What Banks Do With Your Money After You Deposit It

Images by GettyImages; Illustration by Hunter Newton/Bankrate

Banks are intermediaries between depositors and borrowers. The money you deposit into a bank is then lent out by the bank in the form of a variety of loans. But the process, when broken down, is often much more complicated than a bank simply taking deposits and lending them out.

The bank lending process

Only a small portion of your deposits at a bank are actually held as cash. The rest of your money (the majority of the bank’s assets) is invested by the bank into vehicles such as consumer or business loans and government bonds. Borrowers have to pay the bank back with interest. This process, in which banks distribute deposits as loans, is called financial intermediation.

Banks make money by charging more on loan interest than they pay out to depositors. For example, let’s say you deposit $500 into a savings account with a 4 percent annual percentage yield (APY). You’d make $20 in interest after a year, which the bank pays to you.

Meanwhile, the bank might lend out $400 of your deposit as a personal loan with a 10 percent annual percentage rate (APR). The bank makes $40 off of that loan in a year. Because it paid $20 to you in interest, the bank keeps the other $20 as profit, which is used to pay its shareholders.

Consumer or business loans aren’t the only way banks lend out money. They may also invest deposits in safe investments, such as Treasury bonds — a type of investment vehicle in which money is lent out to the government and the government pays interest to the lender.  

Where do banks invest your money?

Banks use your deposits to lend money to other customers, but they also invest the money in:

• Government securities. These include Treasury bonds, notes and bills. These are safe, low-yield investments used to manage risk and meet regulatory requirements.
• Corporate securities. Banks sometimes invest in bonds or equities, but this is typically limited and regulated due to higher risk.
• Interbank lending. Banks lend to each other in the short term to meet liquidity needs or earn a small return.
• Central bank reserves. Banks may keep a portion of your deposit in reserve accounts at the central bank, earning interest the same as consumers do on savings accounts.

Although you don’t directly choose where your deposits are invested, you might be concerned about how your bank chooses to invest your money, especially if you care about finding a bank that aligns with your values.

If you’re concerned about environmental impact, for example, you could look for a bank that lends to environmental initiatives. One way to find an environmentally friendly bank is to look for B-Corp or GABV certifications, which both require that a bank meets certain standards to reduce negative environmental impact.

How much do banks need in cash reserves?

The Federal Reserve eliminated all cash reserve requirements in 2020.

When a bank doesn’t have enough cash to meet demand

Since banks lend out most of their deposits, the whole balance you see on your account isn’t physically there. However, there are instances when depositors withdraw their money en masse and a bank does not have enough in its reserve to pay its customers. This effect is referred to as a bank run. That’s also what leads to banks’ failures. Typically, when a bank’s reserve fails to meet customer demand, regulators close the bank down and the FDIC takes over its assets.

FAQs

What is the main source of income for banks?

Interest earned on loans is typically one of the primary sources of income for banks. They lend money to individuals and businesses at higher interest rates than they pay to depositors. Banks also make money off of fees, including monthly maintenance, out-of-network ATM and overdraft fees. 

How do banks make money if the economy is tanking?

Banks can still make money from existing loans and fee-based services.

Is your money safe in a bank during a depression?

Even during a depression or recession, funds deposited at FDIC-insured banks are covered up to the maximum allowed by law: $250,000 per depositor, per institution, per account type.