What Do Banks Do

Banks connect people who have money with people who need to borrow it. They hold deposits, extend loans, and process payments for both individuals and companies. Banks earn most of their profit from the spread between the low interest they pay on deposits and the higher interest they charge on loans.

Why Banks Matter

There’s a reason that you can find a bank on a lot of street corners. That’s prime real estate, and banks play a pivotal role in the broader economy. They actually provide the lifeblood of financial activities by facilitating transactions, providing credit, and managing risks. Banks serve as intermediaries between savers and borrowers, ensuring the efficient allocation of resources, and significantly contribute to economic growth.

The Importance Of Banks To Individual Consumers

For individual consumers, banks are indispensable in managing personal finances. They offer a safe place to deposit earnings, which is crucial for safeguarding personal wealth.

Banks also provide various financial products like savings accounts, which encourage savings by offering interest on deposits. This not only benefits individuals by enhancing their financial security but also aids the economy by mobilizing savings for productive uses.

Banks also facilitate everyday financial transactions, including bill payments, fund transfers, and credit card services. They provide loans for various personal needs, such as home mortgages, education loans, and car financing. These services not only stimulate economic activity by increasing consumption and investment, but also improve the standard of living for billions across the globe and provide crucial access to capital.

The Importance Of Banking To Companies

Although banks are critical for individual consumers, they are also indispensable to companies.

One of the primary functions of banks for businesses is offering access to capital through business loans, credit lines, and overdraft facilities. This capital is essential for a range of purposes - from starting new ventures and expanding existing operations to bridging cash flow gaps and financing large projects. Such financial support is particularly critical for small and medium-sized enterprises (SMEs), which might not have substantial internal funding sources.

But there are a lot more benefits for companies:

Trade Financing

For companies engaged in international trade, banks are pivotal in providing trade financing. This includes issuing letters of credit, which guarantee payment to exporters, and trade credit insurance, which protects against non-payment by foreign buyers. These services reduce the risk associated with international trade, enabling businesses to expand their global footprint.

Treasury and Cash Management

Banks assist companies in managing their daily financial operations efficiently through treasury and cash management services. These services include managing cash flow, optimizing liquidity, and facilitating transactions. Effective cash management is crucial for maintaining the solvency and profitability of a business.

Risk Management

Banks play a critical role in helping companies manage financial risk. Through various instruments such as derivatives, companies can hedge against interest rate fluctuations, currency risks, and commodity price changes. This risk management is essential for companies to protect their profits and investment.

Investment and Advisory Services

Banks provide investment and advisory services, offering guidance on mergers and acquisitions, asset management, and market strategies. This expert advice is invaluable for businesses making critical strategic decisions, ensuring informed and profitable outcomes.

Payment Processing and Credit Facilities

Banks facilitate efficient payment processing, including electronic funds transfers, point-of-sale systems, and online payment gateways. They also offer credit facilities in the form of business credit cards, which can be crucial for managing expenses and cash flow.

How Banks Make Money & Benefit The Economy

Banks primarily make money through the interest rate spread - the difference between the interest paid on deposits and the interest received from loans. They charge higher interest rates on loans and pay lower rates on deposits, profiting from this spread.

Banks also generate income through fees and charges for various services, including account maintenance, transaction processing, and ATM usage. Additionally, investment banking activities, like underwriting and trading securities, contribute significantly to their revenue.

The benefits banks provide to individuals and companies are interconnected, collectively fueling growth. For individuals, banks facilitate financial security and consumption, while for businesses, they provide the necessary capital for expansion and innovation. This relationship leads to job creation, higher production, and increased trade activities.

Economic growth, in turn, benefits society at large. It leads to higher living standards, improved infrastructure, better healthcare and education, and increased opportunities for social mobility.

What Did We Learn?

Banks are fundamental to the functioning of the economy. By supporting economic activities and fostering growth, they play a critical role in enhancing the quality of life and overall well-being of the society.

Banks not only serve the financial needs of individual consumers and businesses but also contribute significantly to economic development and societal well-being.

Questions

1. What is the primary way banks make money?
2. How do banks support individual financial security?
3. Why are banks important for small and medium-sized enterprises (SMEs)?

Why Banks Take On Risk To Make A Profit

The lesson above breaks down what banks do for individuals and companies, but it's worth sitting with how strange that role actually is. A bank promises depositors they can withdraw their cash any time, then turns around and lends most of that same money out for months or years. That mismatch, short-term promises funding long-term loans, is the core risk every bank manages every single day.

Banks manage that risk by keeping only a portion of deposits on hand, spreading loans across many different borrowers, and pricing each loan based on how likely that borrower is to repay it. A borrower with a longer credit history and steady income gets a lower rate than a borrower the bank knows less about, because the bank is pricing in its own risk of not getting repaid. That's the same logic behind how mortgages work: the bank is always weighing risk against reward before it lends a single dollar. For the mechanics of a single mortgage payment, from principal to interest to amortization, work through Rapunzl's mortgage worksheet.

You can see a version of that same risk-and-reward trade-off inside the Rapunzl investing simulator, where students manage a simulated $10,000 portfolio and decide how much risk to take with each position. Pairing that with live market data shows how the same principle, price risk correctly or lose money, plays out for banks, investors, and everyone else moving capital through the economy.

This explainer comes from Module 23 of the Rapunzl curriculum, part of the Basics of Banking unit. Rapunzl has reached 150,000+ students since 2018 — 81% students of color, with 83% of partner schools in low- and moderate-income communities. Teachers: the accompanying activity and answer key are in the teacher portal.