Transcription
So we have seen lots of changes in the UK retail banking space in the last few years. So today, what I'm going to do is I'm going to talk you through how retail banks actually make money, and then talk a little bit about what started those changes, what's continued to drive those changes, where we are now, and a little bit of insight into where we might be going next.
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So, first things first, I'm going to explain how banks make money, and that's by a system called fractional reserve banking. So let's start off with bank number one. Here we go. This is not a pretty picture, but you get the picture. So there's bank one. We also need bank two because none of this works in isolation. You also need some people. So let's have person A over here. Now, what do you do when you go to the bank? Well, you can do two things. One thing is to take your money to the bank and to deposit your money there. So this person, person A, is going to put a thousand pounds in the bank.
Um, the person A walks away, they're very happy. The bank is holding their money safe, as far as they're concerned. But the bank isn't necessarily holding its money because sitting on that money doesn't do much good for the bank. It's going to use it. It's going to use it to make some revenue, and the way it does that is by lending it. So it's going to give it to person B. But it's not going to give it all to person B because there's something else which is put in place as a safeguard by central institutions, by central banks, by governments, and that's called a reserve. So that's the reserve part of the fractional reserve system. So we have our reserve up here, and how much that reserve is really depends on the the country in question, the governing bodies, the economy. Um, it can change, you know, totally depending on what's happening elsewhere. Coronavirus probably having an impact on fractional reserve banking at this point. But this thousand pounds will be lent out to person B, and as I said, they won't give them the whole amount. So let's say they give them 900 pounds, and 100 pounds goes into the reserve. Great.
So at this point, we've got money going in, money coming out, two of the most central functions of banking. But you might have spotted that nobody's actually making any money on this yet. Well, that comes in in the next bit. So person B is going to go down, and they're going to put their money in their own bank down here. They're going to pay that 900 pounds in, and then, you know, bank number two is gonna do the same thing. Um, it's gonna put some money to its reserve. Oops, if I can spell reserve that. And then it's probably gonna lend some more money to a different person. So this is how money is moving through the system, and this is important because what you have here is the movement of money. So whilst we started off with a thousand pounds, by this point, you've actually got 2,710 pounds in the system. So we're actually making money at this point, but that's making money for this system. The banks themselves aren't making any money yet. That comes in from the interest income bit.
So fractional reserve banking works like this, and then building on top of that system, the banks make money which is called interest income. So this is where we have to introduce more people into the system. But let's say this person has put a thousand pounds in, and the bank has lent 900 pounds to person B. Now, at some point, person B is gonna have to pay that money back. They don't just get to walk away, put it in the bank down here, and forget about it. Happy days. So when it comes to paying that money back, they would draw it from this bank, and they pay it back to bank number one. But they're gonna have to pay that back with interest. We all know about interest. So let's say that we've got an interest, a borrowing interest rate of 25 percent. So this person is going to be paying back the bank 1,100. Oh, sorry, 1225. It'd help if I could do my maths. So that's with an interest rate of 25 down here.
Uh, and then the bank is going to give this person a little bit of a reward for putting their money in the bank, for coming, for choosing bank one rather than bank two. They want to, they want you to come to their bank because if you don't come to their bank and give them your money, they can't then lend it to somebody else and make any money on top of that. So they're going to give person A their money back with a little bit more when person A wants to come to take it out. But they're certainly not going to give them all of that because that's their cut. So what they're going to do is pay person A probably more like, although this is quite optimistic in the current environment as I'm recording this, um, 2.5. So let's say we've got a savings rate of 2.5. And the bit in the middle is held by the bank. So the bank has made 200 pounds of this transaction, basically by doing very little, basically just by facilitating this movement of money. So this is how fractional reserve banking works. This is how retail banks make money. Um, it can be a lot more banks in the system than this, obviously, but that's the basic premise.
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