How Banks Make Money
One of the keys to understanding money is understanding how banking works. Having a grasp of how banks make money can help you make more informed decisions about where you keep your own money, and how you use your money to make more money.
The Business of Making Money
The first thing to understand about banks is that they exist to make money. Banks are businesses. However, instead of providing manufactured products, or offering some of the professional services we expect when we think of business, banks “buy” and “sell” money. (Of course, some banks do provide other services related to finances, including selling insurance and sometimes offering access to securities.)
Banks “buy” money from depositors. Then, they can lend that money out, “selling” it to borrowers. Banks often pay interest on deposit accounts. This is especially true of savings accounts, certificates of deposit and money market accounts. Banks may also pay interest on checking accounts. Banks want to attract more depositors to the institution. This way, there is more money available for banks to lend out. And this is where a bank makes its money.
Loans made to other bank customers (and sometimes to other banks) provide a bank with a way to earn more money. A bank may pay interest on a deposit, but the interest a bank receives on a loan is much higher. If you put $1,000 in a high yield savings account, you might only earn around 1.35%. The bank, though, might be able to loan $900 of that money out at an interest rate that is much higher. Auto loans might garner a rate of at least 5% for banks, and mortgage are in that neighborhood as well. Other types of loans can provide in excess of 14% interest (especially credit cards). The difference between the amount of money a bank pays out in interest, and the money it earns from loans, can make it a rather profitable business.
The way that banks earn money illustrates one of the reasons that banks compete for depositors. The more depositors a bank has, the more money it can loan to others for better returns. It is worth noting, though, that banks can’t always lend out all of the money it has in deposits. The Federal Reserve requires that depository institutions hold a certain percentage of their funds in reserve. For banks with net transaction accounts of $10.7 million to $58.8 million, that number is 3%. Banks with more than $58.8 million net transaction accounts must hold 10% of those funds in reserve. However, even with the requirement to hold funds in reserve, banks can still earn quite a bit – and the Federal Reserve (as of 2008) pays interest on required reserve balances.
How Banks Set Interest Rates
Banks decide on interest rates by using a number of different factors. A bank takes into account the following factors as it sets its rates:
- Number of people who want to borrow money: The demand for loans can affect the sorts of rates a bank will charge. If a bank in a certain area is having trouble finding borrowers, it might lower rates to entice them.
- Amount of money the bank has available to loan out: If banks don’t have much money to lend out, they might adjust rates to reflect that. A bank might increase the interest it pays on CDs and savings accounts in order to encourage depositors to keep their money with the bank so that the money supply available to the bank for loans increases.
- Funds rate: This is the rate that banks charge each other for short-term loans. The target funds rate is set by the Federal Reserve, and it is usually fairly affordable for banks. Banks often use short-term loans from each other in order meet the reserve requirements the Fed imposes. Of course, if a bank borrows money in order to meet its short-term obligations, the loans it makes will need to have higher interest rates so that a profit can be made.
Banks also set interest rates on loans with help from individual customers’ credit situations. When a bank loans out money, there is a risk that the borrower won’t repay it. This means that the bank is out the original amount of money it loaned – and it won’t make money on interest. In some cases, a borrower may pay back part of the loan, and then default on the rest. In order to ensure that the bank gets as much of its money back as possible before a default, those who appear to be higher credit risks are often charged higher interest rates.
Banking and the Economy
Our economy relies a great deal on keeping the cycle of money moving. Banking helps this happen by taking money and then loaning it out. Indeed, if you think about this works, it becomes apparent that the amount money represented in the economy is much larger than what is “actually” there. This reality is enhanced by the electronic nature of many of our transactions. Consider how $1,000 seems to multiply, even if all the banks in the system have a 10% reserve requirement:
You put $1,000 in the bank, and $900 of that can be loaned out. So, that $900 goes into the economy and is spend on something: A car, groceries or some other item. The recipient of that $900 then puts it in the bank. The new bank can loan out $810 of that money. It’s not new money, though: It’s still part of the original $1,000 you put in. And, of course, the cycle continues, since that $810 is loaned out and spent, and then put into a bank by the recipient. The bank can then loan out $729 of that money. But, as you can see, at each stage, money is being spent, and someone is receiving it – and putting it bank into the bank. And all the time, banks are earning interest as loans are repaid. But that same $1,000 can be recycled over and over again.
