Written By: Emmanuel Okoye

From Lagos to London, New York to Nairobi, most people harbor fundamental misconceptions about how banks truly operate. This article will expose widespread myths, moving beyond the simple "deposits are lent out" narrative to reveal the opaque reality of modern banking globally.

SOURCE: How Stuff Works

We'll demystify crucial, often-hidden mechanisms: how commercial banks create money when issuing loans, how fees and charges erode wealth, and how central bank policies influence your finances.

The main angle is to empower the average citizen with a clear understanding of the banking system, enabling them to navigate its complexities, safeguard their money, and challenge practices not serving their best interests.

Dispelling the Deposit Myth: How Banks Really Create Money
The most common global myth suggests banks simply take deposits from savers and lend out that money. This traditional view limits a bank's lending by its cash holdings.

Though deposits are vital, they aren't the primary source for new loans in modern banking, overlooking commercial banks' profound power to create new money.

SOURCE: Corporate finance institute

When a commercial bank issues a loan, it largely creates new money by crediting the borrower's account. This credit creation expands the money supply. For instance, a mortgage means the bank credits your account, creating a new deposit (a liability) and a new loan (an asset) on its balance sheet.

This mechanism is widely explained by central banks themselves, notably the Bank of England, in their analyses of modern money creation. This ability to create credit is a fundamental characteristic of contemporary banking.

The fractional reserve banking concept often gets misinterpreted. Banks hold a fraction of deposits as reserves, but this doesn't mean they lend out multiples. Reserves primarily back payments and aid central bank control, not directly limiting individual loan creation.

The U.S. Federal Reserve, for example, eliminated reserve requirements entirely in March 2020, further underscoring that reserves do not limit lending capacity directly. Modern lending is driven by a bank's confidence in repayment, profitability, and regulatory capital, not merely its deposit base.

This money creation through lending has immense implications for the global economy, as banks actively influence the money supply, inflation, economic growth, and wealth distribution.

Understanding this shifts banks from passive intermediaries to active participants shaping our financial landscape, as credit creation underpins the entire financial system.

This often-hidden power of money creation is a global banking cornerstone. It explains why banking crises are so profound, as lending contractions rapidly shrink the money supply and trigger downturns.

Conversely, expansive lending can fuel asset bubbles and inflation, making this mechanism vital to understanding your bank's influence.

Beyond Interest: Unmasking Banks' Overlooked Revenue Streams

While most consumers focus on interest rates on loans and savings, banks generate revenue from a far broader and often more opaque array of activities that directly or indirectly impact individual consumers.

SOURCE: World Bank

Beyond obvious income from interest paid on loans and credit card balances, banks engage in myriad operations that bolster their profits, sometimes at the expense of unsuspecting customers. These overlooked revenue streams are crucial to understanding a bank's true financial model.

One of the most significant, yet frequently ignored, sources of income comes from a wide variety of fees and charges. These can range from explicit account maintenance fees, ATM withdrawal fees, and overdraft charges, to less transparent fees like foreign transaction fees and returned item fees.

A study by the U.S. Public Interest Research Group found that overdraft fees alone can cost consumers billions annually, often disproportionately affecting low-income individuals. These seemingly small charges accumulate rapidly, significantly eroding individual wealth over time without direct awareness.

Beyond retail banking, large commercial banks are deeply involved in investment banking activities, generating substantial revenue. This includes advising on mergers and acquisitions (M&A), underwriting new stock and bond issues, and providing brokerage services.

Their profitability allows banks to sustain operations and cross-subsidize other areas, often influencing retail services and fees. The scale of these operations contributes significantly to a bank's overall financial strength.

Furthermore, many banks engage in derivatives trading and proprietary trading, using their own capital to trade financial instruments.

This can involve complex contracts derived from underlying assets like interest rates, currencies, or commodities. While high-risk, these activities can yield massive profits, though they also expose banks to significant market volatility.

The interplay of these revenue streams means that banks are not solely reliant on the traditional loan-deposit model. Their diverse income sources provide resilience but also create potential conflicts of interest, as their pursuit of profits might not always align with customers' best financial interests.

