How banks make money

Does banking make you nervous? Do you get overwhelmed by the gobbledygook that bankers spew? Do you know what they supposedly do at work, day in and day out?

Banks will be integral partners in your journey to financial freedom. You will use them to save money, borrow, make payments and buy financial products. Since they will play such an essential role in your life, let us quickly understand how retail banks–the part that deals with consumers like yourself, not corporates–make money. 

At a simplistic level, a retail bank is like any other trading business, such as your local grocery store. The grocer buys products from distributors or manufacturers and sells them to consumers at a higher price, pocketing the difference as profit. Banks do the same, but rather than buying and selling knickknacks, they trade in money—they borrow money from people and then lend it to others to make a profit. 

Interest Income

When you deposit your money into a bank account, the bank essentially borrows it since it is obligated to give it back to you at some point. And since you are doing them a favour by lending them money, they provide you with something additional in return–interest. So, if you lend them (deposit) Rs. 100,000 for a year and the interest rate they offer is 6%, you will get Rs. 106,000 at the end of the year. Banks try to collect as much money as possible through such deposits. 

Now, what do banks do with all that money that they borrow? They lend it to customers as loans. People borrow money on their credit cards as personal loans, home loans to buy property, auto loans to buy cars, etc. Banks evaluate whether they are trustworthy and, if so, lend them money. And, of course, if a bank is loaning out money, it charges . . . interest. The interest a bank charges on loans is significantly higher than the interest it pays to borrow money. If you borrow to buy a home, it may charge you 10 per cent interest; for a car, it may charge you 15 per cent; for personal expenses, it could be 20 per cent. And if you use a credit card for purchases you don't pay back immediately, it may charge you 40 per cent! Let's assume someone borrows Rs. 100,000 as a personal loan to buy a new phone at 20% interest; they will have to pay back Rs. 120,000 at the end of the year to repay that loan. 

The income from borrowing money at a lower rate and lending it a higher rate–Rs. 14,000 (Rs. 120,000 - Rs. 106,000) in this example–is known as net interest income. Of course, there is some risk the bank is taking since some people may default and not pay back the loans. But it is a significant source of a bank's profits. 

Fees and Commissions

The other big income generator for banks is fees and commissions. Banks levy various fees and penalties on customers—fees for using ATMs or walking into a branch, penalties if they are late on payments, annual fees for a credit card, and so on. They also sell various financial products–investment products, insurance policies etc. and make commissions on every sale. Importantly, there is no risk that the banks are taking here, unlike when they make loans, so this fee income is highly significant for banks. 

In Summary

From your perspective, the underlying financial objectives of a bank, therefore, are to: 

• Borrow money by opening as many bank accounts and Fixed Deposits as possible.
• Lend money and make as many loans as possible to trustworthy people.
• Provide services such as ATMs, chequebooks, lockers, credit cards, etc. and charge for whatever they can to earn fees.
• Sell products such as investments, insurance, etc., and make commissions.

As a typical consumer, you will probably engage in all of the above activities, which is why your bankers should be delighted to have you as a client.

And if you understand what their drivers are, you are likely to have a more balanced relationship with them. They are simply trying to buy (borrow) from you, sell (lend) to you, or make a buck by providing a service.

If you look beyond all the complex jargon, products, and fine print, this is essentially what banks are trying to do. So, if you do not get overwhelmed when you step out to buy a bar of soap or box of cereal from your grocer, there is no reason you should get so with your banker!

Rishi Piparaiya has held senior leadership positions in wealth management, strategy, sales and marketing with leading financial services organizations, including Citi, Aviva and Banco Santander. He left his corporate job at the helm of his career to pursue his passions. He is now a bestselling author, world traveller and angel investor.