How Do Banks Make Money? | The Motley Fool (2024)

Have you ever wondered how banks make their money? While the banking business itself can be quite complex, the ways in which banks make money can be surprisingly easy to understand. Here's a quick rundown of the two main ways banks make their money and some key details to know about each one.

How Do Banks Make Money? | The Motley Fool (1)

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How banks make money

At their core, banks make money in two main ways -- commercial banking and investment banking. Commercial banking refers to products like accounts and mortgages, while investment banking refers to services like corporate transactions and wealth management. Here's what each of these terms means and the different revenue streams banks create within them.

Commercial banking

Commercial banking refers to the banking products and services that banks provide to individuals and businesses. These financial services include checking and savings accounts, mortgages, auto loans, personal loans, credit cards, lines of credit, and more. They also include adjacent services such as safe deposit boxes, brokerage accounts, financial planning, and more.

Investment banking

Investment banking refers to services a bank provides to corporations, governments, high-net-worth individuals, and other entities that go beyond commercial banking activities. Investment banks advise clients on mergers and acquisitions, corporate finance transactions, and restructurings. They facilitate things such as initial public offerings (IPOs) and debt offerings and also engage in proprietary stock, bond, and currency trading activities. And, finally, investment banks offer wealth management services to corporations and high-net-worth individuals.

Fees

Banks make their money in a variety of ways, but most can be classified as eitherfees orinterest income. Let's take a look at fees first.

There are many different types of fees banks can collect, both on the commercial banking and investment banking sides of the business. Here's a rundown of some of the most common fee categories:

  • Overdraft or returned item fees: Banks typically assess a charge if a transaction makes a customer's account go into the negative or if it is rejected due to lack of funds. A typical fee for this is $30 to $35.
  • Monthly account fees: With checking accounts in particular, it's common for a modest monthly fee to be assessed, say $10, to cover the bank's costs of maintaining the account. There is usually a way for account holders to avoid the fee, and it is often something else that will make the bank money (such as a certain volume of debit card transactions -- see interchange fees below).
  • Interchange fees: Interchange fees are typically charged when you use a bank's credit or debit card to make a purchase -- but it's the merchant's bank that pays it, not you. Say you have a Bank of America (BAC 1.59%) credit card and use it to make a purchase at a retail store. The retailer's bank must pay an interchange fee to the bank that issued the card -- in this case, Bank of America. The fees paid by merchants on credit card payments are commonly referred to as "swipe fees," and interchange fees are a part of them.
  • Loan fees: Banks often charge origination fees when giving loans. For example, it's not uncommon to pay an origination fee of $1,000 or more for a large loan such as a mortgage.
  • Other account fees: When you look at your checking or savings account's fee schedule, there is probably a list of things youcould be charged for. In addition to those already discussed, common fees include non-bank ATM withdrawal fees, international debit card transaction fees, fees for money orders and cashier's checks, and wire transfer fees.
  • Investment banking fees: Banks that have investment banking operations make money from advisory fees they charge to clients. For example, if a company wants to go public and complete an IPO, an investment bank would get advisory fees for facilitating the process and advising the company on the best course of action.

Net interest margin

When it comes to commercial banking, net interest margin is the primary revenue generator. Net interest margin, or NIM, refers to the spread between the interest income banks take in on loans and the interest the bank pays for deposits after the bank's costs are accounted for. For example, if a bank has a $100 million loan portfolio and its net income from those loans is $2 million, it has a net interest margin of 2%.

Net interest margins depend on a few factors such as the efficiency of the particular banking institution and the types of lending the bank specializes in. They also depend on prevailing market conditions. Specifically, lower market interest rates typically translate to lower NIM, and higher rates tend to produce higher NIM.

How credit unions work

Unlike traditional banks, credit unions are nonprofit businesses. They charge interest and fees, just like banks, but they are typically only focused on covering their expenses and not on delivering large profits to shareholders. Credit unions are technically owned by their members, and their mission is to give members the best rates, fees, and yields on deposits they can while covering the costs of their operations.

Not all banks make money in both ways

Many banks are purely commercial and don't have investment banking operations. This is quite common among regional and local banks, but there are some large banks that operate mainly like savings-and-loan institutions. US Bancorp (USB -3.61%) is one example of a large bank that avoids investment banking. Wells Fargo (WFC 1.36%) has some investment banking operations, but commercial banking accounts for most of its revenue.

On the other hand, some banks focus on investment banking. It's rare to find a pure investment bank these days, but Goldman Sachs (GS 1.78%) and Morgan Stanley (MS 1.05%) are the two largest financial institutions that mainly focus on the investment banking side of the business.

