Banks offer products and services to help you manage your money, but do you know how they actually work?
If you have a checking account or savings account, or if you’ve ever opened a credit card or applied for a loan, then banks are an integral part of your financial life. Banks and the financial services industry are an important part of the economy because they provide the means for people to borrow money, make investments, save for the future and handle smaller tasks (like paying bills).
Here’s a closer look at banks, how they work and why they matter.
How Banks and the Banking Industry Work
Banks, whether they be brick-and-mortar institutions or online-only, manage the flow of money between people and businesses. More specifically, banks offer deposit accounts that are secure places for people to keep their money. Banks use the money in deposit accounts to make loans to other people or businesses.
In return, the bank receives interest payments on those loans from borrowers. Part of that interest is then returned to the original deposit account holder in the form of interest—generally on a savings account, money market account or CD account. Banks primarily make money from the interest on loans as well as the fees they charge their customers.
These fees can be tied to specific products, such as bank accounts, or related to financial services. For example, an investment bank that offers portfolio management to investors can charge a fee for that service. Or, a bank may collect an origination fee when granting a mortgage loan to a homebuyer.
Banking is a highly regulated industry. The Federal Reserve System oversees banks and other financial institutions and coordinates with state regulatory agencies to help ensure banks follow the proper guidelines. Banks are also subject to regulation by other federal agencies, including the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS) and the Federal Deposit Insurance Corporation (FDIC).
The FDIC does many things, but one of the most important for banking customers is insuring deposits. The FDIC insures deposits at banks for up to $250,000 per depositor, per insured bank, for each account ownership category. This means if your bank fails for any reason, the FDIC can help you recover the money in your accounts, up to the allowed limits.
Types of Banks
Banks aren’t identical and several different types of banks handle financial transactions. These include:
- Central banks
- Retail banks
- Commercial banks
- Investment banks
- Shadow banks
- Savings and loan associations
- Credit unions
Central Banks
Central banks manage the supply of money for a country or group of countries. These banks are responsible for setting monetary policy, overseeing the movement of currency and establishing interest rate baselines. In the U.S., the Federal Reserve is the central bank.
Retail Banks
Retail banks are probably what most people think of when they think of banking. These banks offer loans, deposit accounts and other banking services to everyday customers. Retail banks can be brick-and-mortar institutions with branches or online banks.
Commercial Banks
Commercial banks typically cater to businesses or corporations, although they also can serve the needs of individual banking customers. Similar to retail banks, commercial banks also can make loans and offer deposit accounts and other banking services.
Investment Banks
Investment banks can take part in securities trading, manage investor accounts or do a little of both. An investment bank can act as a go-between for investors who want to put money into the markets by helping with the purchase or sale of securities. They also can offer investment advice to clients.
Shadow Banks
Shadow banks aren’t like traditional banks in terms of what they do or how they’re regulated. These nonbank financial institutions are generally unregulated and primarily focus on making investments in credit and debt instruments. Insurance companies and hedge funds are examples of shadow banking institutions.
Savings and Loan Associations
Savings and loan associations aren’t strictly banks either. These financial institutions specialize in helping people borrow money to buy a home or refinance a home they already own.
Credit Unions
Credit unions, sometimes referred to as cooperative banks, offer many of the same services as traditional retail banks. The difference is that while retail banks typically operate for profit, credit unions don’t. Additionally, credit unions typically have membership requirements customers have to meet as a condition of joining. Rather than being FDIC insured, credit unions generally are insured by the National Credit Union Administration (NCUA).
What Banks Do
Banks are primarily in the business of lending money to individuals, businesses and other entities. Again, this money comes from the pooled deposits of other individuals, businesses and entities. In essence, when a bank makes a loan to someone else, it’s borrowing from its depositors.
Banks also can borrow money from other banks and the Federal Reserve. Interbank lending, meaning loans between banks, usually happens on a short-term basis. These loans serve an important purpose: to ensure that banks can meet the Federal Reserve’s liquidity requirements. These requirements help to ensure that banks have enough assets available to manage withdrawal demand.
The Federal Reserve can issue loans to banks and other financial institutions to help address temporary problems in obtaining funding. Banks can pursue this option if they can’t get the loans they need through the interbank lending market. Compared to those loans, the Federal Reserve lends money to banks at a higher interest rate.
Aside from borrowing and lending, banks also play a role in the transmission of monetary policy. This ties in to how the Federal Reserve manages monetary policy in relation to economic shifts. When the Fed changes monetary policy, it’s usually related to one of three things: curbing or encouraging economic growth, managing inflation or reacting to changing unemployment rates.
For example, the Federal Reserve can cut interest rates to encourage consumer borrowing and spur economic growth. Banks, as a result, may reduce the interest rates they charge on loans. In theory, this prompts more people to borrow, which bolsters the economy. The trade-off is that rate cuts aren’t limited to loans; banks also can reduce the rates they pay to savers.
Likewise, when the Federal Reserve raises rates, banks can follow suit and increase the rates they charge on loans or offer on deposit accounts. This makes borrowing more expensive, but it also encourages people to save money since they can earn a higher interest rate.
Types of Bank Accounts
Consumers usually view banks as places to keep money or as places to go to borrow money. The types of accounts you can have with a bank may include:
- Checking accounts
- Savings accounts
- Certificate of deposit accounts
- Money market accounts
- Credit cards
- Auto loans
- Mortgage loans
- Student loans
A checking account allows you to deposit money, pay bills and make purchases by writing checks or using your debit card. Processing transactions is another important job for banks.
When you swipe your debit card or use your ATM card to make a withdrawal, that transaction has to be approved by your bank before it can be processed. Banks also make it possible to make electronic Automated Clearing House transfers or wire transfers between individuals, businesses and financial institutions.
Savings accounts, CD accounts and money market accounts are all options for saving money. These accounts can pay interest to savers, though they each work differently.
Savings accounts, for example, allow you to set aside money you don’t need to spend while keeping it accessible. Depending on the bank, you may be able to access your money at a branch, ATM or online.
CD accounts are time deposits that pay interest over a set period. Common CD terms range from 30 days to 60 months. But it’s possible to find CDs with terms as long as 10 or 20 years. Generally, the longer the term, the higher the interest rate you can earn. Banks can charge a penalty for withdrawing money from a CD before it reaches its maturity date.
Money market accounts can earn interest like a savings account but give you withdrawal options similar to a checking account. For example, you may be able to write checks, make ATM withdrawals or make purchases using a debit card. Banks can, however, limit the number of withdrawals you can make from savings accounts and money market accounts each month.
While banks can pay interest to savers, they also can charge them fees to generate revenue. The most common fees you might pay to a bank include:
- Monthly maintenance fees for checking accounts
- Monthly maintenance fees for savings or money market accounts
- Excess withdrawal fees for savings accounts or money market accounts
- Early withdrawal penalties for CD accounts
- Overdraft or non-sufficient funds fees
- ATM withdrawal fees (if you’re using an out-of-network ATM)
- Debit card replacement fees
- Cashier’s check, certified check and money order fees
Many of these fees can be avoided by choosing an online bank versus a traditional bank. Online banks tend to have lower overhead costs than brick-and-mortar banks, which means they can pass on those savings to customers in the form of lower fees. For the same reason, you may also find better interest rates on deposit accounts at online banks.
Bottom Line
When comparing banks, check the range of products and services offered, as well as the fees and interest rates they pay or charge for borrowing money. Also, keep convenience in mind when it comes to the different ways you can access your money.
