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 central ways banks make their money and some key details to know about each one.
Overview
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 banks offer a full line of products.
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.
Fees
Fees
Banks make their money in a variety of ways, but most can be classified as either fees or interest income. Let's take a look at fees first.
There are many different types of fees banks can collect, both on the commercial banking and investment banking sides of the business. Here's a rundown of some of the most common fee categories:
- Overdraft or returned item fees: Banks typically assess a charge if a transaction makes a customer's account go into the negative or if it is rejected due to lack of funds. The average overdraft fee is about $35, but banks have been under pressure to lower these in recent years.
- Monthly account fees: With checking accounts in particular, it's common for a modest monthly fee to be assessed. There is usually a way for account holders to avoid the fee, and it is often something else that will make the bank money, such as setting up direct deposit. This type of fee is common with branch-based bank accounts but not with online banks.
- Interchange fees: Interchange fees are typically charged when customers use a bank's credit or debit card to make a purchase -- but it's the merchant's bank that pays it, not you. Say you have a Bank of America (BAC 0.11%) 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.
- Loan fees: Banks often charge origination fees when making loans. For example, it's not uncommon to pay an origination fee of $1,000 or more for a large loan such as a mortgage.
- Other account fees: When you look at a checking or savings account's fee schedule, there is probably a list of things you could be charged. In addition to those already discussed, common fees include non-bank ATM withdrawal fees, international debit card transaction fees, fees for money orders and cashier's checks, and wire transfer fees.
- Investment banking fees: Banks that have investment banking operations make money from the advisory fees they charge to clients. For example, if a company wants to go public and complete an IPO, an investment bank would get advisory fees for facilitating the process and advising the company on the best course of action.
Interest income
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 types of lending the bank specializes in. They also depend on the interest rates the bank pays on deposits.
Credit unions
How credit unions work
Unlike traditional banks, credit unions are nonprofit businesses. They charge interest and fees, just like banks, but they are typically only focused on covering their expenses and not on delivering large 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.
Related investing topics
Examples
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 (USB -0.37%) is one example of a large bank that avoids investment banking. Wells Fargo (WFC -0.23%) has some investment banking operations, but commercial banking accounts for most of its 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 (GS -1.2%) and Morgan Stanley (MS -1.13%) 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 sometimes known as universal banks and include such large institutions as JPMorgan Chase (NYSE:JPM), Bank of America, and Citigroup (C 0.46%), just to name some of the best-known ones.
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.
