In this digitally inclined financial market, where each consumer is well informed about all the financial events and news across the world, it is not uncommon to wonder how a bank multiplies its wealth when it has less of deposits and more of withdrawals. It is quite bewildering to know and interpret the money making strategies that various banks and credit unions use to generate money. To simplify it, let’s understand the simplicity behind the working of the banks by going back to the basics of how banks and financial institutions operate in the economy.
Banking is a lot similar to any other business activity that people undertake.
The only difference being in the commodity that they try to buy and sell i.e. money. Banks borrow money from their customers and lend that money to those customers who need it. They also sell other financial products like Certificate Of Deposits (CD), mortgage loans, vehicle loans and house loans.
Some of the most common ways through which banks earn their money are:
- Interest Rate
Have you ever wondered why banks charge higher rates of interest when they loan out money rather than giving interest on the money deposited by their customers?
While the main reason for this discrepancy is the risk factor involved in giving out loans as banks have no indication when and if their loans would be paid in full, this difference in interest rates is also the primary source of income for banks.
Banks don’t just invest money by lending loans to their customers but also invest money in real estate, businesses, and government securities. They also use the deposits to trade in equities, foreign exchange and the commodity market. If the returns are favorable it, they act as a mode of more profits and revenues for the bank.
- Service Fees
Alongside lending and borrowing, banks also offer various services to their customers. They charge annual fees from credit and debit card users, ATM access, late payment penalties on loans, fees on inactivity of your account and also fees on paper statements.
- Financial Advising Services
Banks also provide financial advising services to its customers who want to know the best ways to invest and grow their money, but all this comes at a price too! If companies want any help regarding issue of shares, the issue rate or information about any public offerings, the banks always extend their help to diligent customers.
- Interbank Lending
At times, when a particular bank is deficient in providing its customers with the money they need, they borrow from other banks to maintain their liquidity. For this purpose, banks lend other banks money but at a specific rate of interest. This interest directly goes into the revenue pockets of banks. In this way, banks too help other banks in making money.
Credit Unions work in the same way as banks and generate revenue even though they are known to be non-profit organisations. What differs in their perspective is the fact that credit unions charge higher rate of interests on loans but have lower fees than banks as even though their ultimate motive is not increased profits, they do earn some revenue out of it. They use their excess profits for the proper functioning of the union or distribute it among the members of the union. Rest, all their services and profit generation schemes are similar to banks, which help them earn for their sustainability.