Before getting into how banks make money let us first understand how banks actually work. The primary business of a bank is to borrow money and lend money. They are also used as payment instruments – either withdrawing from ATM or paying by debit card or cheque.

Net Interest Margin

While banks try to borrow money at cheaper rates, they try to lend at higher rates and thus make money on the difference. This difference is called Net Interest Margin.

Where do banks borrow from? There are multiple sources. The money that we have in savings deposit is actually money that a bank borrows from us. But at very low interest rate, typically 4%. They justify this low interest rate by providing other services, primary being access to your money anytime. Similarly Banks borrow through providing Fixed Deposits and selling Bonds and pay around 8% interest on these. Overall interest that a bank like HDFC pays for deposit(savings + fixed deposits) is around 6%.

And how do banks lend money? Individuals and corporates borrow for their financial needs from banks. Housing loan, car loans, personal loans, loans for working capital requirements and capital expenditure (by businesses) are examples of loans that banks provide. Interest rates on loans can vary from 9% for housing loans to 15% for personal loans. The interest rate of these loans are way higher than the rate at which banks borrow.

This difference, NIM, is what banks try to maximize.  NIM varies from bank to bank but typically stands at 3% to 5%. This may sound way too much without doing any hard work of “producing” something or just moving money from depositors to borrowers. Let us also understand where banks spend money.

Operational Costs

Ever wondered how banks pay for the physical branches and ATMs and how they pay money to so many people working in their branches? They need to manage this from the Net Interest Margin they earn by being a middleman between borrowing and lending. More inefficient the banks are, lesser net money they make. Banks like HDFC have very efficient processes and hence do better but still spend lot of money on physical infrastructure. There is a possibility that technology will replace this inefficiency and thus live with lower NIMs passing more benefit to borrowers (lower rate) and depositors (higher rate)

Non Performing Assets

When banks lend money, there is certain risk that borrowers will not pay back principle or interest or both. These kind of borrowers are called defaulters and the loans they default on are called Non Performing Assets (NPAs).In such cases banks have to pay back the depositors or depositors from its own balance sheet and hence incurring extra costs. Therefore it becomes important for banks to have good credit models to understand creditworthiness of borrowers. There is lot of innovation happening in credit models by leveraging technology.

Summary

Banks make money by bridging the gap between borrowers and depositors (or lenders). They also charge for additional services they provide. However they incur operation expenses in being the man in middle. Borrowers default sometime and banks need to cover for that from their earnings. In future, technology can bring more efficiency in banking operation and also build better credit models. Time will tell whether technology will help banks to do better or disrupt them completely.

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