread, or the difference between the interest rate they pay for deposits and the interest rate they receive on the loans they make. They earn interest on the securities they hold.

What is the banking system? ›

A banking system is a group or network of institutions that provide financial services. The major types of banking systems include those made up of commercial, national, and investment banks and credit unions may also be part of a banking system.

What happens to money in the bank? ›

In short, banks don't take the money that you deposit, turn around and loan it at a higher interest rate. But they do use the money you deposit to balance their books and meet the necessary cash reserves that make those loans possible.

How do bank rates work? ›

A bank rate is the interest rate at which a nation's central bank lends money to domestic banks, often in the form of very short-term loans. Managing the bank rate is a method by which central banks affect economic activity.

What are the 7 things to consider when choosing a bank? ›

7 Critical Factors to Consider When Choosing a Bank
  • Scope Security When Choosing a Bank. ...
  • Do They Have the Account You're Looking For? ...
  • Hidden Fees, Annual Fees, Transfer Fees. ...
  • Varying Interest Rates. ...
  • Cash Limits. ...
  • Online Banking. ...
  • Honesty is the Best Policy!
Nov 10, 2018

When choosing a bank what are 4 things you would look for? ›

4 Things to Look For When Choosing a Bank
  • Products and Services That Fit Your Needs.
  • Security for Your Money.
  • Convenient Access to Your Cash.
  • Minimal Fees.
Jun 11, 2018

What are 4 things you should consider before opening a checking account? ›

Before you open a checking account, consider these factors:
  • Insurance.
  • Minimum deposit requirements.
  • Fees.
  • ATM network.
  • Interest and rewards.
  • Mobile app features.

What are 3 functions of a bank? ›

Utility Functions of Bank
  • Issuing letters of credit, traveller's cheque, etc.
  • Undertaking safe custody of valuables, important documents, and securities by providing safe deposit vaults or lockers.
  • Providing customers with facilities of foreign exchange dealings.
  • Underwriting of shares and debentures.

How can I improve my bank knowledge? ›

Given here below are some important tips and aspects to keep in mind if you wish to embark on a successful career in the banking and financial sector.
  1. Finding numbers and problem-solving fun. ...
  2. Developing analytical skills. ...
  3. Having the right technical Know-how. ...
  4. Growing interest in the world of banking & finance.
Sep 21, 2020

How do you do self study for bank exams? ›

Do not start with the mock tests right after your preparation, go for topic-wise easy quizzes. Start with mock tests once you have covered half the topics of the exam. Time your mock tests, this will assist you in taking the exam under time pressure.

What are the 5 most important banking services? ›

The 5 most important banking services are checking and savings accounts, loan and mortgage services, wealth management, providing Credit and Debit Cards, Overdraft services.

What are the 6 roles of banks? ›

The most important functions of commercial banks are discussed below:
  • Accepting deposits: The most significant and traditional function of commercial bank is accepting deposits from the public. ...
  • Providing loans: ...
  • Credit Creation: ...
  • Transfer of funds: ...
  • Agency functions: ...
  • Other functions:

What is the difference between bank and banking? ›

A bank is an institution and banking is the activities of that institution. For example- collecting deposit; discounting of bills, draft, order, money transfer, giving aid to business etc. The Oxford Dictionary: “Banking is the business of a banker and the keeping or management of a Bank.”

What are the 4 types of banks? ›

What are some different types of banks?
  • Retail banks. Retail banks, also known as consumer banks, are commercial banks that offer consumer and personal banking services to the general public. ...
  • Commercial banks. ...
  • Community development banks. ...
  • Investment banks. ...
  • Online and neobanks. ...
  • Credit unions. ...
  • Savings and loan associations.
Oct 12, 2021

How much money do banks hold? ›

Banks tend to keep only enough cash in the vault to meet their anticipated transaction needs. Very small banks may only keep $50,000 or less on hand, while larger banks might keep as much as $200,000 or more available for transactions. This surprises many people who assume bank vaults are always full of cash.

How much money do you need to own a bank? ›

Banks generally need between $12 to $20 million in starting capital. If you start a local community bank, you might be able to raise that money locally. Otherwise, you may have to solicit investors. Once the capital is raised, you must apply to regulatory agencies.

What are the two other most important ways banks make money? ›

Much like any other profit-driven business, banks charge money for the services and financial products they provide. The two main offerings banks profit from are interest on loans and fees associated with their services. Read on for a breakdown of these main services and find out exactly how banks make money from them.

Where do banks put there money? ›

When money is deposited in a bank, the bank can invest it in a variety of things — small businesses, solar farms, derivatives and securities, fossil fuel extraction, mortgages for veterans, you name it.

What are the two main types of banking? ›

Under the umbrella of banking and finance, the industry has commercial banks—which are consumer facing like Bank of America—as well as central banks—the government entities that regulate the industry and manage monetary policy.

