What do banks really do, and how do they make money?

Let’s understand what a bank is, and how it makes money. Asha works in an office and saves 20% of her income every month. This income will not give her any returns sitting in her house. So, she gives it to the bank. The bank promises to pay her 4% interest per year.

Bijoy runs a business and needs some money to make the business grow. So, he comes to the bank and asks for a loan. The bank says, “Sure. But you will have to give me 12% interest per year. And to make sure that you do return my money, I will keep something of yours that is worth more than this. That will give me security that you will not run away with the money.” Bijoy agrees. The bank gives the loan.

If you notice, the bank is only paying Asha 4% for her money but is making 12% on it. The extra 8% is the earning of the bank. In short, a bank is a trader in money.

Why do banks fail?

Let’s suppose there is a third person, Cal, who runs a business. He does not have any security to give to the bank. But he needs the money. He comes to the bank and says, “Look, I don’t really have a security, but I will pay you 18% for that money.”

Now, the bank can make 14% on the same money. But it has to take the risk that Cal may not return the money. What should the bank do?