It might strike you odd if you come face to face with this question, ‘how do banks make money?’ Yes, indeed, the bank is more like the safety vault of our money, so the fundamental question is how and why does it need to make money?
Well, a basic fact that we cannot afford to forget is that banks are after all businesses and they have myriad expenses and need funds to support all the staff that they need to hire for their effective functioning. It is, therefore, very important to understand how banks make money?
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Basics Of Banking
The marketplace is full of various types of products and services. You have to understand that exactly in that way the bank is like a shop that buys and sells money in various forms like loans, deposits, certificates of deposit and many other types of financial products.
In common terms, a bank’s fundamental business is borrowing and lending money. Their earnings comprise of the interest that they earn from independent customers. The interest at which they lend money is always higher than what they borrow money at. This difference in interest rate is what comprises a chunk of the funds earned by both commercial and retail banks. They essentially borrow money from other customers who deposit their hard earned cash in the bank for safekeeping.
In that context, the rate of interest that a bank charges is entirely dependent on the demand and supply dynamics for a particular amount, the number of people who are ready to borrow the amount and the exact amount that the bank can spare as loan. Not just the bank’s availability, but the loan eligibility of every person is dependent on certain norms specified by the country’s central bank. This is because loaning money can be extremely risky business and there never any certainty that the bank will actually get back the amount that is being loaned.
Banks also charge customers a certain amount as charges or fees for taking care of the bank accounts of individual customers. There are few other miscellaneous charges levied by the bank like charges levied for overdraft facilities or cheque facilities and the like.
In case of investment banks there are some additional services like advising firms about their investment decisions, doing initial public offers or share issues that enable companies to list on the exchanges, underwriting IPO issues and levying consultation charges on all of these. They also trade equities and have open forex and debt positions in the market to expand their wealth base.
There are many other services that a bank caters to and levies charges on like teller services, checking statements and account balance, accessing the bank account from any ATM which might not belong to the parent bank and the like. Apart from these, the loans that a bank processes also have a separate set of fee structure levied on all the various types of loans that are issued.
The Various Tools of Raising Funds for A Bank
In that context, it is particularly interesting to look at the various heads through which the bank raises funds.
Levying Interest Rate on Loans
With rising aspiration levels, consumers are trying to look at unique ways of realizing their dream car, house and many such materialistic ambitions. One of the easiest and non-complicated ways of receiving this dream is a bank loan. There are a wide range of loans that are on offer from home loans to car loans, personal loans, travel loans and loans for investing in securities. The bank levies varying degrees of interest rates on different types of loans depending on the duration of the loan and the amount of loan involved.
Normally the rate of interest at which the loan is issued is generally lower than the interest the bank offers on deposits that its consumers make. It is this difference in the rate of interest and the interest earned in servicing the loan that works as one of the primary sources of raising money for a bank.
Even the interest rate that a bank offers on deposits helps it attract new customers to do business with the bank and all the processing and banking fees involved in the process of initiating the deposit is also a source of fund for the bank.
This essentially brings us to the next source of fund for a bank. Think about it when you open a bank account, there are number of fees that you need to pay for getting an account serviced. From processing fees to service charges to loan fees, it is an endless labyrinth of fees. When standalone these are extremely nominal amount, when accumulated this becomes a significantly large sum.
The bank needs this huge amount to pay wages and salaries of the huge employee base that they normally have. The bank needs to maintain this kind of a huge employee base to ensure that customers get a complete range of personalized service.
Many customers who might be shying away from putting their huge deposits in banks due to their inexperience in dealing with banking processes can be attracted in this manner. This kind of personalized service woos them to bring their savings to the bank and take advantage of the lucrative interest rate benefits. Needless to mention it is all the service charges collected as a result of these services is what funds the bank’s expenses.
Think of a shopping mall, if you do not have the required number of customers coming in everyday, buying stuff, eating food at the food courts, availing the services offered by the many stalls that are set up there, what would happen? The shopping mall would eventually close down, and the businessmen would have to wrap up their business very soon.
Now, the same principle applies to a bank. The customer base is any bank’s backbone. Without the target number of customer base, proper functioning of a bank is absolutely impossible. That is why it becomes very important for a bank to nurture its customer base to make money.
When a customer walks into a bank, it is not just one service they look at. Normally there are advertisements of multiple range of service that the bank might be offering and many times when a customer walks in he or she might be wooed into availing another service about which they might not have given any thought till that time.
