The way traditional banks make money
Banks provide financial intermediation. Different types of banks make money depending on how their operations are structured. Each type of bank ultimately makes money by helping to channel money from net savers to net borrowers. First, let’s look at the most common type of bank—a commercial or retail bank, also known as traditional bank—makes money. Wells Fargo (WFC) is an example of such a bank.
Core operations of a commercial or retail bank
These banks accept deposits from customers. Obviously it comes at a cost, in the form of interest paid to depositors—depending on the type of account a bank may not need to pay any interest to some depositors. The depositors can be individuals, companies, or government entities. After meeting certain regulatory requirements that require banks to set aside a certain part of the deposit, they lend out the rest of the money to those who need it. It can be in the form of personal loan, auto loan, mortgages, loans to companies, or any other loans.
Generally, the interest charged from those who took the loans is higher than the interest paid to depositors. The difference in the interest earned and interest paid is the interest income that is essentially the money made by the bank from its core operations. In banking language, the loans are called the “assets” of a bank because it earns interest on them. Deposits are called “liabilities” because a bank has to pay interest on them. The difference between yields on assets and cost of deposits is called net interest margin. Such income is called the income from the core operation of a bank.
Income from other sources
Apart from the income from core operation, a bank also makes money by trading, primarily in government securities. The money for this comes from the money required for regulatory requirements and any excess money that a bank may have. This is called income from treasury operations.
Commercial or retail banks also have a large branch network. They use the strength of their network to earn income by selling various financial products. This is called franchisee income. A bank also earns money by charging its consumers for using various services that the bank provides. This is called fee based income for a bank. The sum of all the revenue streams is the total income for the bank. U.S. Bancorp (USB), PNC Financial Services (PNC), Capital One (COF), or an exchange-traded fund (or ETF) like the iShares U.S. Regional Banks ETF (IAT) has banks that earn income mainly from traditional banking.
In the next part we’ll look at the risks and challenges associated with the business model of commercial or retail banks.