Understanding the US Banking System: How do US banks work?
Posted by Rohit Mittal
If Americans don’t completely understand the US banking system, imagine how difficult it can be for a foreigner to understand. Unfortunately, the complex system tends to confuse all who come across it. Although it is frustrating, it is extremely important to understand so that you can have a better idea of what is going on with your money. Continue reading this article so you can learn more about the US banking system and what you need to know about it to properly manage your finances successfully.
What Types of Banks are there in the United States?
There are several different types of banking institutions that all work in almost exactly the same way. Before we get into exactly what the banks’ function is in the United States, we want to go over the different types of banks you will come across in the country. Keep in mind that the lines aren’t drawn with permanent marker here – some banks might offer a variety of services spanning across the different types of banks in our list.
Retail banks: Retail banks are the ones you come across most often. These banks focus on the consumer and provide the public with a place to deposit money into their own checkings and savings accounts. These kinds of banks give credit cards, offer loans, and offer numerous locations for you to manage your finances.
Commercial Banks: Wikipedia’s definition of a commercial bank really hits the nail on the head. Basically, a commercial bank is “an institution that provides services such as accepting deposits, providing business loans, and offering basic investment products.” These banks started out with the aim to serve the business sector and not just the general public. These banks rely on lines of credit to manage cash flow and provide any other kind of service a business might need.
Credit Unions: A credit union is a member-owned financial cooperative, controlled by its members to provide credit at competitive rates. In other words, a credit union is a not-for-profit organization owned by their own customers that offers banking services to its members. Although similar to commercial or retail banks, credit unions differ in that the members share common characteristics like the location of where they live, what occupation they have, and where they work.
Savings Banks: Savings banks provide a place for people to save their money and accrue interest on their money over time
Savings and Loans: Savings and loan associations specialize in accepting savings, deposits, and making mortgage and other loans.
Online banks: Online banks operate entirely online and do not offer physical brick and mortar locations for you to manage your finances at. These are becoming more popular as our world becomes more digitized.
Mutual Banks: Mutual banks are similar to credit unions in that they are owned by the members or customers instead of outside investors.
Central Banks: The central bank is the big dog that manages the monetary system of the government. The Federal Reserve (central bank) is responsible for managing economic activity and supervising banks. You will understand how they do this when you learn how banks function in the next section!
How do banks in the United States work?
Although there are a variety of different kinds of banks, most operate in the same way by doing the same thing. First, you must understand that a bank is a business at the end of the day and that they need to make money too. We explain how below!
Banks in the US make money off of the money you have put into your bank account. Whenever you put money in your account in the United States, that money gets moved to a large pool of money that is used for other people to buy homes, cars, or finance their business or child’s education.We get more into this at the end of this section. Before you freak out about your money getting “taken from you, I want to clarify something. Banks putting your money into this large pool for other people to use does not mean that your money disappears from your control. You can take out the money that has been credited to your account in cash whenever you want. In fact, you can take out as much as you want whenever you want, up to the amount you have put in of course. It is your money, after all.
Keep in mind that there are limits to how much money you can take out a day from an ATM, but in general, you can make transactions online and write checks to the amount you desire to withdraw. If you want a certain amount of cash withdrawn from your account, you can always go to a brick and mortar bank in your town to request the amount you need from a bank teller. Make sure to take your id and other required documents to take out large sums of money from your account in person.
Now let’s get back to how banks make money off of your money. Banks create money in the economy that technically wasn’t there before by administering loans. This does not mean that banks are giving out an infinite amount of loans to make more money. This would ruin the economy! There are some regulations set in place to control this.
The Federal Reserve (central bank mentioned in our list) is what regulates the lending of money by setting reserve requirements that indicate the amount of money banks are allowed to lend.
We will paint a picture for you in the following example so you can get a better idea of what we mean.
Let’s say you put $1,000 into your bank account into an American bank account. Of that $1,000 dollars, the bank is allowed to lend out $900 dollars of the total you have put in. Based on this example, what would be the reserve requirement for how much money the bank needs to keep from lending? Take a second to think about that question. In other words, what percentage of your deposit did the bank have to keep in its reserve? Ok, now for the answer. If you said 10%, then you guessed the reserve requirement set by the Federal Reserve.
Banks are allowed to lend out 90% of your deposit and can not touch 10% of it. The $900 from your $1,000 deposit goes back out into the economy and ends up deposited into another bank. These banks are then able to lend out 90% of the $900 that was put into the account, and on and on, creating an exponentially increasing amount of money in the economy.
