Do you remember when you opened your first bank account?
Many people open their first account at a young age, then hold money in banks for the rest of their lives. You discover some of the basic types of accounts, like checking and saving accounts. You might even spend time comparing account interest rates or considering buying certificates of deposit.
But who knows how banks make money? And what do banks do?
The answer isn't as complicated as you might think. Read on to learn about all the ways banks make money.
How banks make money
When most of us think of traditional banks, we usually refer to depository banks. A depository bank takes deposits, makes loans, and sometimes offers related services like brokerage accounts and financial advice. Banks help us protect and manage our money.
When depository banks serve individual consumers, it's called retail banking. When they serve businesses, it's called corporate or commercial banking. These types of depository banking work by the same principles and earn money the same ways; the only difference is the clientele they serve.
Investment banks invest in securities — like stocks, bonds, and currency — and offer specialized services to corporations, governments, and other financial institutions. The services they offer include raising capital, underwriting debt and equity securities, and helping with mergers and acquisitions.
Credit unions are another type of banking institution. A credit union is like a non-profit bank, which means it focuses less on making money and more on providing affordable services to its members, who are technically co-owners. Credit unions often receive subsidies to cover their operation costs.
Now that we understand what types of banks exist, let's get into the different ways banks make money.
There are two main ways banks make money: interest and fees.
Interest income
At the most basic level, a bank makes money by borrowing funds from depositors at a given interest rate and lending some money to borrowers at a higher interest rate. They make money from the interest on debt, or the “debt interest.” The bank makes a profit from the difference between these two interest rates, also known as the interest rate spread.
Banks can offer either secured or unsecured loans. Secured loans are extended for large purchases that act as collateral on the loan, like mortgages and car loans. These are one of the largest sources of income for retail banks. If you can’t make your payments, they can seize your house or car.
Unsecured loans include personal loans, lines of credit, and credit cards. These are riskier for the bank because they offer no collateral to secure the loan in the case of a default.
Because of the associated risk, unsecured loans usually come with higher interest rates than secured loans. But both secured and unsecured loans have higher interest rates than savings accounts, checking accounts, and certificates of deposit.
For example, you might have a savings account that earns you a 1.5% annual percentage yield (APY). If you're wondering how banks get away with offering such relatively low interest, there's a simple answer: security. The money you deposit in your savings account is insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000. This security, combined with the easy access you maintain to your money, justifies the low-interest rates banks offer on most deposits.
The bank can use the money in your savings account to make loans at a higher interest rate, like car loans at 3%, mortgages at 5%, student loans at 10%, and credit cards at 18%.
The interest rate spread can be quite wide, making it no surprise that the banking industry profits sizably from interest alone.
Fee-based income
While interest might be a bank's fundamental source of income, banking fees constitute much (if not more) of a bank's profit margin.
Almost every service that banks offer comes with an associated fee. Let's take a look at the most common types of fees:
Account fees
Many checking accounts, investment accounts, and credit cards charge monthly service fees, or maintenance fees. The accounts themselves don't require much maintenance, especially with the rise of online banking. Instead, the money from account fees usually covers the bank's operating costs.
Minimum balance fees
Some accounts don't charge any monthly maintenance fees if you maintain a minimum balance in your account. But if your account balance dips below the set amount, you're liable to be charged a fee.
ATM fees
You've probably noticed that whenever you make a withdrawal from an ATM at a bank where you don't have an account, an extra charge is applied, sometimes up to $3 or $4 per withdrawal. This is another way banks earn money.
Overdraft or insufficient fund fees
If you try to spend more money with your debit card than you have in your account, banks will charge an overdraft fee. The same goes for when you "bounce" a check, meaning you don't have enough funds in your account to cover the amount of the check.
Excessive withdrawal fees
Unlike checking accounts, savings accounts have monthly limits on the number of transfers and withdrawals you can make. When you exceed this number, you get charged.
Interchange fees
When you use your debit or credit card to make an in-store purchase, the merchant pays a processing fee, also known as an interchange fee.
Brokerage fees
More and more retail banks now offer financial services and brokerage accounts to let customers access investments like mutual funds and stocks. These services come with fees and commissions.
Capital markets income
Unlike retail and commercial banks, investment banks don't take deposits or make loans. Instead, they provide specialized capital markets services to corporations and investors in exchange for fees and commissions.
These services include asset management, initial public offering (IPO) management, capital restructuring, leveraged financing, underwriting services, and mergers and acquisition advisory.
What are the main expenses banks pay?
We've seen how banks earn money, but what about the money they spend?
Like any other business, for a bank to remain solvent, it must ensure that its assets outweigh its liabilities. A bank's liabilities fall into two categories: interest expenses and non-interest expenses.
Interest expenses
Banks pay interest expenses to depositors, making up most of a bank's expenses.
Since their principal business borrows money from depositors to make loans, depository banks have large debt loads that incur significant interest payments. Banks must always maintain the ability to pay back the interest they owe, or else they risk insolvency and financial distress.
Non-interest expenses
Non-interest expenses are a bank's fixed operating costs, also known as overhead. These total about 15% of the bank's total expenses.
The most significant non-interest expense for a bank is personnel cost, like employee salaries and benefits. Other substantial expenses include rent, equipment, web hosting, taxes, and professional services like legal counsel, IT support, and marketing.
Final thoughts
Banks are profit-driven businesses whose success depends on earning more money than they spend.
But banks are also a vital part of the economy because they help create liquidity in the market by lending money to those who need it, which leads to an increase in production, employment, and consumer spending.
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