How do banks make money?

By
Wahed Editor
September 23, 2022
How do banks make money?

Banks, like any other profit-driven business, issue charges for the services and products they offer. These services primarily entail accepting deposits. Deposits are funds that people place in the bank with the understanding that they can withdraw them at any time or at a predetermined future date. But what do banks do with all of the money they receive as deposits? Here’s where a lending system comes into play. A significant amount of money the bank receives in terms of deposits is lent to other people. Loans are borrowed for homes, automobile purchases, education or personal requirements. Banks also provide loans to businesses that are looking for capital. While deposits and loans only play a small role in the overall banking game, the vital business of most banks is when interest is earned through this exchange. Profits start rolling in from interest earned by the banks!

What is interest?

When you borrow money from a bank, you pay back the principal amount plus interest. Additionally, your interest rate increases as your loan term increases. Assume you borrow $1,000 from a bank at a 10% interest rate per year.

You will be required to repay $1,000 plus 10% interest, i.e. $100. So the amount you must repay after one year is $1,100. If you borrow it for two years, it adds up to another additional $100, and so on. Year after year, the bank is able to make significant profits because of this surplus.

Alternative revenue streams for banks

Broadly speaking, interest on loans is the most common way for banks to make money. But in addition to interest, banks also charge fees for services like account maintenance and wire transfers, etc. They make a great deal of money from fee-based sources, as they are generally stable and do not fluctuate over time, especially during economic downturns when interest rates are low. 

Here are some bank fees to make a note of:

1. Minimum balance fee: if you fall below a minimum balance in your account at any point, you will be charged a fee at the end of that particular month.

2. Late payment fee: banks charge a fee on payments made later than the pre-determined due date.

3. ATM fee: using an ATM that isn't associated with your bank could cost you. Banks charge you when you reach a certain number of withdrawals outside your bank's network.

4. Withdrawal fee: depending on your account, you may be limited to a certain number of withdrawals per month. After which, banks start charging a fee each time you withdraw.

Banks generate revenue through a mix of activities such as fees for their services, investment banking and wealth management. Investment banking is a strong source of revenue for banks as well. Investment bankers help companies raise money by issuing and selling securities. By wealth management, we mean services like financial planning, asset management, and estate planning.

Takeaway 

The majority of money in the world is held at the bank. Banks keep at least 10% of each deposit on hand but can lend the remaining 90%. While banks do pay interest on the depositors’ funds in savings and investment accounts. But the interest paid out on deposits is at a considerably lower rate than the interest charged by banks on loans. This difference, known as the interest rate spread, is how the bank collects profits.

Disclaimer:

This material has been distributed for informational and educational purposes only and the opinions expressed represent the views of the author and not necessarily those of Wahed Invest LLC or any of its affiliates, directors or personnel (“Wahed”).  Any assessment of the market environment as of the date of publication is subject to change without notice, and is not intended as investment, legal, accounting, or tax advice. Wahed assumes no obligation to provide notifications of changes in any factors that could affect the information provided. This information should not be relied upon by the reader as research or investment advice regarding any issuer or security in particular. Any strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security.

Furthermore, the information presented may not take into consideration commissions, tax implications, or other transactional costs, which may significantly affect the economic consequences of a given strategy or investment decision. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. There is no guarantee that any investment strategy will work under all market conditions or is suitable for all investors. Each investor should evaluate their ability to invest long term, especially during periods of downturn in the market. Investors should not substitute these materials for professional services and should seek advice from an independent advisor before acting on any information presented.

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