How Banks Work

What happens to my money after I put it in the bank? It’s a question worth answering, and I’ll attempt to do so here.

Disclaimer: this is not financial advice, and you should not take it as such.*

If I have £1000 (lucky me!) I can put it in the bank as a deposit. The bank will then split my deposit up into two parts: one it will keep for the purposes of withdrawals and to meet regulations for capital retention, and the rest it will lend.

We’ll suppose that 10% is kept and 90% is released for lending (these may or may not be viable figures depending on the state of the economy and current regulations, so you should not take them as being “typical”)- this lending money could be used for overdrafts, loans, mortgages, or credit cards.

The 90% is given out as loans and the money is paid back with interest, which is how the bank makes its money (there will, of course be overheads surrounding tax, paying your staff, upkeep of accounts and systems, but these will usually be covered).

Savings accounts and accounts with restricted withdrawal capabilities will carry a higher interest rate than current accounts because money in this accounts will tend to stay there for longer and hence the bank can be more sure that it’s going to be available for them to use. In a sense you’re “rewarded” for being committed to having your money there for longer.

That’s not the end of the story though- the 90% is effectively put back into the economy as new money. My £900 might have gone on someone’s credit card (I really hope you enjoy your holiday), and the place they spent it will go on to put the £900 in their own bank. They’ll keep 10 % and so the cycle will continue. Eventually, my original £1000 will have effectively become £10 000, although not entirely for me, sadly. As such, lending is essential for a strong economy… so long as it is done responsibly.

All this, of course, depends on whether the customers who take the money out can afford to pay it back. If the person who used my £900 to fund his holiday never pays it back, what happens?

This is why there are credit checks and why you see ads for companies like Experian telling you how to improve your credit score. If your credit score is too low, the bank probably won’t lend to you, unless they have a particularly high risk appetite (essentially, “risk appetite” is bank speak for “how sure do we want to be that a customer can pay back their borrowing?”). This stops people likely to default from getting your money.

From my point of view, nothing will happen, because I can still go in and withdraw £1000 normally, but the bank itself will take a hit. They expect that some people will default and budget for this (as well as for fraud), and if they don’t they’ll get fined.

This is just a very basic introduction, there are all kinds of nuances which I haven’t mentioned, but I hope it’s been informative.

*Contractually obliged to put that. But I do mean it.

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