The basis of modern banking can be traced back to medieval Italy, where merchants and moneylenders would extend loans to one another. At the time, “banking” primarily consisted of making loans and crediting or debiting accounts. If a merchant needed to borrow money but didn’t have enough collateral, they could appeal to a moneylender. The moneylender would then either extend the loan or not based on their evaluation of the merchant’s business.
Nowadays, banks offer a wide variety of services beyond just making loans. They also offer savings accounts, checking accounts, and certificates of deposit (CDs). In addition, financial institutions act as financial intermediaries, connecting savers with borrowers. And they provide other services such as ATM access, wire transfers, foreign currency exchange, and credit cards. Regardless of the specific service, banks make money by charging for their assistance in one way or another.
Traditional Ways For Modern Banks To Make Money
Here are some of the main ways that modern banks generate revenue:
Interest on Loans
When a bank makes a loan, it essentially gives out its own money in return for an agreement from the borrower to pay that money back over time, usually with interest. The amount of interest charged depends on many factors, including the prevailing market rates, the borrower’s creditworthiness, and the loan term’s length. However, the interest earned on loans is banks’ primary revenue source.
Interest on Deposits
Another way banks make money is by paying interest on deposits. When someone puts money into a savings account or a CD at a bank, they are essentially loaning that money to the bank. In return for using those funds, the bank agrees to pay interest at some agreed-upon rate. The interest rate paid by banks on deposits is usually lower than the rate charged on loans because depositors don’t generally demand as much return as borrowers do.
Modern banks also generate revenue by charging fees for their services. Standard service charges include account maintenance, wire transfer, ATM withdrawal, and overdraft fees. However, with most checking accounts, banks will often waive some or all service charges if customers meet specific requirements, such as maintaining a minimum balance or setting up direct deposits with their employer.
In addition to making money from loans and deposits, banks also invest customer funds in various financial instruments such as bonds and stocks. When done skillfully, this can result in additional income for the bank, which can be passed on to customers in the form of higher interest rates or used to offset losses elsewhere in the business.
Furthermore, modern banks earn profits primarily through Net Interest Margin (NIM). NIM is calculated simply by taking the difference between the average yield earned on assets and average cost incurred liabilities expressed in percentage terms.
The Different Types of Banking
Investment banking differs from retail banking as investment bankers are paid through loans and deposits, underwriting new debt and equity offerings for companies, and advising companies on mergers & acquisitions (M&A) transactions.
Commercial banks engage primarily in retail banking, whereas investment banks engage mainly in investment banking activities. The Glass-Steagall Act was introduced in response to the Great Depression which separated investment banking from commercial banking until it was repealed in 1999.
Retail deposit-taking activities were considered low risk, while investment activities like underwriting were regarded as high risk. Nevertheless, the repeal led many commercial banks like Citigroup, JPMorgan Chase, and Bank One, among others, to expand into investment banking activities.
Investment bankers get paid handsomely through transaction fees, succession fees, etc. In addition, they perform various activities like providing M&A advice and underwriting debt/equity offerings for their clients. Fees charged are generally much higher than traditional lending since the expected return is much higher given the risk involved.
What About Capital Allocation In Modern Banking?
Commercial banks play an essential role in efficient capital allocation since they have better information sets due to narrow focus(compared to conglomerates with diversified businesses) and longer relationships with borrowers, allowing them to understand project risks better.
An entity serves two important purposes when it comes to allocating capital:
- Providing liquidity
- Allocating capital efficiently: Banks play an essential role in providing liquidity, given their unique ability to quickly access large amounts of funds through the central bank’s discount window and the Federal Reserve System(in the US).
They can do this because:
1) They have civic responsibility
2) Stringent regulations require them to fulfill specific reserve requirements(which acts sort of like an insurance policy)
3) Perception that government will always bail them out whenever required(too big fail argument)
This edge sometimes implies that “relationship lending” exists between lenders and borrowers where lenders charge relatively lower rates because they internalize benefits associated with successful projects(higher fee income, market share growth, etc.). But, of course, that wouldn’t have been possible had the project gone wrong (implying the “too big fail” argument exists here, too, since even large commercial banks deemed “too big fail”).