Siddhesh Sonawdekar

How Banks Work

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When you put your money into a money market savings account it earns interest just like in a regular savings account.

The funny thing about how a bank works is that it functions because of our trust. We give a bank ourmoney to keep it safe for us, and then the bank turns around and gives it to someone else in order to make money for itself. Banks can legally extend considerably more credit than they have cash. Still, most of us have total trust in the banks ability to protect our money and give it to us when we ask for it.

Why do we feel better about having our money in a bank than we do having it under a mattress? Is it just the fact that they pay intereston some of our accounts? Is it because we know that if we have the cash in our pockets well spend it? Or, is it simply the convenience of being able to write checks and use debit cards rather than carrying cash? Any and all of these may be the answer, particularly with the conveniences of electronic banking today. Now, we dont even have to manually write that check we can just swipe a debit card or click the "pay" button on the banks Web site.

In this article, well look into the world of banking and see how these institutions work, what you would have to do to start your own bank, and why we should (or shouldnt) trust them with our hard earned cash.

How Banks Work How Banks Work

What is a bank?

According to, a bank is:

an institution that deals in money and its substitutes and provides other financial services. Banks accept deposits and make loans and derive a profit from the difference in the interest rates paid and charged, respectively.

Banks are critical to our economy. The primary function of banks is to put their account holders money to use by lending it out to others who can then use it to buy homes, businesses, send kids to college...

When you deposit your money in the bank, your money goes into a big pool of money along with everyone elses, and your account is credited with the amount of your deposit. When you write checks or make withdrawals, that amount is deducted from your account balance. Interest you earn on your balance is also added to your account.

Banks create money in the economy by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by the Federal Reserve. The reserve requirement is currently 3 percent to 10 percent of a banks total deposits. This amount can be held either in cash on hand or in the banks reserve account with the Fed. To see how this affects the economy, think about it like this. When a bank gets a deposit of $100, assuming a reserve requirement of 10 percent, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it.

In this way, money grows and flows throughout the community in a much greater amount than physically exists. That $100 makes a much larger ripple in the economy than you may realize!

Why does banking work?

How Banks Work How Banks Work

Banking is all about trust. We trust that the bank will have our money for us when we go to get it. We trust that it will honor the checks we write to pay our bills. The thing thats hard to grasp is the fact that while people are putting money into the bank every day, the bank is lending that same money and more to other people every day. Banks consistently extend more credit than they have cash. Thats a little scary; but if you go to the bank and demand your money, youll get it. However, if everyone goes to the bank at the same time and demands their money (a run on the bank), there might be problem.

Even though the Federal Reserve Act requires that banks keep a certain percentage of their money inreserve, if everyone came to withdraw their money at the same time, there wouldnt be enough. In the event of a bank failure, your money is protected as long as the bank is insured by the Federal Deposit Insurance Corporation (FDIC). The key to the success of banking, however, still lies in the confidence that consumers have in the banks ability to grow and protect their money. Because banks rely so heavily on consumer trust, and trust depends on the perception of integrity, the banking industry is highly regulated by thegovernment.

Types of Banks

There are several types of banking institutions, and initially they were quite distinct. Commercial bankswere originally set up to provide services for businesses. Now, most commercial banks offer accounts to everyone.

Savings banks, savings and loans, cooperative banks and credit unions are actually classified as thrift institutions. Each originally concentrated on meeting specific needs of people who were not covered by commercial banks. Savings banks were originally founded in order to provide a place for lower-income workers to save their moneySavings and loan associations and cooperative banks were established during the 1800s to make it possible for factory workers and other lower-income workers to buy homes.Credit unions were usually started by people who shared a common bond, like working at the same company (usually a factory) or living in the same community. The credit unions main function was to provide emergency loans for people who couldnt get loans from traditional lenders. These loans might be for things like medical costs or home repairs.

Now, even though there is still a differentiation between banks and thrifts, they offer many of the same services. Commercial banks can offer car loans, thrift institutions can make commercial loans, and credit unions offer mortgages!

How do banks make money?

Banks are just like other businesses. Their product just happens to be money. Other businesses sell widgets or services; banks sell money in the form of loans, certificates of deposit (CDs) and other financial products. They make money on the interest they charge on loans because that interest is higher than the interest they pay on depositors accounts.

The interest rate a bank charges its borrowers depends on both the number of people who want to borrow and the amount of money the bank has available to lend. As we mentioned in the previous section, the amount available to lend also depends upon the reserve requirement the Federal Reserve Board has set. At the same time, it may also be affected by the funds rate, which is the interest rate that banks charge each other for short-term loans to meet their reserve requirements. Check out How the Fed Works for more on how the Fed influences the economy.

