What a bank does, and how your money moves through it

A bank is a licensed business that takes your money, lends most of it out to other people, and keeps a portion in reserve. When you deposit a paycheck, the bank doesn't lock it in a vault with your name on it. Instead, that money enters a pool. The bank lends it to someone buying a house, someone starting a business, or someone paying off a credit card. You get paid interest on your deposit. The borrower pays interest on the loan. The bank keeps the difference.

The bank's job is to move money between people safely and on schedule. When you write a check or use your debit card, you're asking the bank to move money from your account to someone else's. When your employer deposits your paycheck, money is moving from their bank account to yours. The bank handles the routing, the timing, and the record-keeping. It also holds the license that lets it do this legally—a license that comes with rules about how much money it must keep on hand, who it can lend to, and how it reports what it does.

Key Takeaways

  • Banks lend out most of the money you deposit and pay you interest in return, which is how they fund their operations and pay you for holding your money there.
  • When you make a transaction, the bank routes the payment through clearing systems that can take one to three business days to settle, even though you see the debit when ready.
  • The Federal Reserve sets the interest rate banks charge each other overnight, which affects the rates banks offer you on savings and charge you on loans.
  • Banks are insured by the FDIC up to $250,000 per account type per institution, which protects your money if the bank fails.
  • A bank's profit comes from the difference between what it pays you on deposits and what it charges borrowers on loans, plus fees for services like overdrafts and wire transfers.

How money enters and leaves your account

When you deposit a check or transfer money in, the bank credits your account when ready—you see the balance go up right away. But the money hasn't actually arrived yet. The bank is extending you a short-term loan of that amount, betting that the check will clear. If it doesn't, the bank reverses the deposit and charges you a fee.

The actual movement happens through clearing systems. A check you deposit goes to a Federal Reserve processing center or a private clearing house. That center sends it to the bank that issued the check. That bank verifies the account has enough money, then moves the funds. The whole process takes one to three business days. During that time, the money is in transit—it's not in your account yet, even though you can see it there.

When you spend money with a debit card, the merchant's bank sends a request to your bank asking if the money is there. Your bank says yes or no in seconds. If yes, your account shows the debit when ready. But the money doesn't actually move to the merchant's bank for one to two business days. That delay is why a transaction can show as pending, then post later.

The Federal Reserve and interest rates

The Federal Reserve is the central bank of the United States. It doesn't take deposits from regular people—it works with banks. Every night, banks lend money to each other to cover their reserve requirements. The Federal Reserve sets the interest rate for these overnight loans, called the federal funds rate. This rate ripples through the entire banking system.

When the Federal Reserve raises the federal funds rate, banks pay more to borrow from each other overnight. They pass that cost to you by raising the interest rate on credit cards, home loans, and auto loans. They also raise the interest they pay you on savings accounts and money market accounts, but usually by a smaller amount. When the Federal Reserve lowers the rate, the opposite happens—borrowing becomes cheaper, and banks lower the rates they charge you, but savings rates often fall faster than loan rates rise.

The federal funds rate is not the same as the prime rate, though they move together. The prime rate is what banks charge their most creditworthy customers. Banks charge everyone else a percentage above the prime rate, depending on credit risk.

How banks make money and stay solvent

A bank's main income comes from the spread—the difference between what it pays depositors and what it charges borrowers. If a bank pays you 0.5% on a savings account and charges a borrower 6% on a personal loan, the spread is 5.5%. The bank uses that spread to pay employees, rent office space, and build capital reserves.

Banks also charge fees: overdraft fees when you spend more than you have, wire transfer fees, ATM fees if you use another bank's machine, monthly maintenance fees, and fees for stopping payment on a check. These fees are a secondary income stream. Some banks waive them if you maintain a minimum balance or set up direct deposit.

Banks must keep a portion of deposits on hand as a reserve—money they cannot lend out. The Federal Reserve sets the reserve requirement, which varies by account type and bank size. This requirement ensures a bank can handle withdrawals even if many customers ask for their money at once. The bank earns no interest on reserves, so reserves are a cost of doing business.

FDIC insurance and what happens if a bank fails

The Federal Deposit Insurance Corporation (FDIC) insures deposits at member banks. If a bank fails, the FDIC pays depositors up to $250,000 per account type per institution. Account types include individual accounts, joint accounts, retirement accounts, and trust accounts. If you have $300,000 in an individual checking account at one bank, the FDIC covers $250,000. The remaining $100,000 is uninsured.

