Banking & Central Banks

Everyone has a bank account but almost nobody knows how banks actually work. And yet the decisions made by central banks move every market on earth. Understanding how this system operates gives you a massive edge when trying to make sense of why stocks, bonds, and currencies move the way they do.

How commercial banks make money

Banks borrow short-term and lend long-term. They take your deposits — paying you 2–4% interest — and lend that money out as mortgages and business loans at 5–8%. The spread between what they pay you and what they charge borrowers is how they profit. This is called net interest margin.

But here's the part that surprises most people: banks don't just lend out existing deposits. Through a system called fractional reserve banking, they can create new money when they lend. If the reserve requirement is 10%, a bank with £100m in deposits can lend out £900m. That £900m gets deposited in other banks, which lend out 90% of that, and so on. Money is created through lending. This is why central banks controlling interest rates is so powerful — it affects how much money gets created across the entire economy.

The Bank of England — what it actually does

The Bank of England (BoE) is the UK's central bank. Unlike commercial banks, it doesn't take deposits from individuals or compete for business. Its job is to maintain monetary stability. The three main tools:

• Setting the base rate: the interest rate at which the BoE lends to commercial banks. When this rate changes, everything else follows — mortgages, savings accounts, credit cards, bond yields. This is the most powerful lever in the UK economy.
• Quantitative easing (QE): when the economy needs stimulus and interest rates are already near zero, the BoE creates new money and uses it to buy government bonds from banks and investors. This pushes cash into the financial system, encouraging lending and investment. It also pushes bond prices up (and yields down).
• Macroprudential regulation: overseeing the financial system to prevent excessive risk-taking. Setting rules like minimum capital ratios for banks.

Interest rates and markets — the relationship you need to understand

When the BoE raises the base rate, borrowing becomes more expensive across the economy. Mortgages cost more, so housing demand falls. Business loans cost more, so expansion slows. Consumers with variable-rate debt have less disposable income. Growth slows. This is deliberate — raising rates is how central banks cool an overheating economy and bring inflation down.

For investors, the effect is direct:

• Bonds fall when rates rise (existing bonds with lower coupons become less attractive — as covered in the Bonds section).
• Growth stocks fall more than value stocks when rates rise, because growth stocks' value is based heavily on future earnings, which get discounted more heavily at higher rates.
• Savings accounts become more attractive, drawing money out of riskier assets.
• Currencies tend to strengthen when a central bank raises rates, attracting foreign capital seeking higher returns.

Central bank action	Effect on bonds	Effect on stocks	Effect on currency
Raises rates	Prices fall	Typically falls	Strengthens
Cuts rates	Prices rise	Typically rises	Weakens
QE (money printing)	Prices rise	Usually rises	Weakens

Why this matters for you as an investor

Markets move on expectations, not just facts. When the BoE announces a rate decision, markets have usually already priced in what they expected. If the BoE raises by 0.25% and markets expected 0.5%, that's effectively a loosening — and assets may rally. If the BoE raises by 0.75% when 0.5% was expected, markets often sell off sharply even though rates went up, not down.