How do banks make money and what do they do with yours? - Times Money Mentor (2024)

As King Charles becomes the new face on our cash, we explore what is the nature of money is in 2023 and what banks actually do with yours.

The designs of new coins and banknotes featuring King Charles III have been released and, from the middle of next year, will finally come into circulation. But while there will undoubtedly be a huge fanfare, fewer of us will be using them on a regular basis.

According to UK Finance, 21.6 million of us now live a largely cashless life. By 2032, the banking body reckons cash will account for just 7% of all transactions. For many of us, money is much less about the paper and metal in our wallets than 1s and 0s on a screen.

Banks are increasingly moving online too, indeed some have no physical branches at all. So how has the nature of money and banking changed in the digital age and what do banks actually do with the deposits in our accounts?

In this article, we cover:

• What is money?
• What is a bank?
• How do banks make money?
• What do banks do with my money?
• Is my money safe in the bank?

Read more: How much of your savings are safe in the bank?

*This article contains affiliate links that can earn us revenue

What is money?

When we think of money, we naturally think of the cash in our wallets. But money isn’t just about notes and coins.

Money, according to economists at the Bank ofEngland, is a “store of value”. It also needs to be a “unit of account” and a way of exchanging one thing for another – whether that’s £5 for a pint of beer or four chickens for a cow.

Money, whatever form it takes, is both a symbol and a measure of wealth.

What is the nature of money in the modern economy?

It’s easy to understand our money as an IOU – whether that is the £3 you exchange for a coffee or the £300 a month you pay for a car on finance. Economists refer to this as “broad money” and it relates to currency (coins and notes) and bank deposits.

Only about 3% of all money is actually made up of physical cash. When you borrow from the bank, new money is created and is credited to your account. It is this less tangible cash that makes up the bulk of bank deposits.

Money also goes beyond general consumer spending. You might hear economists talk about base money (or central bank or reserve money), which is the total wealth of central banks.

What are central banks?

Central banks are institutions that manage the currency and money supply of a specific country or region, for example, the Bank of England in the UK and the Federal Reserve (Fed) in the United States.

They also control the cost of money by setting interest rates and can create money digitally – rather than borrowing money or raiding government coffers – in order to stimulate the economy. This process is known as quantitative easing, which our own Bank of England did in the aftermath of the financial crisis.

What is a bank?

Banks are essentially depositories or stores for money. But commercial banks that most of us deal with are also businesses that exist to make a profit for their shareholders

These banks provide us with a safe place to keep our money and help facilitate payments for various goods and services with debit cards, direct debits and bank transfers.

But with all that money knocking around, banks are ideally primed to lend money too, whether that’s with credit cards, personal loans or mortgages.

Retail banks are different from investment banks, which provide financial services to institutional investors, larger corporations and even governments.

An investment bank, for example, might assist a company with an initial public offering (IPO) on the stock exchange or be involved in merger and acquisition activity.

Read more: Best current accounts

What are building societies and credit unions?

Of course, similar day-to-day banking services can also be provided by building societies, and, to a lesser extent, credit unions. The way that both are run is fundamentally different from commercial banks.

• Building societies: The key difference between a bank and a building society is that a bank aims to make profit for shareholders, while a building society exists solely to provide financial services to its members. Effectively, they are owned and work for the people depositing money with them. Building societies range from small institutions, with only a handful of local branches, to much bigger nationwide operations.
• Credit unions: These are financial co-operatives that focus on offering accessible savings accounts and affordable loans, often to people that might otherwise struggle to access banking services. Like building societies, they are not profit making and often serve people working in a specific field or living in a particular area.

Read more: Best basic bank accounts

How do banks make money?

The main way that banks make money is by charging people or businesses to borrow from them.

Banks have access to vast swathes of deposits that they can lend to others for a fee. The difference between the interest they need to pay on deposits and the interest they earn on lending is known as “net interest income”.

