How Banks Work: Deposits, Loans, Payments, and Bank Money

Written by Max Fonji
Founder & Financial Education Writer, The Rich Guy Math
Last updated: September 12, 2026

Financial education disclaimer: This article provides general financial education and is not individualized financial, banking, legal, tax, lending, or investment advice. Banking products, regulations, fees, and institutional practices can vary.

Banks are part of everyday financial life.

Your paycheck may enter one. Your bills may leave one. You might use one to save money, borrow money, receive a mortgage, or send payments.

But what actually happens inside a bank is more complicated than the familiar explanation:

“Banks take deposits from savers and lend that money to borrowers.”

Deposits are extremely important to banks, but a modern commercial bank is better understood as two things working together:

a balance sheet and a payment institution.

A customer’s deposit is a liability of the bank because the bank owes that money to the customer.

Loans, securities, cash, and reserve balances are generally assets of the bank.

And when a bank originates a loan, it can create a matching bank deposit at the same time.

Understanding those ideas makes the rest of modern banking much easier.

For checking accounts, savings accounts, APY, bank fees, deposit protection, and choosing an account, start with our Banking Basics hub.

How Banks Work in 30 Seconds

You deposit money at a bank, and the bank owes that balance back to you. On the bank’s balance sheet, your deposit is therefore a liability.

Banks make loans and hold other financial assets. A loan is an asset because the borrower owes money to the bank.

When a bank makes a new loan, it can create a matching deposit in the borrower’s account rather than simply handing over another customer’s previously deposited dollars.

Banks also process payments, manage liquidity, maintain capital, and operate under banking regulation and supervision.

They cannot lend without limit.

Capital, liquidity, funding, credit risk, underwriting, regulation, profitability, and borrower demand all matter.

Quick Answer: How Do Banks Work?

Banks generally perform several major functions:

• accept deposits;
• make loans;
• help move payments;
• hold financial assets;
• manage liquidity;
• earn interest and fee income;
• operate under capital, liquidity, supervisory, and other regulatory requirements.

When a commercial bank makes a loan, it can create both:

a new loan asset

and:

a new customer deposit liability.

That is one way commercial bank money is created.

But banks cannot create unlimited loans.

Their lending is constrained by factors including:

• capital;
• liquidity;
• funding;
• underwriting;
• borrower creditworthiness;
• expected losses;
• profitability;
• regulation;
• demand for loans.

And despite the classic classroom example that banks must keep 10% of deposits in reserve, U.S. reserve-requirement ratios have been 0% since March 26, 2020.

Federal Reserve source: Reserve Requirements

Why Understanding How Banks Work Matters to You

You do not need to work at a bank to benefit from understanding banking mechanics.

It can help you understand:

• why your bank deposit is a claim on the bank rather than cash stored separately in your name;
• what FDIC insurance does and does not protect;
• why checking and savings accounts can pay different rates;
• why a fintech app may not itself be an FDIC-insured bank;
• why a bank can experience liquidity problems even while still owning valuable assets;
• why Federal Reserve policy can influence borrowing and savings rates without directly setting the rate on your individual account or loan.

Understanding the mechanics also makes it easier to evaluate the banking products you actually use.

Start With the Bank Balance Sheet

The basic accounting equation is:

Assets = Liabilities + Equity

For a bank, common assets can include:

• loans;
• securities;
• cash;
• reserve balances at the Federal Reserve;
• other financial assets.

Common liabilities can include:

• checking deposits;
• savings deposits;
• certificates of deposit;
• wholesale borrowing;
• other obligations.

Equity is what remains after liabilities are subtracted from assets.

That sounds like accounting language, but it explains one of the most important ideas in banking.

Suppose you have:

$10,000 in a checking account.

To you, that $10,000 deposit is an asset.

To the bank, that same $10,000 is a liability.

Why?

Because the bank owes it to you.

The TRGM Bank Balance-Sheet Test

Whenever you are trying to understand a banking transaction, ask four questions.

1. What Asset Changed?

Did the bank receive cash?

Did it create a loan?

Did securities change?

Did reserve balances move?

2. What Liability Changed?

Did a customer’s deposit increase?

