HOW DO WE EARN MONEY?
- Banks are companies (normally listed on the stock market) and are therefore owned by, and run for, their shareholders. Banks need to make enough money to pay their employees, maintain the buildings and run the business.
- There are three main ways banks make money: by charging interest on money that they lend, by charging fees for services they provide and by trading financial instruments in the financial markets.
- Retail and commercial banks need lots of customers to deposit their money with them, as the banks use these deposits to earn enough money to stay in business.
- To encourage people to keep their money in a bank, the bank will pay them a small amount of money (interest). This interest is paid from the money the bank earns by lending out the deposited money to other customers.
- Banks also lend to each other on a huge scale. Most of this lending is on a short-term basis, usually no longer than three months, often just overnight.
- If a bank has a surplus of liquid (available) assets then the bank can make money by lending these assets to other banks in the interbank market. As money flows in and out, banks will both lend and borrow money on the interbank market as needs require.
- The banks lend money to customers at a higher rate than they pay to depositors or than they borrow it. The difference, known as the margin or turn, is kept by the bank. For example, if a bank pays 1% interest on deposits, they may charge 6% interest on loans.
- Lending takes the form of overdrafts, bank loans, mortgages (loans secured on property) and credit card facilities. The bank will work out the cost of making the funds available to the borrower and add a profit margin.
- Loans approved by banks will vary in size, and may have fixed or variable interest rates but, in all cases, the bank will lend the money to the customer at a higher rate than they borrow it.
- Deposits are the banks' liabilities. If everyone was to demand their money back at once, the bank would not be able to pay. Because they lend money out, banks are required to carry a cushion of capital so they have sufficient money to pay those customers likely to withdraw their money at any time.
- Another way banks make money is through charging fees. Most retail and commercial banks will charge for specific services, for example, for processing cheques, for other transactions and for unauthorised borrowing e.g. if a client exceeds an overdraft limit.
- Investment banks earn huge fees for advising large companies and public institutions on issuing bonds and shares (securities), and from underwriting these issues.
- Investment banks charge fees for advising clients wanting to bid for other companies in mergers and acquisitions, or management buy-outs. These deals can be very complex and provide an important source of income as well as an opportunity to underwrite shares related to these deals.
- Investment banks also make their money by trading securities in the secondary markets. Their aim is to sell these securities for more than they pay for them or purchase them for less than they sold them. The difference, called the turn, is kept by the bank.
- Banks also buy and sell currencies of all the nations of the world, trying to take advantage of the different prices of these currencies against each other, which are changing all the time.