Where Do Banks Get Their Money? Deposits, Loans & Capital

Banks serve as financial intermediaries, connecting those who have surplus funds with those who need capital for various purposes. Understanding where banks obtain money for daily operations, lending, and investment is a fundamental aspect of their business model. This system relies on diverse funding avenues that enable banks to facilitate economic activity.

Funds from Customer Deposits

Customer deposits are a primary source of funds for banks. When individuals and businesses place money into accounts, these funds become liabilities on the bank’s balance sheet, representing money the bank owes to its depositors. These deposits also provide the bank with financial resources to extend credit and make investments. This dual nature of deposits as both a liability and a funding source is central to how banks operate.

Deposits arrive in various forms. Checking accounts allow for frequent transactions and immediate access to funds. Savings accounts provide a secure place for funds, usually earning a modest interest rate. Money market deposit accounts offer higher interest rates than standard savings accounts, often with restrictions. Certificates of Deposit (CDs) are time deposits where funds are committed for a fixed period in exchange for a fixed interest rate, and the cost of funding through customer deposits is generally lower compared to other borrowing options.

The volume and stability of customer deposits are important for a bank’s liquidity. These deposits form a stable base, allowing banks to meet withdrawal demands while deploying funds into loans and other assets. This process is part of the fractional reserve banking system, where banks lend out a portion of deposits rather than holding 100% in reserve. Leveraging these deposits enables banks to facilitate economic growth.

Funds from Financial Market Borrowing

Banks also acquire funds by borrowing from other financial entities and capital markets. This borrowing supplements customer deposits, providing flexibility and additional liquidity to meet fluctuating demands for credit or regulatory requirements. These market-driven sources are influenced by prevailing interest rates and broader economic conditions.

One common method is interbank lending, where banks lend funds to one another, often on an overnight basis, to manage their short-term liquidity and meet reserve requirements. The interest rate on these overnight loans in the United States is known as the federal funds rate, a benchmark in financial markets. Banks with excess reserve balances lend to those with temporary shortfalls. These transactions are typically unsecured, meaning no collateral is exchanged.

Another avenue for obtaining funds is borrowing from central banks, such as the Federal Reserve, through facilities like the discount window. This serves as a backstop for liquidity, allowing eligible depository institutions to borrow on a short-term basis, usually overnight, to address unexpected funding needs. The interest rate charged on these loans, known as the discount rate, is typically higher than the federal funds rate, encouraging banks to seek funds from other commercial banks first. Primary credit is available to financially sound institutions and can be used for any liquidity purpose.

Banks also raise funds by issuing debt securities to institutional investors and the public. For short-term funding needs, banks may issue commercial paper, which are unsecured promissory notes. For longer-term funding, banks issue bonds, which are debt instruments that obligate the bank to pay periodic interest payments and repay the principal at maturity. These methods allow banks to access a wider pool of capital, diversifying their funding base beyond traditional deposits.

Funds from Owner Investments and Reinvested Profits

A bank’s own capital, derived from owner investments and retained earnings, forms a foundational layer of its financial strength. This capital serves as a buffer against potential losses and ensures the bank’s long-term solvency. It provides the capacity for a bank to take on liabilities and extend credit, though it is not directly used for everyday lending like deposits.

Initial capital is raised through owner investments, primarily by issuing common stock to shareholders. This equity capital is essential for a bank to commence operations. The amount of capital raised varies depending on the bank’s size and business model.

Subsequent profits not distributed as dividends are retained and reinvested into the institution. These retained earnings increase the bank’s capital base, strengthening its financial position without additional external investment. This internal capital generation contributes to its ability to absorb unexpected losses.

Regulatory authorities impose capital requirements on banks to ensure stability. These requirements, often guided by international standards like Basel III, mandate that banks maintain certain ratios of capital to their risk-weighted assets (RWA). The Common Equity Tier 1 (CET1) ratio compares a bank’s highest quality capital—common stock and retained earnings—against its RWA.

This owner capital acts as a cushion, absorbing losses before they impact depositors or other creditors, protecting the financial system. It provides a margin of safety, allowing the bank to continue operating during financial stress or economic downturns. A strong capital base signifies financial health and enables banks to expand lending activities and support economic development.