Did deposits leave the bank?

Did another form of borrowing increase or decrease?

3. What Happened to Liquidity?

Did immediately usable funds enter or leave the bank?

Did the bank need settlement balances to complete a payment?

4. What Happened to Capital?

Did the bank earn income?

Did it suffer a loss?

Did the transaction affect its loss-absorbing financial position?

This framework is much more useful than memorizing:

“The bank keeps 10% and lends 90%.”

That is not how the current U.S. reserve-requirement framework works.

What Happens When You Deposit $1,000?

Suppose you deposit:

$1,000

into a checking account.

From your perspective:

Bank deposit asset: +$1,000

From the bank’s perspective:

Customer deposit liability: +$1,000

What happens to the bank’s assets depends on how the money arrives.

If You Deposit Physical Cash

In a simplified example:

Cash asset: +$1,000

Deposit liability: +$1,000

The bank’s assets and liabilities both increase.

If Money Arrives From Another Bank

Suppose your employer sends your paycheck from another financial institution.

Your bank credits your deposit.

Behind the scenes, the institutions involved also have to settle the payment through the relevant payment system.

That can involve reserve balances held at Federal Reserve Banks or other permitted settlement arrangements.

The Federal Reserve explains that reserve balances are used by eligible institutions to make and receive payments and support settlement.

Federal Reserve source: Monetary Policy: What Are Its Goals? How Does It Work?

The important concept is:

Your checking-account balance is a claim on your bank. It is not a bundle of specific dollar bills stored under your name.

Does the Bank Keep Your Exact Money?

No.

Banks manage their assets and liabilities collectively.

They do not normally say:

“These exact dollars from Customer A will fund Customer B’s mortgage.”

Deposits are an important funding source, but individual deposits are not normally matched dollar-for-dollar with individual loans.

The bank still must remain capable of honoring valid withdrawals and payments.

That requires managing:

• liquidity;
• funding;
• credit risk;
• interest-rate risk;
• regulatory requirements;
• profitability.

How Banks Create Money When They Make Loans

This is one of the most misunderstood parts of banking.

Suppose a bank approves a:

$50,000 personal loan

and credits the borrower’s account.

A simplified balance-sheet change looks like this:

The bank now owns a new asset:

The borrower owes the bank $50,000.

At the same time, the borrower owns a new deposit:

The bank owes the borrower $50,000.

So:

Assets rise by $50,000

and:

Liabilities rise by $50,000

Federal Reserve research explains that when commercial banks make loans to nonbank borrowers, the lending can create corresponding deposits in the banking system.

Federal Reserve source: Understanding Bank Deposit Growth During the COVID-19 Pandemic

The Bank of England provides a complementary central-bank explanation of the same mechanism.

External source: Money Creation in the Modern Economy

Does That Mean Banks Create Free Wealth?

No.

The borrower receives:

+$50,000 deposit

but also takes on:

+$50,000 debt

The bank gains:

+$50,000 loan asset

while also taking on:

+$50,000 deposit liability

The transaction creates bank money.

It does not create free net wealth for the borrower.

Follow One Loan From Creation to Payment

Suppose Bank A approves a:

$10,000 personal loan

for one of its customers.

Step 1 — The Loan Is Created

Bank A records:

Loan asset: +$10,000

Borrower’s deposit: +$10,000

The borrower now sees $10,000 in the account.

Step 2 — The Borrower Spends the Money

The borrower sends the $10,000 to a contractor who banks at Bank B.

Step 3 — Bank A’s Customer Deposit Falls

The borrower’s deposit at Bank A decreases when the payment leaves.

Step 4 — Bank B’s Customer Receives a Deposit

The contractor’s account at Bank B is credited.

Step 5 — The Banks Settle

Depending on the payment system, settlement can involve transferring reserve or other settlement balances between the institutions.

The important result is:

Creating the loan was a balance-sheet event. Spending the loan created a liquidity and settlement consequence.

That is why both of these statements can be true:

Banks can create deposits when they lend.

and:

Banks still need liquidity and funding.

Why Can’t Banks Create Unlimited Loans?

Because loan creation is only one piece of banking.

