Ever wonder what happens to your money when you put it in the bank? How do they pay you interest on your savings account? I'm about to reveal all the answers and I bet you will be shocked about what happens to your money and your loans with banks after the deal is done.
First, it's important to understand the history of how banks came into being. Of course they haven't been around from the beginning of time but they were born out of necessity like everything else. Societies eventually discovered that trading goods and services wasn't efficient and starting using currency as a common medium of exchange. In early civilizations, most currency was gold and silver based. After some time, people started looking for safe places to securely store their gold and silver. At first goldsmith's and other similar shops did this for a small storage fee. They would hand them a note in exchange that people started trading with others. Eventually this practice evolved into banking and actual banks being formed using paper currency like we do today.
After more time of adjusting to this new service model, banks eventually came together to form the fractional reserve system. This system allows banks to make loans on a fraction of their deposits, meaning the sum of all the checking, savings and CD accounts plus all other assets they have on their books. The current standard is about 12 to 1 but many banks go way above this. In this scenario, if a bank had one million dollars in deposits, they could make twelve million dollars worth of loans. At some point, they're considered insolvent when the ratio becomes too high to manage the risk. This is what occurred with many of them in 2008 when many banks went under. Also when customers withdraw money from a bank in mass and cause a bank run, this impacts the ratio and illustrates why bank runs are so dangerous.
Over the past couple decades banks have invented yet another tool for making money, derivatives. There are all sorts of derivatives in the marketplace that you can trade but some of the favorites of bankers have to do with mortgages, other loans and interest rates. The infamous CMBS are one example. They basically group a whole bundle of loans that they made together in a package and sell them like a bond to another buyer and pocket the difference. They also make many other bets using your money but that is the subject of another article.
To sum it up, this is basically what happens if you deposit $1,000 in your checking account. The bank makes $12,000 or more worth of loans off of your money. They make 4-5% in interest on this loan and either pay you no interest or 1%. They then sell the loan they made with your money to another buyer for another premium, say 1-2%. These numbers are made up and for illustration only but you get the point. Next time you visit your banker you can now say "I know what you're doing with my money".
Jamie has an MBA from Rutgers University and a Professional Certificate in Real Estate Finance, Investment and Development from NYU. He's traded stocks since he was 13 and bought his first property within a year of graduating college. He also flipped properties and got out before the 2008 mortgage meltdown because he was able to see the market turning before it happened. He's started two companies and also has experience in investing in antiques, collectibles, gold, silver and trading futures.