Menu #48: How banks really work

STATS STACK 🥞

20 billion dollars now supports the Federal Emergency Management Agency’s (FEMA) Disaster Relief Fund (DRF), which has quadrupled since 2018 to address the rising costs of natural disasters. Severe storms and tropical cyclones, in particular, have driven the greatest need as disasters continue to increase in frequency and intensity.(Source: Market Briefs)

52 billion dollars in estimated damages from the recent LA fires set a record, underscoring the escalating financial impact of natural disasters.(Source: Bloomberg)

2024 became the hottest year on record, with global temperatures rising 1.6C above preindustrial levels and surpassing the Paris Agreement’s 1.5C target for the first time. (Source: FT)

DEEP DISH 🍕

How banks really work

Let’s have a real talk about what happens to your money when you deposit it into a bank. Most of us picture our savings sitting safely in a vault, waiting for us to access it. But the truth is, banks don’t make money by keeping your cash untouched. They’re using it—actively—and they’re making way more than they’re giving back to you.

Understanding how banks operate can open your eyes to the bigger picture of personal finance and help you make smarter decisions about your money. So, let’s dive into the details.

The Mechanics of Banking: Where Your Money Actually Goes

Banks are in the business of making money, and they do this by using your money to generate returns. This is all made possible by something called fractional reserve banking—a system that lets banks lend out or invest most of the money you deposit.

• Fractional Reserve Banking in Action

  For every dollar you deposit, banks are required by law to keep only a small percentage—usually around 10%—in reserve. For example, if a bank holds $10 million in total deposits, it only needs to have $1 million available in cash reserves. The other $9 million? It’s put to work.

• How Banks Use Your Money

  1. Loans: Banks loan out most of your money for mortgages, car loans, personal loans, and business loans. These loans often carry interest rates ranging from 3% to 20% or more, depending on the type of loan and the borrower’s creditworthiness.

  2. Investments: Banks invest in bonds, government securities, and even the stock market to earn additional returns.

  3. Interbank Lending: Banks can lend money to other banks overnight to meet their reserve requirements, charging interest for these short-term loans.

Why Banks Fear Bank Runs

This system works smoothly—until it doesn’t. If too many customers decide to withdraw their money at the same time, the bank doesn’t have enough reserves to cover those withdrawals.

This phenomenon, called a bank run, is every bank’s nightmare. Historically, events like the Great Depression and the 2008 financial crisis have shown just how fragile the banking system can be when confidence erodes.

Today, deposit insurance (like FDIC in the U.S.) protects individual depositors up to a certain limit, but the underlying system still relies on the assumption that most people won’t ask for their money all at once.

What You Get in Return

For all the ways banks use your money to generate profit, what do you get in return? Not much.

• Low Interest Rates: Most traditional savings accounts offer interest rates under 1%. If you have $10,000 in a savings account earning 0.5% interest, you’ll make just $50 in a year.

• Fees and Restrictions: Many banks charge fees for maintaining your account or withdrawing money too often, further eating into your returns.

Meanwhile, the bank might be earning 5% to 20% on loans, and potentially even higher returns on investments. This is why it’s crucial to ask yourself: Is your money working for you—or just for the bank?

How You Can Flip the Script

The good news is, you don’t need to play by the bank’s rules. Here’s how you can take control of your financial future:

1. Understand the Opportunity Cost

   Every dollar sitting in a low-yield savings account is a dollar that could be growing elsewhere. For example, the historical average return of the S&P 500 is about 8% annually. Compare that to the 0.5% or less you’re earning in your savings account.

   • Using the Rule of 72, your money doubles in 9 years at an 8% return (72 ÷ 8 = 9). At 0.5%, it would take 144 years.

2. Start Investing

   • Index Funds and ETFs: Platforms like Fidelity, Vanguard, and Charles Schwab offer low-cost funds that let you invest in a broad range of stocks.

   • Retirement Accounts: Max out your 401(k) or IRA to take advantage of tax benefits and employer matches.

   • Brokerage Accounts: For non-retirement investing, brokerage accounts allow you to grow your wealth while keeping your money more accessible.

3. Diversify Your Savings

   While it’s smart to keep some cash for emergencies (3–6 months of expenses is a good rule of thumb), consider transferring excess savings to a high-yield savings account or a money market account.

4. Think Like a Bank

   Banks thrive by putting money to work in multiple ways. You can do the same by diversifying your investments across stocks, bonds, and other assets.

The Bigger Picture

Banks play an important role in the economy, but understanding how they operate reveals an important truth: they’re not working in your best interest—they’re working in theirs. By keeping only a small portion of deposits in reserve and leveraging the rest for profit, banks have mastered the art of making money.

But you have the power to do the same. By educating yourself about investing, leveraging tools like the Rule of 72, and being intentional with your financial decisions, you can ensure that your money is working as hard for you as it does for the bank.

Let’s make smarter money moves, together.

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