Banks take deposits, lend them out, and keep the difference

A bank's core job is straightforward: it collects money from people who have it, lends that money to people who need it, and makes profit on the gap between what it pays depositors and what it charges borrowers. When you put $1,000 in a checking account, the bank doesn't lock it in a vault with your name on it. It uses that money—along with thousands of other deposits—to fund mortgages, car loans, business lines of credit, and other lending products. You get a small interest rate (or none at all on checking). The borrower pays a much higher rate. The bank keeps the difference.

This model only works if the bank can count on deposits staying relatively stable. If everyone tried to withdraw their money at once, most banks would fail because the cash isn't sitting there—it's already been lent out. That's why the Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 per account holder per bank. The insurance doesn't come from the bank; it comes from a fund backed by the federal government. It exists to prevent bank runs and the panic that follows when people lose confidence in the system.

Key Takeaways

  • Banks lend out the money you deposit, which is why they can afford to pay you interest and why they fail if too many people withdraw at once.
  • The FDIC insures deposits up to $250,000 per account holder per bank, protecting you if the bank becomes insolvent.
  • Banks make money from the difference between what they pay depositors and what they charge borrowers, plus fees for services like overdrafts and wire transfers.
  • Banks are required to hold a portion of deposits in reserve and follow strict capital rules set by federal regulators to prevent reckless lending.
  • When a bank fails, the FDIC steps in, pays insured depositors, and either sells the bank to another institution or liquidates its assets.

How banks make money beyond interest spreads

Interest on loans is the largest source of bank revenue, but it's not the only one. Banks charge overdraft fees when you spend more than your balance—typically $25 to $35 per transaction. They charge monthly maintenance fees on certain account types, wire transfer fees (usually $15 to $30), ATM fees if you use another bank's machine, and late payment fees on credit cards and loans. Some banks charge fees to close accounts early or to speak with a human being instead of using their app.

These fees add up. A person who overdrafts twice a month and pays $30 each time is giving the bank $720 a year for a mistake. Multiply that across millions of customers, and fee income becomes a significant part of the bank's bottom line. Some banks, particularly online banks with lower overhead, charge fewer or no fees because they make enough from lending. Others rely heavily on fees because their lending margins are tighter.

What regulators require banks to do

Banks cannot straightforward lend out every dollar they take in. Federal regulators—primarily the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the FDIC—set rules about how much capital a bank must hold in reserve and how much risk it can take on.

Banks must maintain a capital ratio, which is the amount of shareholder equity divided by total assets. The exact requirement varies by bank size and type, but large banks typically must hold at least 10.5% of their assets as capital. This acts as a cushion: if loans go bad and the bank loses money, the capital absorbs the loss before depositors are affected. Regulators also limit how much a bank can lend to a single borrower, require stress tests to show the bank can survive a recession, and mandate that banks disclose their financial health quarterly.

These rules exist because bank failures have real consequences. When a bank fails, the FDIC takes over, pays insured depositors from its insurance fund, and either sells the bank to another institution or liquidates its assets to recover what it can. Uninsured deposits—anything over $250,000 per account holder—may recover only a fraction of what was deposited, and recovery can take months or years.

The difference between commercial and investment banking

A commercial bank is what most people think of when they picture a bank: it takes deposits, makes loans to individuals and small businesses, and offers checking and savings accounts. An investment bank helps large companies and governments raise money by issuing stocks and bonds, advises on mergers and acquisitions, and trades securities on its own account.

For decades, the same institution could do both. The 2008 financial crisis changed that perception. Banks that were also investment banks took enormous risks with borrowed money, made bad bets on mortgage-backed securities, and nearly collapsed the entire financial system. The Dodd-Frank Act (2010) imposed stricter rules on large banks and required them to separate some risky trading activities from their core deposit-taking business. The rules are complex and debated, but the basic idea is that banks holding your deposits shouldn't be allowed to gamble with them in the same way an investment firm can.

What happens when a bank fails

Bank failures are rare in the modern era because of regulation and insurance, but they do happen. When a bank becomes insolvent—meaning its liabilities exceed its assets—the FDIC is notified, usually by the bank's primary regulator. The FDIC then takes control of the bank, typically on a Friday after markets close.

