Introduction
The purpose of any business organization is to sell goods and services and make money in return. When an organization sells something to a customer, it gets paid by the buyer. Just like all other businesses, banks also make money by selling products and services. The primary role of a bank is to offer money storage services to its customers. Also, they provide security assurance to customers that their money is safely kept until the time that they will need it back. Another important service that banks offer includes easy and convenient access to money for its customers and investors who would require capital to start or boost a business. By offering these services, banks get revenue to run their activities and profits. There are three major ways through which banks make money. They include net interest margin, interchange, and fees.
Net Interest Margin
Net interest margin is defined as a ratio that compares the success of a firm at investing its firm to the expenses incurred on these investments. The margin can either be negative or positive. A negative value means that interest expenses are more than returns that the investments generate while a positive value means that the business earns more returns than incurred expenses (Werner, 2014). It is calculated by subtracting interest expenses from investment returns and then dividing by average earning assets.
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Banks rely on their customers’ deposits to do business and earn returns, thus, making profits. By depositing money into a bank account, the account holder gives the bank permission to use the money to invest into other businesses such as making loans. The bank will lend money to those who need it at accost, known as the interest rate. On expiry of the lending period, the bank will collect the amount it gave to the borrower plus the accrued interest. A percentage of the interest will be added to saver’s bank account as saving interest while the rest remains as part of the bank’s profit. Banks attract customers by promising some percentage interests on the amount saved. Also, it is a way by which banks appreciate their customers for giving them the opportunity to invest using their money. Net interest margin is the difference between the interest banks earn on top of the amount they loaned out and the interests that are paid to the customers’ bank accounts as returns on savings (Werner, 2014). Net interest margin forms part of the banks’ profits.
Despite the investments banks make with their customers’ savings, they are required to keep a reserve requirement. Reserve requirement is the minimum fraction of a customer’s savings that the bank must keep at hand whenever they are doing business with the deposits. In the United States, the reserve requirement is set by the Federal Reserve. The purpose of this amount is to enable the depositors to withdraw any amount of their savings at any time without a problem. However, the withdrawable amount is subject to the agreement between the bank and its customers (Borio, Gambacorta & Hofmann, 2017). In some banks, withdrawing a huge amount requires that the bank is notified prior to the date of withdrawal so that the bank makes the necessary preparation.
Interchange
Whenever banks process credit and debit card transactions, they make money, known as interchange. The parties involved in the transactions include the card-issuing bank, payment processors, credit card networks such as Visa, and the Merchant bank. The card-issuing bank receives interchange fee to cover for the handling costs, risks involved during the payment, costs of bad debts, and fraud. Any time a card is swiped at a store, the store, which is the merchant bank, pays the interchange fee (Werner, 2014). Most of the fee goes to the issuing banks while the rest goes to the merchant’s bank.
Currently, most businesses accept payment through cards such as Visa and MasterCard. The advantages of this mode of payment are its convenience and security it provides. With the card, a buyer does not need to carry a large amount of cash when going to make purchases. One can purchase goods worth a lot and just swipe the card to settle the bills (Werner, 2014). It feels safer to walk around with a card than carrying cash. If the card gets stolen or misplaced, the holder only needs to notify the issuing bank to block any transaction done. Due to its growing popularity, banks are making good money from the transactions, and currently, it is one of their major sources of profits. Because of interchange fees, banks can offer incentives or rewards to those who transact using their cards. It is another way of promoting the business. Cardholders also pay some regular membership fees, thus, generating income to the banks.
Factors Affecting Interchange Amount
Type of Card: There are two main types of cards, namely; debit and credit cards. Debit cards have PINs and they have lower risks than credit cards. Therefore, debit cards have lower rates of interchange than credit cards (Berg, Davidson & Potts, 2018). There are also rewards cards that charge higher rates to enable the banks to pay for the perks.
Business Size: Large businesses such as supermarkets pay relatively more rates than smaller businesses such as gas stations. However, large companies have a capability to bargain with the credit companies making them to pay less interchange amounts than smaller companies.
Transaction Type: A transaction can be a point-of-sale (POS) type or card-not-present (CNP). POS charges lower rates than CNP due to fewer risks involved (Werner, 2014).
Fees on Services
This is the most recently introduced source of money for banks. For the services they offer banks charge some small fees to fund their operations and pay their staff. This can also be explained as the costs of the services that banks offer to their customers. Fees charged by banks to generate income includes charges on overdraft, non-sufficient funds fees, over-the-limit fees, fees on the wire transfer, account research, and monthly service charges among others. Money earned through fees is also referred to as non-interest income because they are not earned by lending out depositors’ money (Berg, Davidson, & Potts, 2018). Other than the three main sources of profits, banks also earn through bank to bank loans, trading in the financial markets through forex, equity, and commodity market. Some banks recently started to offer insurance services. In overdraft for example, a depositor is allowed to withdraw more than he/she has in the accounts for a limited period of time but they will have to incur some additional costs.
The Relationship between Profits and Interest Rate Management
Bank revenues increase with an increase in the interest rates. Banks charges interests on the money it lends out through loans. Therefore, a hike in the interest rate means that borrowers will pay more to the bank when repaying the loans (English, Heuvel, & Zakrajšek, 2018). While an increase in the rates causes an increase in revenues, it does not mean that the bank’s profitability will also increase. A hike in the interest rates is caused by the general increase in the market rates. Therefore, banks will also incur high rates when funding their investments. Banks issues debts through deposits to finance their loans and investments. They also sell securities in the open market. All these are affected by any change in the market rates (Borio, Gambacorta & Hofmann, 2017). It means that an increase in interest rates on loans will also be felt by the banks when they are paying for their investments and depositors’ interests.
Interest Rates and Net Interest Margins
Banks normally tend to lend long and borrow short. This means people who borrow money from the bank are given more time to pay than the average maturity periods of the deposits. The effect of this practice is felt when market rates change. In case of a decrease in the market rates, the banks’ costs fall more quickly than the interest income (English, Heuvel & Zakrajšek, 2018). This will cause a temporary rise in net interest margins. With time, the net interest margin reduces because loans are repaid, and others renewed at the reduced market rates. Interest rate management is important in stabilizing the market values and the value of an organization’s assets and liabilities. Change in the market rates is caused by factors external to individual banks (Borio, Gambacorta & Hofmann, 2017). If banks had the freedom of changing interest rates that the charge on loans, market rates would be uncontrollable because every business organization would want to make more profits by charging higher rates.
Conclusion
Just like other business organizations, banks also make money by selling goods and services. For the banks, they earn on service provision which is mainly keeping money through deposits and lending it out through loans to investors. The main sources of profits include net interest rates, fees, and interchange. The amount earned through interest sources of income such as net interest rates are affected by market rates which are not within the banks’ control. Banks also earn through non-interest means which involves charging fees on the services it offers. By offering services such as overdraft and wire transfers, banks charge some amounts to cater for the costs involved.
References
Berg, C., Davidson, S., & Potts, J. (2018). A genuine commercial justification for interchange fees .
Borio, C., Gambacorta, L., & Hofmann, B. (2017). The influence of monetary policy on bank profitability. International Finance , 20 (1), 48-63.
English, W. B., Van den Heuvel, S. J., & Zakrajšek, E. (2018). Interest rate risk and bank equity valuations. Journal of Monetary Economics .
Werner, R. A. (2014). How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking. International Review of Financial Analysis , 36 , 71-77.