Finally, many of the larger banks employ a fairly even mix of both types. These are generally known as universal banks and include such large institutions as JPMorgan Chase (JPM -0.4%), Bank of America, and Citigroup (C 2.02%), just to name some of the best-known ones.

The bottom line is that there are many different ways a bank can make money, but each institution is different and will generate revenue in different ways.

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Wells Fargo is an advertising partner of The Ascent, a Motley Fool company. Citigroup is an advertising partner of The Ascent, a Motley Fool company. JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Bank of America is an advertising partner of The Ascent, a Motley Fool company. Matthew Frankel, CFP® has positions in Bank of America, Goldman Sachs Group, and Wells Fargo. The Motley Fool has positions in and recommends Bank of America, Goldman Sachs Group, JPMorgan Chase, and U.S. Bancorp. The Motley Fool has a disclosure policy.

How Do Banks Make Money? | The Motley Fool (2024)

FAQs

What is the main way banks make money? ›

They earn interest on the securities they hold. They earn fees for customer services, such as checking accounts, financial counseling, loan servicing and the sales of other financial products (e.g., insurance and mutual funds).

How do banks generate income? ›

The money that customers deposit in their savings and/or current accounts is the money that banks borrow. Moreover, banks borrow by offering fixed deposits or recurring deposits. On the other hand, banks earn by charging interest on financial products such as home loans, personal loans, car loans and others.

How do banks make the majority of their money? ›

Commercial banks make money by providing and earning interest from loans [...]. Customer deposits provide banks with the capital to make these loans. Traditionally, money earned in the form of interest from loans often accounts for up to 65% of a banks' revenue model.

How do credit card companies make money on 0% interest? ›

Even if you don't accrue any interest, the issuer can make money from every card transaction. It does this by charging the merchant an interchange fee. These fees are usually 1% to 3% of the total transaction amount.

What is the biggest source of income for banks? ›

The primary source of income for banks is the difference between the interest charged from the borrowers and the interest paid to the depositors. Banks usually collect higher interest from loans than the interest they provide for deposits.

How banks actually create money? ›

Banks create money when they lend the rest of the money depositors give them. This money can be used to purchase goods and services and can find its way back into the banking system as a deposit in another bank, which then can lend a fraction of it.

What is the primary way that banks earn money? ›

Interest income is the primary way that most commercial banks make money. As mentioned earlier, it is completed by taking money from depositors who do not need their money now.

Do banks make money from current accounts? ›

Interest on lending: although some current accounts do offer interest, it's less than the interest those banks charge for borrowing using an overdraft, credit card or loan. So the difference between interest banks pay on deposits and the interest they receive on lending works out as a profit for the bank.

How do banks make money off of the credit they issue? ›

The primary way that banks make money is interest from credit card accounts. When a cardholder fails to repay their entire balance in a given month, interest fees are charged to the account.

How do banks run out of money? ›

This happens when people try to withdraw all of their funds for fear of a bank collapse. When this is done simultaneously by many depositors, the bank can run out of cash, causing it to become insolvent.

Where does the bulk of the income of a bank come from? ›

Banks pay depositors less than they receive from borrowers, and that difference accounts for the bulk of banks' income in most countries. Banks can complement traditional deposits as a source of funding by directly borrowing in the money and capital markets.

How do free banks make money? ›

Any type of loan comes with interest, and this is how the bank makes its revenue. The amount of interest that the bank gets from their loans will always be greater than the interest that is paid back to you for keeping money in your checking account.

How do banks make money on 0% loans? ›

In fact, these loans actually accrue interest despite being called 0% interest loans. You just don't have to pay that interest if you pay the installments on time until the debt is paid off. Financial institutions count on the percentage of people who default or miss payments in order to make money from these loans.

How do 0% lenders make money? ›

The 0% is for a certain time frame, and after than the interest rates jumps. They make money when you don't (or can't) pay off the loan during the 0% period and then must pay interest for the remainder of the loan.

Does the debt system help people gain wealth? ›

Bad debt does not help generate income or acquire appreciating assets. Instead, it is used for consumption. Some examples include, Credit Card Debt: Money borrowed on credit cards to finance consumer purchases like electronics, clothes, vacations etc.

What do banks primarily make a profit on? ›

Commercial banks make money by providing and earning interest from loans such as mortgages, auto loans, business loans, and personal loans. Customer deposits provide banks with the capital to make these loans.

How does banking make so much money? ›

Banks make their money in a variety of ways, but most can be classified as either fees or interest income. Let's take a look at fees first. There are many different types of fees banks can collect, both on the commercial banking and investment banking sides of the business.

What is the most profitable part of a bank? ›

Generally, the investment banking and wealth management sectors tend to be some of the most profitable for banks. These areas involve providing services such as underwriting and issuing securities, providing advice on mergers and acquisitions, and managing assets for high-net-worth individuals.

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