We all keep our money in banks. In return, banks give us interest in our savings. But have you ever wondered how banks earn money if they give us more money in exchange for us keeping our money with them?
The money that we deposit in our banks, does not get stored in the lockers of the banks. If banks do that, they'll not be earning any money at all. The money that we deposit in our banks, gets utilized by the banks to give loans to potential clients. The interest rates charged towards repayment of the loans count as an earning for the banks.
Let's assume that you want to deposit $100 to your bank. Suppose the interest rate the bank will give you is an interest rate of 4% per annum. If you withdraw your full amount after one year, you will get $104.
Now let's assume that there is another person who wants to take a loan of $100 from the bank. The bank will charge him an interest of 8% per annum. When he repays the loan to the bank, he would have to pay $108 in total. From the $108 the bank got from him, they will pay $104 to you if you decide to withdraw. This will end up in them having $4 as their profit. And this is how banks earn money.
Suppose the person who took the loan fails to repay the bank, and you want to withdraw your money, how would the bank give you the money in this case? To avoid this inconvenience, banks are required to maintain a certain amount of deposits in their reserves. The percentage of cash required to be kept in reserves is called the cash reserve ratio.