First, let’s look at a simplified version of a banking system. It will be a very basic version without going too much into the details, but it will explain the basics. When someone deposits money in a bank account that money is not actually stored in the bank. Instead, the bank records that you have deposited say $1000 in your account.
The bank is basically keeping a record of how much money you have deposited and they will use this number to determine how much total money is available. This number is called the “money multiplier” and it reflects how many times the original deposit can be loaned out or used by people for purchases before they need to go back into the bank to deposit more money.
Let’s say the money multiplier is 5, which means that your deposit of $1000 can be lent out up to five times before you need to go back into the bank and make another deposit. It also means that there are 20 total dollars available for use in the economy.
where do banks get money to lend to borrowers?
The next step is for the bank to loan out money to people who want to borrow it. For example, let’s say that the bank lends $500 of your deposit to someone who wants a car. The bank is basically creating their own money and giving it over to this person who then goes and buys a car with it. This still doesn’t really change anything else since the bank can’t loan out more than the total deposit and you still have $500 in your account. However, the person who bought a car now also owes $500 to the bank and will eventually need to repay this money.
There is only one problem: banks expect people to pay back their loans! If they think that everyone will pay back their loans then they will not be making any money. This is why banks need to find a way to increase the likelihood that people won’t pay back their loans and give them bad credit scores so that banks can charge more interest on those loans as compensation for the risk.
Banks do this by collecting as much information as possible about you and your financial situation. The more they know, the better chance they have of figuring out if you will be able to pay back your loan or not. However, banks don’t want to lose money either so they need to figure out a way to make sure that you won’t pay them back without giving you such a nasty credit score that no one else will loan you money either.
Fractional Reserve Banking
This system of loaning out more than was actually deposited with the bank is called fractional reserve banking and it is the foundation on which modern-day banking is built upon. Banks don’t keep all of their client’s deposits in their vaults because they need to be able to loan out most, if not all, the money they have so that they can make money.
These days most banks will loan out nearly all of their deposits and keep only a fraction in reserve to ensure that nothing runs into problems should everyone go back at the same time for their money. This is where the central bank comes in because it controls how much money exists and determines how much should be kept as a reserve by the banks. They basically use money as a way to control inflation and economic growth so they try to ensure that there is always enough money in the system for everything that needs it.
This is why we need to decrease the reserve ratio: because we want people to take out loans and spend more money because that will help the economy grow. In China, where they have a more heavily regulated banking system, people can’t take out as many loans as we do which means their banks aren’t allowed to loan out nearly as much money and that has a negative impact on economic growth.
However, if we decrease the reserve ratio too quickly then it might have a negative impact on inflation because there would be too much money in the system. This is why it’s important to do it slowly so that we can monitor how much of an impact it has on both economic growth and inflation.
How does bank profit?
So now you know, where do banks get money to lend to borrowers? but how do they actually turn all of these numbers and accounting into profit? Well, a lot of it is not by actually lending money out to people. Instead, they make their money on the fees that they charge for their services.
For example, you might have a checking or savings account with your bank and they will offer you free online banking as part of that service which means that they don’t need to pay someone to sit at a computer and keep track of everything. Instead, they can hire a few people for that job, however, if you want some help from a live person then they might charge you $5 or so just for your call.
That is how banks make most of their money: by charging high fees on the services that they provide and then using those fees to offset the cost of loaning out their depositors’ money.
If you want a loan from your bank then they will charge you much more than if you were to deposit money there and this fee covers the cost of them loaning out their depositors’ money for free. This is why banks make more money by loaning out their depositors’ money than they do by charging high-interest rates on loans.
At the end of it all, banks make a lot of money in fees and not nearly as much from the interest which is why most of their profits come from services provided rather than making a lot of investments.
