What Are The Different Ways Banks Can Make Money
How Do Banks Make Money? The Top 5 Sources Of Money
Do you ever wonder exactly how banks make money? Banks always seem to have pretty lovely buildings, and many of the skyscrapers in larger cities have a bank's name prominently displayed on the side. Even better, the employees are always well-dressed. It’s one of the few places left where you can find a man wearing a suit that isn’t attending a funeral.
The primary source of income for a bank is lending money. They lend money at an interest rate higher than the cost of the funds they are lending to consumers. Banks pay for money through interest-bearing accounts, CDs, and other short-term instruments. The difference between the interest they pay and the interest they receive is known as the ‘spread.’
Check out these sources of funds for most commercial banks:
1. Deposits are the largest source of money for lending. The amount you have in your local bank in the form of a checking, savings, or similar account. The banks considered these accounts as ‘core deposits.’
These are considered to be very short-term deposits. Although most accounts are several years old, banking customers may withdraw their deposits at any time.
This convenience, plus the fact that deposits are insured up to $250,000, means banks pay little to no interest on this money.
2. Wholesale deposits refer to monies that a bank borrows from wholesale sources. These wholesale sources are typically other banking institutions. This money is typically more expensive than cash obtained through customer deposits.
If you’re ever investing in a bank that relies heavily on wholesale deposits, remember that earnings are likely to be lower since the spread is narrower.
The bank would most likely have to make riskier loans at higher interest rates to make up the difference.
3. Shareholder equity is another source of funds for lending. When a bank issues or sells stock, it will use much of the proceeds for lending. There are many regulations and lending ratios that banks must adhere to when using shareholder equity for lending.
This funding source isn’t free, although it might appear to be. Most banks pay dividends to shareholders, even though they aren’t required to. Equity raised through the sale of common stock shares is called ‘common equity.’
In times of trouble, banks can issue preferred stock to raise the capital they desperately need. This capital is costly. Usually, banks reserve the right to buy back preferred shares and do so when their financial situation improves.
All equity capital is expensive, and banks will avoid using it unless necessary.
4. As other corporations do, banks will also issue debt to raise capital. Bank bonds are like the bonds that any other company issues when it needs to raise money. Debt is a small percentage of the funds banks use to make loans.
5. Most of the commercial bank lending in the United States is consumer lending. The vast majority of consumer lending is residential mortgages. The property secures mortgages for purchase.
The loans are relatively low risk for lenders.
Automobile lending is also a significant source of income for banks. Banks face more competition from these loans. The terms are shorter, with higher interest rates, and these loans yield higher profit per unit of time.
Credit cards are another form of lending. These are unsecured lines of credit. The bank makes money from various credit card fees, the most lucrative being ‘late fees.’
Banks make money primarily through a variety of loan products. The funds for loans come mainly from depositors, though banks also use other sources. The next time you go into your local bank, you’ll have a better idea of what’s paying for all of those employees and fancy branch offices.
