Banks get money to lend to borrowers from two primary sources — deposits by bank customers that they lend to other customers and from the Federal Reserve through its discount window to cover short-term liquidity issues. The interest rates that banks charge on debt will typically correspond to the Federal Reserve’s base rate. Banks cannot lend unlimited amounts, however, and are constricted by the Federal Reserve’s capital requirements.
In its simplest form, bank lending works this way: Banks have savers who deposit money in the bank. The bank then pays the depositor money on top of their bank deposit and lends money out to other bank customers, charging them a higher interest rate. In the world of modern finance, though, it’s not always so simple. Although banks still technically lend money in this way, there are several other moving parts you should know about. Keep reading to learn about how banks get money to fund all types of loans.
How bank loans work
Traditionally, commercial banks collect money from depositors, for which they pay a percentage of interest on the money. They then lend the money out to borrowers and charge a higher interest rate than what they are paying the depositors. The bank pockets the difference between the interest paid to the depositor and the interest paid on the loaned money. Here is an example of how this works, with $100,000 deposited and lent out.
|Cash on hand||$100,000|
|Cost of cash (@3%)||$3,000|
|Charge on loan (@5%)||$5,000|
However, banks are not restricted to lending only the amount of money they hold in deposits. Instead, they use a method called fractional reserve banking.
The fractional reserve banking system
Fractional reserve banking is the concept that banks only need to hold a fraction of what they loan out in cash or in deposit accounts. The way banks really make money is by loaning out multiples of what they have in deposits. For instance, say a bank takes in a deposit of $100,000 but then uses that money to loan out $1 million. Through this method, banks create money and increase the money supply in the banking system and financial systems.
|Cash on Hand||$100,000|
|Cost of Cash (3%)||$3,000|
|Cash Loaned Out||$1,000,000|
|Cost of Cash (3%)||$3,000|
|Charge on Loan (5%)||$50,000|
The interest rates are the same, but the bank can make far more money by lending out multiples of the cash it holds in reserve. Can a bank then lend 20 times or 50 times what it holds in deposits? The answer to this is no, and this is because the government will ensure capital requirements.
Capital requirements are imposed by the federal government and stipulate how much a bank should have in reserve versus what it lends out. For example, if a bank has a capital requirement of 20%, then it can only lend five times what it currently holds in bank reserves because 20% x 5 = 100%.
Where do banks get money to lend?
Banks obtain money to lend to borrowers from two places: depositors who put their money in the bank and central banks like the Federal Reserve, which helps banks cover short-term liquidity issues.
The traditional method of banking consists of banks collecting money from depositors and lending it out. With fractional reserve banking, bank deposits can be multiplied to issue loans up to a certain amount, as long as it’s within the capital requirements that the government imposes on bank lending.
The Federal Reserve also plays a huge role in banks’ ability to obtain money. Sometimes, banks also need to borrow money to fund their operations or short-term liquidity needs. In that case, banks will borrow from the federal reserve’s discount window. This discount window consists of money available from the central bank (i.e. the Federal Reserve) for banks to borrow money to help with liquidity. This allows banks to continue credit facilities and also have a bit of a buffer in case of a run on withdrawals.
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How the Fed’s rate affects bank’s loaning rates
The Federal Reserve’s base rate directly correlates to banks’ interest rates. This means that if you are a saver, you will receive a higher interest rate on the money in your savings account. But for business owners, rising interest rates can cause issues, according to Alex McIntosh, CEO and founder of Thrive Natural Care. “When it becomes more expensive for banks to lend money, the economic impact is vast,” he says. “Businesses can often not access the funds needed for expansion projects, which then leads to downstream implications in their revenue streams, which has an adverse effect on employment.”
If you are a borrower, it becomes more expensive for you to borrow. Let’s look into why that is.
Banks have to compete with treasuries
There is one extremely liquid security that is almost as liquid as cash inside a bank, and that comes in the form of treasury bonds. Treasury bonds are a debt instrument you can buy, in which you loan the federal government money and receive interest, just like any other bond. When the Fed raises interest rates, the bond yields become higher. With the bond yield higher, banks need to increase their interest rates on deposits to become competitive with treasury bonds. It now becomes more expensive for banks to take deposits as they need to compete with treasuries.
