1273537,Gunbir Singh Saini,F1,Q22- How do banks create money?

Banks

A bank is a financial institution that accepts deposits and channels those deposits into lending activities, either directly by loaning or indirectly through capital markets. A bank links together customers that have capital deficits and customers with capital surpluses.

How do banks create money?

Banks are businesses, they need to make money and they do this by lending money at a higher rate of interest than they borrow it. This money is borrowed from other banks or from customers who deposit money with them. They also charge customers fees for services to do with managing their accounts, and earn money from bank charges levied on overdrafts which exceed agreed limits.

How Banks Earn Money:

Banks are companies and are therefore owned by, and run for, their shareholders. Banks need to make enough money to pay their employees, maintain the buildings and run the business. There are three main ways banks make money; by charging interest on money that they lend, by charging fees for services they provide and by trading financial instruments in the financial markets.

Retail and commercial banks need lots of customers to deposit their money with them, as the banks use these deposits to earn enough money to stay in business. To encourage people to keep their money in a bank, the bank will pay them a small amount of money (interest). This interest is paid from the money the bank earns by lending out the deposited money to other customers. Banks also lend to each other on a huge scale. Most of this lending is on a short-term basis, usually no longer than three months, often just overnight. 

The banks lend money to customers at a higher rate than they pay to depositors or than they borrow it. The difference, known as the margin or turn, is kept by the bank. For example, if a bank pays 3% interest on deposits, they may charge 9% interest on loans. Lending takes the form of overdrafts, bank loans, mortgages (loans secured on property) and credit card facilities. The bank will work out the cost of making the funds to the borrower and add a profit margin. Loans approved by banks will vary in size, and may have fixed or variable interest rates but, in all cases, the bank will lend the money to the customer at a her rate than they borrow it. Deposits are the banks' liabilities. If everyone was to demand their money back at once, the bank would not be able to pay. Because they lend money out, banks are required to carry a cushion of capital so they have sufficient money to pay those customers likely to withdraw their money at any time.

Another way banks make money is through charging fees. Most retail and commercial banks will charge for specific services, for example, for processing cheques, for other transactions and for unauthorized borrowing e.g. if a client exceeds an overdraft limit.