The Banking System: Commercial Banking – How Banks Make Money according to Wokorach commercial banks are financial institutions set up to promote and facilitate financial transactions. they are run by businessmen and women with the intension of making profit for their owners. You may not realize it, but banks are just another kind of business. Like all businesses, they can differ in size, overall function and level of success.
Nonetheless, they do share one thing in common. Banks need to make money to continue operating. Most commercial banks make money in three ways. First, the majority of revenue comes from accepting deposits from consumers and then lending that money, with interest, out to individuals and businesses in the form of bank loans. Banks also make money by charging fees. Additionally, banks even earn returns on investments they make. Bank Funding Comes from our Money
The money we deposit into an account is what funds the various loans banks offer. From mortgages to personal loans, the bank essentially borrows money from our accounts, lends it to someone else, collects interest on it and then returns it to us. Of course, our actual balance never changes unless we make a deposit or withdrawal, but our money is always being put to use. If we want to make a withdrawal from our checking account, the bank must provide it to us right then (hence the common term, “demand” account). This means that the bank must maintain enough cash on hand for customers to access their account funds at any time.
On the other hand, when we commit to an investment period of several months or years, the bank can loan money out without us needing it for a while. We are usually rewarded for helping the bank earn more money from interest payments by receiving a higher interest rate ourself. How does a bank profit from interest they collect when they pay us interest too? Consider this: our money market account of Kr50,000 with a 1.25% APY earned you an extra Kr625 this year. That’s great. Our bank loaned out our Kr50,000 for part of a home loan, plus much more from other depositors, and collected several thousand dollars in interest payments. That’s great for our bank as well. Bank Fees Add Up
Interest alone does not make up the sum of a bank’s profits, however. The fees a bank charges in the form of services and penalties also attribute to a large portion of their revenue. Consider all of the fees we have paid over the years. Banks charge monthly service fees for maintaining an account, withdrawal fees when we use an ATM from another bank, application fees for obtaining loans, and numerous penalties for overdrawing, bounced checks, etc. The list goes on. While none of these individual fees are considerably large, though we may have lost an hour’s pay or more to one, the sheer number of charges that occur every day adds up to big bucks. Banks Make Investments, Too
Bank financing and fees comprise most of a bank’s profits, but there is one more strategy they employ. As many businesses do, banks attempt to maximize profits by making their own investments that will hopefully earn good returns. However, they cannot simply make any purchase they wish. Banks must keep a certain amount of deposits liquid at all times, which is defined by the FDIC, and then must primarily invest in loans. Anything other venture must be very low-risk. If we are concerned that banks are gambling our money on investments we never authorized, rest assured that they are limited in what they can do.
Banks do not invest depositors’ money in anything but loans. They use “extra” money for doing so. As mentioned before, banks basically make money by lending money at rates higher than the cost of the money they lend. More specifically, banks collect interest on loans and interest payments from the debt securities they own, and pay interest on deposits, CDs, and short-term borrowings. The difference is known as the “spread,” or the net interest income, and when that net interest income is divided by the bank’s earning assets, it is known as the net interest margin.
DepositsThe largest source by far of funds for banks is deposits; money that account holders entrust to the bank for safekeeping and use in future transactions, as well as modest amounts of interest. Generally referred to as “core deposits,” these are typically the checking and savings accounts that so many people currently have.
In most cases, these deposits have very short terms. While people willtypically maintain accounts for years at a time with a particular bank, the customer reserves the right to withdraw the full amount at any time. Customers have the option to withdraw money upon demand and the balances are fully insured, therefore, banks do not have to pay much for this money. Many banks pay no interest at all on checking account balances, or at least pay very little, and pay interest rates for savings accounts that are well below treasury bond rates.
Wholesale DepositsIf a bank cannot attract a sufficient level of core deposits, that bank can turn to wholesale sources of funds. In many respects these wholesale funds are much like interbank CDs. There is nothing necessarily wrong with wholesale funds, but investors should consider what it says about a bank when it relies on this funding source. While some banks de-emphasize the branch-based deposit-gathering model, in favor of wholesale funding, heavy reliance on this source of capital can be a warning that a bank is not as competitive as its peers.
Investors should also note that the higher cost of wholesale funding means that a bank either has to settle for a narrower interest spread, and lower profits, or pursue higher yields from its lending and investing, which usually means taking on greater risk.
Share EquityWhile deposits are the pimary source of loanable funds for almost every bank, shareholder equity is an important part of a bank’s capital. Several important regulatory ratios are based upon the amount of shareholder capital a bank has and shareholder capital is, in many cases, the only capital that a bank knows will not disappear.
