How Banks Work: From Deposits to Loans

When you put money into your bank account, banks do not just let it sit. They use your deposits to help others get credit and support the economy. You can trust your money is safe. The FDIC protects up to $250,000 per depositor, per insured bank, for each account type. This protection means you can focus on your financial goals while learning How Banks Work.

Key Takeaways

• Banks use your deposits to make loans, helping the economy grow. Your money is not just stored; it circulates to support others.

• FDIC insurance protects your deposits up to $250,000, ensuring your money is safe even if a bank fails.

• Understanding the Five C’s of Credit can help you secure a loan. These include capacity, capital, collateral, character, and conditions.

• Fractional reserve banking allows banks to lend out most of your deposits, creating more liquidity in the economy.

• Always check if your bank is FDIC-insured before opening an account to ensure your money is protected.

How Banks Work

Deposits and Reserves

When you walk into a bank and hand over your cash deposits, you might wonder what happens next. Banks do not just store your money in a vault. They use your cash deposits to keep the financial system running smoothly. You can think of banks as the heart of the economy, pumping liquidity through every part of the system.

So, what do banks actually do with your cash deposits? Here is a simple breakdown:

• Banks accept cash deposits from you and other customers.

• They keep a small part of these cash deposits as reserves. This helps them handle withdrawals and keep liquidity available.

• The rest of the cash deposits go toward making loans to people and businesses.

Banks must always have enough liquidity to meet your needs. Central banks set rules for how much liquidity banks must keep on hand. These rules are called reserve requirements. For example:

• The current required reserve ratio is often around 2 percent.

• In some places, it has been as high as 5 percent.

This means if you deposit $100, your bank might keep $2 to $5 as reserves and use the rest to make loans. Banks sometimes keep even more liquidity than required, just to be safe. This extra liquidity helps banks stay strong during busy times or financial stress.

Note: Reserve requirements help banks avoid running out of liquidity. They make sure banks can always give you your cash deposits back, even if many people want their money at once.

Central banks play a big role in how banks work. Here are some of their main jobs:

• Setting interest rates and controlling the money supply

• Acting as a banker to the government and as a lender of last resort

• Managing foreign-exchange and gold reserves, plus government bonds

• Regulating and supervising the banking industry

• Managing or supervising payment systems and inter-banking clearing

• Producing coins and notes

All these tasks help banks keep enough liquidity in the system. When you think about how banks work, remember that your cash deposits help create the liquidity that keeps the economy moving.

Fractional Reserve Banking

Now, let’s talk about what fractional reserve banking means. This is the system most banks use today. In fractional reserve banking, banks keep only a small part of your cash deposits as reserves. They lend out the rest to earn money and support the economy.

Here is what makes fractional reserve banking different from full reserve banking:

• In fractional reserve banking, banks create new money every time they make a loan. This increases liquidity in the economy.

• In full reserve banking, banks can only lend out money that people have set aside for lending. No new money gets created, so liquidity does not grow as much.

When you deposit money, your bank keeps a fraction as reserves and lends out the rest. The money lent out often ends up as new cash deposits in other banks. Those banks then keep a fraction as reserves and lend out the rest again. This cycle repeats, multiplying liquidity across the whole system.

Let’s look at some key moments in the history of fractional reserve banking:

Banks started using fractional reserve banking in medieval Italy. They learned to use cash deposits to make loans, which increased liquidity. Over time, central banks formed to help manage liquidity and prevent problems like bank runs.

You might wonder why banks do not keep all your cash deposits as reserves. If banks kept all cash deposits in their vaults, they could not make loans. The economy would slow down because there would not be enough liquidity for people and businesses to borrow and spend.

Fractional reserve banking lets banks use your cash deposits to create more liquidity. This system helps banks support growth, handle withdrawals, and keep the economy healthy. When you understand how banks work, you see how your cash deposits help create the liquidity that everyone depends on.

Bank Lending Process

Creating Loans

When you walk into a bank and ask for a loan, you start a process that helps keep the banking system moving. The bank lending process begins with your application and ends with money in your hands. Here’s what happens step by step:

1. Application and Documents
   You fill out a loan application and provide documents like your financial statements and tax returns. The bank needs these to understand your situation.

2. Loan Underwriting
   The bank reviews your application using the Five C’s of Credit. These are:

   • Capacity: Can you repay the loan? The bank checks your income and debts.

