Banking Basics

What is a Bank?

A bank is a financial institution licensed to accept deposits and make loans. At its simplest, a bank sits between people who have money to save and people who need money to borrow — earning a profit on the difference between the interest it pays savers and the interest it charges borrowers.

In most countries, only licensed institutions can call themselves banks, and they operate under strict regulatory oversight. There are several types of banks: commercial banks serve businesses and individuals; investment banks help companies raise capital; savings banks or building societies focus on personal savings and mortgages; and central banks operate at the national level, managing the money supply and setting monetary policy.

Bank Accounts Explained

When you open a bank account, you are entrusting the bank with your money in exchange for certain rights and services. The money in your account is not physically kept for you in a vault — it becomes part of the bank's pool of funds, and you have a legal claim on that amount.

Current Accounts

Designed for everyday transactions — paying bills, receiving wages, making purchases. They offer immediate access to funds, usually via a debit card or online banking. Interest paid is typically very low or zero, as the priority is liquidity and convenience.

Savings Accounts

Intended for funds you do not need immediately. Banks pay higher interest on savings accounts because the money is less likely to be withdrawn at short notice, making it easier for the bank to lend it out.

Fixed-Term Deposits

You agree to lock your money away for a fixed period in exchange for a higher, guaranteed interest rate. Early withdrawal may incur penalties. The longer the term, the higher the rate generally offered.

Fractional Reserve Banking

Modern banking operates on a system called fractional reserve banking. Banks are not required to keep all deposits on hand — only a fraction, known as the reserve requirement. The rest can be lent out.

Here is how it works in a simplified example:

• You deposit £1,000 at Bank A.
• Bank A keeps £100 in reserve (10%) and lends £900 to a business.
• That business pays a supplier, who deposits the £900 at Bank B.
• Bank B keeps £90 in reserve and lends £810 to someone else.
• This cycle continues, multiplying the economic impact of the original deposit.

This "money multiplier" effect means that the total money circulating in the economy is far greater than the base money issued by the central bank. It is why modern commercial banks are often described as "creating money" — when they make a loan, they credit the borrower's account with new money.

How Loans Work

A loan is an agreement where a lender provides a sum of money to a borrower, who agrees to repay it over time with interest.

Mortgages

Long-term loans secured against a property — typically 15 to 30 years. The property acts as collateral: if you cannot repay, the bank can repossess it. Mortgage rates are often lower than unsecured loans because of this security.

Personal Loans

Unsecured loans for a fixed amount, repaid over a set period (usually 1–7 years). Because there is no collateral, interest rates are higher than for mortgages.

Credit Cards

A revolving credit line. You can borrow up to a limit, repay some or all each month, and borrow again. Credit cards typically carry high interest rates — sometimes 15–25% or more annually — making them expensive if balances are carried from month to month.

Business Loans

Loans made to companies to fund operations, investment, or expansion. They may be secured or unsecured, short-term or long-term, and are assessed based on the business's creditworthiness and prospects.

Interest Rates

An interest rate is the cost of borrowing money, expressed as a percentage of the loan amount per year. If you borrow £10,000 at a 5% annual interest rate, you owe £500 in interest each year.

Fixed vs. Variable Rates

A fixed rate stays the same for the life of the loan or a fixed period, giving predictable repayments. A variable rate can change, usually in line with a benchmark such as a central bank's base rate. Variable rates carry more uncertainty but may be lower initially.

Annual Percentage Rate (APR)

The APR includes not just the interest rate but also fees and other charges, giving a more accurate picture of the true annual cost of a loan. When comparing loan products, always compare APRs, not just headline interest rates.

How Banks Make Money

The net interest margin — the spread between borrowing and lending rates — is historically the core profit driver for most retail and commercial banks. When central bank rates rise, banks can often charge more on loans faster than they raise rates on savings, temporarily widening their margins.

Central Banks & Regulation

Commercial banks operate within a framework set by the central bank and financial regulators. Key oversight functions include:

• Capital requirements: Banks must hold a minimum amount of their own capital as a buffer against losses.
• Liquidity rules: Banks must hold enough liquid assets to meet short-term obligations.
• Consumer protection: Regulations govern how banks communicate rates, fees, and terms to customers.
• Anti-money laundering: Banks are required to monitor and report suspicious transactions.

The central bank also acts as the "lender of last resort" — in a crisis, it can provide emergency loans to solvent banks facing a liquidity squeeze, preventing panic-driven bank runs from spiralling into a system-wide collapse.

Deposit Insurance

To prevent bank runs, most countries have government-backed deposit insurance schemes.

• In the United States, the FDIC insures deposits up to $250,000 per depositor, per bank.
• In the United Kingdom, the FSCS covers up to £85,000 per person, per institution.
• In the European Union, most countries guarantee deposits up to €100,000.

Deposit insurance means that even if a bank fails, ordinary depositors do not lose their money up to the insured limit. This guarantee helps maintain public confidence in the banking system.