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The banking business : How banks make money out of your money

By Rukma Singh

When we deposit our hard earned money with banks, we do it with an aim to secure it so that it can later be invested and profits can be earned. What we don’t think is that the whole banking system itself is designed to churn out regular profits. Banks aren’t there for a ‘charitable’ reason, they’re a part and parcel of the commercial economy that runs on money making. Of course, in the process, we’re being provided a service. But that’s not the only motive of their existence.

It’s simple. Banks are businesses. They need to make money as much as we do.

They have quarterly, annual and other such revenue targets. That is not to say that banks will refuse to help us in case they’re in a loss. The entire banking system works on a inter-weaved chain of safe, double-checked mechanisms : both legal and mechanical.

Here’s how banks ‘create’ money.

The most fundamental way of earning money is based on the concept of Money saved is money lent’

When we deposit some money in a savings or fixed deposit bank account, the bank will use that money to create loans. That is how the mechanism works.

Let’s assume that 100 customers deposit a total of Rs 15 crore in a bank as savings. The bank promises to pay them an interest of 4%. When the bank lends money, it charges an interest of 10-12%. So, the total interest a bank will collect on Rs 15 crore lent to individuals and/or businesses is greater than the interest they will pay to 100 customers.

To encourage people to keep their money in a bank, the bank will pay them some amount of money in the form of interest. This interest is paid from the money the bank earns by lending out the deposited money to other customers.

This also happens to be the reason why banks offer lower interest rates on savings, fixed deposits, recurring deposits etc., and charge higher interest rates on mortgages or education loans.

In addition, the banks lend money to customers at a higher rate than they pay to depositors or than they borrow it. The difference, known as the margin or turn, is kept by the bank.

Banks make more money from charging fees than we think they do. This comes from from charging borrowers interest, but the fees banks change are just as lucrative.

  • Account fees: Some typical financial products that charge fees are checking accounts, investment accounts, and credit cards. These fees are said to be for “maintenances purposes” even though maintaining these accounts costs banks relatively little.
  • ATM fees: There will be times when we can’t find out bank’s ATM and we need to settle for another ATM just to get some cash. That process might cost you some money too. Such situations happen all the time and just mean more money for banks.
  • Penalty charges: Banks charge penalties for several reasons. It could be any kind of mishaps, a cheque written for one rupee more than what you have in your account,a late fee, and so on.
  • Commissions: Most banks will have investment divisions that often function as full-service brokerages. Of course, their commission fees for making trades are higher than most discount brokers.
  • Application fees : Whenever a borrower applies for a loan (especially a home loan) many banks charge a loan application fee. They can take the liberty of including this fee amount into the principal of the loan—which means one will have to pay interest on that too.

How easy is it?

The whole aforementioned process isn’t as easy as it looks. It’s not just a give and take, or subtraction and addition of money. It is a fully fledged system involving a series of interconnections.  Banks NEED to be in a position to keep money safely. For an imagined situation where absolutely everyone wishes to withdraw their money, banks need to act in a manner that helps the depositors maintain their faith in them. This is where the role of the apex institution comes in. In the case of India, it is the Reserve Bank of India that serves as the Banker’s bank.  A portion of investors’ deposits has to be parked with it to meet situations of extreme demand.

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