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What Is a Bank and How Do These Financial Institutions Work?


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Imagine what the world would be like if there were no banks. Every time you got paid, you’d have to pick up a big wad of cash and carry it around. If you lost your wallet or purse, you’d lose it all. 

If you wanted to make a big purchase, like buying a home, you couldn’t go to a bank for a loan. You’d have to either find a private lender or save your money until you had enough. But with no bank account, you’d have to stash those savings in your home somewhere. A burglary or a house fire could wipe them out overnight.

Clearly, banks make life easier in many ways. But how do they work? What exactly is a bank, and what does it do?


What Is a Bank?

A bank is a financial institution that helps transfer money among people and businesses. It moves money from people who have extra cash to spare to others who need some now. 

In exchange for the use of the money, borrowers pay interest on the loans they receive. Those who provide the money, called depositors, earn interest on their deposits. In this way, everyone benefits — including the bank, which takes a share of the interest for itself.

Banks can also provide a variety of other financial services in addition to handling deposits and loans. For instance, they can provide credit cards, currency exchange, safe deposit boxes, and wealth management services. However, not every bank offers these services.


How Do Banks Work?

A bank isn’t just a big box that cash goes into and out of. In fact, most of the money in your bank account isn’t in the bank building at all. It’s on loan to borrowers who are paying interest on the loan. A portion of that interest goes to you, while the rest goes to the bank. 

Usually, it’s not a problem that most of a bank’s deposits aren’t stored at the bank. Most depositors don’t need their money at any given moment. Banks only need to keep a small portion of their deposits in cash for people who want to make withdrawals.

But what happens if a whole bunch of depositors want to withdraw their money at once? Can the bank actually run out of money? 

Bank runs like this used to be a serious problem. Depositors might hear a rumor that their bank was unstable. They’d all run to the bank to withdraw their funds at once, and the bank wouldn’t have the money to pay them all. Then the rumor would be true even if it wasn’t before.

To fix this problem, the government created the Federal Deposit Insurance Corporation (FDIC). It grants charters to banks across the country and insures the deposits held at those banks. If one of them fails, the FDIC pays its depositors all the money they held there, up to a maximum of $250,000. 

Thanks to the FDIC, bank runs almost never happen today. Because depositors know their money is insured, they don’t panic at the first hint that their bank might be unstable. 

But in the unlikely event that too many depositors demand their money at once, the bank can either shut down temporarily or put a limit on withdrawals. This gives it time to get more cash by borrowing from another bank or from the Federal Reserve.


What Do Banks Do?

A bank is more than just a place to keep your money. Banks provide a wide variety of financial services for their customers, both in physical bank branches and online.

Provide Bank Accounts

The banking service people are most familiar with and use most often is a bank account. These accounts provide a safe place to keep your money and earn a little interest at the same time.

Types of Bank Accounts

There are several types of bank accounts with different features. They include:

  • Checking Accounts. This type of deposit account gives you easy access to your money. In addition to withdrawing cash at a branch or ATM, you can make purchases directly from your balance using a debit card or a paper check. Banks also offer business checking accounts with extra features like invoicing.
  • Savings Accounts. Like checking accounts, savings accounts can be for individuals or businesses. They generally pay more interest than checking accounts, but they provide less access to funds.
  • Money Market Accounts. A money market account is a special type of savings account that also includes paper checks or a debit card. They pay more interest than other accounts but usually require you to maintain a large balance.
  • Certificates of Deposit. A certificate of deposit, or CD, is like a fixed-term loan you make to the bank. It pays the most interest, but it ties up your money for a set amount of time. If you cash it in early, you pay a penalty.
  • Taxable Brokerage Accounts. Some banks have a separate division that serves as an investment brokerage. At these banks, you can open a taxable brokerage account to hold stocks, bonds, and other investments
  • Merchant Accounts. This type of bank account is for businesses only. They can use it to accept credit and debit card payments from their customers.

Provide Loans

When you open a deposit account, you’re letting someone else use your money in the present in exchange for more money — interest — in the future. When you take out a loan, it’s just the opposite. You’re promising to pay money later in return for the use of money right now.

