Economics / Unit 7: Money, Banking and Financial Markets
7.4 How Banks Work
Notes
Banks are financial intermediaries: they collect money from savers and lend it to borrowers.
- Types: commercial banks (owned by stockholders, serve businesses and individuals), savings and loans (traditionally focused on home loans) and credit unions (nonprofit cooperatives owned by members).
- Fractional reserve banking: banks keep only a fraction of deposits as reserves and lend out the rest.
- Banks earn profit from the spread: the difference between the interest rate charged on loans and the rate paid on deposits, plus fees.
- A bank's balance sheet lists assets (loans, reserves, securities) and liabilities (deposits and money it owes).
- Worked example: a bank pays $1\%$ interest on $100,000 of deposits and lends $90,000 at $6\%$. It earns $0.06 \times 90{,}000 = 5{,}400$ dollars and pays $0.01 \times 100{,}000 = 1{,}000$ dollars, for $4,400 before other costs.
- Collateral is property a borrower pledges to secure a loan; a house secures a mortgage.
Practice
A bank pays $2\%$ interest on savings and charges $7\%$ on car loans. The 5 percentage point difference is called the:
The spread between loan and deposit rates is a main source of bank profit.
Which type of financial institution is a nonprofit owned by its members?
Credit unions are member-owned cooperatives.
A bank has $500,000 in deposits and keeps $10\%$ as reserves. How much can it lend?
Reserves are $0.10 \times 500{,}000 = 50{,}000$, leaving $450,000 to lend.
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