Search
  • Blake

How banks ACTUALLY work

I remember being introduced to banking way back as a kid in primary school, around 6 years old. There was a thing called "Dollarmites", which was a form of savings account from the Commonwealth Bank of Australia (CBA) specifically designed for young children.


Dollarmites was a youth saver program that introduced kids to earning interest on their money that was deposited. As far as I can remember it was a program that most schools offered, at least in the rural outback of New South Wales, Australia.


Since reading a bit about the Dollarmites program while writing this blog post, it turns out that these accounts were dishonestly used by bankers in a widespread scam to meet targets and receive bonuses. Who knew?! My first introduction to banking was surrounded by a national wide scandal!


Anyway, my point with that story was more to say that just about everyone is using a bank as part of their everyday life. If you have a checking account or savings account, or if you’ve ever opened a credit card or applied for a loan, then banks are an integral part of your financial life. Even as far back as 2000BC, merchants gave grain loans to farmers and traders who carried goods between cities.


How Banks Make Money


Banks and the financial services industry are an important part of the economy because they provide the means for people to borrow money, make investments, save for the future and handle smaller tasks (like paying bills).


Banks manage the flow of money between everyday people and businesses. They offer deposit accounts - like debit and savings - for you to use for the storage of your money. The banks then use this money to lend money to other people and businesses.


In return, the bank receives interest payments on those loans from borrowers. Part of that interest is then returned to the original deposit account holder in the form of interest—generally on a savings account.


The main way banks make money is from the interest on their loans and the fees they charge their customers.


Wait, what? The banks don't actually have my money sitting there waiting for me when I want it? Yes and no. The banks are required to hold a certain amount of cash on hand in case of withdrawals. This is called the "reserve".


The Reserve Requirement of Banks


The reserve amount that banks are required to carry will vary depending on the deposit total (total amount deposited into the banks accounts), at least that is the case for US banks anyway.

  • Banks with deposits less than $16 million have no reserve requirement.

  • Banks with between $16 million and $122.3 million in deposits have a reserve requirement of 3%

  • Banks with over $122.3 million in deposits have a reserve requirement of 10%

Technically speaking, if everyone decided to pull all of their money out of the bank at the same time, the bank would likely not have enough to give to everyone. This is known as "a run on the banks" and has occurred a few times in history, usually when the world is having a financial crisis.


Banks Are Highly Regulated


In Countries such as Australia, Canada and America, banking is controlled by a "Reserve System" or a Central Bank. In Australia this is the Reserve Bank of Australia (RBA), in Canada it's the Central Bank of Canada (CBC) and in America it's the Federal Reserve System (the "Fed").


These systems are owned and operated by the federal government of their respective country and they oversee banks and makes sure banks follow the proper guidelines. Banks are also subject to regulation by the Federal Deposit Insurance Corporation (FDIC) among a few others, but the FDIC is what most people will care about because it's the one that guarantees our money up to a certain value.


The FDIC does many things, but one of the most important for banking customers is insuring deposits. The FDIC insures deposits at banks for up to $250,000 per depositor, per insured bank, for each account ownership category. This means if your bank fails for any reason, the FDIC can help you recover the money in your accounts, up to the allowed limits.


Common Types of Banks


There a several different types of banks and some of them operate slightly differently. We'll cover three of the most common banks you're likely to encounter throughout your life:

  • Central Banks

  • Retail Banks

  • Credit Unions

Central Banks


Central banks manage the money supply and set the monetary policy for the country (or countries) in which they operate. As part of this, they are responsible for setting the interest rate baselines. Think of this type of bank as the Mumma bear and the other banks as her baby cubs. She keeps them under control.


Retail Banks


These are the traditional banks you likely have access to in your town or city. They do all the regular functions such as loans, deposit accounts and everyday banking services. Online banks can fall into this category as well.


Credit Unions


Credit unions offer many of the same services a traditional bank would offer. Where they differ is that traditional banks usually operate for a profit, while credit unions do not. Credit unions typically have membership requirements if you wish to join them. Some people may feel more comfortable dealing with a credit union as they feel they've got your best interest at heart because they're not trying to profit from you.


What Banks Do


As we covered previously, banks are mainly in business to give people and businesses loans. The money for these loans comes from pooled deposits of individuals and businesses. Essentially when a bank makes a loan, it is borrowing money from its depositors.


Banks can also borrow from other banks, known as - you guessed it - "interbank lending". This is usually done on a short-term basis for one important purpose: to meet the liquidity requirements set by the reserve system so it has enough to cover any withdrawals that might occur.


The interest rates of interbank lending are much lower than the rates you or I have access to when borrowing money. In America, the interbank rate is set by the Federal Reserve and is based on the current federal fund rate. This is known as the "interbank rate" or the "overnight rate".


The Fed can also lend money to banks but this is usually a last resort for banks because the rates are much higher than interbank lending rates, but still lower than the rates that we see advertised for our loans that we apply for. Banks only pursue this route if other banks don't want to lend to them.


In addition to borrowing and lending, the banks play an important part in carrying out a country's monetary policy. Monetary policy refers to the actions undertaken by a nation's central bank to control money supply and achieve sustainable economic growth.


Monetary policy can be broadly classified as either expansionary or contractionary. When the central bank of a country changes monetary policy, it’s usually related to one of three things: curbing or encouraging (contracting or expanding) economic growth, managing inflation or reacting to changing unemployment rates.


For example, the Fed or central bank can cut interest rates to encourage people to borrow money because it's "cheap" to do so, and this kicks off economic growth. As a result banks may reduce the interest rates they charge on loans because, well, they can. Lower rates are great if you want a loan, but they also result in a lower savings rate offered to you by the bank.


On the other hand, when the Fed or central bank raises rates, banks can follow suit and increase the rates they charge on loans or offer on deposit accounts. This makes borrowing more expensive, but it also encourages people to save money since they can earn a higher interest rate.


Summary


Chances are if you're a human and over the age of six years old, banks are a part of your life. They play an integral role in the world's past, present and future economy with the services they provide to individuals and businesses for borrowing money, investing and carrying out everyday financial transactions such as paying bills.


All banks (except credit unions) are in business to turn a profit and the interest they charge on loans along with the fees they charge their customers (you) is how they do this. They provide you a service and for that you are charged a fee, which is the same for most things in this life.


Regardless of which banks you choose to have your business, it's important to compare the products and services they offer, the fees involved and the interest they charge to ensure they are the best fit for your lifestyle and situation.



Blake - FIRE with a family

4 views0 comments

Recent Posts

See All