Have you ever wondered how banks make their money? While the banking business itself can be quite complex, the ways in which banks make money can be surprisingly easy to understand. Here's a quick rundown of the two main ways banks make their money and some key details to know about each one.
How banks make money
At their core, banks make their money in two main ways -- commercial banking and investment banking. Here's what each of these terms means and the different revenue streams banks create within them.
Commercial banking refers to the banking products and services that banks provide to individuals and businesses. These include checking and savings accounts, mortgages, auto loans, personal loans, credit cards, lines of credit, and more. They also include adjacent services such as safe deposit boxes, brokerage accounts, financial planning, and more.
Investment banking refers to services a bank provides to corporations, governments, high-net-worth individuals, and other entities that go beyond those commercial banking activities. Investment banks advise clients on mergers and acquisitions, corporate finance transactions, and restructurings. They facilitate things like initial public offerings (IPOs) and debt offerings and also engage in proprietary stock, bond, and currency trading activities. And, finally, investment banks offer wealth management services to corporations and high-net-worth individuals.
Net interest margin
When it comes to commercial banking, net interest margin is the primary revenue generator. Net interest margin, or NIM, refers to the spread between the interest income banks take in on loans and the interest the bank pays for deposits after the bank's costs are accounted for. For example, if a bank has a $100 million loan portfolio and its net income from those loans is $2 million, it has a net interest margin of 2%.
Net interest margins depend on a few factors such as the efficiency of the particular banking institution and the types of lending the bank specializes in. They also depend on prevailing market conditions. Specifically, lower market interest rates typically translate to lower NIM, and higher rates tend to produce higher NIM.
Both commercial and investment banking activities generate customer fee revenue. On the commercial side, overdraft fees and monthly checking account fees are two examples of customer fee income. On the investment banking side, fee revenue is the primary means by which banks make money -- collecting fees from clients in exchange for the services previously mentioned. For example, when an investment bank advises a client on a potential merger, that client will pay an advisor fee to the bank.
Interchange fees are typically charged when you use a bank's credit card to make a purchase -- but it's the merchant's bank that pays it, not you. Here's how it works. Say you have a Bank of America credit card and use it to make a purchase at a retail store. The retailer's bank must pay an interchange fee to the bank that issued the card -- in this case, Bank of America. The fees paid by merchants on credit card payments are commonly referred to as "swipe fees," and interchange fees are a part of them.
Not all banks make money in both ways
Many banks are purely commercial and don't have investment banking operations. This is quite common among regional and local banks, but there are some large banks that operate mainly like savings-and-loan institutions. US Bancorp (NYSE:USB) is one example of a large bank that avoids investment banking. Wells Fargo (NYSE:WFC) has some investment banking operations, but commercial banking accounts for most of the bank's revenue.
On the other hand, some banks focus on investment banking. It's rare to find a pure investment bank these days, but Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) are the two largest financial institutions that mainly focus on the investment banking side of the business.
Finally, many of the larger banks employ a fairly even mix of both types. These are generally known as universal banks and include such large institutions as JPMorgan Chase (NYSE:JPM), Bank of America, and Citigroup (NYSE:C), just to name some best-known ones.
These are a few different profit sources investors should know about: net interest margin, interchange fees, and customer fees.
The bottom line is that there are many different ways a bank can make money, but each institution is different and will generate revenue in different ways.