Have you ever wondered how banks make their money? While the banking business itself can be quite complex, the ways in which banks make money can be surprisingly easy to understand. Here's a quick rundown of the two main ways banks make their money and some key details to know about each one.
How banks make money
At their core, banks make money in two main ways -- commercial banking and investment banking. Commercial banking refers to products like accounts and mortgages, while investment banking refers to services like corporate transactions and wealth management. Here's what each of these terms means and the different revenue streams banks create within them.
Commercial banking
Commercial banking refers to the banking products and services that banks provide to individuals and businesses. These financial services include checking and savings accounts, mortgages, auto loans, personal loans, credit cards, lines of credit, and more. They also include adjacent services such as safe deposit boxes, brokerage accounts, financial planning, and more.
Investment banking
Investment banking refers to services a bank provides to corporations, governments, high-net-worth individuals, and other entities that go beyond commercial banking activities. Investment banks advise clients on mergers and acquisitions, corporate finance transactions, and restructurings. They facilitate things such as initial public offerings (IPOs) and debt offerings and also engage in proprietary stock, bond, and currency trading activities. And, finally, investment banks offer wealth management services to corporations and high-net-worth individuals.
Fees
Banks make their money in a variety of ways, but most can be classified as either fees or interest income. Let's take a look at fees first.
There are many different types of fees banks can collect, both on the commercial banking and investment banking sides of the business. Here's a rundown of some of the most common fee categories:
- Overdraft or returned item fees: Banks typically assess a charge if a transaction makes a customer's account go into the negative or if it is rejected due to lack of funds. A typical fee for this is $30 to $35.
- Monthly account fees: With checking accounts in particular, it's common for a modest monthly fee to be assessed, say $10, to cover the bank's costs of maintaining the account. There is usually a way for account holders to avoid the fee, and it is often something else that will make the bank money (such as a certain volume of debit card transactions -- see interchange fees below).
- Interchange fees: Interchange fees are typically charged when you use a bank's credit or debit card to make a purchase -- but it's the merchant's bank that pays it, not you. Say you have a Bank of America (NYSE:BAC) credit card and use it to make a purchase at a retail store. The retailer's bank must pay an interchange fee to the bank that issued the card -- in this case, Bank of America. The fees paid by merchants on credit card payments are commonly referred to as "swipe fees," and interchange fees are a part of them.
- Loan fees: Banks often charge origination fees when giving loans. For example, it's not uncommon to pay an origination fee of $1,000 or more for a large loan such as a mortgage.
- Other account fees: When you look at your checking or savings account's fee schedule, there is probably a list of things you could be charged for. In addition to those already discussed, common fees include non-bank ATM withdrawal fees, international debit card transaction fees, fees for money orders and cashier's checks, and wire transfer fees.
- Investment banking fees: Banks that have investment banking operations make money from advisory fees they charge to clients. For example, if a company wants to go public and complete an IPO, an investment bank would get advisory fees for facilitating the process and advising the company on the best course of action.
Net interest margin
When it comes to commercial banking, net interest margin is the primary revenue generator. Net interest margin, or NIM, refers to the spread between the interest income banks take in on loans and the interest the bank pays for deposits after the bank's costs are accounted for. For example, if a bank has a $100 million loan portfolio and its net income from those loans is $2 million, it has a net interest margin of 2%.
Net interest margins depend on a few factors such as the efficiency of the particular banking institution and the types of lending the bank specializes in. They also depend on prevailing market conditions. Specifically, lower market interest rates typically translate to lower NIM, and higher rates tend to produce higher NIM.
How credit unions work
Unlike traditional banks, credit unions are nonprofit businesses. They charge interest and fees, just like banks, but they are typically only focused on covering their expenses and not on delivering large profits to shareholders. Credit unions are technically owned by their members, and their mission is to give members the best rates, fees, and yields on deposits they can while covering the costs of their operations.
Not all banks make money in both ways
Many banks are purely commercial and don't have investment banking operations. This is quite common among regional and local banks, but there are some large banks that operate mainly like savings-and-loan institutions. US Bancorp (NYSE:USB) is one example of a large bank that avoids investment banking. Wells Fargo (NYSE:WFC) has some investment banking operations, but commercial banking accounts for most of its revenue.
On the other hand, some banks focus on investment banking. It's rare to find a pure investment bank these days, but Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) are the two largest financial institutions that mainly focus on the investment banking side of the business.
Finally, many of the larger banks employ a fairly even mix of both types. These are generally known as universal banks and include such large institutions as JPMorgan Chase (NYSE:JPM), Bank of America, and Citigroup (NYSE:C), just to name some of the best-known ones.
The bottom line is that there are many different ways a bank can make money, but each institution is different and will generate revenue in different ways.
