A bank is a corporation with shareholders just like many other businesses. It makes money by collecting interest on the money it lends, as well as by charging fees and making its own low-risk investments. A bank differs from other businesses in that instead of selling a product or service, a bank essentially sells money. The bank must be able to make money to stay in business.
How Banks Make Money
Banks primarily make money by investing the money you invest with them. In other words, when you put money into a savings account at a specified interest rate, the bank takes that money and invests it in higher-earning methods -- consumer and business loans. Money deposited with the bank is loaned to others at a higher interest rate. This allows the bank to pay interest to its deposit customers and also make profit for itself.
Why Banking Works
Banking has worked for centuries because of the trust of consumers. When you deposit $1,000 into your bank account, you trust that you will be able to take that money back out when you need it. If too many people request money from their accounts and the bank does not have enough in reserves, there is protection of at least $250,000 per depositor per bank through the Federal Deposit Insurance Corporation, as long as the bank is FDIC-insured.
Banks are required by the U.S. Federal Reserve to keep a percentage of deposits in reserves -- from 3 percent to 10 percent, depending on its total deposits. Banks actually create new money with each loan they make. For example, when you deposit $1,000 with your bank, the bank can lend out $900 and keep $100 -- or 10 percent -- in reserves. The recipient then uses that money to pay for various expenses, and the $900 gets deposited into someone else's bank account. Then that bank lends out $810 while maintaining $90 in reserves. In this example, these two banks used a single $1,000 deposit to create an additional $1,710 in new money.
In addition to a promise to repay a loan, many lenders require an asset to be used to secure the loan. If the loan is being used to buy a house or car, those assets become security -- or collateral -- for the loan. If the customer does not meet the loan obligation, the bank can take possession of the asset and sell it to cover some, if not all, of the loan proceeds.
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