How banks work: deposits, loans, margin and capital
A bank borrows from many people in small amounts and lends to others in large ones. Its profit comes from the gap between what it earns and what it pays, and its survival depends on a thin layer of the owners' own money. This lesson builds a small fictional bank, shows how interest margin, credit losses and capital interact, and then compares what JPMorgan Chase and HSBC reported for 2025.
- Level
- Beginner
- Reading time
- About 26 minutes
- Know this first
- Budgets and variances
By the end you will be able to:
- describe a bank as an intermediary between savers and borrowers
- read a bank's balance sheet and say why customer deposits are its main funding
- calculate net interest income and net interest margin and say what drives them
- explain why equity capital is the cushion that absorbs loan losses, and how it changes return on equity
- name the main risks a bank carries, including a run on deposits
What a bank does
A bank is a financial intermediary: it stands between people who have money they do not need yet and people or businesses who need money now. Savers deposit money and are paid a little interest. The bank lends that money out at a higher rate. Doing this at scale lets the saver keep access to their money while the borrower gets a loan of a size and length that no single saver could offer.
This is the first lesson in a module on banking, credit and debt. It follows the money through one bank, using a fictional bank so that every figure can be checked, and then compares the actual 2025 results of JPMorgan Chase and HSBC. The aim is to understand where a bank's profit comes from and what protects it when loans go bad.
The bank's balance sheet
A bank's balance sheet looks like any other, but the proportions are unusual. On one side are its assets, what it owns or is owed: loans to customers, securities such as government bonds, and cash held at the central bank. On the other are the sources of the money: customer deposits, other borrowing, and equity, the money that belongs to the owners. Assets always equal deposits plus borrowing plus equity.
A deposit is an asset to the person who holds it and a liability to the bank, because the bank owes it back. Equity is what is left when everything owed is subtracted from everything owned, which a textbook would call the bank's net worth. The bank in this lesson is called Harbour Bank, and it is not a real institution.
| Harbour Bank, $ million | Amount | Share of the total |
|---|---|---|
| Loans to customers | 600 | 60.0% |
| Securities (bonds) | 250 | 25.0% |
| Cash and central bank reserves | 150 | 15.0% |
| Total assets | 1,000 | 100.0% |
| Customer deposits | 820 | 82.0% |
| Other borrowing | 100 | 10.0% |
| Equity (the owners' money) | 80 | 8.0% |
| Total deposits, borrowing and equity | 1,000 | 100.0% |
Harbour Bank is financed mostly by deposits, with 8% equity. That thin layer is typical of banks. A typical manufacturer is financed with much more of its owners' money. A bank can run with so little because its assets are mostly loans and securities that pay interest, and because many depositors rarely all ask for their money at once.
Net interest income and margin
A bank's main income is net interest income: interest earned on loans and securities minus interest paid on deposits and borrowing. Divided by the bank's assets, it gives the net interest margin, a measure of how wide the gap is between earning and paying. The bank also has to cover operating costs such as staff and buildings, and set aside money for loans that will not be repaid, called credit losses. What remains, less tax, is profit.
Net interest margin is often quoted on average interest-earning assets, and definitions differ between banks. This lesson divides by total assets to keep the arithmetic simple, and says so wherever it matters.
| Harbour Bank, one year, $ million | Amount |
|---|---|
| Interest earned: loans at 7.00% | 42.0 |
| Interest earned: securities at 3.50% and cash at 1.00% | 10.2 |
| Interest paid: deposits at 2.00% | 16.4 |
| Interest paid: other borrowing at 4.00% | 4.0 |
| Net interest income | 31.9 |
| Operating costs, 1.5% of assets | 15.0 |
| Credit losses, 1.00% of loans | 6.0 |
| Profit before tax | 10.9 |
| Tax at 25% | 2.7 |
| Profit after tax | 8.1 |
At the starting settings Harbour Bank earns $31.9 million of net interest income, a margin of 3.19% of assets. After costs, credit losses and tax it makes $8.1 million, which is 0.81% on its assets and 10.2% on its equity. The two returns differ because the bank's assets are about twelve times its equity.
