How Banks Work and Why It Matters

On a rudimentary level, we should realize that banks are a big part of our everyday life. We rely on them to distribute money, to pay bills, and to lend money when making big ticket purchases. And while we use banks nearly every day, very few people really know and understand how they really work. So my goal by sharing this information about banks with you, is to hopefully get you to stop and think about why banks allow us to deposit money, write checks, use an online bill pay system, yet not charge us anything. How can they stay in business if they are providing all these services to us for free? What's the catch? What is going on behind the scenes? What I have learned is that the services they offer to us are a means to have access to our deposits. Many people know that when you make a deposit into a bank that the teller doesn't literally take your money and place it in a vault. Banks are in the business to keep money circulating within the economy. And without a bank, it would be very difficult to keep money in motion for an individual. You have money go into a bank account from an employment or retirement income, then that money is used to pay bills or stored for a later purpose. It's how nearly everyone operates without much thought. We just trust the bank to do what it does. We deposit money without really understanding what they're doing with it. So let's look at what is actually happening when money is deposited into your bank account. On the surface, when you think about the banking system, you may think that if you deposit $10,000 into a bank and then they pay you 1% on your deposit, you make $100 over 12 months. On the flip side, if you go to a Bank and borrow $10,000, they may charge you around 4% or so to have access to those same dollars. So in this example, you would end up paying around 400 bucks over that 12 month period. So on the surface, when you look at the scenario and they take your money, lend it to somebody else, and they make 300 bucks, they pay $100 to you, and charge a borrower 400 bucks in profit to $300. You assume, using this math, that the bank is making 3% by lending out money on your deposit, right? Well, let's look at this math in more detail. Let's assume that someone came to you and handed you $10,000 and asked you to return that money to them in 12 months, along with an additional 100 bucks. So to possess that money for 12 months would cost you $100. You're essentially renting the $10,000 for $100, banks have a 10% reserve requirement, which means that 10 cents has to remain in the bank for every dollar that's deposited, While the other 90 cents can be lent out. It is all numbers on a screen showing you you have money in your bank account, even though that money is not actually there. Remember, the money is being lent out to someone else to buy a house or a car or a boat. So this is what is happening when you deposit money and the money is lent out to somebody else. Bank A receives a million dollar deposit from somebody, and so bank A has to keep the 10% in reserve. So Bank A can then lend out $900,000 in loans. Then what happens is that bank B receives those funds of 900,000 and and Bank B lends out $810,000. And then Bank C receives those funds of 810,000 and Bank C then lends out 729,000 in loans and so on and so on and so on. So as this money is flowing into banks, it is showing up on screens as deposits. Then the money is lent out to somebody else who then goes and deposits the money into their bank where the same dollars then are showing up on their screens and, and in somebody else's account, there was a million dollars deposited in bank A, and the banking system turned it into 3.4 million through fractional reserve banking. That's fractional reserve banking. So why should you care about this? When money is created out of thin air like this, it pumps more dollars into the economy and more money in the system makes the money you have worth less. And when your money is worth less, it takes more of it to purchase things. This means that you must save more to do the same things you want to do. This system creates liquidity concerns for depositors. This makes using a bank, even if we are not borrowing money from it, a system that is robbing us from we.

Sam.