How Do Banks Work? Explained for Kids

Your kid probably thinks the bank is a giant vault full of money, like a dragon's cave. It's not. Banks actually keep very little of your money on hand. Where the rest goes is one of the most important (and surprising) things about how the modern world works.

Banks take your deposits, keep a small fraction on reserve, and lend the rest to other people at interest. They pay you a tiny rate for using your money and charge borrowers a much higher rate. The gap between those two rates is how banks make billions of dollars a year. Your cash isn't sitting in a vault with your name on it.

What happens to your money when you put it in a bank?

When you put $100 in a bank account, you think you're storing it, like putting it in a safe. But legally, you're actually lending it to the bank. The bank now owes you $100, but they don't have to keep it sitting there. They can use it.¹

How do banks lend out your deposits?

Banks are required to keep only a fraction of your deposit on hand (this is called “fractional reserve banking”).² The rest gets lent out: to someone buying a house, a business opening a new store, a student paying for college. If you deposit $100, the bank might keep $10 and lend out $90.

Here's where it gets wild. That $90 the bank lent to someone? That person spends it, and it ends up in another bank account. That second bank keeps $9 and lends out $81. And so on. Your original $100 turns into hundreds of dollars moving through the system. Banks actually create new money through this process. Economists call it the money multiplier effect.³

How do banks make money from interest?

If the bank lends someone $1,000 to buy a car, they might charge 7% interest. That person pays back $1,070 over the year. Meanwhile, the bank pays you maybe 0.5% interest on your savings account. You earn $5 on your $1,000 deposit. The bank earns $70 on the loan. The gap between those two numbers (called the “spread”) is how banks make billions of dollars a year.

In 2023, JPMorgan Chase reported $49.6 billion in net interest income.⁴ That money comes from the difference between what they pay depositors and what they charge borrowers. The Federal Reserve sets the base interest rate, which influences both sides of that equation.

What happens during a bank run?

Since the bank lent out most of your money, they don't have enough to give everyone their cash at the same time. If all the depositors show up at once, the bank runs out. That's called a “bank run.” It happened in March 2023 with Silicon Valley Bank: depositors got nervous, $42 billion was withdrawn in a single day, and the bank collapsed in 48 hours.⁵

To prevent this, the government created FDIC insurance in 1933.⁶ If your bank fails, the government guarantees your deposits up to $250,000. It's a safety net, but it only works because people trust it. Trust is the whole game.

How does Bitcoin compare to keeping money in a bank?

Bitcoin works differently from a bank. When you hold Bitcoin in your own wallet, nobody is lending it out. Nobody is earning interest off it. It's sitting in your wallet, controlled by your keys.⁷ You don't need to trust a bank to keep it safe.

The tradeoff: you're responsible for not losing your keys, and nobody will bail you out if you do. If you want to understand the basics, our guide on what Bitcoin is covers how it works. And for a look at how Bitcoin and traditional money compare, read our Bitcoin vs. dollar comparison.

How to explain banks to kids (parent talking points)

• “Is my money safe in the bank?” Your money is insured up to $250,000 by the FDIC. So even if the bank has problems, you get your money back. But the bank is using your money to make loans while it's in there.
• “Why don't I just keep my money at home?” You could, but cash at home can be lost, stolen, or damaged. And it earns zero interest. A bank at least pays you something (even if it's small) and keeps it safer. The tradeoff is that you're trusting the bank. Meanwhile, that cash still loses value to inflation either way.
• “Does Bitcoin need a bank?” Nope. You can hold it yourself. You're your own bank. That's powerful, but it also means if you lose access, nobody can help you recover it.

Try this at home

The family bank game (20 minutes, ages 6+). One person plays the banker. Everyone else deposits 10 tokens. The banker must keep 2 tokens from each deposit and can lend the rest to other family members (who pay back 1 extra token as interest). After a few rounds, count up how many tokens exist in total versus how many were originally deposited. The number will be bigger. Ask your kid: “Where did the extra tokens come from?” That's how banks create money.

Materials: 40+ tokens (coins, beans, buttons), a notepad to track loans. Time: 20 minutes.

Sources

1. Federal Reserve, “How Banks Create Money”
2. Federal Reserve, Reserve Requirements
3. Federal Reserve Bank of Chicago, Money Multiplier and Monetary Policy
4. JPMorgan Chase, 2023 Annual Report (net interest income)
5. FDIC, Silicon Valley Bank Failure (March 2023)
6. FDIC, FDIC History (established 1933)
7. Nakamoto, Satoshi. Bitcoin: A Peer-to-Peer Electronic Cash System (2008)