How Do Banks Make Money?

How do banks make money? - How Banks Work | HowStuffWorks.  Banking industry to for profit institutions to individual retirement accounts to payments system

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Curious too about the question “how do banks make money?” Since commercial banks are for-profit financial institutions, their job isn’t just to hold your money, it’s to rake in some big bucks of their own. There are a few primary ways banks make money, especially from fees and interest. When you open a savings or checking account at a bank, your money doesn’t just sit there. 

Every time you make a deposit, your bank “borrows” the money from you to lend it out to others. Think about all those auto loans and personal loans, mortgages, and even bank lines of credit. Sadly, money doesn’t grow on trees, so the bank uses your money to help fund these loans temporarily.

In turn for your generosity (that most of the time you are unaware of), you get paid back in the form of interest, sort of a courtesy for trusting that financial institution with your money. 

Here’s a clearer view on how banks make money and can lend that money out to their customers. 

Table of Contents

    What’s a commercial bank?

    A commercial bank is where most people go to do their everyday banking. Commercial banks give businesses and individuals a place to store their money while having access to credit and loans. Again, since one of the reasons a bank operates is to make money, most financial institutions focus on profits from the same customers they serve day to day.

    A commercial bank’s money essentially belongs to its customers, who can withdraw their funds at any time, even on short notice. Because of that, commercial banks offer credit for shorter lengths of time with the backing of real, concrete securities that are easy to sell.

    Now that you know what a commercial bank does, the truth still stands: most of us have no idea how other banks really make a profit. When you consider the fact that a bank holds onto your money and that of other customers, how do other banks afford to keep the lights on, how do banks make money, remain in business, and turn a profit?  

    Bigger banks are also often made up of separate branches that focus on different types of customers and services. For example, commercial or retail banking branches may offer more common banking services, such as checking and savings accounts or giving out personal and business loans.

    If you belong to a credit union that isn’t motivated by profit margins, you may see more interest rate paid to you. Or, in the case of an online checking or savings account, there are no branch locations and minimal overhead costs. This means that you may see more money in the way of automatic savings and other perks.

    At this point you might be wondering: How can money in the bank be loaned out and available to withdraw at the same time? How do banks make money? Don’t worry. Your money hasn’t disappeared on you. Banks don’t lend out all the money they have on deposit. They’re required to keep enough money on hand to handle transactions and withdrawals. Your funds are also protected and insured by the Federal Deposit Insurance Corporation (FDIC).

    How Commercial Banks Work

    Commercial banks provide basic banking system services and financial products to the public, both individual consumers and small businesses. These bank services include checking and savings accounts; loans and mortgages; basic investment banking services such as CDs; and other services such as safe deposit boxes.

    Banks make money from service charges and fees. These fees vary based on the products, ranging from account fees (monthly maintenance charges, minimum balance fees, overdraft fees, and non-sufficient funds [NSF] charges), ATM fees, safe deposit box fees, and late payment fees. Many loan products also contain fees in addition to interest charges.

    Banks earn money from interest they earn by lending money to other clients. The funds they lend come from customer deposits. However, the interest rate paid by banks on the money they borrow is less than the rate charged on the money they lend. For example, a bank may offer savings account customers an annual interest rate of 0.25%, while charging mortgage clients 4.75% in interest annually. 

    Commercial banking systems have traditionally been in buildings where customers come to use teller window services and automated teller machines (ATMs) to do their routine banking. With the rise in internet technology, most banks now allow their customers to do most of the same banking services online that they could do in person, including transfers, bank deposits, and bill payment systems.

    Key Takeaways

    • Commercial banks offer basic banking services, including bank deposit accounts and loans, to consumers and small businesses.
    • Commercial banks make money from a variety of fees and by earning interest income from making loans.
    • Commercial banking has traditionally been in physical locations, but a growing number now operate exclusively online.
    • Commercial banks create money, which is important to the economy because they create money or capital, credit, and liquidity in the market.

    Significance of Commercial Banks

    Commercial banks are an important part of the economy. They not only provide consumers with an essential service but also help create money or capital and liquidity in the market. Commercial banking ensures liquidity by taking the funds that their customer deposits in their accounts and lending them out to others.

