What Do Banks Do With Your Money?

Banks act as intermediaries in the financial system, connecting individuals and entities with surplus funds to those who require capital. They gather money from depositors and channel those funds to borrowers, facilitating a wide range of economic activities. This supports commerce, investment, and personal financial needs, making banks central to a modern economy.

Core Banking Operations

Banks receive money through various deposit accounts. Checking accounts offer easy access for daily transactions, while savings accounts are for accumulating funds. Money market accounts provide higher interest rates than standard savings, and Certificates of Deposit (CDs) require funds to be held for a fixed period for a higher, fixed rate. These deposits form the foundation of a bank’s available funds.

A bank’s primary use for these deposits is lending money to individuals and businesses. This lending generates income and supports economic growth. Most deposited funds are channeled into various types of loans. This process of taking deposits and making loans is known as financial intermediation.

Banks issue a diverse portfolio of loans. Mortgages are loans for purchasing real estate. Personal loans provide funds for individual needs like consolidating debt or home improvements. Auto loans finance vehicle purchases.

Beyond consumer lending, banks support businesses with term loans for capital expenditures or lines of credit for working capital. Credit card lending provides revolving credit to consumers. Each loan type carries different terms, interest rates, and collateral requirements.

Bank Investments and Reserves

Beyond direct lending, banks allocate a portion of their funds into various financial instruments to generate additional income and maintain liquidity. These investments include government bonds, such as U.S. Treasuries, which are considered low-risk and provide stable returns. Banks may also invest in municipal bonds or corporate bonds. These investments diversify a bank’s asset portfolio and contribute to its profitability.

Banks also manage reserves to meet daily withdrawal demands and ensure short-term liquidity. The Federal Reserve reduced reserve requirement ratios to zero percent for all depository institutions in the United States. This means banks are no longer legally required to hold a specific fraction of deposits as reserves.

Despite the elimination of formal reserve requirements, banks still hold funds as reserves for practical reasons. These “excess reserves” are funds held above any zero-percent requirement for liquidity management or other purposes. Banks maintain these reserves to ensure they can readily meet customer withdrawals, process payments, and manage unexpected cash flows.

How Banks Generate Revenue

Banks primarily generate revenue through the net interest margin. This is the difference between the interest income banks earn on their loans and investments and the interest they pay out on customer deposits and other borrowed funds. For instance, if a bank earns 7% on loans but pays 2% on deposits, the 5% difference contributes significantly to its earnings. This spread between lending and borrowing rates represents the profitability of a bank’s operations.

Beyond interest income, banks earn revenue from various non-interest sources, including fees for services provided to customers. Banks charge monthly account maintenance fees and overdraft fees when a customer spends more than available.

Other non-interest income streams include ATM usage fees, wire transfer fees, and loan origination fees charged when a loan is approved. Credit cards generate income through annual fees, late payment fees, and interchange fees from merchant transactions. Banks also provide wealth management services, earning fees for managing investments and offering financial advice.

Ensuring Financial Stability

To protect depositors’ money and maintain confidence in the financial system, several measures are in place. The Federal Deposit Insurance Corporation (FDIC) provides deposit insurance, which protects customer deposits up to a certain limit in the event of a bank failure. In the United States, this coverage is $250,000 per depositor, per insured bank, for each account ownership category. This insurance assures individuals that their savings are secure even if their bank experiences severe financial distress.

Regulatory oversight and capital requirements further support financial stability. Federal regulators, including the Federal Reserve and the Office of the Comptroller of the Currency (OCC), establish rules that ensure banks operate safely and soundly. Banks are required to hold a certain amount of capital, which acts as a buffer against potential losses, reducing the risk of insolvency. These capital requirements are often based on the bank’s risk-weighted assets, meaning riskier activities necessitate higher capital reserves.

Liquidity management practices are also important for a bank’s stability. Banks actively monitor and manage their cash flows to ensure they can meet withdrawal obligations and other short-term liabilities. This involves forecasting cash inflows and outflows and maintaining readily accessible funds. These combined measures, including deposit insurance, capital requirements, and liquidity management, are designed to prevent bank failures and maintain public trust in the banking system.