Most of us trust our banks to look after our hard earned cash, but do you know what they do with it?
How do banks use our money?
When you deposit money into your current or savings account, it doesn’t just sit there, waiting for you to take it out. In the UK, banks earn money by accepting cash deposits from us and then lending this money to someone else.
Banks make a profit from the difference between the interest they pay to savers and the interest they charge to lenders. Banks can legally extend much more credit than they have cash as normally not all depositors will want their money back at the same time. However, the recent UK Northern Rock crisis, which led to the first run on a British Bank in 150 years proves that this is not always the case.
The bigger picture
When we hear the word banking we often think of services like deposit taking, current accounts, mortgages or personal loans. But in practice, these often form only one function of a larger, more complex organisation which also provides services like commercial and corporate banking and investments.
It’s certainly true that some high street current accounts do make money for banks - if they're overdrawn they take interest, if they're in credit they make interest by reinvesting, but these are not generally the main ways that banks make their money.
Some of the UK’s larger high street banks like HSBC, Lloyds TSB and Barclays are huge, global operations. In 2006 HSBC stated that 80 per cent of its business was outside of the UK. The UK is a major international financial centre, handling a third of the world's foreign exchange business.
And even though we might just see banks as a hole in the wall on our high street, big banks are also busy doing business with big investors. Banks also play a part in raising finance for huge infrastructure projects such as dams or roads throughout the world.
Who is funding your overdraft?
Banks perform a key role in both the UK and global economies by making cash available through the loans they make. These loans can be made to retail customers (that’s you and me) but also to large corporations, public institutions, governments and even countries.
But how would you feel if your money was lent to companies involved in the manufacture or sale of weapons? Or what if it was being lent to firms with a bad record on the environment and human rights?
The HM Treasury publishes a list of individuals and organisations which UK financial institutions must not make funds available to. But beyond this, and within the limits of the law, banks are pretty much free to decide who they will and won’t do business with.
Currently not many UK banks have explicit policies that govern who they will and won’t do business with. So, if you want to look after your money ethically, check whether or not your bank’s lending activities match your concerns. Most financial products offer ethical alternatives of some description, either in terms of the product itself or the company offering it.
You could even consider moving your current or savings account to a socially responsible bank. Or if you want to stay put, ask your bank for a copy their investment policy.
It’s less likely that building societies will have exposure to issues such as the arms trade and Third World debt. This is because their business is more with individuals, not large corporations or governments.
See our guide to choosing a bank to learn more about the different approaches banks and building societies take to lending.
Banking options
Here’s the lowdown on the different types of financial institutions that offer current and savings accounts, loans and credit facilities:
High street banks may be listed on stock exchanges and so have external shareholders to consider and pay dividends to. This distinguishes them from other types of institution, which distribute profits to members or in line with a social or environmental mission. An exception is the Co-operative Bank, which is not listed as, but is part of Co-operative Financial Services Ltd.
Building societies tend to concentrate on providing mortgages and personal finance services. They are “mutuals”, which means they are owned by their members – their savers and borrowers – instead of having external shareholders.
"Mission-based" financial organisations provide a focused range of financial services linked to certain social and environmental objectives.