Banking Industry Value Chain: How Banks Earn Profit?
Banks are commercial institutions and like any other for-profit commercial venture, aim to increase their profits by expanding the business. Unlike other stores and shops, banks are selling services rather than products. Banking is a unique business model, and banks have various sources of income like interest spread, commissions, fees, and other revenues. Learn how banks get their funds and how they make money on services. In this article, we look more closely at how banks do business and how they earn profits and explore the value chain of the banking industry.
The Banking Value Chain:
The value chain is a model that describes how banks create value in their products and services. The banking industry “Value Chain” starts with the customer. The rest of the value chain is comprised of a series of value-generating events and activities. For their services, banks need to earn money to keep these institutions going. Now we know that banks are important to the efficient functioning of the financial system. Despite their central role in the economy at large and despite the various functions they perform that helps individuals at large, banks are still businesses. Banks are generally owned by stockholders and their equity capital is constituted of individual stockholders' stake in a bank. Profit is paid out to stakeholders in the form of dividends, although the bank may keep some profit to add to its capital. On average, banks earn a return on assets of just over 1% every year. Banks have traditionally made money by loaning money, earning interest on held securities, and charging fees for customer services.
Banks fill a market need by providing a service and earn a profit by charging customers for that service. The key commercial banking activities are taking in deposits from savers and making loans to households and firms. Banks earn money from various sources but most of their money comes from lending. When banks lend their money, they earn loan interest, which is paid to them by the borrowers of money. Traditionally this has resulted in the main functions of commercial banks being accepting deposits from the public and advancing them loans. However, besides these functions there are many other functions, which these banks perform to earn additional revenue. Let us understand these functions in detail:
Accepting Deposits:
We begin our discussion of the business of banking by looking at a bank’s sources of funds, which are primarily deposits. People who put money into banks are called depositors. Banks encourage deposits by protecting the money and by paying the depositor interest. Interest is a payout, a percentage of revenue earned on the principal over a period. The depositor thus earns some money from the deposits. Depositors are liability to banks and they are the sources for funds.
Providing Funds to Borrowers:
Using the accumulated funds of many depositors, the bank makes loans to customers it considers likely to repay. When banks lend money, they put it to work. The money that people borrow goes to buy products or services, to manufacture goods, and to start businesses. In this way, the money that banks lend works to keep the economy going. The bank charges more interest on the money it lends than it pays depositors, so when the money is repaid; more comes in than going out. Loans are the application of funds for the banking industry. It sourced funds from depositors and have applied these funds by providing loans to borrowers.
Bank’s Income – The Interest Spread:
To earn a profit, a bank needs to pay less for the funds it receives from depositors than it earns on the loans it makes. The difference between what a bank pays in interest and what it receives in interest is the spread or net interest income. The spread is not pure profit. The spread is income or revenue, but the bank incurs a lot of other costs to get this income. To arrive at the figure for profit we need to deduct to all such costs.
Expenditure- Bank's Costs:
Banks incur a large number of costs/expenditures to procure business, safeguard money, and keep its operations going. Some example of costs includes maintaining the security of your money, personnel expenses, building maintenance costs, and so forth. Profit, or net income, is what is left of revenue after costs are deducted.
Other Income Sources:
Banking today is not as simple as earning interest on the spread. Rapidly changing conditions, complex factors, a 24-hour-a-day global economy, and financial interdependency among nations set the banking climate. Some of the activities banks have adopted in response to competition from other financial firms. Banks have additional income sources. In addition to loan income, including credit-card interest, they also charge for various services. Charges include fees for rental of safe-deposit boxes, checking account maintenance, online bill payment, and ATM transactions. It is important to note that banks do not earn interest on money kept on hand for services such as ATM transactions. Thus, banks charge fees to offset lost interest. To keep pace with the rising cost of servicing accounts, fees for services have increased significantly. These service fees provide substantial revenues for banks.
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