How Do Banks Make Money? | The Motley Fool

Have you ever wondered how banks make their money? The banking business itself can be quite complex, as you might imagine.

However, the main ways in which banks make money can be surprisingly easy to understand. Here's a quick rundown of the two main ways banks make money and some key details to know about each one.

A person speaks with a bank teller. — Image source: Getty Images.

How banks make money

At their core, banks make money in two main ways -- commercial banking and investment banking.

Commercial banking refers to products like checking accounts, auto loans, and mortgages.
Investment banking refers to services like corporate transactions and wealth management.

Here's what each of these terms means and the different revenue streams that banks create within them.

Commercial banking

Commercial banking refers to the products and services that banks provide to individuals and small businesses. If you have a checking account at a local bank, that's a form of a commercial banking relationship. This type of banking can also be referred to as consumer banking when referring to products and services for individuals.

Just to name a few, commercial banking financial services include checking and savings accounts, mortgages, auto loans, personal loans, credit cards, lines of credit, and insurance products. They also include adjacent services such as safe deposit boxes, brokerage accounts, financial planning, and more.

Not all commercial banks offer a full line of products. For example, some banks offer certificates of deposit, or CDs, while others don't.

Investment banking

Investment banking refers to services that a bank provides to corporations, governments, high-net-worth individuals, and other entities that go beyond commercial banking activities.

Investment banks advise clients on mergers and acquisitions, corporate finance transactions, and restructurings. For example, if a business is struggling and is wondering whether bankruptcy could be the best option, it might hire an investment bank to help.

Investment banks also facilitate functions such as initial public offerings (IPOs) and debt offerings, which are known as equity and debt underwriting. They also engage in proprietary stock, bond, and currency trading activities. Finally, investment banks offer wealth and asset management services to corporations and high-net-worth individuals.

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About the Author

Matt Frankel, CFP, is a contributing Motley Fool stock market analyst and personal finance expert covering financial stocks, REITs, SPACs, and personal finance. Prior to The Motley Fool, Matt taught high school and college mathematics. He holds a bachelor’s degree in physics from the University of South Carolina, a master’s degree in mathematics from Nova Southeastern University, and a graduate certificate in financial planning from Florida State University. He won a SABEW award for coverage of the 2017 Tax Cuts and Jobs Act. He is also regularly interviewed by Cheddar, The National Desk, and other TV networks and publications for his financial, stock market, and investing expertise.

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Interest income

When it comes to interest income, 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 various types of lending the bank specializes in.

For example, credit card loans tend to have higher interest rates (and more risk) than mortgages and auto loans. They also depend on the interest rates the bank pays on deposits.

How credit unions work

Unlike traditional banks, credit unions are nonprofit businesses.

Credit unions charge interest and fees, just like banks, but they are typically only focused on covering their expenses and not on delivering profits to shareholders. Credit unions are technically owned by their members, and their mission is to give members the best rates, fees, and yields on deposits they can while covering the costs of their operations.

Credit unions are typically designed for consumers and small business banking. They are not investment banks.