How do Banks Make Money – Unicornomy Analysis
Banks – The mammoth organizations that make money by everyone’s sweat and blood! 🙂 Well as every business owner says, “I hate my bank” – They charge a lot of money for various bands of charges blah blah… Well Banks unlike all other sectors make money the exact same way in every country – Borrow & Lend Arbitrage. Every one while hating their bank always wonders, I wonder how do banks make money or what business model of banks is? Here it is in a very detailed article.
How do Banks Make Money
How do Banks make money by lending money that they borrowed from depositors at a higher interest rate than they borrowed it for.
For e.g. If a Bank borrowed 100 Rs @ 8% PA. It will lend about 90 Rs @ 12-25% and will make money in the transaction and about 10 Rs will be invested in long term securities (assume it is getting mature at current date). Bank has to pay back 108 Rs at the end of the year, whereas they have made 112 Rs from lending it and the balance 10 Rs have been invested at 10% i.e. 11 Rs have come back as maturity amount i.e. the bank overall has made about 123 Rs from investment of 100 Rs and to be paid is 108 Rs i.e. a revenue of 15 Rs & this revenue will multiply over time so that the bank can spread its investment over riskier assets and make more money.
Business Model of Banks
Business Model of Banks is pretty complex, with respect to the compliance that it needs to abide by which is pre-set by the nodal banks like Fed, RBI etc., multiple financial evens in the markets that it has to withstand and change its strategy accordingly. Banks have a business model intertwined with the economy and with many other aligned organizations which compliment the banks business in terms of its customer base. Here is a list of various revenue lines that a bank has:
How do Banks Make Money by Lending Money
How do banks make Money via Lending? This principle is called as Arbitrage. You buy something at a lower price, mark it up for profit and then sell it at a higher price depending on the market conditions and the condition of the buyer. Here the depositors i.e. customers deposit the money with the bank against a small interest income which the bank is allowed to dispose off into other money making instruments like loans and investments. The bank has to ensure that the money that it made from the loans (that it gave out) and the investments put together is more than the cost of the bank + payout that needs to go the customer.
How do Banks make Money via Lending Illustration
- Banks Borrow Money from Depositor
- Depositors Deposit Money into the bank at an interest rate (say 4%, India) – In Savings Account – Total Corpus let’s assume is 1000 Crores (Total Payable at the end of the year – 1040 Crores)
- Depositors Deposit Money into Fixed Deposits at an interest rate (say 9%) – Fixed Deposit – Total Corpus assume 10,000 Crores (Total Payable at maturity – 10,900 Crores)
- Thus total money to be returned by the bank to the depositors is 1040 + 10900 = 11,940 Crores
- Total Fees collected for the period till date is say 300 Crores
- The total funds at Banks Disposal – 11,300 Crores (10,000 + 1000 + 300)
- Central Bank (Nodal Bank like Fed or RBI) mandate all the banks to keep a safekeeping portion out of this corpus so that money can be returned to small depositors (called statutory liquidity ratio) – say that corpus is about 4% i.e. 452 Crore
- Thus net funds at disposal 11,300 Crore – 452 Crore = 10848 Crore (Lets say 10,500 Crore, assume 348 Crore for Expenses of the Bank)
- Now this 10,500 Crore is Lent at extremely high rate of interests ranging from 14% to 24% to various categories of borrowers depending on their credit score (the poorer the score, the higher the rate of interest)
- Let’s assume an average of 18% and let’s assume that 2% of the banks loans will be defaulted i.e. not returned to the bank at all
- Total money received by the bank is 10,500 * 98% * (1 + 18%) = 12,266 Crores
- Total Money made by the bank in this activity is = 12,266 – 11,940 = 326 Crores i.e. appx 3% of the corpus at disposal
- Banks make huge money off of loans, these loans can be of following types:
- Personal Loan
- Mortgage Loan (Loan Against Property, Shares etc)
- Working Capital Loan
- Small Business Loan
- Vehicle Loan
- Education Loan
How do Banks Make Money by Charging on Various Bank Services
Banks make lot of money by putting unwanted services to your account, and since the amount is small you let it go because you dont want to fight it out with their customer support. They take undue advantage of this fact and levy charges of all sorts of unwanted services. This is how banks make most of their non lending money. All the services listed below
- Locker Facility : Customers use the locker facility to store valuables, documents, jewellery and cash. They pay a yearly fee as a rent to use this facility.