This explains why banks will generally pay a higher rate of interest to savers who commit to saving over the long term than they will to savers that want instant access to their cash.

But banks also make money by charging their customers fees in certain circ*mstances. This can range from overdraft charges and the sale of additional products to foreign currency exchange, as well as charging customers for fancier, premium current accounts.

Why do some banks charge for current accounts?

Most everyday banking services in the UK are provided free of charge. However, in an attempt to diversify their proposition – and make a bit more money – some banks will charge a monthly fee for certain current accounts.

These are normally “premium” or packaged accounts with added bells and whistles such as breakdown cover and travel insurance or preferential rates on loans or savings accounts.

Read more: How to switch current accounts

Why do some banks offer switching bonuses?

Even though most banks and building societies offer free banking services, the money-making potential from deposits is such that many are willing to incentivise you to switch your current account to them.

Nationwide, for example, will pay £200 to win your business at the time of writing, while Lloyds* and First Direct* pay £175. While it may seem a lot of money to us for doing nothing but switching your account, for the banks it is financially worth it.

We have a round up of the best bank account switching bonuses.

What do banks do with my money?

Banks aren’t a muggle version of Gringotts bank in the Harry Potter books, storing all our riches in underground vaults guarded by dragons.

Only a small portion of the money that you deposit at your bank is actually held as cash at the bank.

Money you pay into the bank will, in most cases, be used to finance your bank’s lending operations.

Although retail banks are required by regulators to keep a certain amount of your deposits in reserve, they can invest the majority. This is likely to be in the form ofloans to both individuals and businesses.

What can I do if I am not happy with how my bank uses my money?

Banks are big businesses that exist to make a profit. So if you aren’t happy with the way your bank operates there are alternatives.

Switching to a building society is one option. They work under different rules and cannot raise more than 50% of the money they lend from wholesale markets – the rest must come from money their own customers have deposited with them.

Alternatively you can consider an “ethical bank” such as Triodos Bank. It will only invest its money in forces for good, such as renewable energy, social housing, education and charities. It avoids financing less ethical areas such as companies involved with deforestation, fast fashion, weapons or tobacco.

Another example is the Charity Bank that lends to charitable organisations.

Look for the Good Egg logo, awarded to financial services providers that meet certain ethical standards.

Why do some banks fail?

If banks can simply create money from nothing, how can they fail?

Historically we always thought of banks as being pretty solid institutions. But the financial crisis showed what can happen when banks create money that doesn’t physically exist.

In 2008, the UK government was forced to nationalise Northern Rock after there was a run on the bank. Customers queued up outside branches to empty their accounts.

The bank had ambitious mortgage lending targets and relied on borrowing money on wholesale markets to finance its operations. Effectively, it was borrowing money from others to lend it out to customers – and making money on the gap between the interest on the two loans.

That meant it could rapidly expand its business as long as people were willing to keep lending it money. But that strategy backfired in the wake of the credit crunch, when it could no longer access the financial markets for cash to refinance its short-term debts. The bank literally ran out of money.

Sadly, it was far from alone in finding itself vulnerable when access to easy cash ran out, with banks across the world failing or being forced to merge to survive.

There were other reasons that contributed to the collapse of Northern Rock. Nonetheless, it highlights the problems that banks can encounter when they lend more money than they have.

Read more: What are the chances of your bank collapsing?

Is my money safe in the bank?

Unsurprisingly, there was a lot of nervousness around the safety of banks after the financial crisis. However, there are now more protections for account holders.

The Financial Services Compensation Scheme, for example, guarantees deposits up to £85,000 per person, per bank. This means that so long as you don’t keep more than this amount in one bank, your money is protected in the event of a collapse.

Controls on banks have been tightened up too, so that bank failures would be managed in a much more orderly way. Costs would fall to shareholders and creditors, rather than the taxpayer.

Read more: How much of your savings are protected in the bank?

*This article contains affiliate links that can earn us revenue.

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