How Banks Work

On the first and the fifteenth of every month, my paycheck is deposited into my bank account.   Some fraction of it is saved, while another(larger) fraction is spent.   They put the money in a vault and protect it from being stolen.   Anything I manage to save and anything I haven’t managed to spend yet, will build interest. The bank pays me to keep my money there, even if it’s just for a short time.   Why would they do that?  If I asked you to hold on to $100 for me, in exchange for giving me $10 next week, you’d laugh at me.  Right?   If I told you that I was expecting you to keep that $100 heavily guarded in a locked room that requires a staff and utilities, you’d try to have me committed, yet that’s what banks do every day.

What’s in it for the bank?

Let’s start at the beginning.     In the financial world, there are fundamentally two types of people:  those who have money and those who need it.

The people who have money get it by producing something or otherwise providing value to someone for something.  They then spend less than they made, leading to an accumulation of money.  Woo!  Rich people! Naturally, this money gets stuffed in a mattress for safe-keeping.   Their money does nothing except collect dust and, occasionally, hungry insects.   It is also used to soften a hard mattress.

People who need money have a few choices.  They can beg for it, work for it, or steal it. The third option leads to perforation or imprisonment, so we won’t address that one.    Now, you can work for your paycheck, like most adults, or you can go, hat in hand, to a charity and ask for money.   But what if you want to start a business?  You’ve invented the super-widget, a device guaranteed to revolutionize the world more than anything since sliced bread or the USB-powered pet rock.   You got a concept and a prototype, you just don’t have the tooling or manpower to produce the millions of super-widgets the world will soon be beating a path to your door to own.   You also lack a marketing budget to tell the world to stock up on path-beaters to make it to your door.  What do you do?

Enter banks.

A bank will approach the first class of people and talk their money out of the mattresses and mayonnaise jars. They offer to hold the money for the people who have it.   They will protect it from theft and they will pay the owner a fee for the privilege of holding on to the cash safely.   Of course savers jump at the chance.   They can quit worrying about the maid making the bed and becoming a millionaire and they can build wealth with no work.   But wait…TANSTAAFL, right?   You can’t get something for nothing.   The world doesn’t work that way.

The bank takes your money–and the money of thousands of people like you–for safe-keeping.   They pay you a fee, called interest.   The rest, the loan out to the second group of people, the ones who need the money.    They set aside some of the deposits so the owners can make withdrawals, but the rest goes into the loan-pool.   People who need money come to the bank, explain their needs and demonstrate their ability to repay the loan, then they are given money for a fee, also called interest.   The interest rate for the borrower is significantly higher–sometimes 20 times higher–than the interest paid to depositors.   The difference between interest earned and interest paid is what pays the bank’s bills. That gap pays for the rent, taxes, and payroll.

Ultimately, a bank’s job is to connect the savers with the spenders in a way that’s reliable enough to ensure everybody benefits. If anybody in the chain ceases to benefit, the system collapses.  Depositors switch back to using mattresses, borrowers go back to their loan-shark grandparents, and banks close their doors.   This is the system that allows the entrepreneurial spirit to thrive, while making money for everyone involved.