Central Bank Policies: The Unseen Hand on Your Finances

Often perceived as distant and abstract, central banks like the U.S. Federal Reserve, the European Central Bank (ECB), or the Central Bank of Nigeria (CBN), wield immense power that directly influences the cost of your loans, the return on your savings, and the overall economic landscape.

Their decisions ripple through the entire financial system, affecting individual households and businesses profoundly. Understanding their role is key to comprehending your personal financial reality.

The primary tool wielded by central banks is the policy interest rate (e.g., the federal funds rate in the U.S. or the Monetary Policy Rate in Nigeria). By raising or lowering this benchmark rate, central banks influence the cost at which commercial banks can borrow money.

When the policy rate increases, banks face higher borrowing costs, passing them to consumers as higher interest rates on loans like mortgages, car loans, and personal loans.

The Central Bank of Nigeria's Monetary Policy Committee decisions, for instance, directly impact lending rates across the country, influencing consumer borrowing behaviour. Conversely, lower policy rates make borrowing cheaper, stimulating economic activity.

Beyond influencing loan costs, central bank policy directly impacts the return on your savings. When policy rates are high, banks offer higher interest rates on savings accounts and fixed deposits to attract funds.

When rates are low, savings returns diminish, sometimes barely keeping pace with inflation. This means your purchasing power can subtly erode even if your principal remains untouched. The Wall Street Journal frequently covers how central bank rate changes immediately affect consumer savings rates at commercial banks.

Central banks also utilize tools like quantitative easing (QE) and quantitative tightening (QT) to influence the money supply and long-term interest rates. During quantitative easing (QE), central banks buy large quantities of government bonds, injecting money. QT involves selling these assets, pulling money out.

The International Monetary Fund (IMF) regularly publishes analyses explaining the global impact of major central banks' quantitative easing and tightening policies on financial markets and economies worldwide.

These central bank actions directly influence the overall economic landscape. Their efforts to control inflation, maintain price stability, and promote full employment determine currency stability, your money's purchasing power, and the likelihood of economic growth or recession.

Empowering Your Financial Journey: Proactive Steps for the Informed Citizen

Armed with a clearer understanding of how banks truly work, individuals can take proactive steps to better manage their finances, avoid hidden pitfalls, and interact more strategically with their banking institutions.

This knowledge shifts power back to the consumer, enabling more informed decision-making in a complex financial world. Financial literacy is not just about budgeting; it's about comprehending the system you're operating within.

First, always read the terms and conditions carefully for any banking product or service, especially regarding fees and charges. Don't assume anything is free; scrutinize account statements for unexpected deductions and query them immediately.

Compare different banks' fee structures for basic services before committing. Consumer protection agencies globally, such as the Consumer Financial Protection Bureau (CFPB) in the U.S., frequently advise consumers to understand all fees associated with their accounts.

Second, compare banking products beyond just headline interest rates. Look at annual percentage rates (APRs) on loans and annual percentage yields (APYs) on savings. For loans, consider both fixed versus variable interest rates, understanding risks and benefits. Banks often have various product tiers; ensure you're in one that truly benefits your financial habits.

Third, diversify your savings and investments. Don't keep all your money in a low-interest savings account if inflation is high. Explore high-yield savings accounts, money market funds, government bonds, or other investment vehicles for better returns, always considering risk tolerance.

Fourth, monitor central bank news and economic indicators. Understanding general trends in interest rates, inflation, and economic forecasts from credible sources can help you anticipate changes in loan costs and savings returns.

This empowers you to make timely decisions, such as refinancing a mortgage before rates rise significantly.

Finally, advocate for greater transparency and fairness in banking practices. Support consumer protection initiatives and choose banks committed to clear fee structures and ethical operations.

Your collective voice can drive meaningful change within the financial industry. By being an informed and active participant, you contribute to a more equitable and transparent financial ecosystem for everyone.

Written By: Emmanuel Okoye