Banks
Many people see banks as being a place where you save money, open a checking account and get loans, but they often don’t understand the larger picture of a banks functions.
Types of Banks
When you think of a bank, the first thing that comes to mind might be the institution that holds your checking or savings account. But there are several different types of banks, all serving different needs.
You might not have heard of all of these banks, but each example probably plays some part in your everyday life. Different banks specialize in distinct areas, which makes sense—you want your local bank to put everything they can into serving you and your community.
Retail & Commercial Banks
Retail and Commercial Banks are the most common type of bank and are what most people think when they think of banks. Both banks' primary functions are to hold and safeguard the deposits of their customers and to supply loans. The main difference that separates retail and commercial banks is that retail banks are used by individuals and provide mortgages and personal loans, while commercial banks generally interact with businesses and usually deal with business loans.
Investment Banks
Most people have no familiarity with investment banks. Investment banks help businesses work in financial markets. If a company wants to go public, borrow a significant amount, or sell debt to investors, they often use an investment bank.
The main function of investment banks is to help large corporations raise money and find investors. Investment banks act as a middle man for large financial transactions. One of the largest roles that investment banks play is in facilitating companies entry into the stock market, known as an Initial Public Offering(IPO).
Credit Unions
Credit unions are similar to retail and commerical banks. They are a not-for-profit organizations owned by their customers (while investors own most banks). Credit unions offer products and services more or less identical to most retail and commercial banks. The main difference is that credit union members share some characteristics in common (where they live, their occupation, or organizations they belong to, for example).
How Banks Make Money
A person deposits money into their bank account, the bank then can then lend other people that money. The depositing customer gains a small amount of money in return (interest on savings accounts), and then lending customer pays a larger amount of money to the bank in return (interest on loans). To make money for itself, the bank keeps the difference between the loan interest and the savings account interest. Another way that banks have begun to make money is by charging customer fees to use the services that banks offer or charging accounts below a certain amount to keep their money in the bank.
Editor's Note
This is a highly simplified model of how banks make money. This was the traditional way that banks generated revenue but modern banks have many different revenue sources to draw from. In addition modern banks will now primarily borrow money from other banks or from the Federal Reserve to free up cash reserves to create more loans rather than use the money that is deposited into the bank by their customers.
The primary and most important way that banks make money is through loans. Banks use the money given to them by customers who deposit their money into the bank to lend out to other people who are looking for loans for homeownership, to start a new business or many other things. While most people do not have enough money to make any kind of significant loan, banks are able to pool many people’s money together in order to make a significantly big loan to get a reliable return on their investment.
When banks loan out money, they charge the borrower interest. The interest of the loan is added to the loan total so that when you borrow money, you will pay more than the amount you borrowed. Banks use the interest gained from loan to first pay the bank accounts that they borrowed from, which is how people’s bank accounts can accrue interest. Then they take the difference from the bank account’s interest and the loan interest as profit.
Banks will lend out a majority of the money that is deposited into its bank accounts. This means that most of the time the amount of money that the bank is supposed to be holding for their customer is not actually in the bank, rather that money has been loaned out to various different people through loans. This practice is known as fractional reserve banking.
Fractional Reserve Banking
When you deposit funds in a bank, that money is typically available for withdrawal whenever you need it. But banks don’t keep all of your cash on hand for safekeeping. Instead, a fractional reserve banking system allows them to invest your money and still show the funds sitting in your account. It’s a core tenet of banking and one way to influence the supply of money and grow the economy.
Fractional reserve banking is the practice of holding a portion—or fraction—of customer deposits in bank reserves and lending out the remainder. Money that would otherwise be idle in bank accounts is circulated, and funds from small deposits are pooled to make loans.
In the U.S., the Federal Reserve sets a reserve requirement—a minimum that banks must actually have set aside. Banks must hold that money as cash in vaults or as deposits with Federal Reserve Banks. For financial institutions with more than $124.2 million in liabilities, the reserve requirement is currently 10 percent. In other words, those banks can lend out $90 of every $100 their customers deposit.
The supply of money grows when banks show money as deposits while simultaneously lending the funds out as loans. When you deposit money into your account, the bank shows 100 percent of the money in your account balance. But the bank is allowed to lend 90 percent of your deposit to other customers. This fractional reserve banking allows banks to greatly expand the money supply which enables economic growth.
Fractional Reserve Calculator
Enter in your bank account balance and set a fractional reserve rate to find out how much extra money your account is adding to your local economy.
The Dangers of Fractional Reserve Banking
Fractional reserve banking works because people typically don’t need access to all of their money at the same time. You may have $1,000 available in your account, but it’s unlikely that you’ll withdraw all of it. If you do, the reserves from other customer accounts should be enough to cover your withdrawal.
Things break down, however, if everybody in the system withdraws their money at the same time. This is often referred to as a “bank run.” When customers fear that a bank is in financial trouble, they flood the bank with withdrawal demands. This would generally mean that the bank would quickly deplete its cash reserve and not be able to give everyone their money back. This leads to many people losing their life savings.
Bank failures during the Great Depression were catastrophic for those who lost their life savings in bank accounts. As a result, the Banking Act of 1933 established the Federal Deposit Insurance Corp., which protects deposits in participating banks up to certain limits.
The FDIC provides a government guarantee that customers will get their money even if a bank’s investments go sour. Credit unions have similar coverage from the National Credit Union Share Insurance Fund.