How Banks Work: From Deposits to Loans
Why banks exist, how they make money, and what fractional reserve means
Your Bank Doesn't Have Your Money
When you deposit $10,000 at Chase, the bank doesn't put $10,000 in a vault with your name on it. It keeps a fraction — historically around 10%, though the Fed reduced the reserve requirement to 0% in March 2020 — and lends the rest to someone else. That borrower spends the money, which gets deposited at another bank, which lends most of that out, and so on. This is fractional reserve banking, and it's how a single $10,000 deposit can create roughly $100,000 in economic activity through the money multiplier.
The system works because not everyone withdraws simultaneously. On any given day, deposits and withdrawals roughly balance. The bank earns the spread between what it pays you in interest (near 0% for years, around 4-5% on high-yield savings in 2024) and what it charges borrowers (6-8% on mortgages, 20%+ on credit cards). That spread — the net interest margin — is how banks make money. JPMorgan Chase earned $49 billion in net interest income in 2023.
When confidence breaks, withdrawals exceed deposits, and the bank doesn't have enough reserves to honor them all. That's a bank run. Silicon Valley Bank collapsed in 48 hours in March 2023 after depositors withdrew $42 billion in a single day — the fastest bank run in history, accelerated by Twitter and mobile banking apps.
The Spread: How Banks Actually Make Money
Banks earn revenue from three main sources. Net interest income — the spread between deposit rates and loan rates — is the largest. JPMorgan's $49 billion in 2023 NII dwarfs anything else on their income statement. Second: fee income from credit cards, wealth management, investment banking, and transaction processing. Third: trading revenue from the bank's own capital markets desk.
The business model is essentially leverage. Banks operate with enormous balance sheets relative to their equity. A typical bank has $10-$15 of assets for every $1 of equity. This means small changes in asset values produce outsized swings in profitability — and solvency. SVB failed not because its loans defaulted, but because rising interest rates reduced the market value of its bond portfolio enough to wipe out its equity buffer.
Central banks serve as the "lender of last resort" — providing emergency liquidity to banks that are solvent but temporarily short on cash. The Fed's discount window, the FDIC's insurance fund ($128 billion), and the implicit guarantee that the government won't let systemically important banks fail create a safety net that doesn't exist in crypto.
What DeFi Takes From Banking — And What It Can't
DeFi protocols replicate core banking functions: Aave handles lending and borrowing, MakerDAO creates synthetic dollars (DAI), Uniswap provides exchange services. They do it without branches, employees, or FDIC insurance — and they do it 24/7 with instant settlement.
What DeFi can't replicate (yet): deposit insurance, consumer protection, credit scoring, and the ability to create money through fractional reserve lending. DeFi lending is overcollateralized — you must deposit $150 in ETH to borrow $100 in DAI. Traditional banks do the opposite: they lend out 90% of deposits and keep 10%. The capital efficiency gap is enormous.
GaiaEx sits at the intersection: a decentralized exchange where your assets aren't lent out fractionally, aren't subject to a bank run, and aren't dependent on an institution's solvency. Understanding how traditional banking works — and where it fails — clarifies exactly what crypto's non-custodial model is designed to prevent.