How Banks Function
Banks earn the income by loaning out money and charging interest on those loans. So, that is how banks earn money.
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Now, less money available in the bank – so a smaller bank that doesn’t have as much money, just deposited it in there and standing in reserve – less money available means you will be able to make fewer loans out to customers, where more money available means you’ll be able to make more loans.
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That makes sense, right? Less money means you’ve got less to loan out, you can make fewer loans. More money in a bank means you’ve got more to loan out, you can make more loans.
Now, both of these situations affect the amount of spending in the overall economy. And that is because a lot of times, people take out a loan to make big purchases. You get a loan to buy a house. You get a loan to buy a car. Sometimes, people get a loan to buy boats, or to start businesses, or just to buy – if they need several appliances at once, they could ask for a loan for that. People get loans for engagement rings. Loans for all sorts of things. So, there are going to be lots of reasons for loans, but if someone’s getting a loan, it’s so that they can spend that money somewhere else. So, giving out more loans means there is going to be more spending in the overall economy. Less money available, fewer loans is going to mean less spending in the overall economy.
Now, how do banks know how much they’re allowed to loan out? Well, banks are obviously not allowed to loan out all the money they have in deposit. And in deposit means money that people have deposited and haven’t spent. Money people are keeping in their savings accounts. Many people are putting into their checking accounts that they don’t actually spend on to the very last dollar in their checking account. People aren’t all going to pull all their money out of a bank at once, unless there’s some kind of a crisis. And banks count on that not happening, or they wouldn’t be able to function.
So, the bank is assuming that people are not going to pull their money out all at once, that while one person is needing a loan for some money, another person is putting money in savings. While one person is, you know, getting $100,000 for a house, another person is putting $20,000 savings here, $10 there, $900 there, $50,000 here.
So, all the different people that are at a bank, most of them are going to have money in their accounts as a deposit, as a balance. And then, the people who are applying for the loans are going to be basically borrowing the money that would be sitting in their account. So, the people still see their money there, and it looks like it’s there, but the bank isn’t really going to have every person’s money, every last dollar of it in the bank. They’re going to loan some of that out so that they can make income, so that there’s a profit in the bank, so that they’re able to pay the bank tellers, and everyone on up. The managers, the whole corporation.
So, they can’t loan out all the money, how do they know how much they can loan out? The amount of money they must keep in reserve, so how much money they actually have to keep within the bank, unspent, actual cash that they could access, is known as the reserve ratio. So, there’s going to be a ratio of actual money there compared to how much money actually should be there. So, if people think that – let’s say 100 people – there’s a million dollars in the bank. Well, the bank may have to actually keep $500,000 in the bank, but they can loan out the rest of it. So, that’s what the reserve ratio is. It says, “Okay, compared to how much you’re supposed to actually have, this is how much you have to really have in hand in the bank.” Now, it may not actually be in your local bank, but it means that the bank can access that amount of money quickly, and hand it over to you if it was called upon to do so. So, a higher reserve ratio means more money has to stay at the bank.
That means there’s a higher amount that has to actually stay in the bank. So, that means there’s less money available for loans. Higher reserve means you’ve got to keep more reserved in the bank, that means you’ve got less money to loan out. Less money available for loans means spending decreases. A lot of people can’t pay out of pocket for things, and so, if they can’t get a loan to spend the money they wanted to spend, and buy the items they wanted to buy, then spending is going to decrease. Conversely, a lower reserve ratio means that you have a lower amount that you have to keep reserved in the bank, and that means more money available for loans, and that means that spending increases.
With more money available for loans, more people are going to buy things, spending increases. And the ratio, this reserve ratio, is determined by the Federal Reserve System. So, that is how banks work. The reserve ratio is determined by the Federal Ratio System, so it’s controlled by the US Government, and not individual banks. And then, banks loan out money and make interest off of the loans that they loan out, and people pay back the money, they have to pay interest on it. So, they make money off of the interest. If it got more money available, they can put out more loans. If they’ve got less money available, fewer loans, and that’s going to affect the amount of us spending in the economy. And, similarly, they can’t loan out all their money, so a higher reserve ratio, keeping more at the bank, means less to loan out, spending decreases. Lower reserve ratio means you’re keeping less at the bank, more to loan out, spending increases. So, you can see how the reserve ratio at a bank, and how much money a bank actually has available will affect how many loans you’re able to make, and how the amount of loans available is going to affect the overall spending in an economy.
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