How Banks make Money

Banks, being companies and listed on stock markets, have to improve the profitability and earn money to keep shareholders happy. Banks achieve so by various ways and means.

Role of Cost of Funds and Lending Rates

Banks main job is to rotate the money from those who have excess to those who are in need. The difference between these two interest rates i.e. interest earned from lending to customers minus interest  expended to deposit holders is its margin or profit. We call it Net Interest Margin (NIM). NIM forms the main source of regular income for Banks as they lend the money to customers once and earn the interest income over the complete loan period.

If Banks have excess money then they lend it to other banks for shorter periods at some fixed interest rate. Providing loans to other banks is considered safer as banks have better liquidity than companies.

In a competitive world, Banks cannot afford to increase the lending rates to customers. As a result, they have to focus more on reducing the cost of funds to increase the profitability. 

What is cost of funds ? 

Banks raise money in three ways:

  1. As Savings Account (SA) from individual customers
  2. As Current Account (CA) from firms and companies
  3. As Deposits from individual customers, companies and other banks

From Bank’s perspective, they pay interest rates of 4.00% for SA, zero interest rate for CA and approximately 8.00% for deposits. If a bank raises equal amount of money, let us say 100, from these three segments then overall it has to pay an interest of 4 for SA holders, 8 for depositors totaling 12. The effective interest rate becomes 4% (12 out of 300). So Banks try to increase the quotient of contribution from SA and CA so that interest outflow becomes minimized. This is the same reason markets and stock analysts give lot of preference to CASA ratio (contribution of CA and SA in overall money raised) while assessing bank’s strength.  

Other Sources of Income

In addition to interest earned, Banks charge some processing fee or one time fee whenever they lend money to customers in the form of loans.

Banks also earn commission by providing various facilities to customers like savings and salary account, cash management, cheque issuance, money transfer and locker facilities etc. Typically, in a Bank, nothing comes free and there will always be some charges associated one way or the other.

Banks provide services where the commission or fee is earned and does not involve money. Examples include facilitating transactions between two parties/customers by acting as a guarantor to one and charging fee for the same. This is called as Commission fee or non-core income.

They also deal with currencies and earn handsome profit by buying the currencies at a lower rate and selling the same higher. These gets included as Treasury Income.

At the end of the day, Banks rely on economies to achieve healthy profitability. If economy is booming then the number of transactions as mentioned above will be more thereby leading to better profits. This is the same reason smaller banks tend to fail during economic slumps or recession period.