Despite the Bank of England explaining how banking works, myths still circulate—correctly understanding bank deposits and capital leads to some surprising and perhaps uncomfortable conclusions. Let’s explore a few.

Deposits Are Loans

Deposits held at a bank are loans to that bank by the deposit holder. That’s why banks usually pay interest on those deposits—they compensate you for the loan you have extended to them. Your deposit is a credit on the bank’s balance sheet, so you end up ‘in credit’ at the bank. They owe you.

Reserves Are Also Loans

Banks hold deposits elsewhere, too—the primary one being at the central bank in their ‘reserve account’. It follows that reserves are loans; only the borrower, in this case, is the central bank. As you earn interest on your deposits (typically), banks earn interest on their reserves.

The Key Difference

However, there is a key difference between deposits and loans, which is why we have two words for essentially the same thing. With a deposit, the borrower sets the interest rate, and the lender can choose to accept it. In contrast, with a loan, the lender sets the interest rate, and the borrower decides whether to take it.

Deposits Are Capital

Every bank needs a mechanism to absorb losses on its assets. If nothing else is in place, deposits fill that role. When a bank incurs a loss on its assets, the deposits in its credit accounts shrink by the same amount. Spreading losses equally over credit accounts is but one approach; others exist. Banks create capital schemes to determine whose credit account takes the hit first.

Bank capital is, in effect, a deposit with additional conditions—greater restrictions and less access—while typically offering a higher return for being at the front of the queue when a loss occurs.

In short, every pound in a bank is part of a lending arrangement. The differences are where you sit in the hierarchy when things go wrong and who sets the interest rate.

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