– Where do Banks get Money to Lend to Borrowers? –
Where do Banks get Money to Lend to Borrowers?: If you just clicked on this article, chances are that you have been wondering where banks get money to lend to borrowers. Trust me, it is worth giving a deep thought on. Read to the end to find out more about the bank and its borrowing capacity.
Traditional introductory economic textbooks treat banks as financial intermediaries, the role of which is to connect borrowers with savers, facilitating their interactions by acting as credible middlemen.
Scope Behind A Bank’s Ability to Lend Out Money
The general notion about the ability of banks to lend money is that it is heavily dependent on the cash inflow in terms of customer deposits. This theory suggests that deposits are the parents of loans.
This belief is also strengthened by the money multiplier theory which tallies fractional reserve banking. In the fractional reserve system, just a portion of the overall deposits of the bank has to be held in a deposit account with the central bank or in cash.
Basically, in this system, the fractional magnitude is determined by the reserve. It is the reciprocal of this that shows the multiple reserves that such banks can loan out per time.
It, therefore, suffices to say that the overall ability of a bank to draw new deposits is not entirely dependent on drawing new deposits but also dependent on the monetary policy of the central bank.
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How Do Banks Make So Much Money?
Additionally, banks usually diversify their business mixes and generate money through alternative financial services, including investment banking and wealth management. However, broadly speaking, the money-generating business of banks can be broken down into:
If you have been wondering how banks make so much money, trust me, you are not the only one on this boat. It’s certainly not fiction that banks make a lot of money.
The sort of money that makes the issue so many bonuses and dividends. Many may think it’s all about the huge money that comes from deals struck on Wall Street.
However, what you may not know is that banks also make a whole lot o of money from retail banking involving loan-taking deposits.
For banks, anything legal can be done to secure new deposits ranging from promos and offers, to free checks, and even give-away. The reason for these strategies is that banks simply cannot make money except you make deposits to them.
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.
In return for depositing their money, depositors are compensated with a certain interest rate and security for their funds.
Then, the bank can lend out the deposited funds to borrowers who need the money at the moment. The lenders need to repay the borrowed funds at a higher interest rate than what is paid to depositors.
The bank can profit from the interest rate spread, which is the difference between interest paid and interest received.
Capital Markets-Related Income
Banks often provide capital market services for corporations and investors. The capital markets are essentially a marketplace that matches businesses that need capital to fund growth or projects with investors with the capital and require a return on their capital.
Banks facilitate capital markets activities with several services, such as:
- Sales and trading services
- Underwriting services
- M&A advisory
Banks will help execute trades with their own in-house brokerage services. Banks will employ dedicated investment banking teams across sectors to assist with debt and equity underwriting. It is essentially assisting with raising debt and equity for corporations or other entities.
The investment banking teams will also assist with mergers & acquisitions (M&A) between companies. The services are provided in exchange for fees from clients.
Capital markets-related income is a very volatile source of income for banks. They are purely dependent on the capital market’s activity in any time period, which may fluctuate significantly.
Banks also charge non-interest fees for their services. For example, if a depositor opens a bank account, the bank may charge monthly account fees for keeping the account open. Banks also charge fees for various other services and products that they provide. Some examples are:
- Credit card fees
- Checking accounts
- Savings accounts
- Mutual fund revenue
- Investment management fees
- Custodian fees
Since banks often provide wealth management services for their customers, they can profit off of the fees for services provided, as well as fees for certain investment products such as mutual funds. Banks may offer in-house mutual fund services, which they direct their customers’ investments towards.
Fee-based income sources are very attractive for banks since they are relatively stable over time and do not fluctuate. It is beneficial, especially during economic downturns, when interest rates may be artificially low, and capital market activity slows down.
Well, you and I will agree on the fact that banks do love fees! Borrower interests may be cool, but there are other cool avenues banks exploit to make money. Here are a few of such fees:
1. ATM Charges
Many of us have, at one point or the other been quite careless with our ATM cards and that usually means a replacement. While we view the money paid for a new ATM as a loss, the banks simply view it as another avenue to make more money.
2. Accounting Fees
There are several accounting services and a product that attracts charges includes but is not limited to investment accounts, checking accounts, as well as credit cards.
These fees are usually tagged as maintenance charges even though we all know such maintenances should not cost much.
3. Application Costs
Every time a potential borrower comes to the bank for a loan, he or she is usually charged an application fee. Some banks even go as far as including the fee amount into your loan principal. This simply means that you will also end up paying interest on your loan application fee as well.
4. Bank Commissions
A lot of banks posse financial divisions that usually work as brokerages. And as you may have guessed, the commission they charge is usually more than what discount brokerages charge.
Where do Banks get Money to Lend to Borrowers?
To answer this question, you note that there are three types of money within the banking system. These include bank deposits, currency, as well as central bank reserves. Therefore, basically, what commercial banks do is create the money which they lend to borrowers.
First, they create a type of money referred to as bank deposits, which are simply spendable monies within bank deposit accounts.
When you get a loan from a bank, the bank simply inputs a credit into your account, which upgrades the amount spendable in your account. The deposit is money.
Finally, I believe by now that all your concerns about where banks get money to lend to borrowers have been met. You have also been given how banks make all the money they have.
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