- Check Books : For all check leaves issued to the customer, a fixed fee per check book is levied
- Internet Banking : When you internet banking to transfer money, make payments etc, charges levies to you are in the range of 5 Rs to 40 Rs.
- Type of Account : If you want a premium account, you have to pay fixed fee for the services or maintain a higher balance at a lower interest rate
- Non AMB : If you do not maintain the minimum annual balance as stipulated by the bank, you pay charges of non maintenance
- ECS / Cheque Return : When you have agreed for automated payments to your EMIs or people who you owe money to and when it returns unpaid – The bank levies a charge on your account (normally called cheque return or cheque bounce charges)
- Mobile Banking / SMS Alerts : You want to bank via SMS or want to get alerts of credits and debits on SMS, bank charges you and makes money
- Account Statement / Passbook : Chargeable
- Credit / Debit / Forex Cards : These instruments are charged a fixed fee for sign up and fixed annually recurring renewal fee. Read the below article for an indepth understanding on the same.
- DeMAT Services : Stands for De-Materialization, mandated by SEBI for keeping shares in virtual accounts, the DeMAT account charges you for trading on the stock exchange, this adds up to the banks income.
Here is a Related Article You Must Read: How do Credit Card Companies Make Money
- Foreign Exchange : Banks sell foreign currency notes with discounting or marking up. For e.g. If 1 USD = 65 INR and you want to buy 100 USD, you will have to pay up 6600 INR instead of 6500 (mark up of 1 INR PER USD) OR you want to sell 100 USD, you will get 6400 INR instead of 6500 i.e. an earning of 100 INR in both the cases
- Cash Management Services : Businesses dealing in lot of cash transactions have to pay a fee basis turnover for management of cash
- Deposits : Cash deposit or deposit in non home branches or some sh*t like this can make you end up paying charges
- ATM withdrawals : In case you withdraw cash at non self bank ATM, you will be levied charges per transaction
- Lost Instrument : In case you lose your card, pin, password, passbook etc, you will be charged for a replacement
How do Banks Make Money by selling 3rd Party Financial Products
Banks make lot of money via commissions or marketing fees earned by selling 3rd party financial products. Banks on account of being present physically across many locations have the advantage of reaching a particular consumer more than any one else, even the original seller of the product will have lesser reach than the bank. They take advantage of this fact and extract marketing fee upto 50% of the value of the product (been there done that 🙂 ).
- Life Insurance Products : Banks get a flat commission (or percentage commission) on selling insurance policies
Here is a Related Article You Must Read: How do Insurance Companies Make Money
- Health Insurance Products : Banks get a flat commission (or percentage commission) on selling insurance policies
- Mutual Funds : Banks get a flat commission (or percentage commission) on selling mutual funds
- Government Bond Sales : Banks sell government of the country’s bonds (similar to fixed deposits but these can not be broken before time)
- Private Company Fixed Deposits : Bank sell fixed deposits of goverment approved deposit acceptors. These deposits are at a higher interest rate than that of the banks and get the bank a decent 1% – 3% fee per sale.
- If any payment gateway wants to integrate their system with the banks API they have to pay some upfront as well as recurring fee
- DeMat Accounts / Securities Accounts : By selling Stock Brokerage Accounts
Here is a Related Article You Must Read: How do Structured Settlement Annuity Companies Make Money
How do Banks Make Money by Commodity Sales
- Banks sell precious metal coins, papers, investment schemes on which they earn money by commission or by discounting or marking up
- Typical commodities include Gold and Silver
Please note that a Blockchain backed business model like Bitcoin Business Model will someday rip apart the business model of banks. That’s all about how do banks make money and about the business model of banks. Please let me know in comments if you find anything else than this.
Disclaimer: The understanding of the How do Banks make money and Business Model of Banks is of the Author’s himself, neither any bank (private or public) or qualified consultants have confirmed or explained the same to the author and the descriptions, stats, facts and figures, if used, are either obtained through secondary web research or interrogation of relevant search professionals or other resources on the web. Please use your own discretion to use this info when required and by continuing to read you agree to indemnify the author & Unicornomy from the entire liability arising out of using this info on your own.