Money and Models Part 3: How Banks Make Money

The whole point of a business is to make money. This series will give a basic crash course in the language of business (accounting), and how various business models work.

 

How Banks Make Money

 

Banks seem impossible. When you put money in your bank account, the bank gives you more money in the form of interest. It seems hard to imagine that a company can make a shirtload of money from just giving people money. But they do. Banks have a lot of money to throw around because of a very clever business model. 

 

Before we start, I want to clarify that the banks I’m referring to are commercial banks, as opposed to investment banks. For most people, commercial banks are what they think of when banks are mentioned (checking accounts, saving accounts, deposits, and such). These banks include Capital One, Bank of America, Wells Fargo, or Chase. Investment banks are the type of banks people go to when they say they want to “go into finance. They’re also the type of banks people think of when they’re talking about “evil” banks. These banks include Goldman Sachs, Morgan Stanley, and Bank of America Merrill Lynch. Notice how some of these companies do both commercial banking and investment banking.


When you set up a checkings account and deposit money into the account, the money sits in the bank’s funds. If the money sits their long enough, it may accrue interest, which means you get even more money on top of the money that sits in the bank. This is convenient, because not only are they  you making more money in interest, but you also don’t have to hold all your money in cash anymore.

 

Every once in a while, if you attempt to take more money out of your bank account than is available, or don’t maintain a deposit minimum in your bank account by the end of the month, you may have to pay a fee. Many people assume this is how banks mainly make their money, but this isn’t true. While banks may make a solid amount of money from fees, it isn’t a good strategy to depend on the mistakes of your customers. Instead, banks make most of their money engaging in loans.

 

When a bank gives a loan, a set amount (the principal) is lent to a party. Over time, the party who received the loan has to pay back the principal in the future, along with additional interest. Over time, the bank makes more total money from the loan, than if they let the money sit around.

 

Banks need to actually have money in order to lend money to others. They get this money from the deposits made by people. When you make a deposit into your checking account, the bank takes that money and lends it to others. When the bank does this with billions of dollars, it makes millions of dollars back.

 

Banks convince you to deposit money into their coffers by offering interest. The more appealing the interest, the more people deposit money into the bank’s account. The more money in the bank’s accounts, the more loans the bank can make. The more loans a bank makes, the more money the bank gets. This system is called fractional reserve banking. Because loans make the bank money, and giving interest to deposits cost the bank money, the interest rates for the bank’s loans will always be higher than the interest rate offered to the bank’s deposit customers. 


Fractional reserve banking has a fatal problem. Since banks don’t keep their deposit money sitting around, the total amount of money the bank has in deposits on paper is always less than the banks available funds. If all of the banks’ customers wanted to withdraw all of their money at once, the bank wouldn’t be able to make all of the transactions, leaving a bankrupt bank and some bankrupt customers. This is called a bank run, and is what happened during the Great Depression.

 

After the Great Depression bank run, the FDIC started insuring people’s deposit money up to $250,000. If a bank goes bankrupt, and some customers were unable to withdraw their funds, the federal government will give them the amount they had in their bank accounts. As a side note, if you ever reach a fortunate point in life where you have more than 250k available to deposit in banks, you can also insure the additional money using CDARS.

 

This is a (simplified) explanation of how banks make money. This industry is highly regulated, so the specifics get exponentially more complicated. However, all commercial banks follow this general model, and they make a lot of money doing so.

 

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