Explainer: How Banks Earn Money?

Explaining Banking: How Banks Earn Money?

There are different types of transactions transpiring within the realms of banking operations. Examples include saving and borrowing money, depositing and withdrawing money, buying and selling other money market instruments and asset classes, foreign currency exchange, and managing the financial transactions of individuals and organizations.

From the aforesaid multipronged banking services, it is interesting to know how banks earn money from being a financial intermediary. This article explores the nature of banking operations, specifically by discussing how banks generate revenues and profits from intermediating among the different financial management requirements of their customer base.

A Backgrounder on the Origin of Banks and the Banking System

Modern banking emerged in Italy during the 15th century. The Medici Bank of the Medici Family was the first institution to consolidate and organize unsystematic banking practices. During the heydays of its operation, the bank was the largest and most respected in Europe. The success of the Medici Bank eventually paved the way for the formalization and institutionalization of banking practices based on the credit system, while also marking a new turning point in the history of money.

Today, banks are regarded as financial institutions that provide specific types of financial services. They operate within the greater umbrella of the financial sector or the financial services industry alongside other financial services providers such as payment gateway providers, asset brokerages and other investment services providers, lending firms, insurance and pre-need companies, and health maintenance organizations.

However, the expansive operation of banks makes banking a considerable independent sub-sector on its own with specific role or purpose in the greater economy. Nevertheless, it is essential to note that banks are still business organizations with the primary objective of generating revenues and earning profits. Through their business model, there are several ways banks earn money.

Understanding How Banks Earn Money or Generate Revenues and Profits

Banks Earn Money Through the Credit System

The modern credit system is one of the primary ways banks earn money, and it centers on borrowing and lending money. Note that banks provide two broad types of service through this process: debit service and credit service.

Debit service includes all forms of savings and investment transactions or services, including opening of savings account, managing time deposits, and providing other money market instruments. The credit service, on the other hand, includes all forms of loan transactions for residential housing or other mortgage transactions for the purchase of real properties, vehicle purchases, business capitalization, and personal loans, among others.

Furthermore, banks have two types of customers. The first includes all depositors who put their excess money on banks for safekeeping or invest their money on money market instruments. The second includes all borrowers who approach banks for financial assistance.

Whenever banks receive money from depositors, they do not actually leave it untouched in a single place. Instead, they use this money or any derivative value to provide lending or credit service to borrowers. Banks are thereby financial intermediaries responsible for facilitating the movement of money from depositors to borrowers.

Banks charge management fees for managing or facilitating the interplay within the credit system. Despite the process of channeling money from depositors to borrowers, banks maintain digitized financial records. Deposited money remains intact in concept. These financial records also include all accounts of borrowed money.

Banks provide depositors or investors with bank statements, transaction history, and/or bank or investment certificates to assure them that their money or investments are intact. For borrowers, banks require them to provide assurance that they are capable of paying their debts in the future. Proof of financial capacity and credibility include income tax returns, employment certification or business documents, and a list of existing assets.

Trust is essentially the foundation of banking and the entire credit system. Depositors need to trust the capacity of their banks to manage their financial assets. In the same fashion, banks need to trust the capacity of their borrowers to pay their debts. A government-mandated body such as a monetary authority or central bank regulates the entire banking industry.

Earning Profits by Placing Interests on Debts

Note that profits are simply overcharges. Banks essentially do the same, particularly by increasing the value of a particular asset or, to be specific, of the credit service. The excess value is known as interest, and in the realms of banking, this is similar to profit.

Apart from requiring borrowers to pay a portion of their entire debt on a given date, banks also charge them to pay interest. This interest is an overcharge. To illustrate further, suppose an individual borrows USD 10,000. Upon the maturity of his debt, he might end up paying USD 15,000 or more, depending on the interest rate.

The actual value of the borrowed amount naturally belongs to the depositors. The remaining excess value or overcharge is divided between the bank and the depositors. In other words, another way banks earn money is by placing interests on different forms of debts or credit products such as personal loans and mortgages.

Generating Revenues Beyond the Credit System

Aside from management charges and placing excess value or interests over borrowed money, banks also make money through a standard fee and markups, as well as by extending their services beyond intermediating between depositors and borrowers.

Through their extended services, banks are able to generate additional profits beyond the credit system. For instance, banks charge fees for other value-added services, including wire transfers and payroll services. Some inter-bank and intra-bank transactions also have fees.

Services to include digital banking, use of automated teller machine, prepaid services, debit or credit card replacement, issuance and replacement of checks, and offline and online bills payment have service or transaction feeds.

They also earn from foreign currency exchange, for acting as authorized collection agents of service companies, and for handling the accounts of organizational or corporate clients. Nonetheless, these revenue-generating activities mean banking services are fundamentally extended beyond the credit system.

Returns from Various Investment Activities

Banks also earn money through investments. It is important to underscore the fact that a small portion of bank deposits are held cash. The rest of the money are invested in different investment vehicles. The most common are loans and mortgages.

Larger banks invest in other securities and assets to maximize the earning potential of their large cash base. Most of these investments include safer or low-risks vehicles such as government bonds and corporate bonds. Banks generate earnings from bond investing either through interests or when held bonds are sold in the secondary bond market.

Some banks also invest in equities and stocks. These are higher-risk investments but have higher return potentials. Earnings from these vehicles come from dividend payment, appreciation of the share price or stock price, and through trading activities.

Other investment options include direct ownership of real estate properties or indirect real estatr investments through real estate investment trusts and mortgage-backed securities. Some banks also earn fees from offering and managing pooled investment funds. Common examples of these investment products include mutual funds and unit trust funds.