Common equity is straight forward. This is capital that the bank has raised by selling shares to outside investors. While banks, especially larger banks, do often pay dividends on their common shares, there is no requirement for them to do so.
Banks often issue preferred shares to raise capital. As this capital is expensive, and generally issued only in times of trouble, or to facilitate an acquisition, banks will often make these shares callable. This gives the bank the right to buy back the shares at a time when the capital position is stronger, and the bank no longer needs such expensive capital.
Equity capital is expensive, therefore, banks generally only issue shares when they need to raise funds for an acquisition, or when they need to repair their capital position, typically after a period of elevated bad loans. Apart from the initial capital raised to fund a new bank, banks do not typically issue equity in order to fund loans.
DebtBanks will also raise capital through debt issuance. Banks most often use debt to smooth out the ups and downs in their funding needs, and will call upon sources like repurchase agreements or the Federal Home Loan Bank system, to access debt funding on a short term basis.
There is frankly nothing particularly unusual about bank-issued debt, and like regular corporations, bank bonds may be callable and/or convertible. Although debt is relatively common on bank balance sheets, it is not a critical source of capital for most banks. Although debt/equity ratios are typically over 100% in the banking sector, this is largely a function of the relatively low level of equity at most banks. Seen differently, debt is usually a much smaller percentage of total deposits or loans at most banks and is, accordingly, not a vital source of loanable funds.
Use of FundsLoansFor most banks, loans are the primary use of their funds and the principal way in which they earn income. Loans are typically made for fixed terms, at fixed rates and are typically secured with real property; often the property that the loan is going to be used to purchase. While banks will make loans with variable or adjustable interest rates and borrowers can often repay loans early, with little or no penalty, banks generally shy away from these kinds of loans, as it can be difficult to match them with appropriate funding sources.
Part and parcel of a bank’s lending practices is its evaluation of the credit worthiness of a potential borrower and the ability to charge different rates of interest, based upon that evaluation. When considering a loan, banks will often evaluate the income, assets and debt of the prospective borrower, as well as the credit history of the borrower. The purpose of the loan is also a factor in the loan underwriting decision; loans taken out to purchase real property, such as homes, cars, inventory, etc., are generally considered less risky, as there is an underlying asset of some value that the bank can reclaim in the event of nonpayment.
As such, banks play an under-appreciated role in the economy. To some extent, bank loan officers decide which projects, and/or businesses, are worth pursuing and are deserving of capital.
Consumer LendingConsumer lending makes up the bulk of North American bank lending, and of this, residential mortgages make up by far the largest share. Mortgages are used to buy residences and the homes themselves are often the security that collateralizes the loan. Mortgages are typically written for 30 year repayment periods and interest rates may be fixed, adjustable, or variable. Although a variety of more exotic mortgage products were offered during the U.S. housing bubble of the 2000s, many of the riskier products, including “pick-a-payment” mortgages and negative amortization loans, are much less common now.
Automobile lending is another significant category of secured lending for many banks. Compared to mortgage lending, auto loans are typically for shorter terms and higher rates. Banks face extensive competition in auto lending from other financial institutions, like captive auto financing operations run by automobile manufacturers and dealers.
Prior to the collapse of the housing bubble, home equity lending was a fast-growing segment of consumer lending for many banks. Home equity lending basically involves lending money to consumers, for whatever purposes they wish, with the equity in their home, that is, the difference between the appraised value of the home and any outstanding mortgage, as the collateral.
As the cost of post-secondary education continues to rise, more and more students find that they have to take out loans to pay for their education. Accordingly, student lending has been a growth market for many banks. Student lending is typically unsecured and there are three primary types of student loans in the United States: federally sponsored subsidized loans, where the federal government pays the interest while the student is in school, federally sponsored unsubsidized loans and private loans.
Credit cards are another significant lending type and an interesting case. Credit cards are, in essence, personal lines of credit that can be drawn down at any time. While Visa and MasterCard are well-known names in credit cards, they do not actually underwrite any of the lending. Visa and MasterCard simply run the proprietary networks through which money (debits and credits) is moved around between the shopper’s bank and the merchant’s bank, after a transaction.
Not all banks engage in credit card lending and the rates of default are traditionally much higher than in mortgage lending or other types of secured lending. That said, credit card lending delivers lucrative fees for banks: Interchange fees charged to merchants for accepting the card and entering into the transaction, late-payment fees, currency exchange, over-the-limit and other fees for the card user, as well as elevated rates on the balances that credit card users carry, from one month to the next.