The banking system is a huge part of our everyday lives. It helps us with everything from depositing our paychecks to buying our first home or a new car. How are banks able to help us with such a wide range of our needs and goals? Part of it relates to the underlying structure of how banks work.
When you deposit money into your account, the bank uses those funds to lend to other customers for a small fee. In a way, you become a lender to the bank, which borrows money from you to lend it to other borrowers. But don't worry—your money always remains your own, and you're not on the hook if those borrowers default.
What happens to your money in a bank
This system of lending and borrowing is just one way that banks make money. When they lend out their customers' money to someone who wants a house or a personal loan, they charge interest. When the borrower repays the loan, the bank receives the money they lent out, plus the amount set by their interest rate.
In general, banks are only allowed to lend 90% of their customers' money. The other 10% must be kept in the bank's vaults or the closest Federal Reserve bank. This is known as fractional reserve banking, and it ensures banks have enough funds on hand to cover any possible withdrawals by customers.
The banking industry also acts as a financial intermediary between people. When you buy something at a store with a debit card, your bank and the store's bank make a transaction on your behalf. Even if you pay with cash, that money will eventually be deposited into the store's bank account. The bank charges a small fee to conduct that transaction, usually by charging a small monthly fee for a checking account.
The money doesn't go into the store's account right away though. Banks keep track of transactions on a ledger and settle with each other in bulk, crediting or debiting accounts that the different banks have between themselves. This keeps the transaction costs for banks down and makes the process as efficient as possible.
Securing your money
So, with all the transactions that banks conduct in a day, how does your money stay secure?
Today, banks are required to be insured by the Federal Deposit Insurance Corporation, or FDIC. The FDIC insures up to $250,000 per person, per account. This is an insurance policy for customer deposits. In the unlikely case that the bank doesn't have enough cash to pay customers, they'll still receive their money through the FDIC.
Since the 2008 financial crisis, regulators have also restricted how much money a bank can lend relative to how much they have in assets, which includes customer bank accounts. If a bank is highly leveraged, that means it has to use its own capital to make loans or investments. These guidelines reduce the chance of default if the economy has a downturn and borrowers can't pay back their loans.
Types of banking services
Borrowing and lending are just some of the services that banks provide. They also help people save and grow their money through checking and savings accounts. They provide advice on different investment options. You can also get a credit card from banks. And of course, the bank is the best place to go for a personal loan, a mortgage or a car loan.
Banks also help small businesses by offering business accounts, including debit and credit cards. They service business loans and can help a company with merchant services, like processing credit card transactions or maintaining their payroll accounts.
These days, more and more banks offer extensive digital services, too. You can deposit your checks and pay bills through your smartphone or computer. You can even opt for online bank statements instead of paper documents sent to you in the mail. Banks also offer extra layers of digital security—you can receive text messages and alerts about your accounts on your phone.
No matter what your financial goals are, or where you are in your life, the banking system is there to help you meet your target.
FAQs
Banks are privately-owned institutions that, generally, accept deposits and make loans. Deposits are money people leave in an institution with the understanding that they can get it back at any time or at an agreed-upon future time. A loan is money let out to a borrower to be generally paid back with interest.
How do you answer the question why banking? ›
Here are some helpful steps you can follow to respond to this question when you're applying for an investment banker position:
- Showcase your interest in the industry. ...
- Focus on how can you can be beneficial. ...
- Include your educational background. ...
- Offer some on-the-job examples. ...
- Highlight your strengths and skills.
Banks, whether brick-and-mortar institutions or online, manage the flow of money between people and businesses. More specifically, banks offer deposit accounts that are secure places for people to keep their money. Banks use the money in deposit accounts to make loans to other people or businesses.
How does the US bank system work? ›
In simple words, the Federal Reserve System is responsible for the country's money supply. The Federal Reserve Banks print money and issue coins, and they also set the reserve requirements for banks. The Board of Governors sets interest rates and approves changes to the banking system.
What are 3 key functions of the banking system? ›
Although banks do many things, their primary role is to take in funds—called deposits—from those with money, pool them, and lend them to those who need funds.
What is banking system in simple words? ›
A banking system is a group or network of institutions that provide financial services for us. These institutions are responsible for operating a payment system, providing loans, taking deposits, and helping with investments.
What are the basics of banking? ›
Banks perform a myriad of functions, including deposits and withdrawals, currency exchange, forex trading, and wealth management. Also, they act as a link between depositors and borrowers, and they use the funds deposited by their customers to provide credit facilities to people who want to borrow.
How does the financial system work? ›
Financial systems act as intermediaries between savers and borrowers, channeling funds from those who have excess funds (savers) to those who need funds (borrowers). This intermediation process facilitates the efficient allocation of capital and promotes economic growth.
How online banking works? ›
You can bank online — transfer money and pay bills electronically — through bank websites or by using a bank's mobile app. Banks often also offer check deposits via their mobile apps. Most standard or traditional banks offer online account management, so you can handle your banking tasks via the bank website or app.
How does the federal banking system work? ›
Federal Reserve Banks distribute currency and coin to banks, lend money to banks, and process electronic payments. At one point, workers' paychecks and the checks written to pay mortgages and most other bills were sent to one of the 12 Reserve Banks, where the checks were processed to settle the debt.
The Federal Reserve System is the central bank and monetary authority of the United States. The Fed works to provide the country with a safe, flexible, and stable monetary and financial system.
How strong is the U.S. banking system? ›
Overall Industry Remains Healthy and Strong
Capital levels, one of the best ways to gauge bank health, are strong, with the Tier 1 risk-based capital ratio and Total risk-based capital ratio both more than 70 basis points above pre-pandemic levels (14.02% and 15.36%, respectively).
What is the process of the banking system? ›
People deposit their money in banks; the bank lends the money out in car loans, credit cards, mortgages, and business loans. The loan recipients spend the money they borrow, the bank earns interest on the loans, and the process keeps money moving through the system.
How does the Bank of the United States work? ›
In addition to its activities on behalf of the government, the Bank of the United States also operated as a commercial bank, which meant it accepted deposits from the public and made loans to private citizens and businesses. Its banknotes (paper currency) most commonly entered circulation through the loan process.
What banking system does the US use? ›
The Federal Reserve System is the central bank and monetary authority of the United States. The Fed works to provide the country with a safe, flexible, and stable monetary and financial system.
Why did banks collapse in the US? ›
Most US banks were similarly exposed to customer withdrawals and underwater bond portfolios, while the Credit Suisse collapse demonstrated the potential for contagion. The Fed's BTFP stopped the panic by allowing US banks to borrow from the central bank using their bonds as collateral.