As long as the system keeps working, the economy keeps growing. But, as we saw with the credit crunch and the recent financial crisis, once the money stops going around, things get a little dicey for our economy in its current form.
Anonymous - #1, Monday, January 17, 2011 - 1:23 PM
Miranda makes this far more complicated sounding than is necessary.
Banks lending on their own book make money on the difference between the interest that they charge on loans and the interest that they pay on deposits. Few large banks lend on their own books; they make money on the difference between the interest that they pay to borrow money and the interest that they earn loaning that money back out, and, far more importantly, fees.
Anonymous - #2, Monday, January 17, 2011 - 1:31 PM
Last year I was calling banks to get local CD rates to make a decision on where to buy a CD. I was appalled when I spoke to an officer at the main bank that I deal with who's interest rates are always rock bottom from others in the area. He actually told me they didn't "need" the depositor's money because they could get "all" they wanted or needed from the Federal Reserve at practically a "0" interest rate!
If the Federal Reserve is actually doing this then what hope is there for the retiree who is trying to make just a decent CD rate to survive on? I called the Federal Reserve and was told they don't just hand out tons of money to any bank. There are restrictions on how much they can get and how they can get it. It is not as easy as the officer at my bank made it sound like. However, it does seem, the Fed's actions are what is keeping interest rates so low for savers. BTW, I made sure that I do not buy CDs from that officer's bank. I use them just mainly for checking at this time. If they don't "need" my money, I will use other banks that do!
Inforay - #3, Monday, January 17, 2011 - 2:09 PM
It looks like the larger the bank, the more money it can borrow from the Federal Reserve at zero percent, and then turn around and purchase treasuries or bonds which pay 3% at no risk. That is why the larger banks (such as Chase) do not need to pay any more than 0.01% to savers, since they can borrow from the Federal Reserve at zero percent, all the money that they want and need. The Federal Reserve has done a tremendous disservice to savers. I would go as far as to say that its actions are irresponsible, since it is forcing otherwise conservative individuals and retirees, against their own better judgment, to get into the stock market because they are earning nothing on their savings. Keeping my retirement account in a money market fund, my account of $46,000 earns 0.32 cents per month. About 2-3 year ago the same account used to earn about $200 per month.
Anonymous - #4, Monday, January 17, 2011 - 4:05 PM
Taking 0% and investing it in 3% Treasuries is not risk-free.
To get 3% you would have to buy a 10-year note. The 0% loans are all short-term. You would have to depend on rolling over those loans. If interest rates went up, the value of your 10-year note would go down. You would stuck with the choice of either selling the Treasuries on the open market at a loss or borrowing money at higher than 3% to finance your holdings.
In any case, (in normal times at least) a bank would have to maintain a certain level of core holdings or risk being shut down.
Anonymous - #5, Monday, January 17, 2011 - 5:12 PM
32 cents/month? Dont forget taxes.
Bill (anonymous) - #6, Monday, January 17, 2011 - 6:11 PM
AARP, and/or the AARP lobby, has done very little, if anything at all, to promote the financial interests and well being of the retired conservative investors. Almost nothing is ever mentioned about the dilemma of the many fixed income seniors and, quite frankly, this is a bit suprising.
Greg2 (anonymous) - #7, Monday, January 17, 2011 - 10:08 PM
To Miranda Marquit,
Thanks for trying to explain how the banks make money, however, your approach i s very naive and simplistic.
That is one of hundreds of ways the banks make money and the most basic of the basic approach and an excuse for the banks not to pay interest to their depositors.
I’m CPA and had work for auditing firms that had looked at banks ledgers entries and I’m not suppose to let everybody know of the banking secrets, but for the sake of the argument, I will give you an example of a simple bank ledger.
Every penny that customer deposits, becomes entered as liability in the books.
Every penny lent out as credit or loan, becomes income in the bank’s books.
