Banks are financial institutions that provide various services to individuals and businesses, such as checking and savings accounts, credit cards, loans, and investments. But how do banks make money from these services? Here are some of the main ways these financial giants generate substantial wealth.
The primary way that banks produce income is by earning interest on the money they lend to customers. Banks get the money to lend from the deposits they receive from other customers, who are paid a lower interest rate for keeping their money in the bank. The difference between the interest rate that banks charge borrowers and the interest rate that they pay depositors is called the net interest margin. The higher the net interest margin, the more profitable the bank is.
For example, if a bank pays 1% interest on a savings account and charges 5% interest on a personal loan, the net interest margin is 4%. This means that for every $100 that the bank lends out, it earns $4 in interest income. Of course, banks also must pay for their operating costs, such as salaries, rent, utilities, and taxes, so not all their interest income is pure profit.
As a consumer, shopping around for the best rates and terms will help you create and maintain your personal wealth.
Another source of income for banks is the fees they collect from their customers for different services. Some common types of fees that banks charge are:
- Monthly maintenance fees: for maintaining your account, usually if you don’t meet certain requirements, such as maintaining a minimum balance or having direct deposit.
- ATM fees: for using an ATM that is not part of their network or for making too many withdrawals in a month.
- Overdraft fees: for spending more money than you have in your account, resulting in a negative balance.
- Foreign transaction fees: for using your debit or credit card abroad or in a foreign currency.
- Late fees: when you don’t pay your loan or credit card bill on time.Origination fees: when you take out a loan or a mortgage, usually as a percentage of the loan amount.
- Interchange fees: fees that banks charge merchants when you use your debit or credit card to make a purchase. The merchant pays the fee to the bank that issued your card, and the bank shares some of it with the network that processed the transaction, such as Visa or Mastercard.
Fees are a substantial source of income for banks, but they can also be a source of frustration for customers who feel like they are being nickel-and-dimed. Some fees can be avoided by choosing a different bank or account type, knowing the rules, and being diligent with your spending and payments.
A third way that banks make money is by providing other financial services to customers and businesses, such as:
- Investment banking: Banks advise companies on their mergers or acquisitions with other firms. Investment banks also help private companies issue stock or bonds to raise money. For example, some prominent investment banks, Morgan Stanley, Goldman Sachs, and J.P. Morgan were the lead underwriters for Rivian Automotive, Inc. (RIVN) during its initial public offering (IPO) in 2021, where it raised nearly $12 billion through the sale of 153 million shares.
- Wealth management: Banks offer financial advice and planning to high-net-worth individuals and families, such as how to invest their money, save for retirement, or minimize taxes. Using a bank for these services may not be ideal due to potential conflicts of interest, limited product options, higher fees, and a focus on selling their own products rather than providing unbiased advice tailored to your specific needs. When choosing a financial advisor, beware of the suitability clause and consider a fiduciary for these services.
- Capital markets: Banks invest their own funds or their customers’ funds in various financial markets. For example, banks may buy and sell stocks, bonds, currencies, commodities, and derivatives. Banks earn returns from these investments, but they also face risks of losing money if the market moves against them, like Silicon Valley Bank in 2023.
These services are usually more complex and specialized than the basic banking services discussed earlier. They also tend to generate higher fees and commissions for banks than interest income. However, it is important to note that they involve higher risks and tighter regulations for banks than lending money.
Banks must comply with various regulations and laws that govern their activities and protect their customers from risk. Some risks that banks must manage are credit risk (the risk of borrowers defaulting on their loans), market risk (the risk of losing money from investments), operational risk (the risk of losses from errors or fraud), and reputational risk (the risk of losing customers or trust due to negative publicity or scandals). As we have seen lately, managing these types of risk is essential in preventing bank turmoil, runs on banks, and ultimately bank failure. Banks must balance their sources of income and their costs and risks to stay profitable and competitive in the financial industry.
To offset these risks, regular bank accounts are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor, per institution, per ownership category. This means that if your bank goes out of business, you will still get your money back up to the insurance limit. When it comes to keeping your money safe, make sure your bank or credit union is insured by the FDIC or the National Credit Union Administration (NCUA) by looking for their logos on their websites or statements. If you have more than $250,000 in an account, consider opening a joint account (covered up to $500,000 if held with someone such as your spouse) or moving some funds to another bank to stay under the FDIC limit.