    Commercial banks play a role in the creation of credit, which leads to an increase in production, employment, and consumer spending, thereby boosting the economy. As such, commercial banking is heavily regulated by a central bank in their country or region.

    For instance, central banks impose lowering bank reserve requirements on commercial banks. This means that banks are required to hold a certain percentage of their consumer deposits at the central bank as a cushion if there’s a rush to withdraw funds by the public.

    Special Considerations

    Customers find commercial banking investments, such as savings accounts and CDs, attractive because they are insured by the Federal Deposit Insurance Corp. (FDIC), and money can be easily withdrawn. Customers have the option to withdraw money upon demand, and the balances are fully insured up to $250,000.

    Therefore, banks do not have to pay much for this money. Many banks pay no interest at all (or at least pay very little) on checking account balances and offer interest rates for savings accounts that are well below U.S. Treasury bond (T-bond) rates.

    Consumer lending makes up the bulk of North American bank lending, and of this, residential mortgages make up by far the largest share. Mortgages are used to buy properties, and the homes themselves are often the security that collateralized the loan.

    Mortgages are typically written for 30-year repayment periods, and interest rates may be fixed, adjustable, or variable. Although a variety of more exotic mortgage products were offered during the U.S. housing bubble of the 2000s, many of the riskier products, including pick-a-payment mortgages and negative amortization loans, are much less common now.

    Automobile lending is another significant category of secured lending for many banks. Compared to mortgage lending, auto loans are typically for shorter terms and higher rates. Banks face extensive competition in auto loans or lending money from other financial institutions, like captive auto financing operations run by automobile manufacturers and dealers.

    Bank Credit Cards

    Credit cards are another significant type of financing. Credit cards are, in essence, personal lines of credit that can be drawn down at any time. Private card issuers offer them through commercial banks. Visa and Mastercard run the proprietary networks through which money is moved around between the shopper’s bank and the merchant’s bank after a transaction. Not all banks engage in credit card lending, as the rates of default are traditionally much higher than in mortgage lending money or other types of secured lending.

    That said, credit card lending delivers lucrative fees for banks interchange fees charged to merchants for accepting the card and entering the transaction, late payment fees, currency exchange, over-limit, and other fees for the card user, as well as elevated rates on the balances that credit card users carry from one month to the next.

    How Do Banks Make Money?

    how do banks make money

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    Banks usually diversify their business mixes and generate revenue for money supply through alternative financial bank services, including investment banking and wealth management. However, broadly speaking, the money-generating or money supply business of banks can be broken down into the following:

    Interests

    When you deposit money in your bank account, banks use that money to loan it out to businesses or people. The banks charge them interest which they collect as their profit. The bank pays you an amount of interest, in exchange for keeping your deposit. They collect even more interest on the loans they issue to others, and this is where they make most of their money.

    If you’re on the borrowing side, banks lend money to you and receive excess interest when you repay the loan. You may experience this with your car, personal loan, or home loans. Businesses also pay interest on loans, and many bank customer’s deposit interest on their credit and debit cards debt.

    Importance of Interest Rates

    The interest rate paid is the amount owed as a fraction of the initial amount. In the short term, the interest rate is set by central banks that regulate the level of interest rates, to create a healthy economy and control inflation. In the long term, interest rates are set by money supply and pressure on demand. A high demand for long term maturity debt instruments will lead to a higher price and lower interest rates.

    Conversely, a low demand for long-term maturity debt instruments will lead to a lower price and higher interest rates. Banks benefit by paying the account holder a low interest rate and being able to charge people that borrow money a higher interest rate. However, banks need to minimize credit risk, which is the potential of a borrower to default on their loans.

    In general, banks benefit from an economic environment where interest rates are falling. When rates are low, banks pay their depositors lower rates, but loans are still lent out with a significant spread.  Additionally, when rates are low, there is more incentive for companies and individuals to borrow money, increasing the demand for loans.  The opposite also holds true. 

    When rates are high, personal loans demand tends to fall as loans are more expensive and the economy tends to be at a stronger point of the economic cycle – meaning that companies should be doing well and not need as much financing.  It also means that depositors might shift from other investments towards bank deposits, which then squeezes a bank’s interest margin.

