A bank makes money in various ways, including charging fees and interest. Banks make money through the process of lending. Customers — or borrowers — take out loans to finance a project or a business idea. The loan is a capital injection that allows the borrower to proceed with their venture. Banks also make money through corporate banking, which includes the traditional activities of helping companies manage their cash flow. Still, it also has more advanced services aimed at assisting companies in raising money. Corporate banking revenues come from fees for loan origination, loan servicing, and providing account information.
What is Banking?
Banking is the process of managing the money supply. Think of it as a system for managing the flow of funds, allowing people to invest and companies to get loans. Think of it as a way for people and companies to manage their money. The bank makes cash by charging fees and interest. The fees are hidden costs that the bank charges for services provided. The interest is an additional amount charged on top of the loan principal. The interest is usually higher than the original loan principal, and it accumulates over time. This is the reason why banks can make money. It is good noting that the article only explains the basics of banking and the monetary system.
The Basics of Banking and the Monetary System
Banking is the process of managing the money supply. Think of it as a system for managing the flow of funds, allowing people to invest and companies to get loans. Think of it as a way for people and companies to manage their money. - Banks make money through the process of lending. Customers — or borrowers — take out loans to finance a project or a business idea. The loan is a capital injection that allows the borrower to proceed with their venture. - The bank makes money by charging fees and interest. Fees are hidden costs that the bank charges for services provided. Interest is an additional amount charged on top of the loan principal. Interest is usually higher than the original loan principal, and it accumulates over time. This is the reason why banks can make money.
The Basics of Money and Banking
Money is any form of a medium of exchange that is accepted by buying and selling. It is a medium of exchange because buyers and sellers generally accept it. - Just like anything else, money comes in different forms. These forms are coins, banknotes, and credit and debit cards. There are also many different sums of money. The Swedish Krona, Swiss Franc, Euro, Japanese Yen, and American Dollars are major currencies used worldwide. - The monetary system is how governments and banks manage the flow of money into and out of a country. Generally speaking, the monetary system consists of two main parts: the money supply and the monetary policy. Below are different ways how banks make money:
Corporate Banking
Corporate banking includes the traditional activities of helping companies manage their cash flow, but it also has more advanced services aimed at assisting companies in raising money. Corporate banking revenues come from fees for loan origination, loan servicing, and providing account information. Companies also pay for advice about whether it makes financial sense to go public, merge, or acquire another company. Corporate banking also creates opportunities for investment banking, which is covered below.
Investment Banking
Investment banking is the process of helping clients raise capital through equity and debt offerings, mergers and acquisitions, and issuing other securities. The objective of investment banking is to make revenue for the bank through fees for providing services, whether related to the issuance of securities or helping with the structuring of the deal. Investment banking revenue comes from fees for services like underwriting securities deals and structuring debt offerings. Investment banking also creates opportunities for corporate banking and mergers and acquisitions, which are covered above.
Credit and Collateral Loans
Banks make money on loans and mortgages in several ways. The most obvious is the interest that the borrower pays on loan, but banks also make money on other facets of the loan, such as the right to foreclose on the property if the loan is not repaid. Loan revenue comes from interest and fees for origination and document review services. Revenue from servicing the loan comes from collecting, foreclosure, or rehabilitation fees.
In order to issue loans to customers, banks need to gather deposits of money from customers. This is called a “credit” deposit, and the customer who deposits money is called a “lender.” Credit deposits are generally offered in return for interest.
- Credit and debit cards are generally processed through the Automated Clearing House (ACH) network. This network is owned by a number of banks and is used to collect ACH payments from customers and then distribute that money to the banks.
- The ACH network works through a system of checks and credits. Each bank that processes payments deposits money directly into its account. Once money enters the account, it can be transferred anywhere with a direct bank connection. This could be another bank account or a merchant’s account.
- Credit and debit card payments are generally settled quickly, usually within two days. Compared to the two to three weeks that credit payments are settled. This is because credit payments can be settled through a third-party settlement system.
- Credit and debit card payments are settled through a process called “carve-out.” During settlement, the bank or card company takes ownership of the funds in that account. This is done so that the funds do not sit in a “pending” state or “closed” state.
- After funds are deposited into a bank account, they are generally used for the following purposes. They can be used for deposits into a customer’s bank account, withdrawals from a card account, or transfers to another institution.
Deposits and Interest
Deposits are generally made to gather interest. This is because banks can charge interest on deposits. The exact amount of interest they charge depends on the type of deposit. Deposits with interest-bearing securities are generally charged a higher interest rate.
- The ACH system generally collects interest deposits. The funds are distributed to the banks that participate in the system.
- Credit cards generally charge an annual interest rate between 15% and 25%. Interest rates on bank loans can range from around 1% to 10%.
- Banking regulations require banks to use a certain percentage of deposits for loans. This is called the “loan-to-deposit ratio” or the “liquidity ratio.” The liquidity ratio is generally between 50% and 100% and is rarely below 50%.
Trading and Commissions
Trading is the purchasing and selling of assets to profit from price fluctuation. Trading requires a lot of capital and is generally only undertaken by large institutions. - Trading is a way for banks to make money through the use of derivatives. Derivatives are financial contracts that derive value from underlying assets like stocks, bonds, commodities, and currencies. Banks use derivatives to derive a profit when the underlying asset increases in price or decreases in price. - Trading also often requires the use of hedging.
Hedging is a financial technique that involves taking a position on both sides of a trade. This means the bank will gain if the price of the underlying asset goes up and will lose if the cost of the underlying asset goes down. - It is worth noting that trading is done on both the buy and sell-side of the market. This is because trading is generally a risk-taking activity that requires a certain amount of capital.
Securities Trading: Trading securities is a popular way for banks to generate revenue. The most common trading product is a stock or bond index fund. Banks that offer index funds usually charge a management fee plus a percentage fee on the funds they manage and their profits from trading.
Derivatives Trading: Derivatives include insurance contracts like annuities, indexation contracts that help companies raise the value of their stocks, and futures contracts that help investors hedge against price declines in a commodity like oil. Each type of derivatives contract has different characteristics, and banks have different policies for offering them, so it’s hard to say which is most profitable.
Commodities Trading: Commodities trading is similar to derivatives trading. Instead of hedging against price declines in one good or service, the contracts also help buyers lock in a cost for future delivery of a particular type of good. One example is when a farmer agrees to sell a certain amount of his crops to a buyer for a set price in the future.
Conclusion
Banks make money in several ways. This article explains the primary revenue sources for banks and how they make money. Meanwhile, to successfully launch a bank, you’ll need to consider which revenue model is best for your bank. Once you know that, you can dive into creating an effective business model. The article explained the basics of money and banking. You learned about the flow of funds, the monetary system, credit and debit cards, and deposits. We also explained how banks make money through lending, credit and collateral loans, and trading and commissions.
