Question

How do banks create money? Show the steps that go from some new cash to many more deposits. What limits the ability of the bank money creation process?

Answer 1

Banks offer numerous “free” services like savings accounts and free checking. In fact, they may even pay you for leaving money in the bank, and you can also boost your earnings by using certificates of deposit (CD) and money market accounts. Unless you work with an online bank, most banks and credit unions also have physical locations staffed by employees. They also run call centers with extended customer service hours.

How do they pay for all of those services? Banks earn revenue from investments (or borrowing and lending), account fees, and additional financial services. Whenever you give money to a financial institution, it’s essential to understand a firm’s business model and exactly how much they charge. But it’s not always clear how banks get paid. There are several ways for banks to earn revenue, including investing your money and charging fees to customers.

The Spread

The traditional way for banks to earn profits is by borrowing and lending. Banks take deposits from customers (essentially borrowing that money from account holders), and they lend it out to other customers. The mechanics are a bit more complicated, but that’s a general idea.

Pay Less, Earn More: Banks pay interest at low rates to depositors who keep money in savings accounts, CDs, and money market accounts. They usually pay nothing at all on balances in checking accounts. At the same time, the bank charges relatively high-interest rates to customers who take out home loans, auto loans, student loans, business loans, or personal loans.

The difference between the low rate that banks payout and the high rate that they earn is known as “the spread,” sometimes called the bank’s margin.

For example, a bank pays a 1% annual percentage rate (APY) on cash in savings accounts. Customers who get auto loans to buy new cars pay 6.27% APR, on average.1 That means the bank earns at least 5% on those funds, and potentially much more than that. They’ll earn even more with credit cards. According to the Federal Reserve, the average annual percentage rates (APR) on credit cards is 16.88%.2

Investments: When banks lend your money to other customers, the bank essentially “invests” those funds. But banks don’t just invest by disbursing loans to their customer base. Some banks invest extensively in different types of assets. Some of those investments are simple and secure, but others are complicated and risky.

Regulations limit how much banks can gamble with your money, especially if your account is FDIC insured. However, those regulations tend to change over time. Banks are still able to boost their income by taking more risks with your money. Besides investing money, banks also charge customers fees to boost their profits.

Accountholder Fees

As a consumer, you’re probably familiar with bank fees that hit your checking, savings, and other accounts. Those charges are getting easier to dodge, but fees still make a significant contribution to a bank's earnings.

For example, Bank of America’s Advantage Plus checking account charges a $12 monthly maintenance fee.3 Over the course of a year, those fees will cost you $144. However, you may be able to waive monthly maintenance fees by maintaining a certain balance or setting up direct deposit.

Banks also charge fees for certain types of actions and “mistakes” you make in your account. If you enrolled in overdraft protection, it’ll cost you $30 or so every time you overdraw your account.4 Worse, you can still pay those fees even if you opted out). Did you bounce a check? That’ll cost you, too. There’s a long list of fees or charges that come as a result of account activity, including (but not limited to):

• ATM fees (including fees that your bank charges, as well as fees from the bank that owns the ATM)
• Lost or stolen card replacement (and extra charges for rush delivery)
• Early withdrawal from a CD
• Prepayment penalties on loans
• Late payment penalties on loans
• Inactivity Fees
• Fees for paper statements
• Fees for talking with a teller if you have an inexpensive online account
• Stop payment requests

Service Fees

In addition to earning revenue from borrowing and lending, banks offer optional services.

You might not pay for any of these, but plenty of bank customers (individuals, businesses, and other organizations) do.

Things are different at every bank, but some of the most common services include:

Credit Cards: You already know that banks charge interest on your loan balances, and banks may charge annual fees to card users. They also earn interchange revenue or "swipe fees" every time you use your card to make a purchase. By contrast, debit card transactions bring in much less revenue than credit cards. That issue is why merchants would prefer you pay with cash or a debit card, and some stores even pass those fees on to customers in the form of credit card surcharges.

Checks and Money Orders: Banks print cashier’s checks for significant transactions, and many also offer money orders for smaller items. Fees for those instruments are often around $5 to $10. You can even re-order personal and business checks from your bank, but it’s usually less expensive to replenish online with a check printing company.

Wealth Management: In addition to standard bank accounts, some institutions offer products and services through financial advisors. Commissions and fees, including assets under management fees, from those activities, supplement bank profits.

Payment Processing: Banks often handle payments for large and small businesses that want to accept credit cards and ACH payments from customers. Monthly and per-transaction fees are common.

Positive Pay: If you worry about thieves printing fake checks with your business account information, you can have the bank monitor all outgoing payments before they’re authorized. But of course, there’s a fee for that.

Loan Fees: Depending on your bank and the type of loan, you might pay an application fee, an origination fee of 1%or so, discount points, or other fees to get a mortgage. Those fees are in addition to the interest you pay on your loan balance.