Love them or hate them, banks are integral to the fabric of the economy of any country. Nevertheless, how they actually generate huge sums of profits is still a mystery to many.
Banking basics tell you that the primary way a bank makes its money is by using yours. When you deposit money into the bank, it goes into a large collective pool of cash that is loaned out by the bank.
This money is used to drive liquidity into the economy by bankrolling everything from investments and personal financing to car loans and mortgages. As banks loan out large sums of money at a much higher interest rate than it pays on its assets (deposits from you), it pockets the difference to make profit. In other words, banks borrow on short-term rates (such as deposit rates) and lend out/deploy capital at long-term rates (investments, institutional loans and mortgages, etc).
Banks within our economy
There are safeguards built into the system to ensure that your money is as safe as possible – banks can after all over-leverage themselves and hence be unable to pay back its short-term loans when business on its long-term loans turn sour. This typically happens in a bank run, when one discovers that his or her bank deposits are suddenly in jeopardy.
Governments set a minimum reserve amount for the bank’s use of your money. For instance, a 10% reserve requirement means that for every $100 deposited, it can only loan out $90. While the $10 is kept as reserves, there is nevertheless $90 of new credit.
It is this money that goes back into the economy – through consumer spending – eventually ending up being deposited with another bank. This means that other banks can then loan out 90% of that $90 to someone else, creating a huge and wide-ranging reach for your initial $100 deposit.
The following is a textbook representation of this multiplier effect:
$100 with a reserve ratio of 10% will become:
$100 X 1/10% = $1000
This economic driving mechanism is not without downside. If everyone who had a bank account decided to withdraw their money at the same time (known as a run on the bank) like in Greece in 2014 or Iceland in the late 2000s, then the bank would simply not have sufficient funds to be able to give you back yours.
It is – in theory – a risk. However, the number of banks that have collapsed, owing people money that it couldn’t pay is extremely small.
Revenue streams of banks
In retail banking, banks make revenues from overdrafts, banking charges and transactional consumer behaviour (for example, taking a small clip of a credit card transaction for processing the payment). It is this side of the business that often makes headlines.
There is often media uproar about the revenue earned by banks (like in 2015 when it was revealed that the top three banks in the US made $1.1b from overdraft fees) and America’s Consumer Financial Protection Bureau reported that 61% of profits in retail banking came from such fees. However, the reality is that banks on average only earn 8% of their revenue from overdrafts.
The vast majority of the profits that banks make come from the lending side of the business. This comes in many other forms, the most popular of which are listed below.
This is the practice of banks lending large sums of money to other banks in an internal industry marketplace. These short term loans are designed to ensure the receiving bank has liquidity at times when it feels there may be a shortage of cash to be made available for withdrawal.
Rates for this loan market change multiple times every day, with varying terms for the maturation of the loan. The shortest loan term is overnight, but there are also one week, and 1, 2, 3, 6 and 12 months loans.
Put simply, credit cards are some of a bank’s largest revenue generators for a reason. According to sg.finance.yahoo.com, Singapore cardholders own the most number of credit cards across the region, with an average of 3.3 cards per individual.
Figures published by the Credit Bureau of Singapore in October 2015 show 85,352 Singapore consumers have overdue unsecured debt totalling $288.4m. With an average interest rate of close to 20% being charged on credit card debt, it is easy to see how banks can make money from credit cards.
Every time you use your card, your bank makes money. The fee is called a “Swipe Fee” and in theory is supposed to be to cover the costs of ensuring the transaction is secure and covering the cost of fraud. Rates vary from bank to bank but are invariably regulated to ensure the cost isn’t too high.
Funds and Insurance
Many commercial banks now offer investment and retirement vehicles to their customers. They also offer a range of products and advice on funds, annuities and portfolios. The big players will probably own their own products, although most smaller banks will just take commission from selling products for other people.
The aforementioned are typical streams of retail banks. There are also more aggressive and riskier business models that investment banks might have. These include a whole gamut of operations in financial markets, private banking services, and many more.