Banks can make money in a variety of ways – fees, advisory services, and more. However, the central function of a bank is to receive deposits from depositors (e.g. people with savings and checking accounts at that bank) and lend out money to borrowers (e.g. families looking for a mortgage to buy a house, people looking to start a business, companies trying to expand their operations, etc.).
People deposit savings in banks so their money is (1) safer than if it were in cash underneath their mattress and (2) earning interest. At the same time, banks are taking the deposits given to them and lending that to borrowers. Those borrowers pay back the money they borrowed over time, and also pay an additional amount of interest to compensate the bank for lending them the money. If the interest earned from lending out money is greater than the interest paid to depositors – and as long as the borrowers pay back all the money as agreed – then the banks make money.
In the below simplified example, [John Doe] has $1,000 in savings to deposit in a bank. The First Savings Bank of Example Town pays [John Doe] a 1% interest rate – or $10 – at the end of the year to compensate [John Doe] for keeping his money at that bank. To comply with regulations, the First Savings Bank of Example Town can lend out 90% of [John Doe’s] deposits, which is $900. The other $100 stays in cash in the bank vault. At the same time, [Jane Smith] requests a $900 loan to open a small business. The First Savings Bank of Example Town loans [Jane Smith] the money for one year at 10% interest. At the end of the year, Jane Smith pays back the $900 loan plus an additional $90 in interest to the bank. Now, the bank has earned $90 from the deposit John Doe made while paying him $10 in interest, for a gross profit of $80. That $80 is used to pay the bank employees, mortgage, etc.
For more information, check out our article on interest rates.
