Since starting my job at a bank, people outside of the industry are always asking me, “How do banks make money?”. Given the redundancies I experience on a daily basis, I question it myself. Banks offer a product just like any other company. Their product is money. And there are two ways to answers how banks make money. We will look at the simple answer today.
In 1950, the banking industry existed around a very simple business model. When you go down to your local bank and make a deposit, you are loaning your money to that bank. My $100 deposit is a loan to my bank. How do I know this? Because the bank gives me interest for my deposit (think about a savings account). The bank will then loan that money out to someone. For simplicity’s sake, we’ll say in the form of a car loan to my neighbor. Everyone in my neighborhood uses the same bank, and so our collective deposits are loaned out to the neighbor. The bank will pay the depositors 3% for our savings, and charge my neighbor 7% for the loan. The difference of 4% is known as the spread, and that money is the bank’s revenue. I love ING Direct because they stick to this business model. They offer their services online to keep costs low. This means they need less of that 4% spread. The end result is better rates on savings and cheaper rates on loans.

That answer is all you really need to understand the banking industry. But if I haven’t bored you, read on.

Banks have gotten more complicated over the years. The Fed requires banks to keep a certain amount of money from being loaned in case all of a sudden many people decide to make withdrawals. All companies feel pressure to increase revenue and profits. Banks are no exception and have developed new products and services to accommodate. There are hundreds of deposit products out there. Sure you’ve heard of checking, savings, and certificates of deposits. Have you heard of Sweeps and Money Markets? They are all variations on the theme to get you to keep your money with that bank. Don’t forget businesses having banking needs too, and there is no shortage of products for them as well.

Loan products are no less complicated. Another question I get asked often is the difference between a loan and a line of credit (aka LOC). Since I do not believe a consumer should ever have a LOC for any reason, my example will be for a company. Let’s say my company wants to buy and move into a building. My bank will give my company a loan for the purchase. But what if I wanted to renovate the building I already operate in? The costs will be high, but I don’t know on Day 1 how much everything will cost. A LOC will provide me with funds on an ongoing basis. Its like a credit card, but could have a limit in the millions of dollars depending on needs.

To review – banks borrow money from you, add a small margin, and resell that money. Just like a car dealership will take your trade-in and sell you a car in the same trip. The dealership takes the margin. The banking industry has become more regulated over the years and at the same time shareholder pressure has driven banks to develop new products.

Tomorrow we’ll look into how banks are making money today. Thanks for reading.

By The Weakonomist

The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics.

categories: banking, business, college of weakonomics, loans