Some people believe banks simply act as a vault for your savings, but they do a bit more than that. Here we'll look at how banks make money.
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Interest on Loans
The word “bank” typically refers to institutions that accept deposits and make loans. One of the primary ways banks make money is from loan interest. When a depositor puts money in a savings account at a bank, they likely receive a small interest rate from the bank on that amount. The depositor expects to be able to get their money back anytime in the future.
Because the depositor doesn't need their money at the moment, the bank is able to borrow some of that money at that rate and lend it out to borrowers at a higher rate. The rate differential, called the spread, is the bank's profit. This process of providing credit is called financial intermediation, and it's the cornerstone of most financial systems.
For example, suppose the bank pays you a 1% interest rate and gives a loan to a borrower at 3%. The bank thus earns 2% in profit. Examples of such loans are auto loans, mortgages, business loans, and personal loans. These loans will typically have an interest rate much higher than that which the depositor is earning on their savings account.
The bank is able to loan out your money due to what's called fractional reserve banking – banks are only required to keep a small percentage of your actual deposits in reserve. Fractional reserve banking is a fundamental part of modern economies.
For example, if you deposit $100 in your account, the bank may only be required to actually hold 10% or $10 in reserve and can lend out the other 90%. Primary reserves are actual cash. Secondary reserves are short-term securities like government bonds.
An obvious way both commercial and investment banks make money is from fees. These fees can take many forms and can be recurring or one-time. These could be things like:
- Account maintenance fees
- ATM fees
- Wealth management fees
- Loan servicing fees
- Overdraft charges
- Interchange fees
- Wire transfer fees
- Corporate transaction advising fees
While this revenue source may sound insignificant at first glance, these fees can add up over time across many accounts. For example, according to the Consumer Financial Protection Bureau, so-called “free” checking accounts generate about $8 billion in annual revenue for banks from overdraft fees alone.
Fees are an attractive revenue source for commercial banks because they are more stable and predictable than others that fluctuate with interest rates and economic conditions.
A bank may choose to invest some of its reserves in assets like stocks, bonds, and real estate just like individuals do, earning them a positive return on that money over time.
For example, a bank can buy a government bond that pays periodic interest payments until maturity, a portfolio of dividend stocks that pays regular cash dividends, or property that is expected to appreciate in value that can be sold later for a capital gain.
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