Ever wondered how banks generate revenue? Today we’re uncovering the secrets of their financial prowess. Banks, as it turns out, have three key money-making revenues:
From the intricacies of interest income to the surprising gains of routine transactions, we’re diving into the depths of banking profitability. This article will answer “How do banks make money,” so let’s get straight into it.
So, how do banks make money? One of the most frequent spaces banks draw profit is with interest income. When you deposit money into a bank – whether in a savings account, checking account, or time deposit like a certificate of deposit (CD) – the bank doesn’t just store that money in a virtual vault. Instead, it puts your money to work.
Banks lend your deposited funds to other customers through loans, such as personal loans, auto loans, and mortgages. When lending this money to others, the bank charges a higher interest rate than the interest your savings account earns. As such, the bank makes interest income from the difference.
For example, if a bank pays you 1% interest on your savings account but lends that money out at a 5% interest rate, it pockets the 4% difference. This is called the net interest margin, a key profit driver in banking.
According to the Federal Deposit Insurance Corporation (FDIC), in 2021, about half of the total income of all FDIC-insured banks came from net interest income.
If you’re still wondering, “How else do banks make money?” look no further than capital markets. A capital market is where buyers and sellers trade financial securities like bonds and stocks. It helps companies raise capital and also offers lucrative investment opportunities.
How do banks fit into this picture, you might ask? The answer lies in three main activities: underwriting, trading, and mergers and acquisitions (M&A) advisory services. Let’s expand on these sources of income in more detail.
Companies need an intermediary to access the capital markets when they want to issue shares or bonds to raise money. This is where banks step in. Banks, especially those with investment arms, help these companies navigate the process of issuing securities and earn substantial fees for this service, ranging between 3% and 7% of the gross proceeds. To put it into perspective, over $14 billion in investment banking fees were generated from debt capital markets underwriting.
Banks are also active traders in capital markets. This can be split into two main categories:
Banks also play the role of strategic consultants in corporate mergers and acquisitions. Whenever a company plans to merge with or acquire another company, they turn to banks – particularly investment banks – to provide guidance, conduct due diligence, and help negotiate terms.
Banks usually charge hefty fees for these high-stakes services, usually a percentage of the total deal value. In 2022, over $30 billion was generated from M&A advisory fees.
The last category in our “How Do Banks Make Money?” guide is the different types of banking fees. Banks charge a variety of fees for the services they provide. It may seem insignificant when you look at them individually, but collectively, they represent a significant revenue stream for banks.
Some of the most common types of fees that banks charge include the following:
Whether it’s through interest income, capital markets, or banking fees, the answer to the question of “how do banks make money?” is multifaceted. Banks earn income from different sources. They profit from the difference between loan and deposit rates, make substantial gains from capital market activities, and generate additional revenue from various fees.
Investment banks make money through underwriting new debt and equity securities, facilitating mergers and acquisitions (M&A), and trading in capital markets. They earn significant fees for these services, contributing to their overall income.
Commercial banks make money primarily through lending. They accept deposits from customers, then lend this money to other customers at higher interest rates, profiting from the difference. Banks also earn from fees for services like account maintenance, ATM usage, and overdrafts.
Banks use the funds deposited into savings accounts to provide loans to other customers. The interest rate they charge on these loans is typically higher than the interest rate paid on savings accounts. This difference, known as the net interest margin, is a significant way banks earn money. Further, some banks may charge maintenance or transaction fees on savings accounts, which also contribute to their revenue.
Banks earn money on debit cards in a few days. One is through interchange fees, which the merchant’s bank pays to the customer’s bank for each transaction. They may also charge fees for ATM use, especially when customers use ATMs outside their bank’s network.