Capital: the cushion under the loans
When a loan is not repaid, the loss is not shared with depositors. It comes out of the bank's profit first and then out of its equity. The depositors are owed their money in full regardless. So the owners' equity is a cushion: it absorbs losses so that the bank can still repay what it owes. A bank whose losses exceed its equity is insolvent, meaning it owes more than it owns.
This is why regulators set minimum capital rules. Under the Basel III framework agreed by the Basel Committee on Banking Supervision, a bank must hold common equity tier 1 (CET1) capital of at least 4.5% of its risk-weighted assets, plus a further 2.5% capital conservation buffer, which makes 7% in total. Risk-weighted assets count a risky loan for more than a safe government bond, so a bank's CET1 ratio is not the same as its equity divided by assets. Basel III also sets two liquidity measures, the liquidity coverage ratio and the net stable funding ratio, which are described below.
Equity involves a trade-off. Less equity raises the return on equity, because the same profit is spread over a smaller base, but it shrinks the cushion. This is leverage, the use of borrowed money, and it magnifies gains and losses alike.
Run Harbour Bank
Set the rate on loans, the rate paid on deposits, the share of assets funded by equity, and the share of loans lost. The securities, cash, other borrowing, costs and tax are fixed as in the tables above. The left page is the income and the right page is the return and the cushion.
The bank holds $80.0 million of equity and $820.0 million of deposits. Interest on its assets is $52.3 million and interest on its funding $20.4 million, so net interest income is $31.9 million, a margin of 3.19% of assets. After $15.0 million of operating costs and $6.0 million of credit losses it earns $8.1 million after tax: 0.81% on its assets and 10.2% on its equity. Loan losses of 13.3% of the loan book would use up all the equity.
Four experiments. First, the starting settings give net interest income of $31.9 million and a profit of $8.1 million, a 10.2% return on equity. Losses of 13.3% of loans would use up all of the equity. Second, cut the equity from 8% to 4%. Deposits rise to fund the gap, net interest income falls slightly to $31.1 million because the extra deposits cost interest, but profit of $7.5 million is now earned on half the equity, so return on equity rises to 18.8%. The cushion shrinks to 6.7% of loans. Third, return to 8% equity and raise the loan loss rate to 5%. Credit losses swamp the margin and the bank makes a loss of $13.1 million, a drop of 16.4% of its equity, leaving $66.9 million. Fourth, restore losses to 1% and raise the deposit rate from 2% to 4%. Funding costs rise faster than income, because the loans were made at fixed rates, net interest income falls to $15.5 million, and the bank makes a loss of $5.5 million even though its credit losses have not changed. A bank's profit depends on how fast its funding costs and its lending rates change relative to each other.
The effect of capital on the same bank, at the starting settings:
| Same bank, different capital | Equity, $ million | Loan losses that wipe it out | Return on equity |
|---|---|---|---|
| Equity 4% of assets | 40 | 6.7% | 18.8% |
| Equity 8% of assets | 80 | 13.3% | 10.2% |
| Equity 12% of assets | 120 | 20.0% | 7.3% |
More equity makes the bank safer and lowers return on equity. Less equity does the reverse. Regulators and shareholders disagree about the right amount, and that tension is behind much of the debate about bank rules.
Liquidity and bank runs
Solvency is one risk. The other is liquidity: having cash when it is wanted. A bank takes deposits that can be withdrawn on demand and lends long, for years. If many depositors ask for their money at once, the bank cannot call in its loans fast enough, and has to sell assets at a loss. This is a bank run. The fear that a bank may fail can bring about the failure, even when the bank was sound. A run on one bank can also spread to others.
