Diversified banks make money in a variety of different ways; however, at the core, banks are considered lenders. Banks generally make money by borrowing money from depositors and compensating them with a certain interest rate. The banks will lend the money out to borrowers, charging the borrowers a higher interest rate, and profiting off the interest rate spread.
Additionally, banks usually diversify their business mixes and generate money through alternative financial services, including investment banking and wealth management. However, broadly speaking, the money-generating business of banks can be broken down into the following:
- Interest income
- Capital markets income
- Fee-based income
Interest income is the primary way that most commercial banks make money. As mentioned earlier, it is completed by taking money from depositors who do not need their money now. In return for depositing their money, depositors are compensated with a certain interest rate and security for their funds.
Then, the bank can lend out the deposited funds to borrowers who need the money at the moment. The lenders need to repay the borrowed funds at a higher interest rate than what is paid to depositors. The bank is able to profit from the interest rate spread, which is the difference between interest paid and interest received.
Importance of Interest Rates
Clearly, you can see that the interest rate is important to a bank as a primary revenue driver. The interest rate is an amount owed as a percentage on a principal amount (the amount borrowed or deposited). In the short term, the interest rate is set by central banks that regulate the level of interest rates to promote a healthy economy and control inflation.
In the long term, interest rates are set by supply and demand pressures. A high demand for long-term maturity debt instruments will lead to a higher price and lower interest rates. Conversely, a low demand for long-term maturity debt instruments will lead to a lower price and higher interest rates.
Banks benefit by being able to pay depositors a low interest rate, and also being able to charge lenders a higher interest rate. However, banks need to manage credit risk – the risk that the lenders may potentially default on loans.
In general, banks benefit from an economic environment where interest rates are increasing. It is because banks can lock in fixed-term deposits, paying a lower interest rate, while still being able to profit by charging lenders a higher interest rate. Intuitively then, banks will be hurt by an economic environment where interest rates are decreasing, since fixed-term deposits are locked in paying a higher interest rate, while interest rates being charged to lenders are decreasing.
Capital Markets-Related Income
Banks often provide capital markets services for corporations and investors. The capital markets are essentially a marketplace that matches businesses that need capital to fund growth or projects with investors with the capital and require a return on their capital.
Banks facilitate capital markets activities with several services, such as:
- Sales and trading services
- Underwriting services
- M&A advisory
Banks will help execute trades with their own in-house brokerage services. Furthermore, banks will employ dedicated investment banking teams across sectors to assist with debt and equity underwriting. It is essentially assisting with raising debt and equity for corporations or other entities. The investment banking teams will also assist with mergers & acquisitions (M&A) between companies. The services are provided in exchange for fees from clients.
Capital markets related income is a very volatile source of income for banks. They are purely dependent on the capital markets activity in any given time period, which may fluctuate significantly. Activity will generally slow down in periods of economic recession and pick up in periods of economic expansion.
Banks also charge non-interest fees for their services. For example, if a depositor opens a bank account, the bank may charge monthly account fees for keeping the account open. Banks also charge fees for various other services and products that they provide. Some examples are:
- Credit card fees
- Checking accounts
- Savings accounts
- Mutual fund revenue
- Investment management fees
- Custodian fees
Since banks often provide wealth management services for their customers, they are able to profit off of the fees for services provided, as well as fees for certain investment products such as mutual funds. Banks may offer in-house mutual fund services, which they direct their customers’ investments towards.
Fee-based income sources are very attractive for banks since they are relatively stable over time and do not fluctuate. It is beneficial, especially during economic downturns, where interest rates may be artificially low, and capital markets activity slows down.