Banks can offer loans for a variety of purposes, including:

  • Home Loans. A mortgage loan is money you borrow to buy a new home. A home equity loan or home equity line of credit is like a mortgage you take out on a home you already own. 
  • Auto Loans. When you buy a car, you can borrow money from the dealer to pay for it. However, car loans from banks and credit unions tend to offer better interest rates.
  • Personal Loans. You can take out a personal loan to pay for anything from a wedding to medical expenses. These are typically installment loans that don’t require collateral (something of value you must give the bank if you don’t pay back the loan).
  • Business Loans. Businesses often take out loans for costs like new premises or equipment. Large companies usually borrow from business-centered commercial banks. Smaller ones can take out small business loans from retail banks.
  • Credit Cards. Some banks offer credit cards for their customers. Every time you use one, you’re borrowing from the bank to pay for your purchases. However, you can avoid paying interest by paying the money back in full when you get your monthly bill.

Provide Banking Services

Banks can provide a variety of other banking services in addition to deposit accounts and loans. However, banks don’t have to offer all these services. They can choose which ones to provide, and they can charge fees for them.

Banking services can include:

  • Debit cards for making purchases
  • Direct deposit of paychecks
  • Online banking and bill payment
  • Electronic money transfers from your account to someone else’s
  • Safe deposit boxes for storing valuables and important papers
  • ATMs for withdrawing money outside of business hours
  • Paper checks for checking account users
  • Official checks, such as cashier’s checks, for secure financial transactions
  • Check cashing services for account holders
  • Money orders, which work like a prepaid check
  • Overdraft coverage in case you spend more money than you have in your account
  • Rolls of coins for machines like parking meters or coin laundries
  • Foreign currency exchange, usually available only at large banks
  • Notary public services for registering an official document
  • Free access to your credit score
  • The ability to redeem a savings bond from the government
  • Wealth management services such as investment advice, accounting, and estate planning

What Are the Four Types of Retail Banks?

There are several types of banks that serve different types of customers. For instance, corporate or commercial banks cater to businesses. Investment banks also work with businesses and provide more complex services.

But the banks most people are familiar with are retail banks, which serve the general public. These fall into four categories based on size.

National Banks

National banks are the largest banks in the country. They typically have large networks of branches and ATMs spread across most if not all U.S. states. Some of them operate outside the U.S. as well.

These banks offer the widest wide array of banking products and services for both business and the general public. The best national banks offer good interest rates, strong mobile banking apps, and features like sign-up bonuses for new accounts.

Some national banks, such as Bank of America and Chase, have both physical branches and an online presence. Others are purely online banks, as discussed below.

Regional Banks

Regional banks are the next largest kind. Their branch and ATM networks are concentrated in a specific part of the country, sometimes within a single state. Their borrowers and account holders all live in or near that region. 

Regional banks vary widely in size. For instance, PNC Bank has more than 2,600 locations across more than half the states in the country. Capital One Bank has around 450 locations concentrated in six states and the District of Columbia. But both are considered regional banks.

Community Banks

The smallest banks in the nation are community banks. They focus their business within a narrow area — often in a single state and no more than one or two major cities. In some areas, especially rural areas, they’re the only bank around.

Community banks don’t offer as many services as larger banks. Their hours, as well as their branch networks, are limited. But because they serve fewer customers, they can get to know them and provide more personalized service than big banks.

Online Banks

Although online banks operate nationwide, they don’t have any physical branches. Instead, customers make most transactions through a website or mobile app. Most online-only banks partner with ATM networks to give customers access to cash without a surcharge.

Online banks can offer higher interest and lower fees than most banks because they have fewer expenses. However, many don’t offer the same range of services as traditional banks. Major online banks include Discover Bank and Ally Bank.


Banks vs. Credit Unions

You can also receive banking services from a credit union. These financial institutions provide deposit accounts, loans, and other services just like a bank. But banks and credit unions differ in a few key ways.

  • Membership. Credit unions are nonprofits owned and operated by a particular group of people. These could be employees of a company, members of a labor union, or residents of a town. To join the credit union, you must belong to this group.
  • Better Rates. Because they’re nonprofits, credit unions can offer their members higher interest rates on savings accounts than most banks. They can also provide lower interest rates on loans.
  • Limited Services. Most credit unions are small institutions. They generally can’t provide the same range of services as large banks.
  • Branches. Credit unions typically have few branches and ATMs of their own. However, many are part of a shared branch network provided by Co-Op Solutions. It allows members of any of its credit unions to receive banking services from any other one across the country.
  • Deposit Insurance. Credit unions can’t be members of the FDIC. Instead, they belong to the National Credit Union Administration, or NCUA. This organization insures all credit union accounts up to $250,000, just as the FDIC does for banks.

How Are Banks Regulated?

There are several different organizations that govern banks in the U.S. Some are at the national level of government, while others are at the state level.

