Banking 101: What You Need to Know, and What Causes Bank Runs
In the Christmas classic, It’s a Wonderful Life, George Bailey, played by Jimmy Stewart, is about to embark on his honeymoon when he notices a run on his bank, Bailey Brothers Building and Loan. He rushes to the bank where he is greeted by a mob of customers, frantically looking to withdraw their money. He tries to calm them down and delivers perhaps the most succinct explanation ever of what a bank does (here’s the clip on YouTube). “You’re thinking about this all wrong, as if I have the money back in a safe. The money’s not here. Well your money’s in Joe’s house, that’s right next to yours, and the Kennedy house, and Mrs. Maklin’s house, and a hundred others. You’re lending them the money to build, and they’ll pay you back as best they can.” We take banks for granted, until they’re in the news, like in March 2023 with the collapse of Silicon Valley Bank and others. But most of us don’t really understand what a bank does, and how fragile the banking system is. Well, read on — Banking 101 explains everything you need to know about banking, but were afraid to ask.
So, how does a bank make money?
Let’s say I want to start Steve’s bank. It takes in deposits and makes loans. The loans are assets of the bank and the deposits are liabilities — assets are what the bank owns and liabilities are what the bank owes. Interest is paid on deposits — say, 3 percent. Interest is charged on loans — say, 5 percent. Net interest income is the difference between the interest the banks receive on loans and the interest it pays on deposits. If the bank has $100 million in each, it takes in $5 million in loan interest and pays $3 million in deposit interest. It has net interest income of $2 million, which it can use to pay salaries and cover other costs of doing business, and hopefully have profits leftover.
Besides net interest income, are there other ways that banks make money?
Yes, there are lots of ways. Along with interest from loans, the bank may invest in securities like Treasurys (yes, that’s how it’s spelt in the…