What is a bank?

Banks are institutions that hold on to money for some people and lend money to others. When you put money in a bank, you are technically lending the bank your money. You agree to hand over cash, and the bank agrees to give the cash back whenever you want it—but they’ll spend it on other loans and investments in the meantime. The bank even pays you a small fee for giving them money, called an interest payment.

The catch is, the interest payment the bank pays you is always smaller than the interest rate borrowers are paying the bank. This gap, called the interest rate differential, is how banks traditionally make their money. An old joke says that all bankers follow the 3–6–3 rule: borrow at 3 percent, lend at 6 percent, and be at the golf course by 3pm.¹ Banks also make an increasing amount of their money from direct charges, like overdraft fees.² 

The description above describes retail, or commercial banks. These are the banks that most people are familiar with; it’s where you probably keep your money and where you probably go first when you need a loan. The banks we have less to do with, but hear about quite often, are investment banks, which lend to bigger businesses and multinational enterprises.

Some banks actually do both investment and retail banking. The term ‘too big to fail’ came up all the time after the financial crisis in 2008 to refer to these giant banks that work in retail and in investment banking. In some sense, bigger banks can be seen as more efficient as they’re able to combine resources and cut overlapping spending. But they’re also  potentially more dangerous, because if something goes wrong on the risky investment side, it can bring down the safer lending and borrowing with it.