What do banks do with my money?

1st Jan 2015 Managing your Money

Have you ever wondered what banks do with your money, and how they work behind the scenes? Here's the lowdown on exactly what goes behind your bank's closed doors.

The way banks work

To make money, banks need to sell profitable products and retain or grow their market share. Here’s how banking works:

Banks sell financial products to customers. These might be mortgages, loans, savings accounts and credit cards.
In order to make a profit, your bank needs to loan out money at a higher rate than it pays on the savings accounts it offers.
So for example, it might charge an interest rate of 4% on its mortgages to homebuyers, and pay 1% interest on its savings account. The difference between the two rates—3%—is its profit.

How do banks stop everyone withdrawing their money at once?

There is a possibility that all the savers might want to withdraw their money at the same time, in which case the bank would have to ask the mortgage borrowers to pay back their money straight away.

In this case, the bank might potentially go bust, so in order to avoid this scenario, banks offer higher interest rates to savers who are willing to put their money into savings account with a notice period.

If savers want to get their money back they have to give notice before they can withdraw it.

Protecting for savers

The 1946 film It's a Wonderful Life features a famous bank run scene

In extreme cases, the government can step in to ensure that the whole banking system doesn’t collapse. For example, in 2007 it looked as though Northern Rock might become a casualty of the worldwide banking crisis.

Despite reassurance from management and the government, customers began to besiege the bank, demanding to withdraw their savings. Those that had instant-access accounts were entitled to do so.

Things became so serious—with long queues forming outside high street bank branches—that the government stepped in and guaranteed that it would protect any money held with Northern Rock. This was successful in calming savers’ nerves.

When savers all try to withdraw money at once this is known as “a run on the bank”. This can quickly become very serious and affect other banks as well.

How banks set interest rates

Banks can also vary the rates they offer to customers in order to increase demand for their products, either because they have some cheap money they want to loan out, or because they want to undercut competitors and increase their market share.

In this case, they might offer a mortgage loan at less than the rate advertised by their competitors.

Banks lend between one another (known as the interbank market) and the rate at which they can borrow money on the wholesale market also affects the interest rates that they can offer customers.

Cross-selling

Once you become a customer of a retail (high street) bank or building society, you might buy another product from them, perhaps a loan, credit card or business account.

It is cheaper and easier for banks to sell products to existing customers. This practice is known as cross-selling.

Also, banks know more about your financial circumstances so they can tailor the deals that they offer you based on the financial information they already hold about you.

Extra charges

Banks make money from current accounts by charging monthly or annual fees, overdraft charges and/or charges for transactions on business accounts.

If you take out a credit card, you might be charged an annual fee for the privilege, and the bank will also make money from charging you interest on the balance of your card if you don’t clear it every month at a specified date.

For this reason, it’s important to read the small print and terms and conditions in any financial product you take out.

Individual pricing

Banks and credit card providers are allowed to offer different rates to different customers depending on how risky they think that customer might be. So if you have a good record of managing your money, and haven’t defaulted on any previous loans, then you might be offered a more competitive deal than if you had no credit history or had failed to pay a previous credit card bill.

This particularly applies to the rate you are offered on your mortgage, credit card, or personal loan. It doesn’t apply to savings rates.

More competitive savings rates tend to be offered to customers who invest their money online (as it’s cheaper for the bank to administer). Banks also tend to offer incentives to customers who are prepared to tie their money up for a year or more (known as notice accounts or bonds).

Find out more key essentials on how banking works with Modern Money Mechanics: A Workbook On Bank Reserves And Deposit Expansion, available on Amazon.

Feature image via Bank of England

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