   • Capital: How much money do you have? A bigger down payment shows you are serious.

   • Collateral: What can you offer if you cannot pay back the loan? This could be a car or a house.

   • Character: What does your credit history say about you? The bank looks at your past payments.

   • Conditions: What is the purpose of the loan? The bank also considers the economy and loan demand.

   Criteria	Description
   Capacity	Your ability to repay the loan, often checked through your debt-to-income ratio.
   Capital	The money or assets you can put toward the loan, showing your financial stability.
   Collateral	The assets you pledge as security for the loan, like a house or car.
   Character	Your credit history and how you have managed debt in the past.

3. Decision and Pre-Closing
   The bank decides if you qualify. If you do, they tell you the terms and get ready for closing.

4. Closing
   You sign the final papers. The bank gives you the money.

5. Post Closing
   The bank sends you a welcome packet and your loan documents.

Tip: Banks use these steps to make sure they lend money to people who can pay it back. This keeps the banking system safe and strong.

Banks do not just give out loans to anyone. They look at loan demand and use the Five C’s to decide who gets approved. When you get a loan, you help the bank lending process work for everyone.

Money Supply and Lending

You might wonder what happens after you get your loan. The answer is simple: the money you borrow does not just stop with you. It moves through the banking system and helps create even more money.

When banks make loans, they create new deposits. This means the money supply grows. Here’s how it works:

• Banks create new deposits when they approve loans. The money appears in your account, even though it did not exist before.

• Central banks can also create money by buying assets like government bonds.

• The government sometimes spends new money into the economy.

The banking system uses something called the money multiplier effect. This effect shows how a single deposit can lead to many loans and more money in the economy. Here’s a simple way to see it:

1. You deposit $100 in your bank.

2. The bank keeps a small part, maybe $10, as reserves.

3. The bank lends out $90 to someone else.

4. That person spends the $90, and it ends up as a new deposit in another bank.

5. The next bank keeps $9 as reserves and lends out $81.

6. This cycle repeats, and the total money in the banking system grows.

Note: The money multiplier is a formula that shows how much the money supply can grow. You can find it by dividing 1 by the reserve ratio. For example, if the reserve ratio is 10%, the money multiplier is 10.

The banking system depends on people re-depositing their cash. If people keep cash at home, banks cannot lend it out, and the money supply does not grow as much. Central banks control how much banks must keep in reserve. This rule affects how much banks can lend and how much money the banking system can create.

The bank lending process connects your deposits, loans, and the money supply. When banks approve loans, they meet loan demand and help the economy grow. Every time a loan is made, the banking system gets stronger, and more money flows through the economy.

Types of Loans

Personal Loans

When you need money for something important, you might look at personal loans. These loans are unsecured, which means you do not need to put up property or a car as collateral. Banks offer personal loans for things like medical bills, home repairs, or even vacations. You can use the money for almost anything.

You usually pay back personal loans in fixed monthly payments. The interest rate can be high. Right now, the average personal loan interest rate in the United States is 20.78% APR. If you want to qualify, banks look at several factors:

You need to show you can handle the payments. Banks check your credit score and your accounts to see if you qualify.

Mortgages

If you want to buy a home, you will probably need a mortgage. This is a special loan for real estate. Banks use your deposits to fund these loans, and you pay them back over many years. Mortgage rates change over time. Here is a look at average rates in the United States:

Rates dropped during the pandemic, then jumped in 2023. Now, rates are around 6.7%. You need to show banks you can make regular payments. They check your accounts and your income before approving you.

Tip: Mortgages help you buy a home without paying the full price upfront. You become a homeowner while making monthly payments.

Business Loans

If you run a business, banks offer many types of loans to help you grow. You can choose from:

• Working capital lines of credit for daily expenses

• Credit cards for flexible spending

• Short-term commercial loans for quick needs

• Longer-term loans secured by property or equipment

• Equipment leasing for new tools or machines

• Letters of credit for international trade

Here is a quick look at some common business loans:

Business loans help borrowers manage cash flow, buy equipment, or expand operations. Banks work with you to find the best option for your needs.

How Banks Make Money

Interest Income

When you think about the primary sources of income for banks, interest stands out. Banks earn most of their money from the interest earned on loans. You deposit your money, and banks use it to give loans to others. They charge borrowers a higher interest rate than what they pay you for your savings. This difference is called the net interest margin.

