How Banks Work In Our Modern Wold
it can be difficult to understand banking since there are so many different types of banks including commercial banks, savings banks, cooperative banks or savings and loan associations, and credit unions. The primary function of a bank is to lend money deposited by account holders to other borrowers who need it for financing business, buying a home, or sending children to college.
Banks create money by making loans. The amount of money that banks are allowed to lend is subject to a reserve requirement by the Federal Reserve. For example, if the Federal Reserve requirement is 10% and a bank receives a deposit of $100, the bank is allowed to lend $90 which goes out into the economy. Eventually, it will be deposited in a different bank where it is again lent out with a 10% reserve which amounts to $81, and so on.
The depositing customer gets a small amount of interest on savings while the lending customer pays a much larger amount of interest on loans. The bank makes money by keeping the difference. The amount of interest a bank charge depends on several factors including the amount of money the bank has on deposit and how many people want to borrow funds. It is also dependent ‘funds rates’ – the interest rates that banks charge between themselves for short-term loans they need to make in order to meet their requirements. Because lending money is a risky enterprise for a bank they will charge higher interest rates for larger and riskier loans.
How Modern Banks Make Money
There are 3 main sources of revenue for banks in retail banking today:
- Net Interest Margin
Net is the difference between the amount of interest the bank pays to depositors and the amount of interest they receive from borrowers. With current low-interest rate policy by the Fed, it means that depositors get very little interest on their savings while bank margins are very high. - Interchange
Every time a purchase is made at a store using a credit card, the merchant pays a percentage of the purchase price to the bank. This is called an interchange fee which could be around 1.7% for credit cards and 1.1% for debit cards. Because most Americans spend more than they save, this is a huge revenue stream for banks. - Fees
The bank charges various fees for their services. This includes ATM fees, monthly service fees, late payment fees, overdraft fees, and penalties. It is estimated that the average household in the US ends of forking out over $200 annually on overdraft fees and bounced checks. Along with foreign exchange charges, these fees can add up to more than 50% of revenue for larger banks.
All this revenue becomes a real cost to customers in the form of fees that show up on monthly statements as well as implicit fees of interchange and net interest margins as merchants pass on the cost of interchange to their customers in the form of higher prices. In effect, every time a person uses a bank service a fee is charged.
Of course, there are costs associated with banking including maintain IT systems, ATM networks, call centers, marketing and advertising, and paying salaries. Maintaining branches used to be a huge cost, however, being online has reduced these costs considerably as very few people actually visit the bank nowadays.
After the recent banking crisis the banking market is now dominated by a handful of large banks and at the scale they operate, retail banking is immensely profitable for them. However, without banks it will be impossible to function in a modern society.