Where Do Banks Get Money to Lend to Borrowers?
The concept of banking dates back to Babylon, and financial institutions as we know them today have existed for centuries too. They also come with an age-old question: “Where do banks get money to lend to borrowers?”
After all, Banks aren’t just for storing deposits; they are businesses that make big profits to cover their extensive operational costs. They do so through a range of financial tools, and we’re here to show you how:
Banks Are Lenders
Banks generate money primarily by being the biggest legitimate financial lenders on the planet. The incentive for banks to offer their range of products comes from one fundamental process, which can be described as follows:
- Borrow money from depositors and reward them with small interest rates.
- Lend this money to borrowers, charging much larger interest rates.
In short, they leverage the money supplied by their banking customers to profit from their borrowing customers. The difference between the small interest fees paid to their depositors and the hefty fees charged to borrowers creates an “interest rate spread.”
Banks spend their customers’ money on loans by following the money multiplier theory: The idea that capital grows through financial activity, i.e., increased spending and investing. The ratio between money earned as a result of that spending and the amount spent is the namesake “multiplier.”
For example, if a bank lends someone $100,000 of its customers’ money and earns back $200,000 in interest, the multiplier will be 2.
When a customer adds money to an account, it isn’t kept in a safe with their name on it. Instead, all of the money is added to a pool. However, to stop the bank from playing fast and loose with customer capital, the Federal Reserve sets the reserve requirement: The total amount of deposits made by customers and how much of that capital should be kept by the bank for when depositors need to make withdrawals.
Additional funds can facilitate lending to new customers to create the interest rate spread. All a bank consumer needs to know is that any money made through deposits will ultimately help banks earn even more, thanks to the interest rate.
Still, lending is just the biggest money-generating business of banks: Nowadays, they also offer a wide range of financial products to create more revenue.
The Money-Making Methods Used by Banks
Any successful financial institution has multiple revenue streams.
As mentioned, banks primarily profit from interest income by borrowing money from customers and lending it to others.
Still, it should be noted that central banks set the interest rates at any given time to ensure that the terms and limits promote a healthy economy. However, the market and public demand from businesses and individual borrowers will set the long-term rates. Ultimately, this has always been the primary way most commercial banks make money.
It’s worth noting that banks still need to generate enough money to cover bad debt and defaulted accounts. This is in addition to the services offered to bank customers, such as bank services (online and offline), transactions, and withdrawal capabilities.
The second method is focused on capital markets through a range of services provided to businesses for investing. Essentially, it is a concept that works by connecting companies who need funds for their projects with individuals who seek smart investments that offer stable returns.
Some of the options that fall under this category include merger and acquisition (M&As), debt and equity underwriting, and trading services. Banks will often handle issues like brokerage through in-house teams to support their endeavors further.
Finally, fee-based income allows banks to grow their profits through a range of additional charges that customers may incur for various reasons. This type of income includes small monthly fees to keep a checking or savings account open, credit card fees, overdraft costs, late payment charges, transaction fees, investment management fees, and more. Fees are particularly important for banks and financial institutions in moments of economic downturn, as interest rates are lower.
What Factors Affect the Ability of Your Bank to Lend Money?
The biggest question facing any bank is, “How much can we lend out at any given time?” This isn’t something that factors into choosing a bank for yourself, as you won’t be privy to that information. However, it will influence the capacity of your bank to be of service.
All lending comes with a degree of risk. Borrowers failing to pay back the principal and interest costs is just one example. Weighing up the risks of individual customers and limits for the institution itself is subjective and takes several factors into account:
- The total amount of deposits currently made by customers
- A realistic amount of capital reserved for depositors
- Money needed to pay interest dividends to depositors
- Revenue from other types of money within the banking system
Banks want maximum ROIs; while they may put strict tools in place to analyze individual applicants, the majority will try to lend out as much money as possible as it will ultimately generate greater profits - not least due to the multiplier effect.
However, a government framework is in place to ensure that all lenders adhere to specific regulations. It includes the reserve requirements. The ratio between the capital an institution must hold and the total deposits by customers depends on the state of the economy (e.g., inflation), and other factors.
The trade-off between risk and return remains the most significant factor in a bank’s ability to lend money, in part because deposit accounts are insured by the government, even in the almost impossible situation where all customers want to access their funds at the same time.
As long as a bank can find a way to gain more customers to open deposit accounts, it will be in a position to lend out more cash - not least when supported further by bank commissions and the fees charged for all related services.
How Banks Gain Deposits
Their entire business model relies heavily on deposit accounts and the interest spread, so banks use aggressive marketing strategies to encourage people to join their business. While anything they do must adhere to government advertising regulations, there are several things that banks can use to win customers:
- Ensuring their branding is frequently seen
- Offering a higher interest rate on savings accounts
- Special promotions like 0% balance transfers for 12 months
- Offering free transactions and withdrawals online and offline
- Removing application costs and including free extra services like insurance
Banks additionally want to advertise customizability: Consequently, accounts may be specifically designed for students, mortgage savers, senior citizens, and other demographics.
All in all, the ability of banks to lend money isn’t entirely reliant on deposits, but it is the backbone. If their customer base of depositors grows, their pool of borrowers can too.
Most consumers don’t know where banks make their money. The short answer is that they do it by borrowing money from depositors and lending it to other customers at an increased cost. These institutions are also supported by a system of extra services, fees, and commissions.
Cumulatively, those assets yield tremendous returns, which is why banks boast the ability to make billions.
Where does a bank get money to lend?
Banks generate income through various avenues, including ATM charges and account services. Primarily, though, their ability to grow capital hinges on new deposits from customers who store their money in savings accounts. The funds subsequently gained through lending money to others can cover what they’ve borrowed, plus interest, while still turning a profit.
Where does the money for loans come from?
When it accepts a loan application, the lender gets money from the ‘pool’ - the centralized collection of all deposits made by customers. After all, Banks do not need access to enough capital to cover all accounts. They simply need enough to cover any withdrawals. Any additional reserves can subsequently be used to facilitate loans.
Where do banks invest your money?
As well as asking “where do banks get money to lend to borrowers?”, many wonder how they use it. Banks invest their money in a range of securities and opportunities. Businesses and people are two obvious sources. They can additionally turn to stock markets, although the government regulates how much they can trade. Creating additional in-house services like insurance is another investment that pays dividends in the long run.
I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.
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