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.
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.
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!
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.
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.
Thanks for pretending to be a CPA after taking an Intro to Accounting course at your local community college and further confusing readers here. In fact, credits and debits, income and liabilities, are entered the way they are per federal regulations and GAAP (Generally Accepted Accounting Principles) rules and are not some industry secret.
Are banks underpaying savers? Sure, and they are not incentivized to pay more due to the way lending works these days. The problem is not the banks, the problems lie in the banks' incentives set up by the FED.
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.
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
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.
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.
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.
“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.
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.
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.
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 )
1. Were you told that the Federal Reserve Bank Policies and Procedures as well as the Generally Accepted Accounting Principles (GAAP) requirements imposed upon all Federally-insured (FDIC) banks in Title 12 of the United States Code, Section 1831(a), prohibit banks from lending their own money from their own assets or from other depositors? Did the bank tell you where the funds for the loan were to come from?
2. Were you told that the contract you signed, the promissory note, was going to be converted into a 'negotiable instrument' by the bank and become an asset on the bank's accounting books? Did the bank tell you that your signature on that note, makes it 'money', according to the Uniform Commercial Code (UCC), sections 1-201(24) and 3-104?
3. Were you told that your promissory note would be taken, recorded as an asset of the bank, and then sold by the bank for cash, without "valuable consideration" given to obtain your note? Did the bank give you a deposit slip as a receipt for the promissory note you gave them, just as the bank would normally have to provide when you make a deposit to the bank?
4. Were you told that the bank would create a new account at the bank that would contain this money that you gave them?
5. Were you told that a check from this new account would be issued with your signature, without your knowledge, and that this new account would be the source of the funds behind the check that was given to you as a "loan"?
If you answered "No" to any of these questions, YOU HAVE BEEN CHEATED! How does that make you feel? It is now up to you to demand your deposit back and to challenge the validity of this bank loan Agreement. Since the banks and other lending institutions cannot allow "full disclosure" of your loan Agreement and cannot answer your challenges about it, their silence is the key, along with other necessary steps that can be learned by you, to get your deposit back and/or "payoff" their alleged loan to you.
Also they usually sell the note in huge bundles with other notes as "security packages" and make a killing constantly selling your note... believe it or not they get paid the principal amount of the note more than 2 or 3 times; before you ever start making monthly payments to "amortize" the note.
This is the big secret in bankingand it does not Follow GAAP; Many CPA'S have attested this is what the banks are essentially doing; and Banks pretty much pay off Auditors to keep this hush hush... Essentially if ever asked to "PROVE" that someone owes them; they can not... for they are not the holder in due coarse anymore (they probably sold the note).
If you read Modern Money Mechanics you can see how Money Is created
"Assuming that someone deposits 10.000$ in bank A. Bank A will then have the ability to lend out 9000 $ (with a 10 percent reserve requirement). But do these 9000$ actually come from the initial 10.000$ deposited? From the "Modern money mechanics" I get the impression that banks create this money as a cheque or electronic transfer:
"If business is active, the banks with excess reserves
probably will have opportunities to loan the $9,000. Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise by $9,000. Reserves are unchanged by the loan transactions. But the deposit credits constitute new additions to the total deposits of the banking system.
All it takes is someone to "Depose" a Promissory Note into the Bank to create the funds.... then they monetize the note and pay back the person the value of the Note they essentially stole ;) then they sell the note to make even more money cause they think people are too stupid to realize they have claim to the note in the case of foreclosure
This is based on my understanding; maybe some banks follow the rules and do things right and lend their own money that people lent them from actual deposits (doubtful nowadays) actually the complete irony is that in order to win a court case you have to prove damages did we ever decide if intangible damages are damages? after all the money they lent you never really existed and since its a renewable "resource" if you will; that has almost no limit really they are not harmed at all because they never risked any of their own money in the first place... they could have lent you a million dollars and then deleted, it would of had the same net effect on them as if they lent it to you to buy a house
If someone can prove this wrong I would like to point out that the book keeping entries that the banks make when getting a PNote from a "borrower" looks exactly the same as when a "customer" lends or "deposit" a check into his or her checking account its the same exact entries.
Ask any accountant if you "lend the bank money" when you deposit money/checks into a bank account then ask them if the bank "lent you money " when you withdraw that same money they don't just like they don't lend you anything when you hand them a promissory note loaning someone money to loan you money is not a loan.
Read more: http://wiki.answers.com/Q/Do_banks_provide_consideration_for_promissory_notes#ixzz25EWUKcf8
Loans are credited to the borrowers account, out of nothing more than typing numbers and handing them a check, created of money that did not exist 10 minutes before. I wish deposits were as simple as portrayed above - but that's not the case.
Sources: Read "Modern Money Mechanics," issued by the Federal Reserve Bank of Chicago.