Banks also have to manage:

• capital requirements;
• liquidity;
• funding costs;
• borrower credit risk;
• expected loan losses;
• concentration risk;
• underwriting standards;
• supervisory requirements;
• profitability;
• loan demand.

A bank that makes too many poor-quality loans can suffer large losses.

A bank that loses funding rapidly can face liquidity pressure.

A bank whose capital becomes inadequate can face regulatory intervention or failure.

So:

The ability to create deposits through lending is not unlimited lending power.

What Happened to the 10% Reserve Rule?

Many people learned about banking using an example like this:

A customer deposits:

$1,000

The bank supposedly keeps:

$100

and lends:

$900

because it is required to hold 10% in reserve.

That leads to the classic formula:

Money multiplier = 1 ÷ reserve ratio

That model can be useful for understanding a simplified or historical framework.

But it should not be presented as the current U.S. banking rule.

The Federal Reserve reduced reserve-requirement ratios to 0% effective March 26, 2020.

Federal Reserve source: Reserve Requirements

That does not mean banks no longer need liquidity.

And it does not mean they can lend without constraint.

It means current U.S. lending is not mechanically limited by a rule requiring banks to hold 10 cents of reserves for every dollar of transaction deposits.

What Are Bank Reserves?

A reserve balance is a balance an eligible financial institution holds at a Federal Reserve Bank.

From the commercial bank’s perspective, reserves are assets.

From the Federal Reserve’s perspective, reserve balances are liabilities.

Reserve balances can help banks with:

• payment settlement;
• liquidity management;
• monetary-policy implementation;
• other operational needs.

Ordinary consumers do not have Federal Reserve reserve accounts.

Your checking account at a commercial bank is different.

Bank Reserves vs. Bank Capital

These are not the same thing.

Bank Reserves

Reserve balances are assets held at Federal Reserve Banks.

Think primarily:

liquidity and settlement

Bank Capital

Capital is part of the bank’s loss-absorbing financial structure.

At a simplified accounting level:

Equity = Assets − Liabilities

Suppose a hypothetical bank has:

Assets: $1 billion

Liabilities: $900 million

Equity: $100 million

Now suppose asset values fall by:

$40 million

Assets become:

$960 million

Liabilities remain:

$900 million

Equity falls to:

$60 million

The loss reduced the owners’ financial cushion.

Actual regulatory capital is more complicated than simple book equity.

Banks can be subject to capital measures such as Common Equity Tier 1 and capital ratios based on risk-weighted assets.

Federal Reserve source: Minimum Capital Requirements

The core distinction is:

Reserves help handle liquidity and settlement. Capital helps absorb losses.

A Simplified Bank Balance Sheet

Consider this hypothetical bank:

The accounting equation works:

$1 billion = $900 million + $100 million

These figures are illustrative only.

They are not intended to represent the average U.S. bank.

Their purpose is simply to show where the pieces fit.

How Banks Make Money

Banks can earn money through both interest income and noninterest income.

Net Interest Income

Banks may earn interest on assets such as:

• loans;
• securities;
• reserve balances and other eligible assets.

They may pay interest on:

• savings deposits;
• CDs;
• borrowings;
• other funding.

A simplified calculation is:

Net interest income = interest income − interest expense

But don’t confuse that with another common shortcut.

Suppose a bank charges:

7%

on one loan and pays:

3%

on one savings account.

The difference is:

4 percentage points

That does not mean the bank earns a 4% profit margin.

Actual results also depend on:

• credit losses;
• operating expenses;
• taxes;
• asset mix;
• funding costs;
• fee income;
• other expenses.

Noninterest Income

Depending on the institution, noninterest revenue can come from:

• payment services;
• account services;
• trust services;
• asset management;
• loan origination;
• loan servicing;
• other financial services.

Different banks can have very different business models.

How Payments Move Between Banks

Suppose:

A customer at Bank A pays $100 to a customer at Bank B.

No employee needs to carry a $100 bill between the institutions.

At a simplified level:

1. The payment is initiated.
2. Bank A records the payment or pending payment.
3. Payment information travels through the relevant network.
4. The banks settle the resulting obligation.
5. Bank B credits the recipient according to the system’s rules.