National banks are under the control of the Office of the Comptroller of the Currency (OCC). It grants charters to these banks and sets rules about how they operate. It examines banks regularly to make sure they are keeping customers’ money safe and treating them fairly.

Smaller banks are under the control of state banking departments. Each state banking department, or agency, grants charters to banks within its borders and sets rules about their practices, such as how much interest they can charge. It audits and inspects banks to make sure they are following these rules.

However, state banks also receive some supervision at the national level. Some state banks are members of the Federal Reserve, or Fed. These banks are subject to oversight from the Fed as well as the state. 

State banks that do not belong to the Fed are supervised by the FDIC. The FDIC is also a backup supervisor for other banks. It ensures that banks follow federal consumer protection laws such as:


What Does the Federal Reserve Do?

There’s one other institution that controls the banking system: the Federal Reserve. This body serves as the central bank of the U.S. But rather than being a single bank, it’s a group of 12 banks spread across the country, all governed by a central board.

The Fed is responsible for:

  • Setting Monetary Policy. The Federal Reserve aims to prevent both inflation and recessions by controlling the nation’s money supply. Its main method for doing this is raising and lowering interest rates.
  • Supervising Banks. Many state banks are members of the Federal Reserve system. The Fed authorizes, inspects, and regulates them. In addition, it stress tests large banks to make sure they have the funds to handle a financial crisis.
  • Banking for the Government. The Fed performs banking services for the government. Its member banks collect taxes, process government checks, and sell government securities, such as Treasury bills.
  • Banking for Other Banks. The Fed distributes paper money to banks. It processes checks and electronic payments for them. And it makes loans to banks if they can’t borrow enough from other banks to meet their needs for cash.
  • Doing Research. Federal Reserve Banks conduct research on the economies of their region, the nation, and the world. They distribute this information through publications, websites, speeches, and educational workshops.

Banking FAQs

Read on for answers to other commonly asked questions about banks.

What Is a Central Bank?

A central bank, also called a national bank, serves other banks rather than the general public. Its job is to keep the country’s financial system running smoothly. 

The central bank controls the nation’s money supply and aims to keep the currency stable. It also regulates banks under its control. One of its jobs is to make sure banks hold enough cash in reserve to cover a sudden surge in withdrawals.

The Federal Reserve serves this role in the U.S. Other central banks around the world include the Bank of England, the Bank of Japan, the People’s Bank of China, the Swiss National Bank, and the European Central Bank.

Is a Bank a Safe Place to Keep My Money?

In a word, yes. Putting your money in the bank protects it from theft, fire, and all the other mishaps it could face if you kept it at home. 

Even though the bank lends out most of the money it receives, it keeps enough in reserve to let you withdraw your funds at any time. And even in the unlikely event that your bank shuts down, FDIC insurance guarantees that you’ll get your money back.

How Do Banks Make Money?

The main way banks make money is by making loans at a higher interest rate than they pay on deposits. If a bank charges an average of 8% interest on its loans and pays an average of 1% on checking and savings account deposits, it earns a profit of 7%. 

Banks also make money from banking fees. For instance, they can charge you a fee for overdrawing your account, for using another bank’s ATM, for making too many transactions, or for making no transactions at all. 

What Is the FDIC?

The Federal Deposit Insurance Corporation, or FDIC, provides insurance for bank deposits. It guarantees all deposits held at its member banks up to a maximum of $250,000 per account.

The FDIC also plays a role in regulating the banking system. It supervises all state banks that aren’t members of the Federal Reserve and serves as a backup supervisor for other banks. It regularly examines banks to make sure they comply with consumer protection laws. And if a bank fails, the FDIC is in charge of selling its accounts to other banks.


Final Word

Banks make our economy work better. They make it easier to save by giving you a safe place to store your money, and they make it easier to spend by making loans that provide liquidity. They make it possible to go to college or buy a house without saving for decades first.

Banks perform these same services for business, as well. Loans made to companies allow them to expand by building new factories or hiring more workers as demand for their products grows. That helps the economy as a whole grow faster.

To learn more about banks and how to use them wisely, check out our banking archives.

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Amy Livingston is a freelance writer who can actually answer yes to the question, "And from that you make a living?" She has written about personal finance and shopping strategies for a variety of publications, including ConsumerSearch.com, ShopSmart.com, and the Dollar Stretcher newsletter. She also maintains a personal blog, Ecofrugal Living, on ways to save money and live green at the same time.

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