You may not realize it, but banks are just another kind of business. Like all businesses, they can differ in size, overall function and level of success. Nonetheless, they do share one thing in common. Banks need to make money to continue operating.
Most commercial banks make money in three ways. First, the majority of revenue comes from accepting deposits from consumers and then lending that money, with interest, out to individuals and businesses in the form of bank loans. You are most likely very familiar with the fact that banks also make money by charging fees. Additionally, banks even earn returns on investments they make. Below is an explanation of how banks accomplish these methods of producing revenue.
Bank Funding Comes from Your Money
Do you ever wonder why long-term investments, like CDs and money market accounts, provide higher interest rates than checking or traditional savings accounts? Perhaps you have questioned the minimum balance you are required to maintain. The truth is, your money earns your bank money, too.
The money you deposit into an account is what funds the various loans banks offer. From mortgages to personal loans, the bank essentially borrows money from your account, lends it to someone else, collects interest on it and then returns it to you. Of course, your actual balance never changes unless you make a deposit or withdrawal, but your money is always being put to use.
If you want to make a withdrawal from your checking account, the bank must provide it to you right then (hence the common term, “demand” account). This means that the bank must maintain enough cash on hand for customers to access their account funds at any time. On the other hand, when you commit to an investment period of several months or years, the bank can loan money out without you needing it for a while. You are usually rewarded for helping the bank earn more money from interest payments by receiving a higher interest rate yourself.
How does a bank profit from interest they collect when they pay you interest too? Consider this: Your money market account of $50,000 with a 1.25% APY earned you an extra $625 this year. That’s great. Your bank loaned out your $50,000 for part of a home loan, plus much more from other depositors, and collected several thousand dollars in interest payments. That’s great for your bank as well.
Bank Fees Add Up
Interest alone does not make up the sum of a bank’s profits, however. The fees a bank charges in the form of services and penalties also attribute to a large portion of their revenue.
Consider all of the fees you have paid over the years. Banks charge monthly service fees for maintaining an account, withdrawal fees when you use an ATM from another bank, application fees for obtaining loans, and numerous penalties for overdrawing, bounced checks, etc. The list goes on. While none of these individual fees are considerably large, though you may have lost an hour’s pay or more to one, the sheer number of charges that occur every day adds up to big bucks.
Banks Make Investments, Too
Bank financing and fees comprise most of a bank’s profits, but there is one more strategy they employ. As many businesses do, banks attempt to maximize profits by making their own investments that will hopefully earn good returns. However, they cannot simply make any purchase they wish. Banks must keep a certain amount of deposits liquid at all times, which is defined by the FDIC, and then must primarily invest in loans. Anything other venture must be very low-risk.
If you are concerned that banks are gambling your money on investments you never authorized, rest assured that they are limited in what they can do. Banks do not invest depositors’ money in anything but loans. They use “extra” money for doing so. Further, President Barack Obama has been pushing for more rigid bank regulation laws and was reported earlier this year by CNSNews.com as calling for restrictions on how banks can invest funds. He proposed that financial institutions, including banks, be prevented from “owning, investing, or sponsoring a hedge fund or a private equity fund that is not related to serving customers.”
The banks also charge fees on pretty much everything to business customers – I get a four page statement detailing all my bank fees each month. They range from “oh, that makes sense” (fees for returned deposited items, for example) to “that’s freaking insane” (cash deposit fees, for example).