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What do banks do? We know that most banks serve to accept deposits and make loans. They act as safe stores of wealth for savers and as predictable sources of loans for borrowers. In this way, the major business of banks is that of a financial intermediary between savers and borrowers. The bank simplifies this process by eliminating the need for savers to find the right borrowers and the right time to directly make a loan.
Banks are generally trusted by the public. When people put their savings into banks, they receive little more than a paper receipt in return. There are two organizations in place to ensure that banks are trustworthy with individuals' money and reasonable in the loans that they make. The Federal Deposit Insurance Corporation guarantees that deposits, up to $100,000 per account, will be returned to the depositor, even if the bank fails. Individual banks also have a board of directors to regulate the sizes and interest rates of loans the bank makes. This board is charged with ensuring that the bank is taking reasonable risks with its depositors' money.
Banks serve another important role. When you look at a check or a debit card you will usually see the name of a bank. Individual banks serve as the issuing and regulating bodies for many financial services often employed by consumers. In this way, banks are able to give depositors access to their money while also maintaining a large number of loans.
What happens when you deposit money into a bank? First, the money is recorded (usually by computer) and added to your account. It is then placed into the vault. At various times during the day, money is removed from the vault and taken to a second bank. This bank, unlike the first, does not serve individuals. It is a "banks' bank," usually a branch of the Federal Reserve. The first bank is able to make deposits, withdrawals, and take out loans from the second bank.
When you walk into a bank to withdraw money or to take out a loan, the reverse of the process outlined above occurs. If the first bank does not have enough money in the vault to cover the withdrawal or the loan, the first bank goes to the second bank and withdraws money. If the first bank does not have enough money in its account at the second bank, then it must take out a loan at a lower rate of interest than the loan that it will eventually give to the individual borrower. In this way, a bank is able to accept deposits, honor withdrawals, and make loans without having to maintain all of the deposited cash on hand in the vault.
How do banks make money? As financial intermediaries, they earn enough to support their activities by the difference between the interest rate paid to savers and the interest rate charged on loans. When customers make deposits in a savings account, they earn interest on the principle. Similarly, when customers take out loans, they pay interest on the principle. By charging the borrower a slightly higher interest rate than that which is given to the depositor, a bank is able to cover its expenses.
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