Does the Federal Reserve ever change the reserve requirement? That is a great question! Depending on how the US economy is doing, the Federal Reserve will regulate different metrics (fed tools) to fit the economy’s needs at the time. So if the Federal Reserve lowers the requirement, that means less money will be held onto, consequently pumping more money out into the economy! The fancy term for this process is called the “expansionary monetary policy”. If the federal reserve wants to slow economic growth and reduce liquidity (amount of money in the economy), they will raise the requirement so that less money gets put into the economy. The fancy term for that is called a contractionary policy. The lower the requirement, the more money banks get to make off your money because it’s more money they can lend out!
And there you have the hack to how banks make money off your money. Got it? If not, check out more on the Federal Reserve requirement here. This also connects to interest rates which we will get into next.
What are Interest Rates?
Interest rates are the key to how banks make more money with your money. Basically, an Interest is how much you are charged for borrowing money, which can be expressed as a percentage of the amount you want to borrow. For example, if you want to borrow $1,000 in a year at an interest rate of 10%, by the end of the year you would have to pay back the bank the $1,000 plus 10% of the $1,000 you borrowed. This comes out to a repayment of a total of $1,100 by the end of the year. Here is more about interest rates if you feel a little lost!
Ever heard of the term borrowers beware? That is because there is always a cost associated with borrowing something, and that cost can pile up if you are not careful with paying back the money you have borrowed. Banks graciously lend you money, as long as you pay them back in full with interest! They make you agree to terms that will ensure them they get their money back. What happens if you do not pay the bank back? If you do not pay back on your loans or credit, your credit score will suffer. Doesn’t sound like a big deal to you? Well, in the United States it is a huge deal! Having good credit in the United States is extremely important for you to be able to buy homes, cars, and other large sum purchases you will need as you settle down in the country. Do not ruin your credit in the United States!
How does the bank calculate the interest rate?
Interest rates among all banks differ and will depend on several variables, including the number of people who want to borrow, and the amount of money the bank is allowed to lend (reserve requirement set by the Federal Reserve – go back to the previous section if you did not get this part). The amount of money a bank has can also be affected by the interest rate that banks charge each other for short-term loans to meet their reserve requirements. Yes! Banks also borrow money from each other so that they can comply with the Federal reserve requirement. Banks can also borrow from the central bank itself but usually refrain from doing so because borrowing from the reserve comes at a higher cost than borrowing from regular banks. Lastly, whatever amount of risk associated with the borrowing you will be doing is directly correlated to the amount will be charged for your interest rate. The riskier the lending is for the bank, the higher the interest rate will be for you. Banks have processes set in place to set interest rates for all different kinds of loans.
Types of Accounts You Will Use at a Bank
The two types of banks account that most consumers get are checking accounts and savings accounts. If you want to learn about the other bank accounts offered by banks, read this article.
Checking accounts: Checking accounts allow you to deposit and withdraw money as frequently as possible. It is the most liquid asset you have at a bank. Once you open a checking account in the United States you will receive a checkbook and a bank card. (Some banks are abstaining from handing out checkbooks for free and will have you pay for them). With these two items, you will be able to make purchases and pay your bills. Depending on the account you get, these kinds of accounts might have minimum monthly balances and service fees to pay. There are plenty of banks without these fees so do your research to find out which one is right for you.
Savings accounts: Savings accounts also include service fees and monthly minimums and are generally for long-term deposits that you can earn interest on over time. As an international student, you probably will not be needing a savings account because it is for very long-term use. Depending on what you are looking for, however, this could be perfect for you. If you are looking at ways to make money off of your money, we recommend that you look into the stock market or investing in other accounts like mutual funds or even cryptocurrencies!
These are the two types of accounts users generally choose, but ask your bank teller or online bank associate if you might need something else. They are usually very helpful with what you will need.
Can I get a credit card at my bank?
This is a very good question but is left answered in another article! We explain everything you need to know about how to get a credit card in the United States if you are looking to build up your credit while you live there! Follow our other guides to learn more about what credit is and how you can build yours here.
Wrapping it up…
We hope we have given you a better idea of what the banking system in the United States is like and what is actually going on with your money. We know it can be a little confusing but we are glad you got through this entire article! If you have any more questions on how US banks work and what you should expect to happen to your money, then feel free to contact us! We look forward to hearing from you and wish you luck opening your account in the US!
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