How Banks Use Deposits
When you deposit money in a bank, the bank does not keep it in a vault — it immediately puts your money to work by lending most of it to other customers at much higher interest rates, keeping only a small fraction in reserve.
How It Works
This practice is called fractional reserve banking. When you deposit $1,000, the bank records a $1,000 liability to you (it owes you that money on demand) and simultaneously creates a $1,000 asset. It then lends out a large portion — historically 80 to 90% — to mortgage borrowers, credit card holders, businesses, and other customers who pay interest rates ranging from 7 to 24%.
The bank earns high interest on those loans while paying you near zero on your deposit. The difference — called the net interest margin — is the core of bank profitability. A bank that pays 0.1% on $1 billion in deposits and earns 7% on $900 million in loans collects roughly $63 million in net interest income annually from that pool.
Banks also invest deposits in securities: US Treasuries, mortgage-backed securities, and other bonds. These earn lower yields than loans but are more liquid — the bank can sell them quickly if it needs cash. The mix of loans and securities in a bank's asset portfolio reflects its appetite for yield versus liquidity.
Deposit money does not just sit in the bank's accounting system — it circulates through the economy. When the bank loans your deposit to a homebuyer, the homebuyer pays the home seller, who deposits the money in their bank, which lends it out again. This circulation is how a single dollar of deposits can support multiple dollars of economic activity — and why economists call deposits the 'raw material' of the banking system.
Why It Matters
Understanding how banks use deposits explains why digital finance is so threatening to them. Banks have spent decades with a captive supply of cheap funding — consumer deposits that earn near nothing. Any technology that offers consumers a better alternative — like yield-bearing stablecoins — directly attacks the bank's cost of funding and therefore its profitability.
Understanding how banks create money through this process also explains why bank runs are so dangerous — depositors who withdraw en masse can drain a bank of cash faster than it can liquidate its loans. It also explains the purpose of the Federal Reserve's interest rate policy. When the Fed raises rates, it raises the cost of borrowing — which banks pass on to loan customers — but banks are slow to raise deposit rates. This asymmetry is how banks dramatically expand their margins during rising rate environments while consumers are left behind.
Real-World Example
You deposit $10,000 in your local bank's checking account. The bank pays you $1 per year (0.01%). It lends $8,000 of your deposit to a car buyer at 8% — earning $640. It invests another $1,500 in Treasury bonds at 4.5% — earning $67.50. It keeps $500 in reserve. Total income from your $10,000 deposit: approximately $707. It pays you $1. The net margin to the bank from your deposit: $706.
The Full System
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