Several bank transactions perpetuate within the realms of banking operations. Examples of these include saving and borrowing money, cash deposit or withdrawal, credit or debit card purchases, bills payment, debt settlement, payroll management, and foreign currency exchange. From these multipronged banking services, it is interesting to know how banks earn money from being a financial intermediary.
This article explores the nature of banking operations, specifically by discussing how banks generate revenues and profits from intermediating among the different financial management requirements of their customer base.
A backgrounder on banks and the banking system
Modern banking emerged in Italy during the 15th century. The Medici Bank of the Medici Family was the first institution to consolidate and organise unsystematic banking practices. During the heydays of its operation, the bank was the largest and most respected in Europe. The success of the Medici Bank eventually paved the way for the formalisation and institutionalisation of banking practices based on the credit system.
Today, banks are financial institutions that provide specific types of financial services. Hence, they operate within the greater umbrella of the financial sector or the financial services industry alongside other financial services providers such as the stock market, lending firms, insurance companies, preneed companies, and health maintenance organisation.
The expansive operation of banks, however, makes banking a considerable independent subsector of its own. Nonetheless, banks are still business organisations with the primary objective of generating revenues and earning profits. Through their business model, there are several ways banks earn money.
Banks earn money through the credit system
The modern credit system centres on borrowing and lending of money. This system is one of the ways banks earn money. Note that through this process, banks provide two broad types of service—debit service and credit service.
Debit service includes all forms of investment transactions or services including savings account, time deposits, and other high-yield investments. The credit service, on the other hand, includes all forms of loan transactions for residential housing, vehicle purchase, business capitalisation, and personal loan.
Furthermore, banks have two types of customers. The first includes all depositors who put their excess money on banks for safekeeping and the second one includes all borrowers who approach banks for financial assistance.
Whenever banks receive money from depositors, they do not actually leave it untouched in a single place. Rather, they use this money or any derivative value to provide lending or credit service to borrowers. Banks are thereby financial intermediary responsible for facilitating the movement of money from depositors to borrowers.
Despite the process of channeling money from depositors to borrowers, banks maintain digitised financial records. Deposited money remain intact in concept. These financial records also include all accounts of borrowed money.
To assure depositors that their money are intact, banks usually provide them with bank statements, transaction history, and/or bank or investment certificates. For borrowers, they need to provide banks with an assurance that they are capable of paying their debts. They do this by providing proof of financial capacity expressed through income tax returns, employment or business certification, and/or list of existing assets.
Trust is nonetheless the foundation of banking and the entire credit system. Depositors need to trust the capacity of their banks to manage their financial assets. In the same fashion, banks need to trust the capacity of their borrowers to pay their debts.
Earning profits by placing interests on debts
Profits are overcharge. Banks essentially do the same, particularly by increasing the value of a particular asset or to be specific, of the credit service. The excess value is known as interest and in the realms of banking, this is similar to profit.
Apart from requiring borrowers to pay a portion of their entire debt on a given date, banks also charge them to pay an interest. This interest is an overcharge. To illustrate further, suppose an individual borrows money amounting to $10,000. Upon the maturity of his debt, he might end up paying $15,000 or depending on the interest rate.
The actual value of the borrowed amount naturally belongs to the depositors. The remaining excess value or overcharge is divided between the bank and the depositors. In other words, another ways banks earn money is by placing interests on different forms of debts such as personal loans and mortgages.
Generating revenues beyond the credit system
Aside from placing excess value or interests over borrowed money, banks also make money through a standard fee and markup setup.
Through their extended services, banks are able to generate additional profits beyond the credit system. For instance, banks charge fees for other value-added services including wire transfers and payroll services. They also earn from foreign currency exchange and for acting as authorised collection agents of service companies. Nonetheless, this essentially means diversification of banking services beyond the debit and credit services.