Have you ever wondered how banks make money? They couldn’t be willing to keep your money for free, can they? Here’s how banks make money.
Essentially, banks do not make a profit until they have your money, thus acquiring and retaining customers is critical for banking firms. This is why they offer sign-up and referral bonuses, waive direct deposit fees, and provide benefits to high-value clients.
Banks, like any other business, have expenses and revenue sources that they strategically use to expand.
How Do Banks Make Money?
Diversified banks generate revenue in a variety of ways; nonetheless, at their core, banks are considered lenders. Banks typically generate money by borrowing funds from depositors and rewarding them with a fixed interest rate. Banks will lend the money to borrowers while charging them a higher interest rate and benefitting from the interest rate spread.
Furthermore, banks typically diversify their business portfolios and create revenue from various financial services such as investment banking and wealth management. However, roughly speaking, the money-making business of banks can be divided into the following categories:
- Interest income
- Capital markets income
- Fee-based income
Most commercial banks make the majority of their money through interest income. As previously said, it is performed by taking funds from depositors who do not require them right now.
Depositors are provided with a particular interest rate and security for their funds in exchange for depositing their money.
The bank can then lend the deposited monies to borrowers who require the funds right away. Lenders must repay borrowed cash at a higher interest rate than depositors get. The interest rate spread, which is the difference between interest paid and interest received, allows the bank to profit.
Why Are Interest Rates Important?
Clearly, the interest rate is vital to a bank as a key source of revenue. The interest rate is a proportion of the principal amount owed (the amount borrowed or deposited). The interest rate is established in the near term by central banks, which manage interest rates to support a healthy economy and keep inflation under control.
Long-term interest rates are determined by supply and demand forces. Demand for long-term debt instruments is expected to increase, resulting in higher prices and lower interest rates. Low demand for long-term maturity debt instruments, on the other hand, will result in lower prices and higher interest rates.
Banks benefit from being able to give low-interest rates to depositors while charging higher interest rates to lenders. Banks, on the other hand, must manage credit risk, which is the risk that a lender would default on a loan.
Banks, on the whole, profit from an economic climate in which interest rates are rising. Because banks may lock in fixed-term deposits at a lower interest rate while yet charging lenders a higher interest rate, they can profit. Intuitively, banks will be harmed by a declining interest rate environment, because fixed-term deposits are locked up at a higher interest rate, while interest rates charged to lenders are reducing.
Capital Markets-Related Income
Capital markets services are frequently provided by banks to firms and investors. The capital markets are essentially a marketplace that connects firms looking for funding to fund expansion or projects with investors looking for a return on their investment.
Banks promote capital market activity by providing a variety of services, including:
- Services in sales and trading
- Services for underwriting
- Advice on mergers and acquisitions (M&A)
With their own in-house brokerage services, banks will assist in the execution of trades. Banks will also hire specialized investment banking teams to help with debt and equity underwriting across sectors. It essentially aids firms and other entities in raising financing and equity. The investment banking teams will also assist with cross-company mergers and acquisitions. Client fees are collected in exchange for the services.
Banks’ capital market income is a very variable source of revenue. They are completely reliant on the activity of the capital markets at any particular time, which can fluctuate dramatically. During moments of economic recession, activity tends to slow down, whereas during periods of economic expansion, it tends to pick up.
Non-interest fees are also charged by banks for their services. If a depositor creates a bank account, for example, the bank may charge monthly account fees to keep the account open.
Fees are also charged by banks for a variety of different services and goods. Here are a few examples:
- Credit card fees
- Checking accounts
- Savings accounts
- Mutual fund revenue
- Investment management fees
- Custodian fees
Banks benefit from fees for services supplied, as well as fees for some investment products such as mutual funds because they frequently provide wealth management services to their customers. Banks may provide in-house mutual fund services to which their customers’ money is directed.
Fee-based income sources are appealing to banks since they are reasonably steady and do not fluctuate over time. It’s advantageous, particularly during economic downturns when interest rates are artificially low and capital market activity slows.
Expenses Banks Pay
Banks, like any other business, have their own set of expenses to cover in order to keep things going. They are as follows:
Non-interest expenses account for around 15% of a bank’s operating costs, with a median of $400,000 for branches across the country. Standard operational expenditures like staff pay and benefits, equipment and IT, rent, taxes, and professional services such as marketing are included in these costs.
Banks, on the other hand, incur “interest expenses,” which are the costs of interest on loans they take out, similar to what you pay when you take out a loan. As previously stated, banks may pay interest on their account holders’ deposits, short- and long-term loans, and trading account liabilities.
The good news is that there are numerous options available to assist you in managing your finances. The difficult aspect is determining which is the best fit. Don’t be afraid to shop around before making a decision. Even if they provide you a free account, that bank will profit handsomely from your deposits, therefore you deserve to bank with the institution that feels appropriate.