Final answer:
Banks serve as financial intermediaries, collecting deposits to lend out to borrowers. They make profits from the interest difference and assess risks through credit scores and their balance sheet. Investment in financial instruments can also increase a bank's earnings.
Step-by-step explanation:
Banks act as financial intermediaries, a role crucial to the economy. They achieve this by taking deposits from savers, who are then paid interest, and lending out these funds to borrowers, including households and businesses, charging them interest. Banks use the difference between the interest paid to depositors and the interest received from borrowers to cover their costs and make a profit. This process is essential for facilitating transactions, saving, and borrowing in the economy.
Banks attract deposits by offering interest on savings accounts and drawing funds from larger banks or central banks like the Federal Reserve in the U.S. They also invest in various financial instruments such as stocks and bonds to earn higher returns. However, the more money held in the bank's vault, the less they have available to lend out, which could potentially reduce their profits from interest on loans.
When banks lend money, they consider the borrower's credit score to assess the risk of default. A balance sheet displays a bank's assets, including loans and bonds, and liabilities, such as deposits. The difference between these is the bank’s net worth, which can be affected by loan defaults or changes in market interest rates.