BlogsHow do Banks (and related entities) work?

How do Banks (and related entities) work?

July 18, 2022

The next in-line to becoming financially knowledgeable is understanding - How do Banks work?  

Banks (and related entities) are the largest contributors to consumer spending, directly or indirectly.  

How? – Credit!  

Credit is the most misunderstood financial instrument out there – almost treated as an evil (especially in India specifically)  

It’s a double-edged sword, for sure. But it’s the most powerful tool to transform/upgrade societies.  

Without credit, a middle-class household earning INR 10LPA, can never dream of owning a house worth, let’s say, INR 75L – or afford quality education, healthcare or transform lifestyles.  

The same holds true for a small business – without working capital credit lines or short-term debts, these businesses will never be able to grow.  

It’s safe to say – the economy, globally, runs on credit!  

So, how is credit created?  

You and I store our money with Banks. So do companies.  

Banks lend a portion of this money (based on a bunch of strict guidelines and regulations) to their customers or other companies.  

These borrowers pay interest to the Bank.   Simplistically, keeping all other things constant, Banks take a cut of that interest (called “net interest margin”) and give the remaining interest back to us – called “savings interest rate” (if it is a savings bank account).  

It is also important to note, Banks run on a simple philosophy that is at the core of human psychology – TRUST.  

The consumer trusts that their money in the banks is safe. That the Government or RBI or whoever will come to the rescue on an odd chance of that the bank facing bankruptcy.  

This has happened time and again in history.  

On a side note, you will be surprised to know – this concept of concentrated power and trust in a handful of Banks and the Government is one reason why Cryptocurrencies exist.  

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