Have you ever wondered how do banks work? With many bank accounts being free to use, and savings accounts letting you earn interest while they look after your money, you’ve got to wonder how banks make their money.
But without any physical products to sell, how does banking work?
In this article, we’ll discuss how banks work.
What Is A Bank?
Before we look at how banking works, we first of all need to define what banking is.
A bank is an institution that deals with money and substitutes for money; for example, credit cards and checks. A bank may provide various financial services. Banks will allow you to keep your money with them and they will also make loans.
When Did Banking Start?
The earliest banks emerged in Assyria, India, and Sumeria around 2000 BC when merchants would make loans to farmers and traders.
During the Greek and Roman empires, banking started to become more formalized and began operating out of temples. Deposits were taken and money was changed.
The first international banks with branches in different cities and countries started to spread from Italy in the medieval and renaissance periods.
How Do Banks Work?
A bank makes its profits from the difference between the interest it pays out on savings compared to the interest it charges on loans.
Banks are an essential element of the economy. By repurposing account holders’ money to be used for loans, they keep businesses and individuals afloat financially.
Savings and Borrowing
So, we’ve established that banks make their money by using the cash deposited by account holders to make up the loans that they pay out to those that need the money.
But, to encourage people to leave their money in their accounts for long periods, banks will pay interest on the money that is saved. This incentivizes people to give banks their money on the premise that when they withdraw it, they’ll see an increase.
Because the amount of interest that is charged on loan repayments is higher than that which is paid on a savings account, the bank makes a profit.
An example of this would be if you were to place $10,000 into a savings account with an interest rate of 1.50%, you would expect to see a return of $150 in a year.
That same $10,000 could then be used to loan to someone at an interest rate of 6.50% APR. The return on this would depend on how long the loan was repaid over, but it could be several times the amount of interest that they payout.
How Else Do Banks Make Money?
Interest on loans is only the tip of the iceberg for the way that banks earn money. Banks will earn a lot in fees.
Not all bank accounts are free. Some financial products will charge fees. These include some checking accounts, credit cards, and investment accounts.
These charges are generally regarded as administration charges, however, the accounts take very little administrating.
If you miss a payment on a loan or forget to pay your credit card. You’ll get a penalty fee put on your account. Go over your overdraft limit on your bank, you’ll get charged from it.
Penalty fees can be very expensive and often seem disproportionate, however, they are a constant source of income for banks.
If you need to use an ATM that is owned and operated by a bank that is not your own, you could get a charge. Every time this happens, this is an extra profit for the bank.
Loan Application Fees
Certain loan applications may be subject to additional fees. Often, these fees can be included in the principal of your loan. This means that you end up paying twice. You’ll pay the fee and the interest on the fee.
For banks with an investment department that provides brokering and stock trading services, a commission fee will be charged.
What Are the Different Types of Banks?
There are several different types of banks. These are as follows:
- Commercial banks
- Retail banks
- Community banks
- Internet banks
- Credit unions
- Investment banks
- Merchant banks
- Sharia banks
- Central banks
Let’s explore the difference between these types of banks.
Commercial banks offer services to businesses and private individuals. Whereas retail banks will offer deposits and credit to individuals.
Smaller than a commercial bank, a community bank will focus on the local area and provide a more personal service.
Internet banks exist solely online. While most banks offer e-banking as standard service, some online banks have no branches meaning they have lower running costs. With this banking customer experience solution, banks can improve their online service.
A credit union is a type of bank that is owned by the people who use it.
The way that a credit union is set up will mean that they can provide more personalized services at a lower cost. Often, a credit union will be open to people from certain areas or backgrounds.
An investment bank loan money to big businesses. It finds the money through stock offerings or bonds. An investment bank will also assist with mergers and acquisitions.
For smaller businesses, merchant banking provides bridging loans, financing, and other forms of corporate credit.
A Sharia bank is one that operates within the restrictions of the Islamic faith. This means that they won’t lend to companies that make their money through gambling or alcohol.
Central banks are national authorities that control banking regulation. Their purpose is to keep the economy level, avoid inflation and unemployment, and create monetary policy. The Federal Reserve is an example of a central bank.
Money Makes the World Go Round
How do banks work? In summary, they do this by lending out the money that you deposit and charging interest and fees on the money that they lend.
Whether you love them or hate them, banks are here to stay and form an essential role in keeping our economy working. For more great articles, be sure and explore the rest of the site.