How Banks Work

Most of the time people have no idea how banking really works, and that is a very good thing! Because it means that there are no widespread issues going on and it doesn’t really matter to people how it works, it just does: paychecks get deposited, bills get paid, ATMs have cash for people, and it’s not something to worry about.  Which is how it should be.  However, recently it hasn’t really been that way at all.  Much of the reason is because banking, at least in the OECD nations is done on the basis of “fractional reserve banking”.

What is fractional reserve banking?  Basically, let’s imagine a small town bank with 1,000  customers who all have $50,000 in average deposits – checking accounts, savings accounts, CDs, etc.  That would be 1,000 x $50,000 = $50,000,000 ($50 million) in deposits.  Now, let’s say that the bank pays an average of 1.00% in interest on this money: they would owe $500,000 annually in interest, plus they would need to pay rent on the bank branch, utilities, salaries for all the tellers, security, managers and officers, insurance, office supplies, etc.  So, in short, it doesn’t work if the bank was to just take in deposits and hold them – it needs to take the deposit money and put it to work making money of its own: both to pay the agreed upon interest and all the expenses (and then some, because banks are for profit enterprises).  So banks hold a fraction of their deposits in reserve, in case they are requested by the depositors on any given day, and take the rest and either make loans or buy assets, like treasury bonds and bills.

When it comes to making loans the banks needs to evaluate the borrowers and ensure they are highly likely to pay back the loan, with interest.  When it comes to investing in bonds its important to analyze and forecast the future value of the bonds so that if the bank is forced to sell in a hurry it doesn’t lose money on the investment.  So the banks take risk, and they do it with (mostly) their depositors’ money.  All of this also means that when a lot of depositors demand their money at once the bank is in a tough spot: it needs to provide the depositors their money, but doing so may require it to sell its loans and investments.

This scene, from the movie It’s a Wonderful Life depicts the problem for a bank perfectly: it keeps enough cash on hand to satisfy some depositors demanding their money on a given day; usually it is a multiple of how many actually do, but if everyone wants their money on the same day there could be trouble!

The Bailey Building and Loan “bank run” depicted in the film needed to only deal with as many as its customers as could fit in its building, as opposed to recent bank runs in the last few weeks where customers could use an app on their phone to move some or all of their deposits out from anywhere.  So, while banks can move faster than ever – there’s more markets and more opportunities to sell assets the same day to meet depositor demand, the depositor’s ability to demand cash is also much faster and easier than in the past, so the fundamental risk for banks has not changed.  All of that said, the existence of the FDIC means that depositors are covered for all deposits up to $250,000, and would have no need to demand their cash, or accept pennies on the dollar for their deposits, in most cases.

Welcome to Money Wizard

Welcome to Money Wizard! 

We look forward to bringing you helpful insights on how to save, invest, and protect your money.  Some of the upcoming articles will focus on:

  • Savings account options 
  • How CDs work and making them work for you
  • Retirement savings options 
  • Insurance and Annuities

There will be plenty more to come besides that as well.