Every penny originated as, let say house purchase, becomes income entry even though
the bank makes a check to the person or sends it to the other bank for deposit. When that checks comes back to the originating bank, is entered as liability against the income entry of the same check entered previously.
Huh, you say, well it is true, the bank made money out of thin air, remember, bank books must be in balance at all times, therefore the mortgage payments are entered as liability, remember the received money are liability to any bank.
Hard to follow, but this is only one example of how the banking system works, it is not obvious to the savers and the customers. I have not even mentioned the re-investments of the cash, securities, bonds, derivatives, stocks, reserves and many other sub categories of internal and external money sweep on daily bases and circular patterns of the bank assets.
It is very complicated and only top notch CPAs are allowed to look and manipulate such ledger entries.
So, please don’t get offended by my explanation of the banks ledger entries, like I said, this is only one example, but yours is for the public to read and to give excuse for the low rates paid to the savers. The banks are under order from the FEDs and FDIC to keep the rates very low and has nothing to do with the present interest rates or banks profit-abilities arising from the present environment.
Look at the big banks, they are overflowing in cash that comes back from hundreds of, off the books bets and investments. Remember again, the bank’s ledger is in balance at all the times, but the off the books investments are not regulated and are entered separately in the sub accounts, affiliates, investment brokerages, global sweep accounts and many many more undisclosed sub accounts.
Anonymous - #8, Monday, January 17, 2011 - 10:23 PM
Greg2,
I don't know if this "I am a CPA about to tell you bank secrets" message is being posted by you all over the place or if many people are copying it from the same source, but I do know this: You can't even fake accounting terminology half convincingly. I am not going to help you by explaining the errors so you can correct them next time, but it is obvious you are not a CPA.
Anonymous - #9, Monday, January 17, 2011 - 11:11 PM
To Poster #8.....
Thank you for being the first to question the post by Greg2. I am also a CPA(retired) and found the post to be rife with errors and ramblings to the point that it is almost as if it were written by a third grader. The statement at the beginning of the post..."Every penny lent out as credit or loan, becomes income in the bank's books"....is a preamble to the incorrect and absurd statements continued thereafter. Surely the banks can not be that bad or secretive, at least not the ones I have done work for. lol
Anonymous - #10, Monday, January 17, 2011 - 11:46 PM
Most of this article gets summed up succinctly in a few seconds in the movie "It's a wonderful life". Seems like another article written for 2nd graders, or someone who's recevely immigrated from a 3rd world country.
Anonymous - #11, Tuesday, January 18, 2011 - 1:52 AM
I agree that AARP and other senior oriented organizations have said little about how the low rates have impacted retirees. Even if they did raise big concerns, the Fed and Government will ignore it and be focused on the young unemployed and not the old retired sector of the US population.
Anonymous - #12, Tuesday, January 18, 2011 - 6:59 AM
I think this was a well written article. Yes, I'm sure there are more technical aspects that could be explained in more detail But that wasn't the point. It's a shame some people here seem to have nothing better to do than insult the author.
Jo (anonymous) - #14, Tuesday, January 18, 2011 - 7:47 AM
Banks are definitely in the business of making money; there's absolutely nothing wrong with this. What I find truly egregious is that most banks, especially the largest ones, keep two sets of books. One is for the auditors and the Fed. It's in perfect order....the numbers are in balance.
The second one is what the banks use for themselves and where they "cook the books," fudging numbers in order to give themselves their end-of-year bonuses. No one but the upper executives can look at this particular one.
That's all that needs to be said.
Anonymous - #15, Tuesday, January 18, 2011 - 8:46 AM
Gee, nobody mentioned another way banks make money...they lie, cheat and steal it too. No, not all banks but far more often thanmost would imagine!
Anonymous - #16, Tuesday, January 18, 2011 - 10:22 AM
Miranda’s article is amateurish and for beginners, does not belong here.
Greg2 did bring a valid points of how the banks make money and the irrelevancy of the interest rates to profitability ratio,
The second sets of books are standard for most banks and that is where they make the money.
