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Recently, I had a lengthy conservation with a good friend of mine who had a ton of basic personal finance questions contained within. I thought it might be interesting to start an irregular “Your Money 101″ series to answer and explain some of his questions.

Most Dominicans see banks as being a place where you save your money or where you get open a checking account or where you can get loans, but a lot of people often don’t understand the big picture of how a bank functions. Let’s walk through it in simple (baby) steps so that you can understand why a bank exists.

First of all remember, a bank is a just like any other business: it strives to make as much money as possible. They make money by simply moving money around; keep that in mind as we go through the different services that a bank provides.

Most people the first service that they become familiar with in terms of a bank is a savings account. At first glance, a savings account is a situation in which you give a bank your money for a period of time, withdraw it whenever you like, and depending on how long leave it there it earns a small amount of money for you. What actually happens, though, is that a savings account is actually a loan, except this time you’re the lender. It’s no different than any other loan, except it’s really flexible: you can lend as much as you want to the bank and get that loan paid back whenever you’d like. Because of this flexibility, though, the interest you make on this loan is pretty low.

Likewise a checking account, at most banks, is no different than a savings account: you’re lending the bank your money, but with a checking account, they pay your interest with services (dealing with the checks you write, etc.) instead of interest.

The other major area that people think of when they consider a bank is loans: they lend money to people for buying a home, car, and other things.

So how does a bank make money? For starters, they take the money you loan them and earn a pretty strong return with it, then give you a part of that return in the form of interest. So, each dollar you put into your account with the bank makes them a little bit of money.

Let’s say, for example, that the bank has a savings account with a 1.5% rate of return, which is likely better than most banks in Dominica. They take the money from your account (and a lot of other savings accounts) and use all of that money to buy (for example) a treasury note, which is guaranteed returns about 5%.

Even better, let’s say that someone else comes into the bank and wants to borrow some money to start up a small business. The bank offers to lend them the money for the car at 7% return, so they take that money from the accounts at the bank and give it to the borrower. Then, the borrower pays back that money plus the interest, of which they pass on 1.5% to you, keeping 5.5% for them.

On top of that, banks today make a lot of money from fees. You get charged when you use the wrong ATM, when you overdraft a check, interest on your credit card(s) balance and so on. Each of these activities only costs the bank a few cents to handle, but it costs you a few dollars.

To summarize it, a bank works by paying people small amounts to lend their money, then lending that money onto others for larger amounts. They manage that whole process, and then keep the difference between the large amount (interest on loans) and small amount (interest from a savings account).

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1 Comment »

Comment by Dan
2008-04-04 09:52:04

That explanation is a good start, but omits a critical factor — leverage. A bank can lend out more money than it takes in in deposits, because the probability of all its depositors calling for their funds simultaneously is low. The multiple of loans out to deposit in is the leverage. In the US, since the Great Depression, the government guarantees deposits (up to a certain amount per account per depositor, presently $100,000 in federally chartered banks) but covers its insurance bets by requiring the insured banks to maintain a liquidity (cash or cash-equivalent) reserve; this is equal to the maximum leverage. For example, a 20% reserve would mean that a bank could lend out at most five times its deposits.

When depositor confidence becomes low enough, a run on the bank can commence. That is what the Federal Deposit Insurance Commission (FDIC) prevents. Because of the FDIC insurance, regular depositors don’t run on the banks in a panic to get their money. But since the Great Depression, the nature of banking in the US and the world has changed. The big investment banks (such as Bear Stearns) are not regulated and are not insured. And a collapse of such a bank could have catastrophic effects on the world’s financial markets. That is why the US Federal Reserve Bank stepped in and “rescued” the bank anyhow. It is beyond the scope of this note to go into, but the rescue raises many new questions.

 
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