Loaning money is also inherently risky. A bank never really knows if itll get that money back. Therefore, the riskier the loan the higher the interest rate the bank charges. While paying interest may not seem to be a great financial move in some respects, it really is a small price to pay for using someone elses money. Imagine having to save all of the money you needed in order to buy a house. We wouldnt be able to buy houses until we retired!

Banks also charge fees for services like checking, ATM access and overdraft protection. Loans have their own set of fees that go along with them. Another source of income for banks is investments andsecurities.

How do you start your own bank?

How Banks Work How Banks Work


Some of the benefits of a state-chartered bank include local access to decision-makers and, sometimes, faster responses to questions and concerns. Local decision makers also may be more familiar with the local economies and market conditions. Local regulatory assessment fees are often lower than federal fees, as well.

What if you wanted to start your own bank? Do you just rent some space, put out a sign and started taking deposits? Not exactly. Lets look at the steps you have to go through in order to start your own bank. The rules and requirements vary from state to state, so in this article well use the requirements from the state of Florida.

The Organizing Group

Just as with any business, youll first have to make some pre-planning decisions like who your partners (called the organizing group) will be. Youll also have to write a business plan. All of these things will be taken into consideration when you apply for a state or federal charter.

charter is an agreement that governs the manner in which the bank is regulated and operates. It authorizes the organization of the bank by either the state or federal agency. The agency that charters the bank is primarily responsible for protecting the public from unsafe banking practices. It conducts on-site examinations to make sure the banks financial condition is good and that the bank is complying with banking laws. State charters and federal charters typically do not differ too much in the way the bank conducts business. They do, however, differ in other areas. For example, in Florida, a state bank is not required to be a member of the Federal Reserve System, while federally chartered banks are. Also, state-chartered banks are regulated by state agencies, while federally chartered banks are regulated by federal agencies.

How safe is your money in a bank?

The 12 regional Reserve Banks act as the service division of the Federal Reserve  they carry out the monetary policy set by the Federal Reserve Board and regulate and supervise financial institutions. The agency that charters the bank is also responsible for conducting on-site examinations to make sure the bank is complying with banking laws. In addition to this supervision, your money is also protected by insurance.

That "FDIC" logo you see as you walk in the door means that you hold insurance on your deposits. Depositors are typically protected for up to $100,000.

Deposit insurance came about because of rumors of banking trouble that lead to panics and everyone running to the bank to withdraw all of their money. It didnt take much to make people uneasy about the security of their money in the bank. If they heard of the slightest hint of trouble, they ran to the bank to withdraw. This lead to the failure of many banks and huge losses of savings for many people. This roller coaster of personal finance lasted for many years and throughout the Great Depression of the 1930s. Finally, in 1934, Congress established the Federal Deposit Insurance Corporation (FDIC), which initially provided deposit insurance coverage of $2,500 per depositor. This greatly improved the security of banks and reduced the number of bank failures by almost 4,000 from 1933 to 1934.

Public confidence in the banking system has improved tremendously since the FDIC was established. The trust that depositors need in order to make the system work is maintained, and the economy keeps humming.

Banks also carry private banking insurance  specially designed private coverage to protect deposits in the case of burglaries, robberies, vandalism, etc.

Checking Accounts

How Banks Work How Banks Work

Banks offer lots of financial products for their depositors. The checking account is one of the most common ones. Its convenient because it lets you buy things without having to worry about carrying the cash or using a credit card and paying its interest. While most checking accounts do not pay interest, some do these are referred to as negotiable order of withdrawal(NOW) accounts. Some say that checks have been around since about 352 B.C. in the Roman Empire. It appears that checks really started becoming popular in Holland in the 1500 to 1600s. Dutch "cashiers" provided an alternative to keeping large amounts of cash at home and agreed to hold depositors money for safekeeping. For a fee, they would pay the depositors debts from the account based on a note that the depositor would write sounds a lot like a check!

Todays banks do the same thing. It became a little more complicated when lots of banks became involved and money needed to be shifted from one bank to the next. To make things easier, banks now have a system of check "clearinghouses." Banks either send checks through the Federal Reserve or use a private clearinghouse to transfer the funds and clear the check. Here is a diagram of how that works.

Loans, Checks and Savings

Aside from checking accounts, they offer loans, certificates of deposits and money market accounts, not to mention traditional savings accounts. Some also allow you to set up individual retirement accounts (IRAs) and other retirement or education savings accounts. There are, of course, other types of accounts being offered at banks across the country, but these are the most common ones.

How Banks Work How Banks Work

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