Over the weekend, the FDIC works to find another bank willing to buy the failed bank's deposits and assets. If a buyer is found, depositors wake up Monday morning to find their accounts transferred to the new bank, their debit cards still work, and their insured deposits are protected. If no buyer emerges, the FDIC pays insured depositors directly from its insurance fund, usually within a few days. Uninsured depositors become creditors in the liquidation process and may recover some or all of their money, but only after the bank's assets are sold and the proceeds are distributed according to bankruptcy law.

The FDIC maintains a list of failed banks on its website. Between 2008 and 2012, 488 banks failed in the United States. Since then, failures have been rare—typically fewer than five per year—until 2023, when Silicon Valley Bank, Signature Bank, and First Republic Bank failed in quick succession, shaking confidence in the system temporarily.

How banks decide who gets a loan

Banks use credit scores, debt-to-income ratios, employment history, and collateral to decide whether to lend and at what rate. A credit score, typically ranging from 300 to 850, is a number that summarizes your history of borrowing and repaying. It's calculated by credit bureaus—Equifax, Experian, and TransUnion—based on payment history, amounts owed, length of credit history, new credit inquiries, and credit mix.

A higher score means lower risk to the bank, so you get a lower interest rate. A lower score means higher risk, so you either pay a higher rate or are denied altogether. For a mortgage, most banks want a score of at least 620, though 740 or higher gets the best rates. For a credit card, 670 or higher is typical. For a car loan, banks are often more flexible because the car itself serves as collateral—if you don't pay, the bank repossesses it and sells it to recover the loan.

Banks also look at your debt-to-income ratio: the total of your monthly debt payments divided by your gross monthly income. Most banks want this to be below 43% for a mortgage, meaning if you earn $5,000 a month, your total debt payments shouldn't exceed $2,150. This rule exists because people with high debt loads relative to income are more likely to default.

The role of the Federal Reserve

The Federal Reserve is the central bank of the United States. It's not a commercial bank—you can't open an account there—but it acts as a bank for banks. The Fed sets interest rate policy, which influences how much banks charge borrowers and how much they pay depositors. When the Fed raises its benchmark rate, banks raise their prime lending rate, and credit cards, adjustable-rate mortgages, and home equity lines of credit all become more expensive. When the Fed lowers rates, borrowing becomes cheaper.

The Fed also acts as a lender of last resort. If a bank runs short on cash but is otherwise solvent, it can borrow from the Fed's discount window at a rate set by the Fed. This prevents temporary liquidity problems from turning into bank failures. The Fed also regulates large banks, conducts stress tests, and sets capital requirements. During the 2008 crisis and again during the COVID-19 pandemic, the Fed lent trillions of dollars to banks and other financial institutions to prevent a complete collapse.

Frequently Asked Questions

Is my money safe in a bank?

Deposits up to $250,000 per account holder per bank are insured by the FDIC, so they're protected even if the bank fails. Amounts over $250,000 are not insured and may be lost if the bank becomes insolvent. If you have more than $250,000, you can spread it across multiple banks or use account ownership categories (like joint accounts or retirement accounts) to increase your coverage.

Why do banks charge overdraft fees?

Banks say overdraft fees cover the cost of processing a transaction that exceeds your balance and the risk that the transaction will fail. Critics argue the fees are disproportionately high and that banks deliberately process transactions in an order that maximizes overdrafts. Some banks now offer overdraft protection, which links your checking account to a savings account or credit line so transactions don't bounce.

Can a bank take my money if I owe a debt?

Yes, through a process called garnishment or levy. If you owe a debt and a creditor wins a judgment against you in court, the creditor can ask the court to order your bank to freeze your account and send the funds to the creditor. The bank must comply with a valid court order. Some funds, like Social Security deposits, are protected from garnishment in most cases.

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

A bank is a for-profit business owned by shareholders. A credit union is a nonprofit cooperative owned by its members. Credit unions typically offer lower fees and better rates on savings, but they may have stricter membership requirements and fewer branches. Both are insured by the FDIC or the National Credit Union Administration (NCUA) up to $250,000 per account holder.

Why do banks need so much capital?

Capital acts as a cushion against losses. If a bank makes bad loans and borrowers default, the bank loses money. Capital absorbs those losses before depositors are affected. Regulators require banks to hold capital because a bank with no cushion can fail quickly, and a bank failure can spread panic to other banks. The 2008 crisis showed what happens when banks don't hold enough capital relative to the risks they take.