The oldest bank in the world has been operating continuously since 1472. In the 500+ years since, you might think the banking world would have been through some great changes. The truth is, though, it hasn't. In fact, the banking business model is pretty much the same as when it originated: 2,000 years ago during the Roman Empire.
So what is a bank, aside from being a place to deposit your paycheck? And how do banks earn money, aside from charging you fees when you overdraft or withdraw cash from an unaffiliated ATM? For the most part, a bank is a business like any other. It has shareholders, who expect to see profits, and it has customers, without whom the bank couldn't exist.
How Banks Pass The Buck
Broadly speaking, there are two types of bank customers: depositors and borrowers. The depositors provide a flow of money into the bank through their checking accounts, savings accounts, and certificates of deposit, and the borrowers borrow money to pay for mortgages, college tuition, and the occasional speedboat.
The bank is a kind of mediator between each party, paying interest on the money coming in and charging interest on the money going out. However, the interest the bank pays to the depositors is usually a lot less than the interest it charges the borrowers. The difference between these two figures is called the net interest margin, and it's how most banks earn money.
Net interest income was once half-jokingly (half-seriously) referred to as the 3-6-3 rule: Bankers could borrow money at 3% interest, loan it out at 6% interest, pocket the difference, and tee off at the golf course at 3 p.m. The system is a bit more complicated than that, but banks still profit on the vast majority of their customers' deposits—as much as 90%.
Why We Trust Banks
So, here's a question: If only a fraction of the money you deposit at a bank is kept in a vault, and the rest goes to people who have taken out loans, where does the money come from when you make a withdrawal from your account? Well, the bank makes sure to keep enough money in reserve to cover the day-to-day spending habits of its customers. However, if a lot of people tried to withdraw their savings at the same time, the bank might have a problem. This is what's called a "bank run" (or "a run on a bank"), and it's when serious problems can arise.
Bank runs were common throughout the Great Depression, when widespread panic about the economy saw influxes of people lining up to withdraw their life savings. Unfortunately, this only made things worse, and soon led to the collapse of thousands of banks across the country when they all ran out of money. Thankfully, the Banking Act was signed in 1933, which, among other things, created the Federal Deposit Insurance Corporation (FDIC).
The role of the FDIC was to promote confidence in the banking system by protecting depositors' money from the banking system. At the time, bank customers were automatically insured for up to $2,500 of their deposits, should their bank become insolvent. Today, that limit has been raised to $250,000, but it doesn't come free: Banks need to pay around 1%-2% of the total of their deposits to cover their FDIC insurance premium.
Fees, Fees, Fees
Which brings us to the second major cash cow for banks: fees. America’s three biggest banks (Bank of America, JP Morgan Chase, and Wells Fargo) made $6 billion on ATM and overdraft fees alone in 2015. As CNNMoney points out, that equals $25 for every adult in the United States.
There are also late payment fees, account maintenance fees, and fees that don't even show up on your statement. For instance, every time you use your bank credit card or debit card, the vendor you are buying from has to pay that financial institution a percentage of the sale. This is called an interchange fee, and it's one reason some businesses are cash only.
The Bottom Line
There are many costs associated with banking—both for the customer and the bank itself—but it is possible to navigate your way around the system while incurring fewer fees and maximizing your interest. The key is to assess your banking needs and choose a financial institution that works for you and your money.
If you're new to all this, that might mean signing up for the most basic products, and upgrading once you have a clearer idea of your banking behavior. Remember the bank needs you as much as you need it. When it comes down to it, your money is a lot better off earning interest than it is sitting under your mattress collecting dust.