Banks are financial institutions licensed to receive deposits and make loans. According to the FDIC, about 94.6 percent of U.S. households were banked in 2019. People earn interest on their money by depositing it into banks, but how do banks earn money? Where do banks invest their money?
Banks charge fees for specific products like maintaining bank accounts, excess withdrawal fees, withdrawal penalties, and debit card replacement fees.
How do different types of banks make money?
There are different types of banks and depending on their particular business type and operations, their income and investments differ somewhat. These are the types of banks, broadly speaking.
- Commercial banks
- Investment banks
- Credit unions or cooperative banks
Commercial banks cater to businesses, corporations, and individuals. They make loans and offer deposit accounts and other banking services. Most of their income is usually tied to interest fees. They make loans from the pooled deposits of individuals, businesses, and other entities. The difference between the rate at which they lend and the rate at which they take the money is known as the spread. Lending to others is essentially how the banks invest their funds.
Banks maintain a balanced portfolio of loans.
Banks maintain a balanced portfolio of loans depending on their profit motivation and the state of the economy. The types of loans made are:
- Real estate loans: Banks offer long-term lending on homes, farmland, and business property. They also invest in home equity lines of credit and construction loans.
- Commercial loans: Banks provide business loans to big institutions, small businesses and others borrow funds in fixed amounts or via a line of credit through the bank, from which the bank takes interest charges.
- Consumer loans: Loan types include auto loans, personal loans, student loans, and credit cards.
Banks can invest in other instruments.
However, there are other ways that banks make investments. The Fed removed the reserve requirement for banks following the banks in a bid to encourage them to lend more. Prior to this, banks were required to maintain reserves of up to 10 percent of their deposits. These reserves could either be kept as cash in the vault or as a deposit with its local Federal Reserve bank.
Banks can invest in government securities since they seek security in uncertain times. For example, in the two years following the financial crisis of 2008, bank lending fell by $220 billion. Purchases of U.S. government securities rose by $337 billion.
What do investment banks invest in?
Investment banks cater to institutional clients and individuals with high net worth. They can do several other operations. They can take part in securities trading, offer wealth management, portfolio investment, and mergers and acquisition advisory. The bulk of their revenues come from fees. They usually have their own investment portfolios as well.
Investment banks could partner with or create venture capital or private equity funds to raise money and invest in private assets. These funds could be used to buy a stake in a promising private company. They can resell or take the company public after it becomes more valuable. Through proprietary trading, investment banks can deploy their own funds in the financial markets. However, after the Great Financial Crisis of 2008, several restrictions have been placed on proprietary trading.
Meanwhile, credit unions, which operate on a not-for-profit basis, mostly operate like retail banks. Since their profit motivation is different than traditional banks, they usually don't do much risk lending. According to American Banker, credit unions were flush with deposits in the wake of the COVID-19 pandemic. Deposits rose and lending slowed in many categories.