Banking Industry Business Model - Understanding How the Banking System Works
Banks are commercial profitable institutions and need to increase their business, grow their revenue, and provide returns to their owners. Unlike other stores and shops, banks are providing services rather than selling their products. Learn how banks get their funds and how they make money on services. Read more to learn how the banks earn their profit!
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. For their services, banks need to earn money to keep these institutions going. 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.
Depositors:
People who put money into banks are called depositors. Banks encourage deposits by protecting the money and by paying the depositor interest, a percentage of revenue earned on the principal over a period of time. The depositor thus earns some money from the deposits.
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.
Interest Spread:
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 costs have yet to be considered.
Banking Costs:
Costs include maintaining the security of your money, personnel expenses, building maintenance costs, and so forth.
Profit, or net income, is what's left of revenue after costs are deducted.
Other Income Sources:
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 significandy. These service fees provide substantial revenues for banks.
Investments:
Banks, like people and other corporations, make money on investments. They invest in stock markets and some types of securities and government bonds. While investing their money in instruments other than government bonds, they face the same risks as other investors. They hire professional investment staff to maximize their return on investments.
Assets and Liabilities:
- Why aren't deposits themselves a form of bank income? The money in them doesn't really belong to the bank. You may not like to think of your savings account as a problem for the bank, but it is one in theory. If depositors simultaneously want all their money from all their accounts, banks would be in trouble.
- An asset is anything of value. In financial terms, that usually means money. A liquid asset is anything that can readily be exchanged, like cash.
- A liability, in financial terms, is a cash obligation. If you borrowed $5 from a friend for lunch, you have a liability of $5 and your friend has an asset of $5. The asset's liquidity depends on how quickly you've agreed to repay the sum and how reliable you are.
- For banks, deposits are liabilities. Depositors have the right to request their funds, and the bank must pay them. Money the bank borrowed is also a liability, a debt to be paid.
- A bank's assets are its loans and investments, which may be less liquid by contract than deposits. Deposits may have to be returned any time, but assets can arrive in small amounts over a long period.
- Because banks have more money out working than they keep on hand, two principles of the banking business come into play.
- A bank's liabilities exceed its reserves. The money is loaned out, and the reserves don't match the total of deposits (liabilities). However, the money is out working, financing businesses and expanding the economy.
- A bank's liabilities are more liquid than its assets. A bank must give depositors their money if they request it. The bank's assets, however, may be less liquid because they are tied up in longer-term loans, so the bank can't get them as quickly. If many depositors need their money at once, the bank must either break its promise to depositors or pay until its reserves are gone. If the bank fails, unpaid depositors lose their money.
- Banking today is not as simple as earning interest on the spread. Rap¬idly changing conditions, complex factors, a 24-hour-a-day global economy, and financial interdependency among nations set the banking climate.
Suggested Reading and Resources
Related Links
You May Also Like
-
Definition of Bank: Meaning of the term Bank and the Business of Banking
What do we mean by the word bank? How did the word bank originate? What is the most simple and concise definition of a bank that explains the fundamentals of the banking process? Does the definition of banking vary from country to country? What are the key differentiators between any other business and a Bank? Get answers to all these questions and explore the basics of bank and banking as an industry.
-
History of Banking: Evolution of Banking as an Industry
Banking is one of the oldest industries and banking in the form that we know of began at about 2000BC of the ancient world. It started with merchants making grain loans to farmers and traders while carrying goods between cities. Since then, the banking industry has evolved from a simplistic barter system and gift economies of earlier times to modern complex, globalized, technology-driven, and internet-based e-banking model. In this article, we will take you through the major events and developments in the history of the banking industry.
-
History of Banking: Famous Banks from the Past
Seven hundred years ago a bank was established in Venice, which made transactions resembling modern banking. In 1407, another bank was founded in Italy under the name of Banco di San Giorgio which was one of the oldest chartered banks in Europe. Sveriges Riksbank (Riksbanken), is the central bank of Sweden and the world's oldest central bank. The Bank of England is the second oldest central bank in the world, and most modern central banks have been based on that model. Let us explore some interesting events as we learn more about these early banking institutions.
-
History of Banking: The Gold Standard & Fractional Reserve Banking
Gold has always been considered as a safe economic investment and treated like a currency. All of the economically advanced countries of the world were on the gold standard for a relatively brief time. Under a gold standard, the value of a unit of currency, such as a dollar, is defined in terms of a fixed weight of gold and banknotes or other paper money are convertible into gold accordingly. Explore the fascinating history of the gold standard through the lens of history and also learn why banks hold back a certain fraction of deposits as reserves.
-
Overview of Banking Industry: The Industry Basics
Banks play a key role in the entire financial system by mobilizing deposits from households spread across the nation and making these funds available for investment, either by lending or buying securities. Today the banking industry has become an integral part of any nation’s economic progress and is critical for the financial wellbeing of individuals, businesses, nations, and the entire globe. In this article, we will provide an overview of key industry concepts, main sectors, and key aspects of the banking industry’s business model and trends.
-
Banking Sector, Segments & It's Classifications
The banking industry players deal in a variety of products from savings accounts to loans and mortgages, offer various services from check cashing to underwriting, caters to different types of customers from individuals to large corporates, serve diverse geographies from rural villages to cross-border operations. Thus the banking industry is made up of several types of banks, with their own objectives, roles, and functions. In this article, we will explore the various sectors, segments, and classifications of banking based on parameters like products, customers, types, etc.
-
Type of Banks: Different Types of Banks in India & their Functions
This article explains the banking structure in India and how different banks are classified as per RBI Norms. The Indian banking industry has been divided into two parts, organized and unorganized sectors. The organized sector consists of Reserve Bank of India, Commercial Banks and Co-operative Banks, and Specialized Financial Institutions (IDBI, ICICI, IFC, etc.). The unorganized sector, which is not homogeneous, is largely made up of money lenders and indigenous bankers. Learn what we mean by nationalized banks, scheduled banks, public sector banks, private banks, and foreign banks.
-
Types of Banks: Different Banks & their Classifications (Global)
The banking industry caters to various sections of society thus the focus of banking becomes varied, catering to the diverse needs of clients through different products, services, and methods. To meet this, we need distinctive kinds of banks addressing complex business & social needs. In this article, we will explain various types of banking institutions ranging from retail banks, commercial banks, co-operative banks, investment banks, central banks to various other types of specialized banks.
-
Banking Operations: Understanding Various Transactions & Activities
Banks perform a variety of operations ranging from basic or primary functions like day to day transactions at a branch to others that maybe the agency or general utility services in nature. The transactions that are incidental to revenue/sales or sustaining the business are an important element of the banking industry value chain. In this article, we will look at the key operations performed in the course of banking.
-
Banking Industry Business Model - Understanding How the Banking System Works
Banks are commercial profitable institutions and need to increase their business, grow their revenue, and provide returns to their owners. Unlike other stores and shops, banks are providing services rather than selling their products. Learn how banks get their funds and how they make money on services. Read more to learn how the banks earn their profit!
