How do Banks Make Money? Explanation, Examples
While the term "bank" may conjure a monolithic image, the reality is far more nuanced. The world of banking can be broadly divided into:
Retail Banks: Think of your local branch where you have your checking and savings accounts. For example, Wells Fargo and Bank of America are giants in this space.
Commercial Banks: These cater to businesses, providing loans, treasury, and cash management services.
Investment Banks: Institutions like Goldman Sachs and J.P. Morgan, which offer services in underwriting and M&A advisory.
The profit-making strategies differ across these banks. Let’s dive into the primary sources.
Key Revenue Streams for Banks
Interest Rate Spread
Banking, as many of us understand it, is built on a foundation of trust. When you deposit money in a bank, you're essentially lending to the bank.
They pay you interest for this "loan" and then lend this money out to other customers at higher interest rates, pocketing the difference. This practice is termed the Interest Rate Spread.
Imagine a simple scenario. You deposit $10,000 in a bank savings account earning 0.5% interest annually. In a year, the bank pays you $50. Now, the bank loans out that $10,000 to another customer in the form of a mortgage at a 4% interest rate. From this customer, the bank earns $400 in a year. Subtracting the $50 paid to you, the bank makes a net profit of $350.
This model is foundational for retail and commercial banks. It's also why banks are so eager to have deposits; they're the cheapest form of capital for them.
Fees and Commissions
Beyond the money banks make from lending, a significant portion of their revenue comes from a plethora of fees. These charges might seem minuscule on an individual level, but when spread over millions of customers, they amount to substantial sums.
Monthly Maintenance Fees: For the convenience of banking services, many institutions charge a monthly fee, especially if account balances drop below a certain threshold.
Wire Transfer Fees: Transferring money, especially internationally, often comes with a cost. Some banks charge both the sender and receiver.
Overdraft Fees: If you've ever spent more than what's in your checking account, you've probably been hit with an overdraft fee. These charges were in the spotlight in 2019 when U.S. banks accumulated over $11 billion from them alone.
Loan Origination or Service Fees: This is a one-time fee charged by the bank when initiating a new loan, serving as a setup fee for the loan process.
Trading and Proprietary Trading
Many large banks are involved in trading activities. This can be trading on behalf of their clients (like when you buy a stock through a bank's brokerage service) or proprietary trading where banks invest their own money.
2019 was a notable year for trading, especially for banks like J.P. Morgan. Volatile markets often lead to more trading activity as investors look to buy low and sell high. This increased activity translates to more commissions for banks and potentially higher profits from proprietary trading.
Investment Banking Activities
Investment banks have a dual role; they provide advisory services to corporations and governments and raise capital by issuing and selling securities in the capital markets.
When Facebook went public in 2012, it needed an investment bank to handle the Initial Public Offering (IPO). Goldman Sachs was one of the lead underwriters and earned considerable fees and reputation points for facilitating one of the largest tech IPOs ever.
Asset Management and Private Banking
While most of us are familiar with regular banking services, there's a high-end segment dedicated to the uber-rich and institutional investors. These services can range from simple wealth management advice to intricate financial planning and strategy.
Take UBS's Wealth Management division. They don't just offer to manage money. They craft investment strategies, offer estate planning, and even philanthropy advice, managing hundreds of billions and earning a percentage as fees.
Innovations and Emerging Revenue Channels
The banking industry, though age-old, is not impervious to change. The emergence of digital banking, FinTech partnerships, and cryptocurrencies are forging new revenue streams.
Banks that once relied heavily on brick-and-mortar operations are now collaborating with tech giants like Apple to launch credit products.
The Costs: Where Banks Spend
Operating a bank is no small feat. While they pull in significant revenue from various channels, they also encounter substantial costs and expenses, essential to keep the institution running smoothly, maintain trust, and ensure compliance with ever-evolving regulations.
Regulatory and Compliance Costs
The financial sector is one of the most tightly regulated industries in the world. Following the 2008 financial crisis, regulations have intensified, pushing banks to allocate more resources to ensure compliance.
Dodd-Frank Wall Street Reform and Consumer Protection Act: Introduced after the 2008 crisis, this U.S. federal law forced many banks to rethink their strategies and invest heavily in compliance infrastructure. It aimed to reduce risks in the financial system. Adhering to this alone costs banks billions.
Anti-Money Laundering (AML) and Know Your Customer (KYC) Regulations: To combat fraud and illegal transactions, banks are required to have robust systems in place to verify the identities of their clients and monitor transactions. Implementing and maintaining these systems is costly.
The day-to-day costs of running a bank can be immense. These include:
Physical Branch Costs: Rent, utilities, maintenance, and security for each branch.
Salaries and Benefits: From the tellers at the local branch to the high-flying investment bankers in skyscrapers, human resources are a significant cost. Benefits, bonuses, and training programs also add up.
Technology Infrastructure: With the rise of digital banking, banks are investing heavily in technology, from maintaining servers to developing user-friendly apps and ensuring top-notch cybersecurity.
Risk Management and Loan Loss Reserves
Lending money is a risky business. Not all borrowers will pay back, and banks have to be prepared for these eventualities.
Provisioning for Bad Debts: Banks use sophisticated models to predict the amount of loan defaults they might experience in a given period. They set aside a portion of their earnings, known as provisions, to cover these expected losses.
Capital Buffer: Regulatory bodies require banks to maintain a certain level of capital to ensure they can weather economic downturns. This means banks can't use all their deposits for lending; they have to keep some in reserve.
The subprime mortgage crisis that led to the 2008 financial crash is a prime example. Many banks had extended loans to customers who couldn’t pay them back. Those who hadn't set aside enough capital or reserves faced severe consequences, with some even going under.
Marketing and Customer Acquisition
To stay competitive and attract new customers, banks spend considerably on marketing, advertisements, and promotional offers. Be it the cost of running national advertising campaigns, sponsoring events, or offering sign-up bonuses for credit cards, these expenses play a vital role in a bank's strategy to capture market share.
Mergers and Acquisitions
Larger banks often grow by acquiring smaller ones or merging with peers. Such activities come with significant costs: due diligence, advisory fees, legal costs, and more.
When Bank of America acquired Merrill Lynch in 2008, it wasn't just the purchase price; the integration of systems, personnel, and operations all came with associated costs.
The world of banking is multifaceted, with revenue pouring in from multiple channels. From the layman's savings account to the complex realms of proprietary trading and M&A, banks have mastered the art of money-making, adapting continually in a shifting financial landscape.