One of the keys to understanding money is understanding how banking works. Having a grasp of how banks make money can help you make more informed decisions about where you keep your own money, and how you use your money to make more money.
The Business of Making Money
The first thing to understand about banks is that they exist to make money. Banks are businesses. However, instead of providing manufactured products, or offering some of the professional services we expect when we think of business, banks “buy” and “sell” money. (Of course, some banks do provide other services related to finances, including selling insurance and sometimes offering access to securities.)
Banks “buy” money from depositors. Then, they can lend that money out, “selling” it to borrowers. Banks often pay interest on deposit accounts. This is especially true of savings accounts, certificates of deposit and money market accounts. Banks may also pay interest on checking accounts. Banks want to attract more depositors to the institution. This way, there is more money available for banks to lend out. And this is where a bank makes its money.
Loans made to other bank customers (and sometimes to other banks) provide a bank with a way to earn more money. A bank may pay interest on a deposit, but the interest a bank receives on a loan is much higher. If you put $1,000 in a high yield savings account, you might only earn around 1.35%. The bank, though, might be able to loan $900 of that money out at an interest rate that is much higher. Auto loans might garner a rate of at least 5% for banks, and mortgage are in that neighborhood as well. Other types of loans can provide in excess of 14% interest (especially credit cards). The difference between the amount of money a bank pays out in interest, and the money it earns from loans, can make it a rather profitable business.
The way that banks earn money illustrates one of the reasons that banks compete for depositors. The more depositors a bank has, the more money it can loan to others for better returns. It is worth noting, though, that banks can’t always lend out all of the money it has in deposits. The Federal Reserve requires that depository institutions hold a certain percentage of their funds in reserve. For banks with net transaction accounts of $10.7 million to $58.8 million, that number is 3%. Banks with more than $58.8 million net transaction accounts must hold 10% of those funds in reserve. However, even with the requirement to hold funds in reserve, banks can still earn quite a bit – and the Federal Reserve (as of 2008) pays interest on required reserve balances.
How Banks Set Interest Rates
Banks decide on interest rates by using a number of different factors. A bank takes into account the following factors as it sets its rates:
- Number of people who want to borrow money: The demand for loans can affect the sorts of rates a bank will charge. If a bank in a certain area is having trouble finding borrowers, it might lower rates to entice them.
- Amount of money the bank has available to loan out: If banks don’t have much money to lend out, they might adjust rates to reflect that. A bank might increase the interest it pays on CDs and savings accounts in order to encourage depositors to keep their money with the bank so that the money supply available to the bank for loans increases.
- Funds rate: This is the rate that banks charge each other for short-term loans. The target funds rate is set by the Federal Reserve, and it is usually fairly affordable for banks. Banks often use short-term loans from each other in order meet the reserve requirements the Fed imposes. Of course, if a bank borrows money in order to meet its short-term obligations, the loans it makes will need to have higher interest rates so that a profit can be made.
Banks also set interest rates on loans with help from individual customers’ credit situations. When a bank loans out money, there is a risk that the borrower won’t repay it. This means that the bank is out the original amount of money it loaned – and it won’t make money on interest. In some cases, a borrower may pay back part of the loan, and then default on the rest. In order to ensure that the bank gets as much of its money back as possible before a default, those who appear to be higher credit risks are often charged higher interest rates.
Banking and the Economy
Our economy relies a great deal on keeping the cycle of money moving. Banking helps this happen by taking money and then loaning it out. Indeed, if you think about this works, it becomes apparent that the amount money represented in the economy is much larger than what is “actually” there. This reality is enhanced by the electronic nature of many of our transactions. Consider how $1,000 seems to multiply, even if all the banks in the system have a 10% reserve requirement:
You put $1,000 in the bank, and $900 of that can be loaned out. So, that $900 goes into the economy and is spend on something: A car, groceries or some other item. The recipient of that $900 then puts it in the bank. The new bank can loan out $810 of that money. It’s not new money, though: It’s still part of the original $1,000 you put in. And, of course, the cycle continues, since that $810 is loaned out and spent, and then put into a bank by the recipient. The bank can then loan out $729 of that money. But, as you can see, at each stage, money is being spent, and someone is receiving it – and putting it bank into the bank. And all the time, banks are earning interest as loans are repaid. But that same $1,000 can be recycled over and over again.
As long as the system keeps working, the economy keeps growing. But, as we saw with the credit crunch and the recent financial crisis, once the money stops going around, things get a little dicey for our economy in its current form.