How do banks make money?
This is a question that was asked by one of my readers.
One of the numerous functions of banks is to provide consumers and businesses with a means of storing money and obtaining credit.
However, many financial organizations are likewise concerned with making money from the same people they serve.
Knowing how banks make money will help you figure out what to look for in a new bank.
Diversified banks generate revenue in a variety of ways; yet, at their core, banks are lenders.
Banks make money by borrowing money from depositors and paying them a certain interest rate in exchange.
They will lend the money to borrowers, charging them a higher interest rate and benefitting from the interest rate differential.
Alternative financial services, such as investment banking and wealth management, help banks diversify their business models and create revenue.
How Do Banks Make Money
- Interest earnings
- Earnings from fees
- Profits from capital markets
Earnings From Fees
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.
Checking accounts, credit card fees, savings accounts, investment management fees, mutual fund earnings, and custodian costs are just a few examples.
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.
Still asking the question on how do banks make money? Continue reading to learn more.
Income from Capital Markets
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 help in capital market activity by providing a variety of services, including:
- mergers and acquisitions advisory
- Sales and trading services
- Underwriting services
With their own in-house brokerage services, banks will assist in the execution of trades.
Banks will also hire specialised 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 corporate mergers and acquisitions (M&A). 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.
The principal source of revenue for most commercial banks is interest income.
It is completed, by removing money from depositors who do not want their funds right now.
Depositors are compensated with a particular interest rate and the security of their savings in exchange for depositing their money.
The bank can then lend the deposited monies to borrowers who require cash immediately.
Lenders are required to repay borrowed cash at a greater interest rate than depositors are paid.
The interest rate spread, or the difference between interest paid and interest received, allows the bank to profit.
By now I know the question on how do banks make money has been answered.
Interest Rates’ Importance
After learning how banks make money through interest rates, it is also prudent to learn the importance of interest rates.
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.
If demand for long-term debt instruments is expected to increase, it results 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 borrowers.
Banks, on the other hand, must manage credit risk, which is the risk that a borrower 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 borrowers are reducing.
Ways to Cut your Banking Expenses
While banks may provide services that are beneficial to you, you may also look for methods to save money by lowering your banking bills since now you are aware of how banks make money.
1. Do not use overdraft services
Accepting an overdraft from your bank or credit union may result in overdraft costs.
To avoid nonsufficient funds fines, keep an eye on your balance and balance your checkbook on a regular basis.
2. Seek out no-fee banking options
Look for banks that don’t charge a minimum balance or a monthly service fee if you only want a simple checking or savings account.
Even having a fee-free checking account, bear in mind that there may be other charges, such as ATM fees levied by third-party providers.
3. Be wary of high-pressure sales tactics
Bank tellers are often thought of being helpful customer service representatives.
However, at other banks, they have a dual role and are also expected to sell products.
Tellers may try to persuade you to open additional bank accounts in order to reach their sales targets (remember the Wells Fargo fake account scandal).
When you buy investments or insurance products from a bank, the bank can earn commissions or collect fees.
Be wary of potential conflicts of interest if your financial adviser works for a bank, especially if your adviser is paid on commission.
4. Be aware of what you’re getting for your money
If you believe the advantages outweigh the costs, paying a charge for a service or product is a good choice.
Annual credit card fees, for example, may be justified if the benefits of perks and rewards outweigh the costs.
However, many rewards cards, notably travel cards, do not charge an annual fee.
5. When applying for a loan, do some comparison shopping
Fees and interest on a loan, especially if you’re taking out an auto loan or a mortgage, may be one of your biggest banking expenses.
When looking for a lender, you can shop around – you don’t have to borrow money from your present bank.
Shopping for a loan isn’t always bad for your credit, and you’re under no obligation to accept a loan offer once you’ve been accepted.
Comparing offers from various lenders will assist you in locating a loan with the lowest fees and interest rates feasible.
In general, the less money you spend on banking fees and penalties, the more money you’ll have to pay off debt, save for the future, and invest.
While banks may profit from providing these services, you will both benefit in the long term.
Conclusion on How do Banks Make Money
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 frightened to look about 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.
On the question of how do banks make money, I hope you have learned a thing or two.