Thus the amount of money that a bank makes is directly proportional to the total amount of customers it is able to attract and the range of service it is able to attract.
Another very popular mode of earning money for a bank is through the rate of interest earned via inter-bank lending. In simpler terms, it means that when one bank lends money to another bank, a certain amount of interest is levied on it. This directly goes into the bank’s kitty of funds that it raises for its effective functioning and faultless maintenance. The steady fund inflow is one of the most fundamental triggers to maintain this service record and attract additional customers.
Most of this lending is for the short-term, sometimes just overnight loans and at times extending for 3 months also. These loans are essentially for addressing a bank’s daily liquidity needs and day to day expenses and payouts that might be lined up on a daily basis. The benefit of an inter-bank lending for the borrower bank is the fact that rate of interest at which it takes the loans is always at the best possible rates compared to any loan from other sources. This helps the bank save crucial interest outgo that might otherwise have drained its balance sheet. Hence, this two becomes a form of earning for the bank.
Inter-bank lending is not just in terms of money lending and borrowing. If the bank has surplus assets that it can put forth in the market place, it can even make money by putting out these assets on loan to customer banks. In this way instead of these assets being NPAs or non-performing assets for the bank, it is a unique way in which it can turn a liability into a profit making proposition and instantly opens up a revenue source for the bank without too much of a service cost.
You might have often heard these being mentioned in financial results of the banking companies. It is, for this reason, that rising NPAs is seen as a negative for the future growth of the bank while a decrease in it is always given a big thumbs up by the street, especially in terms of the bank’s future outlook.
Auction of Assets
Many times when an individual or a company defaults on a specific loan, the bank impounds on the collateral that was given in exchange of the loan amount and puts it up for sale. These can involve a wide range of products ranging from houses, cars and other personal belongings including jewellery.
The bank has to bear additional cost for the maintenance and upkeep of all these properties and ensure that no damage is done to them. In contrast to that auctioning these properties is an easy way for the bank to recover the defaulted loan amount as well as dispense with the collateral that it had taken over.
Thus, this kind of disposal of the asset is not just profitable but also a low expense affair for the bank while try to boost its bottom-line in the best possible manner.
Trading In Securities
Many banks, especially the investment banks are active traders in the equity, forex and commodity markets. They have a huge customer base who are invested in the various financial instruments floated by them like Mutual Funds, SIPs and the like.
The bank in turn uses this amount to invest in various securities trading as well as open positions in the debt market as well. What this does is helping the bank in fat-lining its profit parameters as well as maximising gains for its customers through this wide-ranging investment basket. The favourable rate of return acts as an easy trigger for additional interest and increased interest in the investment tools offered by a particular bank.
Charges for Financial Advice & Services
This is another interesting and hugely beneficial service offered by investment banks. Many big companies which are not listed thus far and plan and initial public offering seek the advice from established financial institutions like investment banks for effective execution of their red herring prospectus and eventual offering.
This is also applicable for all those companies that are looking to explore the markets for a follow-on public offering. The bank provides crucial advice in terms of what rate the issue should be priced, the total number of shares issued, conducts the due diligence of the interested company and many such associated services. Of course, all of this is for a price. This is the advisory fee that the bank charges in return for its services and the time it spends to finalize the deal for the specific company.
A lot of times a bank’s help is sought in negotiating crucial acquisition and mergers of companies as well. The logic is when a big investment bank is involved; the chances of good deal are always higher with limited scope for foul play. Fair pricing is also another great motivation for involving an investment bank to negotiate M&A deals.
Charges For Vaults
Many of us are scared to keep our precious jewellery, important documents at home. The threat of theft makes them nervous, and the bank comes to the aid of all such customers. They have vaults of various sizes and dimension to suit the needs of many different types of customers who require these vault services.
The bank charges annual fees for the maintenance, upkeep and also monthly rental in return for these services. While customers are happy that their precious documents and jewelry are in safe hands, the banks use this unique opportunity for enhancing its profit base.
Maintaining a vault does not require a huge manpower either. In that way, it is yet another low expense formula to enhance the bank’s earnings.
Apart from these the bank charges many miscellaneous fees like charges for issuing a cheque book or ATM card or access of debit card or credit card transactions internationally. While the service charge for these specific ones are very nominal, and the customer doesn’t mind paying given the convenience it entails, the bank rakes in significant sum by sheer number power.
As a result, banks make the business of money making a means of making money for them.