In our fifth semester of undergraduate studies, we had a course on Banking. Among the new things that I learned was that banks make money in a variety of ways, with four of these being their core money-making activities. Let’s learn a bit more about those activities.
Money-making Activity #1: Transformation
Transformation is the number one activity of banks, without which you really cannot call a bank a bank. The word sounds really fancy, but it essentially means this: that banks take deposits and lend loans. It also implies that banks take money from where there is a surplus of it and channelize it into places that have a deficit of it.
You can look at it this way: You have a bunch of money stashed in your piggy bank. It’s essentially just lying there, doing nothing. Your big brother knows this. He also knows that he has run out his own pocket money. So, he comes up to you in need of a favor. Will you lend him $50 to buy a new outfit for a party he has coming up? You say, “Absolutely not!” He offers to pay you back in one week when he gets his pocket money. You still aren’t convinced. “How about if I also treat you to ice-cream?”
Now we’re talking.
Here’s how the example may play out in the real, more serious world of banking:
If you have more money than you need, you may deposit it in a bank. Banks will then lend this money to someone in need — for example, a business that needs funds to expand.
In return, you will get interest — your ice-cream treat!
This function is called transformation for a reason. Here’s how the transformation part may come into the picture:
a. The deposits that banks take are usually small in amount and pooled together to lend out one big loan to one person or entity.
b. The money is deposited by individuals for a short time period, whereas the loan given out is for the longer term.
c. Without the option of depositing your money with the bank, you may have lent it to your big brother, who would have been bound to return it to you for fear you’d make his life living hell if he didn’t — signifying lower risk compared to letting banks invest your money in outlets with a higher risk than what the average depositor (here, you!) would have wanted to take.
What this says is that banks are transforming:
- the scale / quantum / size of money (small deposits pooled to advance one huge loan),
- the duration / time period / maturity (short-term deposits into a long-term loan), and even
- risk (using deposits — pooled from individuals who want to keep their money safe — to provide money to borrowers who usually signify higher risk).
Who would’ve thought there was so much to it, huh?
So, how do banks earn money through transformation?
Right. Well, we all know,
When we borrow money from banks, they don’t give it to us for free.
They charge interest (their ice-cream treat!).
On the other hand, individuals like you and me, who have deposited our money with the bank, don’t give it to the banks for free either!
We expect the bank to pay us interest (our ice-cream treat!).
The difference, i.e.
the interest income that banks receive on loans advanced
minus
the interest that they pay on the deposits they have with them
is their net interest income (NII) in value.
This is also called their net interest margin (NIM) in percentage, i.e. the interest charged on or earned from loans minus the interest paid on deposits.
And voila! This is how banks make their money.
Money-making Activity #2: Intermediation
While asset transformation is banks’ number one business activity, most banks also deal in a range of financial services. When banks offer services in the form of asset/wealth management, underwriting, custodianship, etc., they earn money in the form of fees, commission, spreads, and/or brokerage. All of this money earned by acting as an intermediary and performing various financial services is money earned from the activity of intermediation.
Money-making Activity #3: Payments
Banks also execute payments. Need to get your bills paid? Have to pay your tuition fees? On a shopping spree? No problem! Checks, credit cards, and internet and mobile banking have made making payments a lot easier. In return, banks charge money from customers who wish to avail of these facilities. Take credit cards, for example. Those who have been late in paying their dues will know how much banks can earn as interest on those dues.
Money-making Activity #4: Investments
Not only do banks invest money for their clients by offering wealth management services, but they also invest their own money in long-term investments as a precautionary measure. And when someone invests their money elsewhere, they expect to get a return. The same is the case with banks. When they invest their own money, they earn interest, which serves as yet another means of income.
Ta-da! There you have it. Four ways banks make money.
Who knew banks did so much more than just accept deposits and advance loans?
Special thanks to my Banking professor at college for equipping me with the basic understanding and knowledge to write this article.
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