How Banks Operate

There are three different kinds of banks, which are central banks, retail or commercial banks, and investment banks. Central banks manage the money supply and other economic factors, retail banks act as a financial intermediary between parties, and investment banks assist and participate in the securities industry.

So each of these different types of banks perform very different functions, even though they are all called banks. Banking itself is essentially the management of financial resources, which may consist of money, securities, or a country’s currency and money supply, depending on the type of bank we’re talking about.

A great deal of the money in the world is managed by banks, and a number of the largest ones hold trillions of dollars in assets all by themselves. $15 trillion in assets are held by banks in the U.S. alone, and the world’s 4 biggest banks are actually in China these days, and these 4 hold almost that amount in assets themselves.

The stock market also holds a lot of assets, as does the bond market, but bank assets are right up there with these, in the tens of trillions of dollars. So the banking system does play a major role in the world’s economy, especially since it does keep money moving, and this is one of its main functions.

There are two basic forms of monetary assets, which are equity and debt. Equity would be holding stock in something, indicating the ownership of a company, shares in it in other words. Debt covers everything else, and it is debt that banks hold the most of, both debt that they owe and debt that they are looking to collect upon in the future.

Banks As Borrowers

The assets of a bank are primarily promises of others to repay money loaned to them. Of course there are other assets involved, for instance byuildings that the bank owns, fees they collect, the value of the securities they hold, and other non interest earning assets, but their main asset is interest bearing loans, at least as far as retail banks go, which is what people normally think of when they think of a bank.

So where do banks get this money to loan out?  Some of it comes from non interest bearing income, some of it comes from the profit they make on lending money at interest, but most of it comes from their borrowing money from their depositors, which they pay interest on in many cases.

Not all bank accounts are interest bearing, a lot of checking accounts don’t pay interest for instance, and even some savings accounts don’t, unless your money on deposit hits a certain minimum balance for instance.

In all cases though, whether the bank is paying interest on a deposit or not, the money on deposit with them is a loan by the depositor to the bank. The bank keeps part of this to handle withdrawals from their depositors, and uses the rest, most of it, to conduct their business, which primarily consists of loaning this money out to others at a profit, at a higher rate of interest than they are paying.

So while people think banks are a place to park their money, this really isn’t the case. They do park it there, but it just isn’t kept in a vault waiting for them to take it out, and if it were; then the bank would charge a fee for this, not pay for the privilege.

Instead, when you give your money to a bank, you are lending it to them, with their promise to pay it back, and this isn’t really any different than their lending money to you, other than banks tend to be a lot more reliable than borrowers as far as paying it back and in an orderly fashion as agreed.

So in both the cases of your lending money to a bank and their lending it to you, someone is holding the debt of the other and the other is indebted, the creditor in other words. So this really is all about money lending, on both sides of the equation.

Of course people do sometimes worry about the bank being able to pay their loans back to them, and banks sometimes do fail, and this is why some governments guarantee deposits at banks up to a certain amount, to ensure that people loan money to banks with a high degree of confidence.

So the safety part is a big reason people do business with banks, even more so than for the small amount of interest they earn, as having their money in a bank is safer than keeping it at home or elsewhere.

Banks As Lenders

Banks are involved in a number of different types of loans to people and businesses, and borrowing money from a bank or other lender is a huge part of everyday life nowadays.

Unless you are using cash, there is always some sort of borrowing involved, some sort of credit. If you use a credit card to make a purchase, the credit card issuer, usually a bank, is extending you credit, even though you may pay off the balance immediately.

Even using a debit card involves the use of credit in a sense, where you are agreeing to pay the merchant at a future time by way of a financial transaction between your bank and theirs. Even though these transactions settle within one of two days, there’s still short term credit involved.

People borrow money from banks for all sorts of reasons, especially in looking to buy a home. Mortgages consist of the majority of funds borrowed, and if one had to save up these huge amounts, it may take two or three decades to do so, and very few people want to wait this long.

So instead, people save up a small portion of the price, the downpayment, and the bank lends them the rest, which they pay back over a number of years, 25 or 30 typically. This allows them to enjoy living in the home as they pay off their loan.

People will also very often borrow to buy a car, or any big ticket item that they may not have the funds to pay for right away, but want it right away. This is the essence of credit, you get it now, you pay for it later, and this is an arrangement many people find most appealing.

Businesses will often borrow from banks as well, and the loans or lines of credit often are much larger than what consumers tend to borrow.

Banks make a profit on this lending by charging a higher rate to lend it than they pay to borrow it, although not all loans are repaid, and part of the interest charge is to compensate for losses due to default. This is why loans are often priced according to risk, with people who are seen to be less risky getting better rates.

Banks As Transaction Intermediaries

Another big role of banks is to facilitate financial transactions between parties. If two people want to exchange money, they usually agree to have their banks conduct the transaction between themselves on behalf of the parties. So if you buy something at a store, your bank and the store’s bank will get together and see that the funds are transferred.

If everyone paid in cash and held cash, then there wouldn’t really be the need for a bank for any of this, but this just isn’t efficient, and electronic payments have really taken over these days as the preferred means. Even if someone pays in cash, the merchant isn’t going to just hold the cash, they will be depositing it at a bank, so even in these cases banks are involved.

The money doesn’t specifically go from one person’s account to another as many people think. Transactions between banks are kept on a ledger and settled in bulk, by crediting or debiting accounts that banks have between themselves, or with the central bank. Otherwise the process would be very cumbersome and the fees charged would have to be much higher.

Many banks do charge fees for transactional accounts, and a lot of people think they should not be paying merely to gain access to their own money, but they fail to realize that banks do provide a service here and this does involve at least some expense on their part to process. Banks also do not make money on deposits that are only held for a brief period, and they are in the business of making money like all businesses are, so they have to justify this expense somehow.

A bank may offer free checking though as an incentive to attract business, where they lose money on these accounts but with the idea of making a profit on other services they may provide to these clients, and people do tend to bring more business to a bank if they have their main transactional account there.

Other Functions of Banks

While banks don’t exactly store your money in your vaults, waiting for you to come pick it up, they do typically offer safety deposit boxes which work this way, where one can securely store anything that can fit into one. These are offered for a fee of course.

Banks will often also provide investment advice, and access to various investments, anything from self directed online trading accounts to buying mutual funds and other investments face to face. Larger banks may even have their own mutual funds. One may even buy precious metals in a retail setting at a bank.

Banks may also be involved in the securities industry more directly, facilitating stock or bond issues, as well as both trading in securities themselves. Banks may also manage derivatives such as options, and also serve as market makers in financial markets, where they offer securities to be sold and also purchase them to be sold to others.

Banks even are dabbling in insurance these days, as well as a number of other financially related activities such as trusts and estate planning. Due to their very large asset base and expertise in finance, banks are well positioned to serve a wide variety of financial needs, all with the comfort of knowing that you are dealing with a very well regulated institution where trust is at the forefront, which is what banks are really all about, managing trust.