Banks get money from their reserves as well as from profits earned from interest payments and other fees they charge to consumers for their financial services.
Most of us use a commercial bank to safely store our money. However, how much do we know about how banks work, especially when it comes to lending money? For example, when someone borrows a personal loan from a bank, where does that money come from?
Keep reading for more information on how banks get money to lend out.
The Primary Way That Banks Make Their Money
The main way that banks make money is from their customers who deposit with them. They then use that money to then lend to other customers. Here is more information on how this works for profit:
Banks will set up incentives of interest (averaging from 0.01% to 0.03%) for customers who decide to keep their money with them. This money is then added to a larger pool from which they lend. This loan money will have significantly higher interest rates than what the bank gives to depositors. For example, banks will lend at an average between 10% to 30%. Exact interest rates for bank loans are based on a few factors including the loan type and borrower’s creditworthiness.
With this in place—a lower interest rate for deposits and a much more significant one for lending—banks can profit.
With bank lending, banks rely on a fractional reserve banking system. This system allows them to lend more than the actual amount of deposits at hand, creating a money multiplier effect for profit. The federal reserve system sets the regulatory capital requirements banks need to maintain in order to lend money.
Sources From Which Banks Acquire Money For Lending Purposes
|Source of Funds
|Implications for Consumers
|Banks borrow from other banks to manage liquidity.
|May impact interest rates and loan availability.
|Central Bank Borrowing
|Banks can borrow from the central bank in times of need.
|Ensures banks have funds to meet consumer lending needs.
|Issuance of Bonds
|Banks issue bonds to raise capital from investors.
|Helps banks maintain a diverse portfolio for stable lending.
|Banks convert loans into securities for sale to investors.
|Can increase a bank’s liquidity and capacity to offer new loans.
|Deposits from foreign customers and financial institutions.
|Contributes to the diversity and stability of available funds.
|Large deposits from big corporations or other financial entities.
|A significant, though less stable, source of funds for lending.
|Banks acquire deposits through brokerage firms.
|Expands the pool of available funds but may come with higher costs.
|Funds from the bank’s own equity or stock issuance.
|Strengthens the bank’s capital base for sustained lending.
So, Is My Money Supply Safe With a Traditional Banking System?
Knowing banks use their customer funds to lend out can sound slightly alarming. But, most commercial banks and regional banks have FDIC (Federal Deposit Insurance Corporation) insurance, which protects customers’ money up to $250,000 in case of a financial crisis or anything else that can put banking customers’ money at risk.1
What Kinds of Loans Do Banks Have?
You may hear about bank loans—an umbrella term for loans you can get from a bank. There are all kinds of loans that a bank can give out, which usually make up most of their revenue; here are some examples:
Personal loans are loans with monthly installments and are some of the most common and versatile options available. They can be for a large or small amount. The interest rates and eligibility will vary depending on your credit history and the bank’s underwriting.
Business loans can be used by small or large businesses to start, maintain, or grow. These loans are usually for several thousands of dollars which means a good amount of profit for a bank.
Mortgages are some of the most significant loan options a lender can offer. These loans will be for hundreds of thousands and usually mean income for decades.
Private student loans are available through banks, interest rates will be higher than federal student loans. Still, they can help those who do not have access to those federal options. A bank may see revenue for anywhere between five to 10 years.
Banks may have several different types of credit card options available for existing banking customers and for those who do not have any accounts with them. The good thing about credit cards for banks is that revolving credit can mean revenue for many years, as long as the borrower keeps the credit card account open.
Car loans can be used to finance a car purchase. With a payback period averaging about three years, a bank can definitely make good money by offering car loans.
Can Banks Create Money?
One common misconception that many people have is that all banks have the ability of money creation out of nowhere. That is just not the case; central banks or reserve banks are the only ones allowed to print money. A central bank will try to do this strategically for economic stability.
A Few Other Ways That Banks Earn Money
When banks extend credit from bank deposits, they make most of their money. However, there are a few other ways that banks make money; here are the two different primary modes of profit for banks and similar depository institutions:
Bank Account Fees
Another way a financial institution like a bank makes money is through different account fees. Most people are familiar with the standard bank account fee you must pay when opening a bank account. On top of that, there may be other fees bank customers will be charged depending on your activity. Here are some standard bank fees that customers face:
Non-Sufficient Funds Fee
A non-sufficient funds fee of NSF fee is charged when a customer doesn’t have enough money in their bank account to make a purchase and doesn’t have overdraft protection in place. Their bank account will then go into negative, which if not taken care of right away can mean additional fees. NSF fees are usually around $35.
An Overdraft Fee
Overdraft protection is a feature that banking customers can add to their accounts. It allows them to spend money even if they don’t have sufficient funds in their bank account. When this occurs, there will be an overdraft fee instead of going into negative. Just like an NSF fee, not paying your overdraft fee can have expensive consequences. Overdraft fees are also around $35.
Bank Account Closure Fees
If a customer has opened their bank account recently, they may be charged a fee for closing it— generally around $25. Usually, this period can be anywhere from 30 to 60 days after opening.
There can be fees for multiple transfers between internal and external accounts. These fees average around $35 per transaction.
Another source of revenue for banks is their investment advice for businesses and individuals. Experts from banks can help you determine the best way to spend your money and help you figure out different money goals with new or existing assets. Wealth management is another service that can fall under this category.
FAQ: Where Do Financial Institutions Get Their Money?
The Federal Reserve, as the central bank of the U.S., sets monetary policies and reserve requirements that determine how much banks can lend. By adjusting these parameters, the Federal Reserve can influence the money supply and lending capacities of banks.
A central bank has the authority to print money, directly influencing a country’s money supply. In contrast, commercial banks can’t print money but can expand the money supply through fractional reserve banking by lending out a portion of their deposits.
Yes, besides banks, there are various financial institutions like credit unions, savings and loan associations, and non-banking financial companies that can lend money to individuals and businesses.
Fractional reserve banking allows banks to lend out a significant portion of their deposits while keeping only a fraction as reserves. This system amplifies the lending capacity of banks and indirectly increases the supply of money.
Through the process of fractional reserve banking, banks can lend out more than they have in actual deposits. This act of lending and subsequent redepositing of funds effectively multiplies the money in circulation, contributing to the growth of the supply of money.
The authority to create or print money is reserved for the central bank to maintain economic stability and control inflation. Commercial banks, however, can expand the supply of money through lending activities but cannot directly create money.
Other financial institutions, like credit unions or non-banking financial companies, also lend money, which indirectly contributes to the supply of money. While they don’t operate exactly like banks, their lending activities still influence the overall flow of money in the economy.
Bank deposits form the foundation of a bank’s lending capacity. Through fractional reserve banking, these deposits enable banks to lend funds, fueling investments, and economic activities, which in turn drive economic growth.
CreditNinja’s Thoughts on Bank Reserves
Banks acquire money to lend to consumers who want to borrow money in various ways. Primarily, banks use deposits from customers, offering them a lower interest rate and then lending this money at a higher interest rate, thus making a profit. This system allows banks to lend more money than they hold in actual deposits.
While banks tend to use funds from customers when they lend out money, it’s important to note that your money is typically safe when stored in a bank. CreditNinja is dedicated to making sure everyone knows the best way to safely and efficiently handle their finances.
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