What a bank actually does

A bank looks like a place that keeps your money. It is not. It is a place you have lent money to, and what it does with that loan is the whole subject.

Three transformations

Maturity transformation. Depositors want their money back on demand. Borrowers want twenty-year home loans. A bank stands between them, borrowing short and lending long.

Size transformation. Thousands of small deposits become a handful of large loans. No individual saver could fund a factory; a bank aggregating them can.

Risk transformation. A depositor takes almost no credit risk. The bank takes all of it, across a diversified book, and is paid the difference.

The third is where the income is. The spread between what a bank pays depositors and charges borrowers — the net interest margin — is the core of banking, and it exists because the bank is bearing a risk the depositor is not.

Why the mismatch is the business

Working the problem: if a bank held every deposit as cash, it would earn nothing, pay you nothing, and serve no purpose. The usefulness comes precisely from not holding it.

So a bank keeps a fraction liquid and lends the rest. In India two requirements set the floor: the cash reserve ratio, a share of deposits maintained with the RBI, and the statutory liquidity ratio, a minimum holding of liquid assets, mostly government securities. Both are monetary policy instruments, and chapter 6 returns to them.

The rest is lent. Which means the money is genuinely not there if everyone asks at once.

The bank run

That is the second half of the problem, and it has no complete solution.

A bank can be entirely solvent — its loans worth more than its deposits — and still fail, because loans cannot be turned into cash quickly at full value. A run is therefore self-fulfilling: if you believe others will withdraw, withdrawing first is rational even if the bank is sound.

Three defences, none of which removes it:

Deposit insurance. In India, deposits in insured banks are covered by DICGC up to a limit per depositor per bank. If small depositors know they are covered, they have no reason to run.

The central bank as lender of last resort. A solvent bank short of cash can borrow against collateral rather than dump assets.

Regulation of capital and liquidity. Chapters 3 and 4.

The honest position: a bank is a confidence mechanism with a solvency requirement attached. Chapter 12 is what happens when the confidence goes.

The balance sheet, read correctly

This is where most people's intuition is upside down.

Assets	Loans to customers, government securities, cash and balances with the RBI
Liabilities	Deposits, borrowings
Equity	Share capital and reserves

Your deposit is the bank's liability, and your loan is the bank's asset. The language of a bank statement is written from the bank's side, which is why a credit to your account is a credit in their books too — they owe you more.

Chapter 2 of the Accounting subject makes this exact point: the two sides describe the same resources from opposite directions.

What makes one bank better than another

Four things, and they trade against each other:

• Cost of funds. A bank with many current and savings accounts pays less for its money than one dependent on bulk deposits. This is the single biggest structural advantage in banking.
• Credit quality. Lending to people who repay. Chapter 4 is how that is measured.
• Operating efficiency. Cost-to-income ratio.
• Capital. Enough to absorb losses without failing, and not so much that returns collapse. Chapter 3.

A bank chasing growth by lending to worse borrowers can look excellent for several years, because loans go bad slowly. The reported numbers of a bank lag its decisions by longer than almost any other business, which is why this sector rewards scepticism.

The point

A bank borrows short from depositors and lends long to borrowers, transforming maturity, size and risk — and is paid the spread for bearing a risk the depositor does not. That mismatch is the business, not a defect, but it means the money genuinely is not there if everyone asks at once. Deposit insurance, a lender of last resort and capital rules reduce the danger without removing it.