Banks set interest rates for loans based on several factors. Your credit score, the size of your down payment, and the length of your loan all play a part. Shorter loan terms usually mean lower rates. Adjustable rates might start low but can change over time.

• Higher credit scores can lead to lower interest rates.

• Larger down payments can reduce interest rates.

• Shorter loan terms often result in lower rates.

• Adjustable rates may start lower but can change over time.

“Mortgage rates typically move in lockstep with 10-year Treasury yields. When they rise, we must adjust pricing to maintain spreads.” – Kevin Ryan, CFO of mortgage lender Better.

Your credit history matters, too. If you have a high credit score, you get a lower interest rate. If your score is low, banks see you as a risk and charge more.

Banks also look at the economy. Inflation, central bank policies, and market conditions all affect interest rates. When inflation rises, interest rates usually go up. Central banks, like the Federal Reserve, set policies that influence these rates.

This table shows that while banks rely mostly on interest, non-interest income has grown over time.

Fees and Other Revenue

Banks do not just make money from interest. They also earn revenue from fees and investments. You might see fees for using an ATM, making too many withdrawals, or not keeping a minimum balance. Here are some common fees:

• Minimum account balance fees: Charged when your account drops below a set amount.

• Withdrawal and transfer fees: Applied after you make too many transactions in a month.

• ATM fees: Charged for using out-of-network ATMs.

• NSF fees: Charged when you do not have enough money for a transaction.

• Overdraft fees: Applied when your account goes below zero.

• Late payment fees: Charged if you miss a payment.

Banks invest in stocks, bonds, and other assets. These investments help them earn extra money. Over the past two decades, non-interest income has shifted from a small role to a major part of bank revenue. Fee income now makes up almost half of non-interest income for both large and small banks.

The financial crisis changed how banks earn money. Many banks increased service charges to make up for lost interest income. Today, banks focus more on fee-based services and investments to keep their revenue strong.

Deposit Safety

FDIC Insurance

You might wonder what happens to your money if your bank fails. The answer is simple: FDIC insurance protects your deposits. The Federal Deposit Insurance Corporation (FDIC) covers your money up to $250,000 per depositor, per insured bank, for each account ownership category. This means if you have a checking account, a savings account, and a certificate of deposit at the same bank, each account type gets its own coverage up to the limit.

FDIC insurance gives you peace of mind. Even if a bank closes, you do not lose your insured money. Over the past 20 years, there have been 570 bank failures, but insured depositors received their money back because of FDIC payouts. You do not need to apply for this protection. It happens automatically when you open an account at an FDIC-insured bank.

Tip: Always check if your bank is FDIC-insured before opening an account. Most banks in the United States carry this protection.

Banking Regulations

Banking regulations work behind the scenes to keep your money safe. These rules make sure banks follow strict standards and treat you fairly. Here are some important regulations that protect your deposits:

Regulatory agencies like the FDIC and CFPB check banks regularly. They review compliance programs and issue reports. If a bank does not follow the rules, agencies can order them to fix problems or even stop certain activities. These steps help keep your money secure and make sure banks act responsibly.

Note: Banking regulations and FDIC insurance work together to protect your deposits and build trust in the financial system.

When you look at what banks do, you see a clear path from deposits to loans and profits. Here’s what matters most:

1. Long-term loan commitments help banks build strong relationships and boost profits.

2. Picking the right customers from the start leads to better results.

3. Well-structured loans keep customers coming back.

You can feel safe knowing your money is protected.

• The FDIC insures your deposits and checks banks for safety.

• It steps in if a bank fails, keeping trust in the system.

Learning what banks do helps you make smart choices with your money.

FAQ

What happens to your money after you deposit it in a bank?

Your bank uses your deposit to help make loans for other people and businesses. The bank keeps a small part as reserves. The rest goes to support the economy.

What is the main way banks make money?

Banks earn most of their money from interest. They pay you a small amount for your savings, then charge borrowers a higher rate for loans. The difference is their profit.

What does FDIC insurance cover?

FDIC insurance protects your deposits up to $250,000 per depositor, per insured bank, for each account type. If your bank fails, you get your insured money back.

What types of loans can you get from a bank?

You can get personal loans, mortgages, and business loans. Each type has different uses and requirements. Banks help you choose the best option for your needs.

What should you check before opening a bank account?

Always check if your bank is FDIC-insured. Look at fees, interest rates, and account features. This helps you keep your money safe and avoid surprises.