If you have $250,000 in a checking account and $250,000 in a savings account at the same bank, both are fully insured because they are different account types. If you have $250,000 in a checking account and $250,000 in a money market account at the same bank, only one is fully insured—the FDIC treats money market accounts as savings accounts for insurance purposes.

Bank failures are rare. The last major wave was during the 2008 financial crisis. The FDIC has a fund built from fees banks pay. When a bank fails, the FDIC either arranges for another bank to buy it or pays out depositors directly. The payout usually takes a few days.

How banks handle different types of accounts

A checking account is designed for frequent transactions. The bank expects you to deposit and withdraw regularly. Most checking accounts pay little to no interest. A savings account is designed for money you're not spending when ready. Banks pay interest on savings accounts, though the rate varies. A money market account is a hybrid—it pays higher interest than savings but requires a larger minimum balance and limits how often you can withdraw.

A certificate of deposit (CD) is an agreement where you give the bank a sum of money for a fixed period—three months, one year, five years. In return, the bank pays a higher interest rate than a savings account. If you withdraw before the term ends, you pay a penalty, usually a few months of interest. CDs are insured by the FDIC just like savings accounts.

A money market fund is different from a money market account. A money market fund is an investment product, not a bank deposit. It is not FDIC-insured. It invests in short-term debt issued by governments and corporations. The value can fluctuate, though usually by small amounts.

How banks clear payments between institutions

When you send money to someone at a different bank, the payment goes through a clearing system. The most common systems are the Automated Clearing House (ACH), which handles direct deposits and bill payments; the Federal Reserve wire system, which handles large transfers; and the check clearing system, which processes paper checks.

ACH transfers take one to three business days. Your bank sends a batch of transfers to the Federal Reserve or a private ACH operator at the end of the business day. The operator sorts them by destination bank and sends them out. The receiving bank processes them the next morning and credits the recipient's account. If you initiate an ACH transfer on a Friday evening, it won't arrive until Monday or Tuesday.

Wire transfers are faster but more expensive. Your bank sends the money directly to the receiving bank using the Federal Reserve wire system or a private network like SWIFT. The transfer usually completes the same business day, sometimes within hours. Wire transfers are irreversible once sent, which is why banks charge more for them and why they're used for large or time-sensitive payments.

How banks manage risk and comply with regulations

Banks are heavily regulated. The Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the FDIC all oversee different aspects of banking. Banks must report their financial condition regularly, undergo audits, and maintain capital ratios that show they have enough money to absorb losses.

Banks also manage credit risk—the risk that a borrower won't repay a loan. They do this by checking credit scores, requiring collateral, and diversifying their loan portfolio so they're not exposed to one industry or geography. They manage interest rate risk by matching the length of their deposits to the length of their loans. They manage liquidity risk by keeping enough cash on hand to meet withdrawals.

Banks also comply with anti-money-laundering rules. They report large cash deposits, monitor for suspicious activity, and verify the identity of account holders. These rules exist to prevent criminals from using banks to hide the source of illegal money.

Frequently Asked Questions

Why does my bank show a transaction as pending for days?

Pending means the merchant has requested the money but it hasn't actually moved yet. Your bank deducts it from your available balance when ready to prevent overdrafts, but the actual transfer between banks takes one to two business days. Once it posts, the transaction is complete and the money has arrived at the merchant's bank.

Can a bank lose my money if it invests it poorly?

Your deposits are insured by the FDIC up to $250,000 per account type, so you're protected if the bank fails. However, if you invest money through the bank in stocks or mutual funds, those investments are not FDIC-insured and can lose value. The bank's poor investment decisions don't affect your insured deposits.

Why do banks charge overdraft fees if I only go over by a few dollars?

Overdraft fees are a revenue source for banks, and they're charged per transaction that exceeds your balance. If you overdraft by $5 on three separate transactions, you pay three overdraft fees. You can opt out of overdraft coverage so transactions are declined instead, though some banks charge a fee for this service too.

How does a bank decide what interest rate to offer me?

Banks set deposit rates based on the federal funds rate, competition from other banks in your area, and how much they need deposits. Savings rates are typically lower than loan rates because banks profit from the spread. Your credit score doesn't affect deposit rates, but it does affect loan rates—borrowers with higher scores get lower rates.

What's the difference between a bank and a credit union?

A credit union is a member-owned cooperative, not a for-profit business. Members are usually employees of a specific company or residents of a specific area. Credit unions typically offer lower loan rates and higher savings rates than banks because they return profits to members instead of shareholders. Deposits at credit unions are insured by the National Credit Union Administration (NCUA), not the FDIC, but the coverage is the same: $250,000 per account type.