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Introduction to banking

Sal Khan of the Khan Academy explains what services a commercial bank provides and how it differs from an investment bank.

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What I want to do in this video is give a very high level overview of what banks do.

And even when we talk about banks, we have to be a little bit careful. Because the term “Bank” is used to refer to two types of entities. Sometimes they are part of the same organization, but sometimes they are different.

There is the idea of the Commercial Bank and then there is the Investment Bank.

And they have different functions. Once again, we do have some entities that have, part of what they do is commercial banking and part of what they do is investment banking. But these are two fundamental, different types of businesses. And you definitely have entities that are only commercial banks, and you have other entities that are only investment banks.

When most of us, in every day terms, think of banks, places where we can deposit our money or places where we can go to get loans, we are thinking of commercial banks. We are thinking of commercial banks, and once again, they do many, many, many things. But their primary function is that they take deposits, and then they loan out some of those deposits.

And the general idea is they might provide the person depositing their money with some interest and some other services and they’ll then take a fraction of that money and then loan it out, usually at a higher interest rate. They then use that spread between the two interest rates to pay for their expenses and then also generate income for their shareholders.

So let’s just think a little bit about how this might work – just to make sure we have a reasonable framework for it.

So let’s say that you were to go to your local, commercial bank and you were to deposit $100.

All the numbers that I’m putting here, I’m just using simple numbers just for the sake of argument. These aren’t necessarily the numbers you’re going to see and these numbers actually change over time depending on economic conditions and the circumstances for either yourself or your bank.

But let’s say you deposit $100. Now the bank can’t loan out all $100. Let’s say this was a checking account or some type of on-demand account, which means you could go at any time to this bank and say, “I would like to withdraw $100”. But they are allowed to set aside some reserve and then loan out the rest.

And so once again, I’m going to make some very rough assumptions here. I’m not saying that these are exact numbers in today’s world or the world of whenever you are watching this video, but they will set aside 10% for the sake of argument, for reserves, which would be $10. And then they could loan out 90%.

A 90% loan, and in this case, that would be $90.

Let’s say, in exchange for you depositing your money, when you get access to some services of the bank, they might give you a check book, you can use their ATM card, you can go to the facility and talk to people about different ways where you could put your money, different types of accounts where you could deposit your money – savings accounts, checking accounts, CDs, things like that and maybe they also give you interest.

And so let’s say, that the interest that they give you, and once again, the circumstances might be different, depending on different circumstances, let’s say that they give you 1% interest. 1% annual interest.

And in very rough terms, let’s say that they’re able to loan $90 out at 5% interest.

So over the course of the year, just very rough numbers, 5% of $90, they’re going to generate $4.50 in incremental interest. They pay you $1. So this 1% right over here is $1 of interest that they have to pay you – so this becomes $101. So let me write this down. They’re going to generate $4.50 in interest. They’re going to subtract out, they’re going to have to pay you that $1. So minus $1. Now they have $3.50 and they will use this $3.50 of interest to pay their expenses, the cost of their buildings, their employees, their information technology and whatever is left over after all of their expenses, that’s essentially going to be their profit.

So this is a very, very rough overview of how commercial banks work.

And they are essentially playing two primary roles, or I guess one primary role in society.

They are the go-between, between people who want to save money and people who need to borrow money for maybe starting a business or investing in some other way.

So they’re really the connector between the savers, the people depositing the money, and the borrowers, the people who are going to use that money in some place, or maybe invest it somehow.

Now an investment bank is not about deposits. An investment bank, and I’m not going to go into it. We could probably do 10s of videos into all of the things an investment bank does. But just to make it a little bit concrete, an investment bank helps, often times, one thing it does is it helps companies raise money. So you might be familiar with initial public offerings, where a company selling shares on an open market. That is often underwritten and facilitated by an investment bank.

An investment bank might be involved in the trading of securities. They might do research that facilitates things like the trading of securities and it goes on and on and on and on. But the whole point of this video is just to give you a very rough overview of one, that “a bank” could refer to a commercial bank or an investment bank, but some banks are both. But these are two different parts of their businesses and the commercial bank is what most people think about, and once again, at a very high level, this is how they operate.

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