When you go into your local banking branch, there are probably 1 or 2 people inside while you withdraw $40 out of your free checking account.
You may ask yourself, “How does this bank make money? They’re not charging me anything to use their services.”
Well, it’s not simply out of a bank’s goodwill and generosity….
Retail Banking
First, let’s talk about how banks make money on the retail side of their business. In other words, how a bank makes money from regular customers like you and me.
Interest Income
Interest Income is simply the interest a bank makes from using deposits from customers’ savings and checking accounts and using it to fund higher revenue businesses.
The bank pays you minimal interest on your deposits. The average interest is currently .06%, according to BankRate.com.
According to data from the 2019 Federal Reserve Survey of Consumer Finances, which is published every 3 years, the average checking account balance was $4,160.
The interest adds up to a whopping $2.48 per year for each checking account holder.
Now this is where it becomes interesting….
How Banks Use Depositor’s Account to fund higher revenue services
- Credit Cards (18.24%)
- Personal Loans (10.49%)
- Auto Loans (4.08%)
- Home Equity Lines Of Credit (4.11%)
- Student Loans (6.03%)
*Average APR
An Example of How a Bank makes money from customer deposits:
ABC Bank has 1,000 checking accounts with an average balance of $4,160. This means they have $4,160,000 in cash. They only have to pay their depositors $2,496 a year in interest.
So, they have $4,157,504 to lend out for auto loans at a 4.08%. The bank therefore makes nearly $170,000 from the auto loans while only paying $2,496 in interest.
Pretty sweet, right? The difference between what a bank pays on deposits and what they earn in interest called Net Interest Income.
Some of the largest banks in the U.S. can earn upwards of $50 billion per year in Net Interest Income. In general, when interest rates are lower, the spread between what banks pay customers on their deposits and what they can charge for different loans tightens therefore banking profitability shrinks and bank stocks price tend to fall.
Moving on…
Now, there is a concept called Fractional Reserve Banking which requires banks to keep only a percentage of depositors’ money available through what the Federal Reserve calls the minimum reserve ratio.
Plus…
There are also many other factors banks take into consideration, such as default risk and prepayment risk, to name a few. However, the specifics of the factors go beyond the scope of this article.
Below is an example of the different types of fees banks charge. While they are seemingly small numbers, these fees represent a critical component of how banks make money.
- Overdraft fees ($33)
- Late fees ($28)
- Inactivity fees ($5-$20)
- Paper statement fees ($2-3)
- ATM fees ($3)
- Application fees ($25 – $50)
Let’s take a closer look…
An article recently published in the Wall Street Journal highlighted how the U.S. Banking system brought in a whopping 31.3 BILLION in overdraft fees in 2020 alone!!
That’s not chump change, even for the biggest largest banks.
Capital Markets
The capital markets are also a significant source of revenue for banks. Within Capital Markets, the core areas are Investment Banking as well as Sales & Trading.
Investment Banking Fees
Investment Banking is a large part of a Bank’s revenue. There is a wide range of Investment Banking services, but let’s cover the most common.
- Mergers and Acquisitions (M&A): Company A wants to buy Company B. The investment bank will help determine the right “price,” break down the financials, and assist with any other due diligence along the way.
- Underwriting Services: This is a process through which a bank helps a company raise capital (money). The most well-known service is helping take a company public or preparing them to trade publicly (IPO). Another way banks help companies raise money is through debt financing, meaning they help sell bonds to institutional investors.
The top 5 U.S. banks had investment banking revenue of $37 billion in 2020!
Revenue from Sales & Trading
Banks make the majority of their trading revenue from clients such as institutional investors, corporations, hedge funds, mutual funds, and pension funds, just to name a few.
Now, Sales & Trading go hand-in-hand. The salesperson pitches products to clients, suggests trade ideas, and maintains the overall relationship. On the other hand, trading is mainly responsible for managing the Profit & Loss of their book and executes trades with the client.
- Sales Credits: When a trade is executed, there is oftentimes a margin or profit on the trade that the bank considers a sales credit. Part of the sales credit will go to the salesperson. It is then the trader’s job to maintain that margin by hedging in the market so they can declare a positive P&L. This doesn’t always work perfectly, as we heard in the news many times before.
Does anyone remember The London Whale?
The Bottom Line
As bank customers, we have no control over investment banking and trading services.
That said, banks have certainly been taking a lot of heat regarding fees they charged to individual customers, especially since COVID-19 hit.
For example, Senator Elizabeth Warren slammed banks at a recent Senate Committee hearing for collecting overdraft fees during the pandemic. In addition, there has been commentary from analysts that expect the Consumer Financial Protection Bureau will encourage the Biden Administration to limit overdraft fees.
As individuals, it’s best to be aware of what types of fees you are being charged and follow the guidelines to prevent reoccurring charges in the future.
While many banks have not completely eliminated overdraft fees, companies are becoming more flexible.
Many times, if you call the bank and ask for a fee to be reversed, customer service representatives will often cancel the charge, particularly if you are experiencing hardship.
For example, a friend recently lost their job while still having auto-pay set for a few of their utilities. This resulted in nearly $90 in overdraft fees. After they called their bank, the customer service representative happily reversed the charges without fuss.