Different payment systems operate differently.

For example:

Fedwire Funds Service provides real-time gross settlement for eligible transfers.

Federal Reserve source: Fedwire Funds Service

FedACH processes ACH payments and settles entries through financial institutions’ settlement accounts.

Federal Reserve source: Automated Clearinghouse Services

ACH, debit cards, checks, wires, and instant payments do not all use the same process or timeline.

That’s also why understanding the difference between your current balance and available balance matters in everyday banking.

Checking Accounts, Savings Accounts, and CDs

These are all deposit products, but they perform different jobs.

Checking Accounts

Checking accounts are generally designed for frequent transactions.

They may support:

• debit cards;
• direct deposit;
• checks;
• transfers;
• bill payment.

Savings Accounts

Savings accounts are generally designed to hold cash while paying interest under the account’s terms.

If you’re comparing deposit yields, our High-Yield Savings Account Guide explains how APY, access, fees, and deposit protection fit together.

You can also compare currently reviewed products in our Best High-Yield Savings Accounts guide.

If you first need to understand the difference between deposit yield and borrowing cost, read APY vs. APR.

Certificates of Deposit

Certificates of deposit, or CDs, are time deposits.

They can involve:

• a defined term;
• maturity date;
• stated APY;
• renewal rules;
• early-withdrawal penalties.

Which deposit product is best depends on what job the money needs to perform.

How FDIC Insurance Works

FDIC deposit insurance protects eligible deposits if an FDIC-insured bank fails.

The standard insurance amount is:

$250,000 per depositor, per insured bank, for each ownership category.

It is not $250,000 for every account.

Suppose one person has:

Checking: $150,000

and:

Savings: $150,000

at the same FDIC-insured bank under the same single-owner category.

Those balances are generally added together when determining insurance coverage.

Eligible deposit products can include:

• checking accounts;
• savings accounts;
• money market deposit accounts;
• certificates of deposit.

FDIC insurance does not turn investments such as:

• stocks;
• bonds;
• mutual funds;
• crypto assets;
• annuities

into insured bank deposits.

FDIC source: Deposit Insurance at a Glance

What Happens if a Bank Fails?

When an FDIC-insured bank fails, the FDIC can arrange for another institution to assume insured deposits or can pay insured depositors directly.

The important distinction is:

insured deposits

versus:

uninsured balances.

Money above applicable insurance limits can become a claim in the failed bank’s receivership.

If your deposits approach the insurance limit, verify your coverage rather than assuming each account receives its own $250,000 limit.

Banks vs. Fintech Apps

A banking app is not necessarily a bank.

Some financial-technology companies provide the interface while customer funds are held at one or more partner banks.

Before treating money inside a fintech app as equivalent to a deposit opened directly at an insured bank, ask:

• Which institution actually holds the deposit?
• Is that institution FDIC insured?
• When are the funds placed at the bank?
• How are ownership records maintained?
• What conditions apply to pass-through deposit insurance?
• What happens if the nonbank company itself fails or loses access to its partner?

The FDIC makes an important distinction:

Nonbank companies themselves are not FDIC-insured banks.

Deposit insurance can potentially apply after funds are placed at an FDIC-insured institution and the applicable requirements are satisfied.

FDIC source: Banking With Third-Party Apps

This is why our Banking Basics framework begins with understanding where the money actually sits.

What Does the Federal Reserve Do?

The Federal Reserve is the central bank of the United States.

Its banking-related responsibilities include:

• conducting monetary policy;
• providing reserve accounts and settlement services to eligible institutions;
• supervising certain banking organizations;
• helping promote financial stability;
• supplying currency;
• supporting parts of the payment system.

The Federal Reserve does not directly set the rate on your individual mortgage, auto loan, credit card, or savings account.

The Federal Open Market Committee sets a target range for the federal funds rate, and Federal Reserve policy influences broader financial conditions.

Individual consumer rates are then affected by:

• lenders;
• deposit institutions;
• financial markets;
• borrower characteristics;
• product terms;
• competition;
• other economic conditions.

