How does the banking system work?

A bank is an intermediary that sits between savers and borrowers. When you deposit money, the bank does not lock it in a vault. It keeps a small fraction on hand to meet withdrawals and lends the rest to households, businesses, and other banks, earning interest on those loans. Crucially, the act of lending creates new money: when a bank grants a loan, it credits the borrower's account with a fresh deposit that did not exist before. Most money in a modern economy is created this way, as commercial-bank deposits, not as physical cash. Banks also run the payment system, settling transfers between accounts so that buying groceries or paying rent moves numbers between ledgers. They profit mainly from the gap between the interest they pay depositors and the higher interest they charge borrowers.

The deeper principle is maturity transformation. Depositors want their money available instantly, but borrowers need funds locked up for years — mortgages, factories, expansion. Banks bridge this gap by borrowing short and lending long, which is enormously useful but inherently fragile. It works only because not everyone withdraws at once; on any given day, deposits flowing in roughly offset those flowing out, so a thin reserve suffices. The whole arrangement rests on confidence. If depositors believe their money is safe, they leave it in place and the system is stable. If they fear a bank cannot pay, they rush to withdraw, and because the money is tied up in loans, even a healthy bank can collapse. This is a bank run, and the possibility of one shapes nearly every rule governing banking.

Today this system is anchored by central banks like the Federal Reserve, the European Central Bank, and the Bank of England. They set the base interest rate that ripples through every loan and savings account, and they act as lender of last resort, supplying emergency cash to solvent banks facing a run. Governments add deposit insurance — in the United States, the FDIC guarantees deposits up to $250,000 per depositor — so ordinary savers have no reason to panic. Regulators require banks to hold minimum levels of capital and liquid assets as a buffer against losses. You see the machinery whenever a mortgage is approved, a card payment clears, or a bank fails: the 2008 financial crisis and the 2023 collapse of Silicon Valley Bank both showed how quickly trouble at one institution can spread.

It is widely believed that your deposit sits untouched in a vault, but in reality your balance is a claim on the bank, most of which has been lent out. Many assume banks can only lend money savers have already deposited; in fact, lending itself creates new deposits, and reserves are arranged afterward. People often think deposit insurance means the government stockpiles everyone's cash, when it is really a guarantee funded by bank premiums, meant to stop panics rather than to hold every dollar. And it is a myth that only insolvent banks suffer runs — because deposits are lent long, even a fundamentally sound bank can be toppled if too many customers demand their money at the same time.