How Do Banks Make Money?

Do you wonder how exactly banks make money? Banks always have pretty lovely buildings, and many of the skyscrapers in larger cities have the name of a bank 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 lend to consumers. Banks pay for money through interest-bearing accounts, CDs, and other short-term instruments. The difference between the interest they pay and receive is the spread.

Check out these sources of funds for most commercial banks:

1. Deposits are the largest source of money for lending. This is your money in your local bank as a checking, savings, or similar account. These are frequently referred to as core deposits.

• These are considered to be very short-term deposits. Though most accounts are several years old, banking customers can withdraw their deposits anytime.
• This convenience, plus deposits are insured to $250,000, means that banks pay little to no interest for 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 money acquired through customer deposits.

• If you're ever investing in a bank that relies heavily on wholesale deposits, remember that the earnings are likely less since the spread is less.
• The bank would 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 shares of stock, they'll use much of that money for lending. There are many regulations and lending ratios banks must adhere to when using shareholder equity for lending.

• This funding source isn't free. Most banks pay dividends to shareholders, even though they aren't required to. Equity raised through the sale of common shares of stock is referred to as common equity.
• In times of trouble, banks can issue preferred stock to raise desperately needed capital. This capital is costly. Usually, banks reserve the right to buy back preferred shares and do so when then their financial situation is better.
• All equity capital is expensive, and banks will only use this source of funds if necessary.

4. Banks will also issue debt to raise capital like other corporations. Bank bonds are like any other company's issues when it needs to raise money. Debt is a small percentage of the funds banks use to make loans.

5. Most commercial bank lending in the United States is consumer lending. The vast majority of consumer lending is residential mortgages. Mortgages are secured by the property being purchased. This makes these loans relatively low-risk for the lenders.

• Automobile lending is also a significant source of income for banks. Banks face more competition with these loans. The terms are shorter with higher interest rates, and these loans have higher profits per unit of time.
• Credit cards are another form of lending. These are unsecured lines of credit. The bank makes money from all the various fees associated with credit cards, the most lucrative being late fees.

Banks make money primarily through a variety of loan products. The funds that are used for the loans come mainly from depositors, though there are other sources of funds that banks utilize. The next time you visit your local bank, you’ll better understand what’s paying for those employees and fancy branch offices.