Typically, as centers for money and financial services, banks deal with lending money and keeping it secured for their customers. However, have you ever wondered how banks make money? Genuinely, similar to any other profit-driven enterprise, banks charge for their services and financial goods. Banks’ principal sources of income interest on loans and fees linked with their services. Nevertheless, you can read this article for a summary of the ways that banks earn income. You should know this because learning about appropriate money management methods can keep banks from taking advantage of you.
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How Do Banks Earn Income?
Generally, many banks earn income in a variety of ways. Nonetheless, at their core, banks are considered lenders. Banks usually borrow money from depositors and repay it with interest. For example, banks will lend money to borrowers, charging higher interest rates and benefitting from the interest rate spread.
Furthermore, banks typically expand their business portfolios and generate income from financial services such as investment banking and wealth management. However, the money-making business of banks can be divided into the following categories:
1. Interest Income
Most commercial banks make the income of their money through interest income. As previously said, it is performed by withdrawing funds from depositors who do not require them right now. Thus, depositors are given a particular interest rate and security for their funds in exchange for depositing their money.
Besides, the bank can then lend the deposited monies to borrowers who require the funds immediately. Lenders must repay borrowed cash at a higher interest rate than depositors get. Notably, the interest rate spread, which is the difference between interest paid and interest received, allows the bank to profit.
Obviously, the interest rate is essential to a bank as a critical income generator. The interest rate is a proportion of the principal amount owed, the amount borrowed or deposited). In the short term, interest rates are determined by central banks, which manage interest rates to maintain a healthy economy and limit inflation. However, long-term interest rates are determined by supply and demand pressures. High demand for long-term debt products will increase prices and decrease interest rates. On the other hand, low demand for long-term debt instruments will result in lower costs and higher interest rates.
2. Capital Markets Income
Usually, banks frequently offer capital market services to both companies and investors. Capital markets are simply a marketplace. They connect companies in need of finance to fund expansion or projects with investors who have capital but want a return on investment. Banks enable capital market activity by providing a variety of services, including:
- Sales and trading services
- Underwriting services
- M&A advisory
Banks will assist in the processing of deals using their in-house brokerage services. Moreover, they will also hire specialized investment banking teams across industries to help with debt and equity underwriting. It simply assists firms or other entities in raising financing and equity. The investment banking teams will also assist with corporate mergers and acquisitions (M&A). Client fees are collected in exchange for the services.
Capital market income is a highly volatile source of income for banks. They are entirely dependent on the activity of the capital markets at any particular time, which might fluctuate dramatically. In general, activity will slow during periods of economic recession and increase during moments of economic prosperity.
3. Fees-Based Income
Banks also charge non-interest fees for their services. If a depositor creates a bank account, the bank may charge monthly account fees to keep the account open. Banks also impose costs for a variety of other services and products. Here are the examples:
- Credit card fees
- Checking accounts
- Savings accounts
- Mutual fund revenue
- Investment management fees
- Custodian fees
Banks frequently provide wealth management services to their customers, so they can benefit from service fees and fees for specific investment products such as mutual funds. Additionally, banks may provide in-house mutual fund services to guide their customers’ investments.
Fee-based income sources are particularly appealing to banks because they are steady and do not change over time. It is advantageous, particularly during economic downturns when interest rates are artificially low, and capital market activity slows.
What Are Banks’ Major Expenses?
We have already seen how banks generate income. However, what about their expenditures? A bank, like any other business, must ensure that its assets exceed its liabilities to stay profitable. A bank has two types of liabilities: interest and non-interest expenses.
1. Interest Expenses
The majority of a bank’s expenses are interest payments to depositors. As their primary operation entails borrowing money from depositors to provide loans, depository banks carry substantial amounts of debt and suffer significant interest expenses. Therefore, banks must always be able to repay the interest they owe. Otherwise, they risk insolvency and financial difficulties.
2. Non-Interest Expenses
Importantly, a bank’s fixed operating costs are non-interest expenses, commonly known as overhead. These represent around 15% of the bank’s total expenses. Personnel costs such as salary and benefits are significant non-interest expense for a bank. Nevertheless, rent, equipment, web hosting, taxes, and professional services such as legal counsel, IT assistance, and marketing are also significant expenses.
Conclusion
In short, banks are profit-driven enterprises that must earn more money than they spend. On the other hand, they are an essential part of the economy because they assist in creating liquidity in the market by lending money to people in need, increasing output, employment, and consumer spending. Now that you understand how banks manage their bottom lines, you may believe it is time for you to take an active role in managing your finances.
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Source: CFI