Understanding Banking and Compound Interest

Introduction

• Common misconception: Banks keep your money in a vault until you need it.
• Reality: Banks operate differently, involving lending and interest.

Historical Context

• Two Houses:
  • Your house: No lock, vulnerable.
  • Rich guy's house: Secure with moat, dragon.
• You (a baker): Successful, earning lots of money, but vulnerable to theft.
• Rich guy's offer: "I'll keep your money safe in exchange for a fee."

Evolution of Banking

• Rich Guy 2's Proposition:
  • Offers to keep your money safe without charging a fee.
  • Additionally, promises to pay you extra money (interest).

Bank's Operation Model

• Money is not kept idle in vaults.
• Loan Process:
  • Another townsperson (a prospective butcher) borrows your deposited money.
  • The butcher pays back with interest once the business is successful.
• Interest Flow:
  • Original depositor is paid interest from the interest charged to the butcher.

Safety and Risk Management

• Banks assume not all depositors will withdraw at the same time.
• Allows banks to lend portions of deposits while keeping enough on hand for withdrawals.

Business Model Summary

1. Initial Deposit: You deposit money at the bank.
2. Loan Creation: Bank loans money to a new business (e.g., butcher shop).
3. Interest Cycle:
   • Butcher repays the loan with interest.
   • Bank pays you interest for your deposit.

Conclusion

• Compound interest is a result of banks lending your money rather than storing it.
• Banks profit by charging borrowers interest and sharing a portion with depositors.
• Birth of banking: Safe storage and interest earning through lending.

Moving Forward

• This explanation simplifies the concept of banking and interest.
• More detailed understanding of compound interest to follow.