Federal Reserve source: Monetary Policy Explained

Fractional-Reserve Banking: What the Term Means Today

The phrase fractional-reserve banking historically describes a banking system in which banks do not keep every dollar of customer deposits as immediately available cash or reserve balances.

That broad idea can still be useful.

But it should not be interpreted as:

“Modern U.S. banks legally keep exactly 10% and lend exactly 90%.”

They do not.

U.S. transaction-account reserve-requirement ratios are currently 0%.

Banks still face:

• capital requirements;
• liquidity requirements;
• funding constraints;
• supervision;
• credit risk;
• underwriting limits;
• market conditions.

Federal Reserve source: Reserve Requirements

Why Can a Bank Run Happen?

Banks can hold longer-term or less-liquid assets while customers can move deposits quickly.

That creates liquidity risk.

If many depositors suddenly withdraw or transfer money, a bank may need to produce large amounts of immediately usable liquidity.

And a modern bank run does not require people physically standing outside a branch.

Deposits can leave electronically.

That’s one reason banks manage combinations of:

• cash;
• reserve balances;
• liquid securities;
• borrowing capacity;
• other funding sources.

Liquidity Problems vs. Insolvency

These are related but different problems.

Liquidity Problem

The bank may own assets worth more than its liabilities but still struggle to produce enough immediately usable money to meet short-term withdrawals or payments.

Insolvency

The value of the bank’s assets is no longer sufficient relative to its liabilities.

A bank can therefore experience a liquidity crisis without being insolvent.

And sufficiently large asset losses can eventually create a solvency problem.

Common Banking Myths

Bottom Line

Banks become much easier to understand once you stop imagining them simply as vaults that pass savers’ physical dollars to borrowers.

Follow the balance sheet instead.

A customer deposit is:

a liability of the bank.

A loan is:

an asset of the bank.

Making a loan can:

create a matching deposit.

Reserve balances help with:

liquidity and payment settlement.

Capital helps:

absorb losses.

FDIC insurance protects eligible deposits against a specific risk:

failure of an FDIC-insured bank, subject to applicable coverage rules.

And modern U.S. bank lending is not governed by a rule saying banks must keep exactly 10% of deposits and lend the remaining 90%.

The framework to remember is the TRGM Bank Balance-Sheet Test:

What asset changed? What liability changed? What happened to liquidity? What happened to capital?

If you can answer those four questions, most modern banking mechanics become much easier to understand.

Sources & References

Federal Reserve Board — Reserve Requirements
Explains that reserve-requirement ratios were reduced to 0% effective March 26, 2020.

Reserve Requirements

Federal Reserve — Understanding Bank Deposit Growth During the COVID-19 Pandemic
Explains how commercial-bank lending to nonbank borrowers can create corresponding bank deposits.

Understanding Bank Deposit Growth

Federal Reserve — Monetary Policy: What Are Its Goals? How Does It Work?
Explains reserve balances, monetary-policy implementation, and interbank settlement.

Monetary Policy Overview

Federal Reserve — Fedwire Funds Service

Fedwire Funds Service

Federal Reserve — Automated Clearinghouse Services

FedACH

Federal Reserve — Minimum Capital Requirements
Explains regulatory capital requirements and measures such as Common Equity Tier 1.

Minimum Capital Requirements

FDIC — Deposit Insurance at a Glance
Explains the standard $250,000 per depositor, per insured bank, per ownership-category framework.

Deposit Insurance at a Glance

FDIC — Banking With Third-Party Apps
Explains how nonbank fintech companies differ from FDIC-insured banks and when pass-through deposit insurance may apply.

Banking With Third-Party Apps

Bank of England — Money Creation in the Modern Economy
Provides a complementary central-bank explanation of how commercial-bank lending can create deposits.

Money Creation in the Modern Economy

About the Author

Max Fonji is the founder and financial education writer behind The Rich Guy Math. He researches and explains personal-finance concepts using calculations, authoritative sources, practical examples, and plain language. His work focuses on helping readers understand how money decisions work rather than providing individualized financial advice.

Our editorial process: The Rich Guy Math may use AI-assisted tools during research, drafting, editing, and production. Important financial claims, calculations, sources, assumptions, and limitations are reviewed before publication.