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How Banks Work





History shows a curiously consistent banking model over millennia, tracing its roots to early civilisation when lenders would loan grain to traders and farmers. As minted currencies were introduced, banks emerged as secure places for the wealthy to store their assets and today’s banks fundamentally operate in the same way, serving as intermediaries between savers and borrowers.

Unsurprisingly, their aim is to make a profit, which they do in a variety of ways.

Generating a profit

As banks lend out the money deposited with them, they commonly generate revenue through the process of ‘financial spreading’, in which they make a profit from the difference between the average (lower) interest rates paid on deposits compared to the interest rates they charge borrowers. For example, simplistically, a bank could pay interest of 1% on £1 of deposits, and lend that £1 out at 10%.

Fractional-reserve banking takes this a step further. Also centuries old, it was borne from the realisation that all of a bank’s depositors don’t tend to want access to all of the deposits at any one time, meaning that a bank doesn’t need to hold all of those deposits in reserve. This process creates new money by using a ‘money multiplier’ approach, in which banks are able to lend out amounts far in excess of the value of the deposits that they’re holding as reserves, charging interest on the loans while still providing customers with a presumed safe level of access to their funds (determined by the capital adequacy ratio enforced by their regulator). In our simplistic example, a bank still pays interest of 1% on £1 of deposits, but has granted loans of £10 against that £1 of deposits, again at 10%.

Although this stimulates the supply of money available in the economy (and generates significant profit for banks), the method is not without risk. As we’ve seen with a number of high street banks, fractional-reserve banking carries the potential for financial instability: if too many depositors withdraw their funds simultaneously (if there’s a ‘run on the bank’, for instance) and there are insufficient reserves to meet demand, banks risk collapse. It’s often the taxpayer who picks up the bill if a bank fails.

If it ain’t broke, why fix it?

So, if the aim of a bank is to make a profit through the lending of funds — a model that’s worked effectively over the years and remains essentially unchanged — why are consumers starting to demand something different? After all, as the saying goes, if it ain’t broke, why fix it?

Because as a society, the way we live, work, use our money and engage with companies — banks included — is radically changing.

Banks play an undisputable role in the functioning of the economy. Socially conscious consumers are increasingly realising that this power can be harnessed for the benefit of society — that banks have the ability, if they were so inclined, to direct funds to drive sustainable growth. Hence, demand for a more ethical approach to banking is on the rise.

Finance and conscience co-existing for the greater good

In a world where increasing value is placed on sustainability, social responsibility and transparency, consumers want to know: how do banks align with the greater good of both society and the planet, benefitting not only their shareholders but also the communities they serve and the environment we all share?

The rise of online and mobile banking and payments has led to the decline of chequebooks and cash, and the emergence of fintech start-ups as both challenger banks and payment firms (E-Money Institutions or EMIs) are revolutionising the global banking landscape. These fintechs have been leading a shift towards greater convenience, efficiency and technology-driven solutions in modern banking.

Unprecedented pace of change

But we live in transformative, sustainability-focused times. While moving away fully from the centralisation of banks may be a slow process, thanks to exponential advancements in technology, as well as regulatory, socio-economic and environmental changes, the pace of modernisation of the banking industry is rapid.

Today’s consumers nonetheless still lack choice when looking for a socially conscious bank, those who set out with sustainability and ESG principles at their core, and prioritise financing projects that benefit society and the planet while avoiding investments that harm them.

Thousands of businesses across the world strive to become more ethical and to better serve society and the planet; banks, too, have it in their power to ‘do the right thing’. In the case of Science Card, we are building a product range that feeds directly into supporting research projects aligned with the UN’s Sustainable Development Goals.

We believe it’s time for the banking industry to embrace the transition to greater sustainability. By creating a socially conscious model that aligns financial services with responsible investments, transparency and social engagement, we can demonstrate that financial services can help change the world for the better, too.

Join us in our mission.