When every month draws to a close, financial struggles and money worries rear their ugly heads to torment us. When that happens, and suddenly, an urgent yet unavoidable expense surfaces, you might find yourself in a pickle. In such a scenario, you might turn to a bank to lend you some money to fulfil your need. But who does a bank turn to? Have you ever found yourselves wondering where do banks get their money from? How is it that they’re never at a loss for funds? How do they raise such an enormous amount of capital? Keep reading to satiate your curiosity and learn more about the whys and hows of banking finance.
If we were to have an eagle’s eye view of the whole situation, banks are, at their very core, lenders. That means they lure depositors to store their extra capital with them and, offer them a small interest in exchange. They then lend these idle funds to external borrowers who need money immediately. The bank charges these customers with a significantly higher rate of interest. The difference between the two is the bank’s profit, which the bank loves to maximise. This is called interest income. It is the most primal way in which a financial body makes money.
While banks would love to set their interest rates as per their own whims and wishes, in most cases, that is not permissible. These rate ranges are regulated and enforced by central banks such as the Reserve Bank of India (RBI). This is done to maintain a thriving economy and avoid inflation. What’s more, interest rates are dependent on demand and supply statistics.
Long-term maturity debt instruments are liabilities such as bank loans, credit lines, bonds, etc., with a repayment due date after 12 months of inception. When the demand for such instruments increases, banks sell them at a higher price and lower interest rates. However, if this same demand falls to the ground, these financial bodies might find it more profitable to sell them at lower prices but with greater interest rates.
One point to be considered in such a ballgame is credit risk. Some debtors might default by not paying back their dues. If many borrowers indulge in such behaviour, it might create a difficult situation for the bank.
Banks often offer brokerage services to various organisations. They do so by connecting companies or firms in need of funds with those with extra capital and who want to use them profitably. This is called a Capital Market. Moreover, these financial institutions also deploy investment banking teams to provide specialised services to organisations. These groups help their clients manage debt and equities proficiently. Another value-add service is the assistance given out during companies’ mergers and acquisitions. Here, the clients pay a significant amount as service fees to the bank.
One point to be noted is that Capital Market earnings are volatile. Market and corporate activity across the board might soar and fall considerably, which means these prospects become unforeseeable. Recession and inflation both have a part to play in how the demand graph moves.
One final trick that banks have up their sleeves: service charges. You might be aware that these financial bodies charge fees for every service that they provide. This includes credit card fees, custodian fees, monthly account fees for checking and savings accounts, and so much more. Also, mutual fund investments might be charged a service fee, with some banks even offering in-house mutual fund products to customers.
For multiple reasons, service fees are an attractive source of income for financial institutions. Firstly, such charges have little tendency to fluctuate and usually stay the same or even hike over time. These income streams further prove their worth during economic slumps, when interest rates of other tools may be decreased to adapt to the market, and consequently, the demand for capital markets might be diminished.
Like people, banks and other financial institutions, need money to survive and sustain themselves. Without significant funds backing them up, they will fail to achieve the very purpose they were created for: lending and managing money. As a result, these institutions put in tremendous effort to secure more capital. One way that banks do this is by borrowing money from central banks. This is called ‘cost to funds.’
Banks generally engage in this behaviour to maintain a steady cash flow required for day-to-day sustenance in transactions. Then, they profit by charging their lending customers a higher rate of interest. The difference between the interest paid to the central bank, and interest earned through loaning out money to customers, is the bank’s profit to keep. Usually, when central banks, such as the Reserve Bank of India, hike their repo rates consecutively, the banks raise their interest rates on loans offered to customers.
So, there you have it. Banks rely on different sources of income to keep them afloat. This is how banks operate, raise capital, and manage to stay profitable in today’s fiercely competitive world of finance.