What happens to my husband's bank account if he dies? ›

Most bank accounts that are held in the names of two people carry with them what's called the "right of survivorship." This means that after one co-owner dies, the surviving owner automatically becomes the sole owner of all the funds.

What happens to bank account when someone dies without a will? ›

What happens to a bank account when someone dies without a will? If someone dies without a will, the bank account still passes to the named beneficiary for the account.

How long can you keep a deceased person's bank account open? ›

When a bank account owner dies with assets that are insured by the Federal Deposit Insurance Corporation (FDIC), their FDIC coverage continues for six months after death.

Why do banks borrow money overnight? ›

A bank may experience a shortage or surplus of cash at the end of the business day. Those banks that experience a surplus often lend money overnight to banks that experience a shortage of funds so as to maintain their reserve requirements. The requirements ensure that the banking system remains stable and liquid.

Who decides the bank rate? ›

Ans. bank Rate is decided by the Reserve Bank of India.

What is bank rate based on? ›

A bank rate is the interest rate banks pay on temporarily loaned funds from the central bank. The loan amount multiplied by the bank rate is the total amount of interest banks are charged on their loans.

What bank is credit Karma? ›

Introducing Credit Karma Money™

Banking services provided by MVB Bank, Inc., Member FDIC. Maximum balance and transfer limits apply.*No purchase necessary.

What are three bank fees? ›

7 common banking fees and how to avoid them
  • 7 common banking fees. Monthly maintenance/service fee. ...
  • Monthly maintenance/service fee. ...
  • Out-of-network ATM fee. ...
  • Excessive transactions fee. ...
  • Overdraft fee. ...
  • Insufficient fund fee. ...
  • Wire transfer fee. ...
  • Early account closing fee.

How do you know if a bank is good? ›

8 steps to choose a new bank
  1. Identify the right account. ...
  2. Look for banks that charge low or no fees. ...
  3. Consider the convenience of a bank branch. ...
  4. Take a look at credit unions. ...
  5. Find a bank that supports your lifestyle. ...
  6. Examine digital features. ...
  7. Understand the terms and conditions. ...
  8. Read reviews for banks you're considering.
Mar 8, 2022

Who is the best bank to bank with? ›

Best national banks
Financial institutionInterest rate on savingsMinimum deposit to open savings
Bank of America0.01%$100
Chase Bank0.01% (Rate effective as of 8/6/21. Interest rates are variable and subject to change.)$0
Discover Bank1.80%$0
Alliant Credit Union1.70%$5 (deposit made by Alliant)
1 more row

What are the three types of checking accounts? ›

Some of the different types of checking accounts are regular (basic) checking accounts, premium checking accounts, student checking accounts, senior checking accounts, interest-bearing accounts, business checking accounts, and rewards checking accounts.

Which type of bank is most widely used? ›

This is test Q
QuestionAnswer
1. Which of the following should NOT be considered when choosing a bank?D. The size of the bank
2. Which type of bank is most widely used?A. Commercial banks
3. Which type of bank has customers who are also owners?B. Credit unions
33 more rows

Can a bank ask where you got money? ›

Banks usually ask for details regarding the source of your money because they're trying to make sure that it's legitimate. Banks usually have several checks and controls in place to prevent fraud, and they want to make sure that you're not a fraudster who is committing the crime of identity theft.

What I Wish I Knew Before opening a bank account? ›

What to Know to Open a Checking Account
  • Research your checking account options.
  • Understand FDIC-insured.
  • Check your credit.
  • Know what you need to open a checking account.
  • Make sure you understand all the fees.
  • Find out what happens if you overdraw your account.
  • Decide whether you also need other banking products.
May 19, 2022

What questions are asked when opening a bank account? ›

9 questions to ask before opening a bank account
  • What are the bank's fees? ...
  • Where are the bank's ATMs? ...
  • Is there a minimum balance required? ...
  • What's the accounts' interest rate? ...
  • Does the bank have good customer service? ...
  • Does the bank have online banking and a mobile app?

What are the 4 types of banks? ›

What are some different types of banks?
  • Retail banks. Retail banks, also known as consumer banks, are commercial banks that offer consumer and personal banking services to the general public. ...
  • Commercial banks. ...
  • Community development banks. ...
  • Investment banks. ...
  • Online and neobanks. ...
  • Credit unions. ...
  • Savings and loan associations.
Oct 12, 2021

How do banks operate and make money? ›

They make money from the interest on debt, or the “debt interest.” The bank makes a profit from the difference between these two interest rates, also known as the interest rate spread. Banks can offer either secured or unsecured loans.

Where do banks put your money? ›

When money is deposited in a bank, the bank can invest it in a variety of things — small businesses, solar farms, derivatives and securities, fossil fuel extraction, mortgages for veterans, you name it.

What happens to your money when you put it in the bank? ›

In short, banks don't take the money that you deposit, turn around and loan it at a higher interest rate. But they do use the money you deposit to balance their books and meet the necessary cash reserves that make those loans possible.

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