Who ever supports Miranda is a troll on this web site.
darkdreamer4u - #17, Tuesday, January 18, 2011 - 10:52 AM
Rather pathetic reaction to this article. To criticize mistakes would be alright, but just to denounce it as amateurish and naive/simplistic and thus not belonging here is over the top. As long as there are no factual errors, Miranda's writing may well be helpful to some visitors of this site. So STFU!
Anonymous - #18, Tuesday, January 18, 2011 - 11:33 AM
Whoever supports Greg2 is the REAL troll on this website.
CraigPD - #19, Tuesday, January 18, 2011 - 12:22 PM
Inforay, .32 (.0083%)? Is that factoring penalty fees? ;) Smells like Chase Savings. 2-3 years ago it may have been WAMU and those days are long gone. Seriously, time to throw in the towel and move on.
Frank (anonymous) - #20, Tuesday, January 18, 2011 - 12:28 PM
What are Miranda’s credentials?
Who is defending her?
A family member(s) or friend(s) like: darkdreamer4u, Anonymous - #18, Anonymous - #12 and Anonymous - #8, who might be the same person sticking the head for a bellow average artical on the banks and pretending to be know it all troll(s).
People have rights to express their feeling about Miranda’s bad posting, get over it.
Anonymous - #21, Tuesday, January 18, 2011 - 12:44 PM
Ken, when is that post on how the Fed works supposed to come out? People here keep airing their ignorance on this, and it is getting old.
Inforay - #22, Tuesday, January 18, 2011 - 12:48 PM
Craig PD: Actually my retirement account is with T. Rowe Price, Summit Cash Reserve Fund (money market account). I have been too badly burned to get into any of their stock funds. It is either the Prime Reserve Fund or Summit Cash Reserve Fund. No penalty, no fees, a strightforward retirement account. Chase pays even less at 0.01%!! Wish I had the nerve to throw in the towel! I hope people won't post too many comments about my stupidity.
Steven (anonymous) - #23, Tuesday, January 18, 2011 - 1:58 PM
To: darkdreamer4u - #17
You wrote:
“As long as there are no factual errors”
This is a factual error that Miranda wrote:
“The way that banks earn money illustrates one of the reasons that banks compete for depositors.”
Show me one bank that compete for deposits and I let you off the hook from your erroneous defense of Miranda’s posting.
Every fact she posted is not actual knowledge of the way the banks make the profits.
darkdreamer4u - #24, Tuesday, January 18, 2011 - 6:19 PM
if banks weren't interested in attracting depositors, then wouldn't you expect them to not offer any interest bearing accounts whatsoever? The mere fact that you earn interest on money you deposit with banks indicates to me that they want you to do so for whatever reason(s). One reason may well be to build a relationship in hopes you borrow money down the road at a profitable interest rate - it nevertheless constitutes competition for your deposit.
Steve (anonymous) - #25, Tuesday, January 18, 2011 - 8:20 PM
darkdreamer4u - #24 and Miranda are both naive when it comes to:
Banks paying interest on deposits and
banks that want you money without paying you interest.
Those are two different scenarios and has nothing to do with Miranda’s posting of “How Banks Make Money" and your support of her.
No bank is fighting for your money today, since they can get it from the FEDs and back door windows and from other banks as inter-bank loans at very low rates or near 0% and most of the back door money are overflowing into every bank that finances short and long term obligations.
If the banks are allowed by FDIC to close your CDs, they would have done it by now and the interest paid would be next to nothing on those contracted CDs, since most of the CDs are long term obligations, the banks hate to keep them on the books, since there is so much free money available around.
QE2 is coming soon and the banks are already lined up to get their share for pledging worthless securities as collateral for it. So, no bank with right mind is out there waiting for your deposit. If you know one, please post it here.
Justin (anonymous) - #27, Sunday, January 23, 2011 - 2:32 AM
@Steve #25, you did not address the question by darkdreamer4u. If banks did not want depositors money, they would not be offering any interest on it - not even 0.01%! According to your post, the banks would have closed current CDs if they could (and this is probably true for CDs paying higher than current rates), but it does not explain why they pay anything over 0% on NEW CDs... after all, if they don't want your money, why would they pay for it? We all know they are not a charity...
