How Do Banks Make Money? Understanding the Business Model of Banks

How Do Banks Make Money? Understanding the Business Model of Bank

Hello, friends!  

We all save our money in banks, and in return, banks pay us interest on our savings. But have you ever wondered how banks themselves earn money? In this article, we’ll break down the business model of banks and explain how they turn your deposits into profits.

What Do Banks Do With Your Money?

Contrary to what movies might show, banks don’t just store your money in a giant locker and keep it safe. Instead, they use your money to give loans to others. The interest they charge on these loans is how they earn their income.

Let’s simplify this with an example:   

• You deposit ₹100 in a bank, and the bank pays you 4% interest per year.

• The bank then lends that ₹100 to someone else at an 8% interest rate.   

• When the borrower repays ₹108, the bank keeps ₹4 as profit after paying you ₹104.  

This difference between the interest banks pay you and the interest they charge borrowers is called the Interest Rate Difference, and it’s a primary source of income for banks.

What Happens If Everyone Wants Their Money Back?

A critical question arises: What if the bank has lent out your ₹100, but you urgently need to withdraw it? Or what if the borrower can’t repay the loan?  

This is where Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) come into play. The Reserve Bank of India (RBI) mandates that banks keep a portion of deposits as reserves:  

• CRR: Banks must keep 4% of deposits as cash reserves.  

• SLR: Banks must maintain 18% of deposits in government bonds, gold, or other approved securities.  

This means banks can only lend out about 70-80% of the deposits they receive. However, if too many depositors demand their money at once, a Bank Run can occur, leading to the bank’s collapse. While rare, this has happened in cases like PMC Bank and Yes Bank, where bad loans caused financial instability.

How Do Banks Earn in Low-Interest Countries?

In countries like Germany, where loan interest rates are as low as 0.5%, banks face a challenge. To compensate, they:  

1. Reduce interest rates on savings accounts (sometimes to 0%).  

2. Charge monthly fees for maintaining bank accounts.  

This model is already common in Western Europe, where banks rely less on interest rate differences and more on fees and commissions.

 Other Sources of Income for Banks

Apart from interest rate differences, banks earn money through:  

1. Fees and Commissions: Charges for services like account maintenance, ATM usage, and transactions.  

2. Investments: Banks invest in government bonds, gold, and the stock market to generate additional income.  

Expenses of Banks

The biggest expense for banks is employee salaries, which account for 30-40% of total costs. Other expenses include operational costs, technology investments, and regulatory compliance.

Real-Life Examples: SBI vs. HDFC Bank

Let’s compare India’s largest public and private banks:  

• SBI, being a public sector bank, has social responsibilities and often invests in government-directed projects.  

• HDFC Bank, as a private bank, focuses on profitability and has a lower NPA (Non-Performing Assets) ratio.  

Key Metrics to Judge a Bank’s Performance

1. Net Interest Margin (NIM): The difference between interest earned and interest paid, expressed as a percentage of total loans.  

2. Gross NPA Ratio: The percentage of loans that have turned into bad debts. A ratio above 7-8% is considered risky.  

Can You Start a Bank?

Yes, you can! Starting a private bank in India requires:  

•  An initial capital of ₹5 billion.  

•  Approval from the RBI, which regulates all banks in India.  

 Conclusion

Banks earn money primarily through the interest rate difference between what they pay depositors and what they charge borrowers. They also generate income through fees, commissions, and investments. While public sector banks like SBI have social responsibilities, private banks like HDFC focus on profitability. Understanding this business model helps us see how banks operate and why they play a crucial role in the economy.

If you found this explanation helpful, let us know which business model you’d like us to explore next!  

Thank you for reading!