Banks and regulators manage this in several ways. Banks hold cash and easily sold bonds, as Harbour Bank does. Regulators require a minimum liquidity coverage ratio, which compares high-quality liquid assets with expected cash outflows over 30 days, and a net stable funding ratio, which compares the stable funding a bank has with the funding its assets need over a year. Many countries insure deposits up to a limit, so that small depositors have less reason to run, and central banks can lend to a bank in difficulty.
JPMorgan Chase and HSBC
Two of the world's largest banks, one American and one based in London with most of its business in Asia, report the same kind of figures. The ratios below are worked from their published numbers for 2025. They are comparable in structure, but not in every definition.
| Full year 2025, $ million unless stated | JPMorgan Chase | HSBC |
|---|---|---|
| Net interest income | 95,443 | 34,794 |
| Year-end total assets | 4,424,900 | 3,233,034 |
| Net interest income as a share of year-end assets | 2.16% | 1.08% |
| Net interest income as a share of revenue | 52.3% | 51.0% |
| Loans as a share of deposits | 58.4% | 55.3% |
| Credit-loss charge as a share of loans | 0.95% | 0.39% |
| Equity as a share of assets | 8.2% | 6.4% |
| Reported CET1 capital ratio | 14.6% | 14.9% |
Net interest income was about $95.4 billion at JPMorgan and $34.8 billion at HSBC, and about half of revenue at each. In both cases, customer deposits were far larger than loans, so the loan-to-deposit ratio was under 60%. HSBC's net interest income is a smaller share of its assets, and its equity a smaller share too. JPMorgan charged more for credit losses relative to its loans. Both reported CET1 ratios well above the 7% Basel III figure, though the minimum that applies to a given bank also depends on its size and on national rules.
One warning about definitions. HSBC reports a net interest margin of 1.59%. JPMorgan reports a net yield on average interest-earning assets of 2.50% on a managed basis. The two are built differently and should not be compared directly, which is why the table uses net interest income divided by year-end total assets for both, a measure that is simple but crude. JPMorgan's large markets and trading business, for example, affects the denominator.
What this lesson cannot tell you
- Harbour Bank is a simplification. A real bank has thousands of products, fees, trading income and derivatives, and its loans reprice at different times.
- The ratios are not like-for-like. Banks differ in accounting, regulation, business mix and the way they define a margin.
- A year-end snapshot hides risk. Interest-rate risk, concentration in a sector and the quality of individual loans do not show in these ratios.
- Capital ratios are not guarantees. A bank with a high ratio can still face a liquidity problem, and the risk weights are themselves estimates.
- The rules change. Basel III figures are those in the Basel Committee's summary and national regulators may apply more.
Common mistakes
Treating deposits as the bank's money
Deposits are the bank's debts. Only the equity belongs to the owners.
Confusing net interest margin with profit margin
The margin is a measure of the interest gap before costs and credit losses. It says little about profit on its own.
Reading a high return on equity as a sign of strength
A bank can raise its return on equity by holding less equity, as the calculator shows. A high return built on a thin cushion is a risk.
Mixing up solvency and liquidity
A solvent bank can still fail if depositors run. A bank short of cash today may still own more than it owes.
Comparing banks' margins without checking the definition
Average or year-end assets, interest-earning assets or total assets, and managed or reported figures can each change the result.
Try it yourself
1. A bank has assets of $800 million. It earns $40 million in interest and pays $18 million. What are its net interest income and its net interest margin on total assets?
Show the working
Net interest income = 40 − 18 = $22 million. Net interest margin = 22 ÷ 800 = 2.75%.
2. A bank has $2,000 million of assets, including $1,200 million of loans, and equity of 5% of assets. It loses 3% of its loans. How much equity is left, and what share of assets is it?
Show the working
Equity = 5% × 2,000 = $100 million. The loss = 3% × 1,200 = $36 million. Equity left = 100 − 36 = $64 million, which is 64 ÷ 2,000 = 3.2% of the original assets. The cushion held, but it is 36% smaller.
