What Do Banks Do?
There are three different types of banks, which are commercial banks, investment banks, and central banks. Commercial banks are what most people think of as banks, who take deposits from people, offer the ability to make financial transactions, loan money, offer various investments, and so on.
Investment banks deal with corporations and assist them with things like the underwriting of financial instruments, stocks and bonds for instance, and also perform other financial services to them related to investments. Central banks govern the issuance of currency, interest rates on lending money to banks, and other financial affairs of a national interest and are operated by governments.
Since this is a site on personal finance, we will be referring to banking as commercial banking, as the other two forms are outside the scope of our site.
A bank is chartered by the government to process financial transactions for clients, involving both the depositing and lending of money, and in selling investments. There’s a separate section involving certain types of investments, the trading of financial investments, and banks do offer these investments to their clients, but we will deal with those in the investment section.
There are three main components to what a bank does, three main reasons why someone would deal with a bank, and some of them do overlap a bit. They are to process transactions, to pay interest for money on deposit, and to lend money to clients to be paid back with interest.
Banks offer various financial products to fulfill these needs to people, and while banks do more than this behind the scenes, for instance banks do a fair bit of investing themselves, besides using your money to loan to others, we’ll just be dealing with the interaction between banks and their individual clients.
We also will have a separate section called “personal finance” which will deal with some of these products in detail, from a personal perspective, and some of these products may be provided by banks and some may be offered by other institutions, but for now we’ll speak of the role of the bank in providing these products and services.
Banks and Financial Transactions
There are some people who do not use a bank for financial transactions, in other words they just may use cash exclusively to spend, get paid in cash, and keep all their cash at home, but these days that’s a very small percentage of the public.
One of the most fundamental functions of a bank is to be a place where money can be stored securely, and at one time, prior to the plastic age, people would use them to store their cash.
While some people still do that, and purely use cash for all their transactions, it is very common that some other form of payment besides cash is used, either to pay them or with their paying others.
Getting paid by check is on the way out, but there are still people who get paid this way, and when you cash a check at a bank you are using the bank as a transactional medium. They pay you the cash or deposit the check into your account and clear the check for you, whereby they receive the funds from the issuing bank where the check was drawn upon.
All non cash transactional instruments are a promise to pay a certain amount of money. This is even the case with electronic transactions, as even they take time to settle, for the recipient, the person’s bank in the case of an electronic deposit, or the merchant with electronic payments, to receive the money in their accounts.
Processing financial transactions for their clients does cost banks money, and they may charge a fee for a transactional account, called a checking account, or they may provide this service as a courtesy for their clients, with the hope that they will do more of their banking with them.
Banks As Institutions of Deposit
Banks also hold money on deposit for clients, and generally will pay them a certain rate of interest for doing so. So clients receive several benefits from this. Their money is held in a safe place. It is generally readily accessible when they need it, at least in deposit accounts anyway. It also earns them a rate of interest, although not all accounts pay interest, but interest bearing ones do.
Banks are willing to pay interest to people for keeping money in their bank for a reason. It just isn’t kept in a vault waiting for them to take it back out. Banks use money on deposit for various purposes, including lending it out to other clients, and investing it as well.
The idea behind this is to make a profit on the depositors’ money that they hold, and they set the interest rates that they pay out in accordance with this, to ensure that overall, they will indeed profit from the arrangement.
Depositors are generally happy to receive this interest, although those with substantial amounts may also shop around for the best rate, and therefore interest rates paid by banks are influenced at least somewhat by market conditions, as are all aspects of banking.
Banks do keep enough currency on hand, not lent out or invested, to accommodate the demand for it. They also have other arrangements in place to ensure that their depositors are able to receive their money upon demand, so this isn’t a worry anymore like it used to be with some of the small banks in centuries past. It’s much more organized now.
Banks will offer people even higher interest if they agree to keep their money on deposit for a set period of time, called certificates of deposit. So for instance if you agree to keep a certain amount of money with a bank for a year, you can earn more interest. Typically, the longer the term, the higher the interest rate paid.
In the United States, deposits are insured by the FDIC, up to $250,000 per depositor per institution, providing depositors with peace of mind and security. Governments also tightly regulate banks to ensure compliance with accepted business practices.
Banks As Lending Institutions
The third major function of commercial banks is to lend money to clients. This is where banks make a lot of their profit, and they lend at a higher rate than they pay out, and after operating costs are deducted, including losses from loans not paid back, the rest is profit.
There is always some risk involved in banks lending money, and they want to make sure that the risk is kept acceptable to them. So there are several factors that are looked at in determining the creditworthiness of a potential borrower.
There are 5 “C’s” that banks look at when determining credit worthiness, as follows:
The first and perhaps most important criterion is financial capacity, the means to repay the loan over time, and in a timely way. This requires that one has enough income, and that this income is stable enough.
One’s credit history is another determining factor, and banks use credit scores to look to predict the likelihood of someone defaulting on a loan, and if the risk is too great, the bank will decline the loan. One’s credit history will often also determine the rate of interest, with more risky loans requiring them to charge a higher rate to offset the additional risk perceived.
Collateral may be pledged, for instance with a mortgage, or with some car loans, where the bank places a lien on the property pledged, and may take possession upon a default of the loan or mortgage.
Capital is the fourth “C”, which means the amount that the potential borrower has provided out of their own resources. A down payment on a car would be an example of this. By investing their own money, borrowers are seen as more invested in the loan and therefore more likely to pay it back.
Finally, one’s character is often assessed, which may include one’s past history with the bank, the stability of their employment, and other factors. This is less of an influencer but may guide decisions that are close.
In addition, banks will sometimes look to the purpose of the loan to decide whether to extend it or not, for instance a loan that is used to buy an investment will be looked upon more favorably than one that is used for a vacation, due to the retained value of the investment reducing the risk of losses significantly.
Loans from banks consist of both installment accounts, where a certain sum is advanced and is paid back over time, and revolving accounts, such as credit cards and lines of credit where one may borrow variable amounts up to the credit limit and make at least periodic minimum payments.
Borrowers also have an obligation to assess their need to borrow properly and must also exercise prudence, and you can’t just rely on banks to do this all for you. Many a borrower has gotten into serious financial trouble by not paying enough attention to exceeding their capacity to repay, or properly accounting for changing circumstances.
Sometimes there’s just no way you can plan for an event, and if we required 100% certainty of repayment, it would be close to impossible to get a loan from a bank, nor should one take a loan either. It’s all about keeping the risks reasonable though, on the part of both banks and borrowers, and when that’s done, borrowing can be a beneficial arrangement overall to all parties.