How Does a Bank Work?

How Does a Bank Work?

You have a bank account. You visit your bank branch every month and deposit money or take out cash. You know the mechanics of being a customer at the bank but you have never really understood how banks work.

Not to worry, the answer is very simple and is right here in this article.

A bank is a commercial entity, a financial institution that manages your checking account, gives out loans and products like certificates of deposits. Certificates of deposits are given to either individual customers or small businesses at the time of investment.

Basically, a bank is the business of making and giving out money.

But how does a bank make money?

Commercial banks earn money through loans and interest income from a business, personal or auto loans and even mortgages. Investment banks, on the other hand, use complicated financial methods to gain profits. However, let’s stick to commercial banks here.

Now, banks essentially deal with two major things: deposits and loans. Core deposits from checking and savings accounts are the largest resources for commercial bank funds. These are short term deposits and will be extracted at some point in the future.

Banks use these deposits to earn their income and profit. A commercial bank will get the money for their loans from customer’s assets and money deposited in the bank.

The bank will use the customer deposits in checking and savings accounts, certificates of deposits, and money market accounts as capital. This capital is then a loan from the depositing customers who are sometimes, paid interest.

You can easily withdraw your deposits and rest assured that all your money will not be given out in mortgages. Your money is insured by the Federal Deposit Insurance Corporation in the US.

Loans are given out for certain periods at fixed rates and can have property securities. Mortgages are given out on houses, using houses as securities, as loans to pay off over a certain period of time.

When your economy has a fractional reserve banking system, banks will create money through claims to assets and will create credit to make loans. This strategy is often called the multiplier effect and is delimited by law to a certain amount.

Banks will have to use liquid cash as deposit claims up to a certain level in a reserve ratio. This ratio is 10% for American banks.