3. A bank earns $12 million after tax on assets of $1,000 million and equity of $80 million. Find the return on assets and the return on equity, and say how they are related.
Show the working
Return on assets = 12 ÷ 1,000 = 1.2%. Return on equity = 12 ÷ 80 = 15%. Return on equity = return on assets × (assets ÷ equity) = 1.2% × 12.5 = 15%. The assets are 12.5 times the equity, so leverage multiplies the return on assets by 12.5.
4. A bank has loans of $700 million and deposits of $1,000 million. What is the loan-to-deposit ratio, and what would it mean if the ratio were above 100%?
Show the working
700 ÷ 1,000 = 70%. A ratio above 100% would mean the bank lends more than its customer deposits and must fund the rest from the market or other borrowing, which can be less stable than deposits.
5. Why can a bank that owns more than it owes still fail?
Show the working
Because of liquidity. Depositors can withdraw on demand while the loans are repaid over years. If enough depositors withdraw at once, the bank cannot pay them without selling assets at a loss, and it may fail even though it was solvent on paper.
Where this is used
- A bank analyst studies net interest income, funding and credit losses to judge whether profits are sustainable.
- A regulator tests whether a bank holds enough capital and liquid assets to survive a downturn or a run.
- A company treasurer chooses banks with the financial strength to hold its deposits and lend to it.
- An investor compares banks' returns on equity alongside the amount of capital behind them.
Key terms
- Financial intermediary
- An institution that channels money from savers to borrowers.
- Deposit
- Money placed with a bank, which is the bank's liability.
- Net interest income
- Interest earned on assets minus interest paid on funding.
- Net interest margin
- Net interest income divided by a measure of the bank's assets. Definitions differ between banks.
- Credit loss
- The cost of loans that are not repaid in full.
- Capital or equity
- The owners' money in the bank, which absorbs losses before depositors are affected.
- CET1 ratio
- Common equity tier 1 capital divided by risk-weighted assets, the main regulatory capital measure.
- Solvency
- Having assets worth more than the liabilities.
- Liquidity
- Having cash, or assets that can be sold quickly, to meet payments as they fall due.
- Bank run
- A rush of depositors to withdraw money because they fear the bank will fail.
Questions people ask
Does a bank lend out my deposit directly?
Not as such. Deposits are pooled, and the bank lends against the pool while keeping some cash and liquid assets to meet withdrawals. Your claim on the bank remains a claim for the full amount.
Why do banks hold so little equity?
Because most of the money they use is borrowed from depositors, and the cost of that money is low. Regulators set minimums so that the thin cushion is not thinner than the risk justifies.
Why is net interest income so large for banks?
Lending and taking deposits is their core business, and a small gap on a very large balance sheet adds up. Fees and trading income add to it in large banks.
Are deposits safe?
In many countries deposits up to a stated limit are covered by an insurance scheme, and banks are regulated. Rules and limits vary by country, so check the scheme that applies to you.
Sources and review
- JPMorgan Chase & Co., Management's discussion and analysis, 2025, for net interest income, revenue, the provision for credit losses, loans, deposits, total assets, stockholders' equity and the CET1 ratio.
- HSBC Holdings plc, Annual results announcement for 2025, published 25 February 2026, for net interest income, revenue, expected credit losses, loans and advances to customers, customer accounts, total assets, total equity and the CET1 ratio.
- OpenStax, Principles of Macroeconomics 2e, section 14.3: The role of banks, for financial intermediation, the bank balance sheet, net worth and bank runs.
- Bank for International Settlements, Basel Committee on Banking Supervision, Basel III phase-in arrangements: summary table, for the CET1 minimum, the capital conservation buffer and the liquidity coverage and net stable funding ratios.
How the numbers were checked: every figure for Harbour Bank was recomputed in plain code, the calculator, which runs separately, was compared with that code across a grid of inputs, and every ratio for JPMorgan and HSBC was recomputed from the published figures cited above. Harbour Bank itself is invented for teaching and is not a forecast of any bank.