Step into any bank in the world and you will see a host of busy employees working at different counters, air-conditioned cabins for managers, super secure storage facilities and dozens and dozens of forms. Obviously, all these things cost a lot of money. Since a bank not only stores your money but also pays you back some amount on the deposits, you may wonder how it gets all the money to run its daily operations and pay you interest every now and then. For this, you need to understand the dynamics behind banking and find out exactly how your lender uses your money to make more money for itself.
Just like any other business, banks are commercial entities established with the primary purpose of earning profits. Broadly speaking, a bank has four main ways of making money – through interest margin, levying different types of fees and charges for facilities it provides, by investing in the market, and selling insurance products.
Let’s explain each in detail.
One of the main sources of a bank’s income is the net interest revenue it earns, i.e. the difference between the interest the bank earns on the money it lends and the interest it pays on the money you deposit. When you deposit money with the bank, you allow it to use your money to hand out loans to other customers.
Don’t worry, the bank does not literally take your money and hand it over to another customer. It basically uses the money deposited by all customers as an investment to make more money. So for instance, when you deposit money into a bank, the lender will loan it out to others in the form of credit cards, mortgages, student/auto loans, etc. The bank will then charge interest from the borrowers and will give you back a fraction of the amount it ends up earning. The amount given back to the customers is a sort of incentive to make them deposit more money with the bank.
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Aside from storing your money, a bank offers a host of facilities to its customers for which it charges money. In fact, banks earn a significant chunk of their revenues by collecting fees from customers. Banks charge money for a myriad of services such as interchange fees (for processing credit and debit transactions), account maintenance charges, locker facility charges, withdrawal fees, and so on. Some lenders even charge “teller” fee from their customers, which is the money you pay for availing the services of an expert who can resolve queries about your account.
Apart from service fee, banks also earn money through penalties which are slapped on customers in case of lapses on their part. The primary examples of such penalties are late credit card payment, failure to meet minimum balance requirements, overdraft charges, etc.
Investment and insurance products
Several banks have a large client base who invest in financial instruments sold by them such as investment funds, wealth plans, etc. The banks, in turn, invest this amount in various securities as well as open positions in the debt market. The bank also sells mortgage-back securities to investment banks or other institutions. These investments help banks earn profits.
Apart from securities, banks also tie-up with insurance companies to sell insurance products to their customers. There is even a term for this called “Bancassurance”. The partnership between a bank and the insurer is mutually beneficial as the insurance firm gets access to the bank’s customer base, while the bank can offer more services to its clients and earn additional revenues from the sale of such products.