    Defaulted assets

    A defaulted asset is an asset that is 30 or more days delinquent in the payment system of principal, interest, fees, or other amounts payable under the agreeable terms of the item. A common banking practice is to sell or auction off items put up as collateral on defaulted loans. This may be a house that’s been foreclosed on or a car that’s been repossessed.

    So, where does the unclaimed collateral go? You guessed it. The money garnered from the sale or resale of the items is funneled back into the bank’s budgeted collateral go.  You guessed it. The money garnered from the sale or resale of the items is funneled back into the bank’s budget.

    Banking fees 

    Another huge portion of a bank’s monthly income is made from various fees paid by their customers. Oftentimes, for example, charge account maintenance fees or penalty fees if your monthly balance sheets fall under a specified amount. Fees are attached to everything from account transfers to canceled checks.

    And, of course, there’s the dreaded overdraft fee for those times you might try to spend more money than you have in your account. In fact, in 2019, large banks made more than $11.68 billion from customers in bank fees, particularly from overdraft fees. Depending on the type of credit and debit cards you have, you may also be responsible for an annual card fee, and that’s not counting late fees or inflated interest rates if you carry a balance from month to month.

    Brick-and-mortar banks may also charge teller fees, fees to obtain bank statements, vault and safety deposit box fees, and other application and loan fees. This may seem like too many fees to handle, but remember, not all banks are fee driven, and choosing the right place to hold your money is important to your financial success.

    Interchange fee

    Interchange fees are the amounts paid between banks for the acceptance of card-based transactions. For example, if you use your debit card to make a $20 transaction, $20 is withdrawn from your bank account. But that’s on your end. Merchants, on the other hand, are typically charged a transaction fee by both your bank (the card issuer) and the merchant’s bank for electronic payment systems.

    This is another way for financial institutions to make money, interchange fees are a way your card issuer can afford to come up with the money to pay out credit card rewards, like cashback.

    Capital Markets-Related Income

    Banks often provide capital markets services for corporations and investors. The capital markets are essentially a marketplace that matches businesses that need capital to fund growth or projects with investors with the capital and require a return on their capital. Banks facilitate capital markets activities with several services, such as:

    • Sales and trading services
    • Underwriting services
    • M&A advisory

    Banks will help execute trades with their own in-house brokerage services. Furthermore, banks will employ dedicated investment banking teams across sectors to assist with debt and equity underwriting. It is essentially assisting with raising debt and equity for corporations or other entities. The investment banking teams will also assist with mergers & acquisitions (M&A) between companies.

    The services are provided in exchange for fees from clients. Capital markets related income is a very volatile source of income for banks. They are purely dependent on the capital markets’ activity in any given period, which may fluctuate significantly. Activity will generally slow down in periods of economic recession and pick up in periods of economic expansion.

    Fee-Based Income

    Banks also charge non-interest fees for their services. For example, if a depositor opens a bank account, the bank may charge monthly account fees for keeping the account open. Banks also charge fees for various other services and financial products that they provide. Some examples are:

    • Credit card fees
    • Checking accounts
    • Savings accounts
    • Mutual funds revenue
    • Investment management fees
    • Custodian fees

    Since banks often provide wealth management services for their customers, they can profit from the fees for bank services provided, as well as fees for certain investment products such as mutual funds. Banks may offer in-house mutual fund services to direct their customers’ investments towards.

    Fee-based income sources are very attractive for other banks since they are relatively stable over time and do not fluctuate. It is beneficial, especially during economic downturns, where interest rates may be artificially low and capital markets activity slows down.

    Additional ways banks make money

    There are other avenues banks take to make their profit, such as:

    Investing their funds in addition to making money on customers’ investments, banks invest their own money to turn a profit. Advisory or consulting service banks can also make money by becoming an adviser or consultant for outside businesses by assisting them with financial goals and strategies.

    Earning commissions Banks may have partnerships or relationships with other financial institutions like brokerage services and investment services that pay them a commission to refer to their customers.

    Recap

    Commercial banks are a critical component of the U.S. economy by providing vital capital to businesses and individuals in the form of credit and loans. They provide a secure place where people save money, banks earn interest, and make payments through checks, debit cards, and credit cards.

    However, keep in mind that banks are also in the business of money creation, so the relationship between you and your bank of choice should be mutually beneficial. Also, you can apply bank’s principles of creating money to your own finances and grow your income through the concept of infinite banking.