Anonymous - #28, Sunday, January 23, 2011 - 10:28 AM
Justin, you sound like darkdreamer4u, starting fight for small technical issues.
Steven has the valid point. Banks pay small interest because they re-invest your CD money at a higher rates. They act like sharks, give me the money and don't ask for good rates, we will keep the profit made out of your money. Do you see that, well...that is how the banks operate and pay you very small interest.
They can do the same thing with the FEDs funds they received or will receive again and again.
Justin (anonymous) - #29, Saturday, February 5, 2011 - 11:54 PM
#28, yes money is cheap now, so banks can pay you little, but they still want your money, because otherwise they would not pay you at all. Steve claimed banks don't want your money. That is false. They do, and they are paying "market" prices for it, which based on Fed's policies today are very little. Whether banks pay you 5% and loan money at 8% or pay you 1% and loan money at 4%, they are in business of making money just like the article describes. You can claim that makes them "sharks" and yes, they will "keep the profit made out of your money". So what? Welcome to capitalism. Guess what - any other for-profit company you deal with is the same way - they are they for the profit made out of their customer's money...
darkdreamer4u - #30, Saturday, February 12, 2011 - 9:34 AM
@Steve:
Read this: http://online.wsj.com/article/SB10001424052748703313304576132593769879956.html
(posted today in the Forum by Ken: Wall Street Journal's Guide To Checking Account Bonuses )
Anonymous - #31, Wednesday, September 14, 2011 - 2:48 AM
Come on guys, of course the bank still want deposit. The Fed 0% loan to bank won't be forever. they need to provide their customer comprehensive services to buid relationship and sell them products.
JohnK (anonymous) - #32, Friday, January 13, 2012 - 7:49 AM
My contribution and question is: why so many Chase branches? Near my zip code of 60062, you can find there are at least 30 BRANCHES nearby, in fact within 7 miles of me! I believe most of these have sprung up in the last 5 years or so. Is Chase so flush with cash and has nothing else to do with it, or maybe they are trying to buy up all real estate in the north Chicago suburbs?? I'm sure that they don't need so many branches merely to handle retail customers. Can't be.
Inforay - #33, Friday, January 13, 2012 - 8:54 AM
JohnK, what an astute comment! In my area in California, Chase not only took over all the Washington Mutual branches, but is also opening many more new branches in the close vicinity. In other cases, when a bank took over, they shut down branches and laid off employees. In the case of Chase, they are also doing a lot of hiring and every branch has a huge banner outside which says "Now Hiring." Pretty much evenyone I know has a Chase account and Chase credit card now. I had been wondering about this, but since they seemed like a good employer (sone of my friends are now working for Chase) and the service is decent, I hadn't given much thought to the motivation. My concern is htat now that so many of us have linked accounts and linked bill pay it is going to be too difficult and time consuming to close out accounts, so maybe they may start raising our fees, which has already happened once. They will, however, link your accounts if you meet with someone, to avoid the fees.
Anonymous - #34, Wednesday, February 8, 2012 - 4:00 PM
Well-written article, but this is just a basic way of how banks make money. Aside from lending money out to earn interest, banks also make money from the various fees they charge to customers and non-customers alike. Examples include overdraft fees, savings overdraft protection fees, debit card fees for using atm/debit cards at foreign atms, merchant services fees for business owners who utilize credit and debit card payment processing systems through the banks they use, loan origination fees, administrative fees, etc. These are just examples, but I am pretty sure you all can see just how complex the money-making machine is at most of these banks we are talking about.
to 10 and 16 (anonymous) - #35, Thursday, April 5, 2012 - 4:14 PM
if you caN DO BETTER START YOUR OWN WEB SITE
Anonymous - #36, Thursday, April 19, 2012 - 1:57 AM
Greg 2 explained it best. Keep in mind banks also lose money due to delinquent debt, fraud, and overdrafts. Banks pay employees and employee benefits. Not all are great! Some are awful but most I find are good. I also have to add that banks also borrow from other banks at low interest rates. I am also aware that China lends to us though I am not sure if it first goes to the FED then the FED lends to the banks. Its true that FED lends to banks but as do investors. Its complex. Not a straight definition.
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