Where Do Banks Put Their Money?

Banks, as financial institutions, do not merely act as static repositories for money. Instead, they actively deploy the funds they receive from depositors and other sources to facilitate economic activity, generate revenue, and adhere to regulatory requirements. Understanding how banks manage and allocate these vast sums provides insight into the broader financial system and its impact on individuals and businesses. This multifaceted management involves careful consideration of liquidity, risk, and profitability across various financial activities.

Managing Physical Cash Holdings

While many people associate banks with large vaults filled with currency, physical cash represents a relatively small proportion of a bank’s total assets. Banks hold physical cash primarily to meet the daily transactional needs of their customers, such as ATM withdrawals and teller services. This cash is a circulating medium for immediate public use.

The logistics of managing physical cash involve operational considerations. Banks incur costs related to physical security, transportation via armored car services, and the labor-intensive process of counting and sorting currency. Maintaining these physical reserves is necessary for operational continuity. Most money in the modern financial system exists in digital form, as electronic balances rather than tangible notes and coins.

Depositing Funds with Central Banks

A significant portion of commercial banks’ funds is held as deposits with central banks, such as the Federal Reserve in the United States. These deposits serve several functions within the financial system. Banks maintain these accounts to facilitate interbank settlements, allowing for the smooth transfer of funds between different financial institutions.

Historically, banks were required to hold a percentage of their deposits as reserves with the central bank, known as reserve requirements, to ensure liquidity and stability. While the Federal Reserve reduced reserve requirement ratios to zero percent in March 2020, banks still maintain balances at the central bank. These deposits provide a safe and liquid place for banks to store excess funds. By influencing the overall supply of these reserves, central banks can affect interest rates and the broader money supply in the economy.

Lending and Investing Activities

The primary way banks put their money to work is through various lending and investment activities, central to their business model. Banks extend numerous types of loans to individuals and businesses, earning interest income. These loans include mortgages for home purchases, auto loans for vehicles, and personal loans for various consumer needs.

Banks also provide commercial and industrial loans to businesses, supporting capital expenditures, operational needs, and expansion projects. Credit card debt is another form of lending where banks extend revolving credit lines to consumers, generating revenue through interest charges and various fees. The interest rates charged on these loans are higher than the rates banks pay to their depositors, creating a net interest margin that is a source of profitability.

Beyond lending, banks invest a portion of their funds in various securities. These investments include government bonds, such as U.S. Treasuries, which are considered highly liquid and low-risk instruments. Such investments help banks manage risk, diversify their asset portfolios, and provide a stable return on assets. Banks face regulations limiting their direct investment in higher-risk assets like corporate equities to protect depositor funds.

Banks engage in asset-liability management (ALM) to balance their assets, such as loans and investments, with their liabilities, primarily deposits. This practice aims to ensure both profitability and solvency by mitigating risks arising from mismatches in interest rate sensitivity and maturities between assets and liabilities. Effective ALM supports a bank’s financial stability and its ability to meet obligations to depositors and creditors.

Interbank Lending and Borrowing

Banks engage in short-term lending and borrowing with each other in the interbank market. This market allows banks to manage their immediate liquidity needs. For instance, a bank facing a temporary shortfall in funds can borrow from another bank with a surplus, avoiding the need to sell off longer-term assets.

The interest rate charged on these overnight interbank loans in the United States is known as the federal funds rate. This rate is a benchmark that influences other short-term interest rates throughout the economy. The smooth functioning of the interbank market supports the stability of the entire financial system, ensuring that banks can meet their obligations and maintain confidence.