Federal Reserve’s discount window becomes more expensive
Just as it becomes more expensive for banks to pay depositors, it becomes more expensive for banks to borrow from the Federal Reserve for their liquidity issues. Banks borrow a ton of money from the Federal Reserve throughout a fiscal year. The more expensive it is to borrow from the Federal Reserve, the more interest must be charged on loans to make sure everything is profitable.
Derek Jaques, an attorney who deals with various aspects of business and finance, says the Fed’s rate is extremely important for a bank’s ability to lend money. “The Federal Reserve’s consistent rate hikes have put a lot of pressure on the economy in general,” he says. “But when it becomes more difficult for businesses to obtain the capital they need, it becomes especially burdensome.”
Bank loans vs. liabilities
When a bank makes a loan, it becomes an asset. This loan can be held by the bank or sold to someone else that will then hold the loan note. When a bank takes on a deposit, this is technically considered a liability. This is because the bank must honor the withdrawal of the deposit should the customer wish to withdraw, but they also must pay interest on that loan.
Think of it this way — a liability for you in the form of a loan is actually an asset from the bank. Likewise, an asset for you, such as the money in your savings account, is a liability for a bank. Regardless of where banks get their money or the capital reserve requirements that are being implemented by the government, a bank still needs a good balance sheet. This is why giving loans can be seen as risky; there is a risk the bank won’t get paid back. By creating a loan at a bank, you create an asset that is a net plus for the books.
Where do banks get money to lend to people?
Banks get money to lend to people from deposits as well as from central bank money such as that supplied by the Federal Reserve. Technically, banks could also get money from injections of capital, equity sales, and various other loans and debt products. However, in the majority of cases, banks obtain money to lend to people through the aforementioned routes, depositors and the Fed.
Do banks loan their own money?
That all depends on how you define “their own money.” Most of the money lent out will be from deposits that are protected up to $250,000 through the Federal Deposit Insurance Corporation (FDIC), as well as through the central bank. However, a shareholder could inject a bunch of capital, take an equity stake in a bank, and loan it out. This is an unusual circumstance, however, and not typically how banks extend credit loans.
How do banks decide who to lend to?
Some banks have computer algorithms measuring risk profiles; other banks will use a more humanistic approach to handling clients. Although each bank has different parameters, the No. 1 goal is to make money and eliminate as much risk as possible. In the vast majority of cases, banks will use a combination of numbers and metrics, as well as a human eye confirming everything. That being said, as more and more businesses turn to algorithms over a human touch, you could see pushback in the future.
How do banks create money by lending?
Money creation is made possible by the fractional reserve banking system in which banks can lend multiples of the money they take in via deposits. In many cases, the fractional reserve system can multiply deposits by a significant factor, such as 10 times the original amount, depending on regulations. For instance, $100,000 can become $1 million with the fractional reserve system. This is how banks create “new money.”
- Banks get money to lend to borrowers in two ways, from depositors and from the Federal Reserve.
- Under the Federal Reserve banking system, banks are able to lend out multiples of what they have in deposits as long as they are within the capital requirements imposed by the government.
- As the Fed raises interest rates, commercial banks will also raise the interest rates they provide on their savings accounts and the interest charged on loans.
- Although it can seem counterintuitive, a loan from a bank is really an asset, whereas deposits in a bank are a liability.
View Article Sources
- Reserve Requirements – Federal Reserve
- What Is Fractional Reserve Banking and Is It Good or Bad? – Foundation for Economic Education
- The Basics of the Federal Reserve System (FRS) and Understanding the U.S. Central Banking System – SuperMoney
- 4 Ways Banks Are Making Money Off of You – SuperMoney
- Federal Reserve Interest Rate Hikes – SuperMoney
- 2023 Personal Loans Industry Study – SuperMoney
- Understanding Bond Yield, its Significance, Relevance, and Calculations – SuperMoney
- What is an Interest-Bearing Loan? – SuperMoney