It is pretty convenient for all of us that banks are willing to lend us money. Maybe you have a mortgage, a car loan, a student loan, or have received some other type of lending from a bank. Have you ever wondered where banks get the money they lend?
First, let’s consider what a bank does. Wikipedia offers a good, concise description of the function of banks: “A bank connects customers with capital deficits to customers with capital surpluses.” [Source: Banking – Wikipedia. Downloaded October 20, 2010 from http://en.wikipedia.org/wiki/Banking] Of course, there is more than one way for banks to capture funds from customers with capital surpluses.
The primary sources of lendable funds for banks are: (1) Checkable deposits (i.e., bank accounts on which holders can write checks), (2) Non-transaction deposits (i.e., CDs and other deposit instruments on which people cannot write checks), and (3) Borrowings (yes, banks borrow, too). Each of these sources represents a liability on a bank’s balance sheet. [Source: Mishkin, Frederic S. Economics of Money Banking & Financial Markets. Boston: Addison-Wesley, 2004. Pages 220-221]. Banks can also liquidate their assets to raise fund (e.g., by selling securities that they hold).
So, when you deposit your paycheck in a checking account at First Bank of Wherever, you are providing funds that will eventually be loaned out to others. Similarly, if you decide to put your money into higher-interest-rate accounts like CD’s, you are once again funding your bank’s lending.
Inevitably, though, your bank does not always have enough deposits to meet their desired lending level. When the bank needs extra money, it simply borrows from other banks.
Raising money sounds like a big hassle for banks, right? So why do they do it? Primarily because they make a profit on the difference between their cost of money (e.g., the pittance they pay you as interest on your checking account) and their income from lending (e.g., the hefty interest rate they charge on a mortgage).
Banking – Wikipedia. Downloaded October 20, 2010 from http://en.wikipedia.org/wiki/Banking
Mishkin, Frederic S. Economics of Money Banking & Financial Markets. Boston: Addison-Wesley, 2004. Pages 220-221.