Banks primarily make the majority of their money by profiting from the difference between the interest they pay to individuals and businesses for deposited funds and the higher interest they charge on the loans they issue. This fundamental banking activity is often referred to as profiting from the net interest margin or interest rate spread.
The Core Principle: Net Interest Margin
At its heart, banking is about financial intermediation. Banks act as a bridge between those who have surplus money (depositors) and those who need to borrow money (borrowers).
Financial institutions gather funds from millions of individuals and businesses who deposit money into various accounts, such as savings accounts, checking accounts, and certificates of deposit (CDs). For these deposits, banks pay a relatively low interest rate as compensation for the use of the funds. This makes the deposits a bank's liabilities, as they owe this money back to the depositors, plus interest.
Once banks have accumulated these funds, they lend them out to other individuals, businesses, and even governments in the form of diverse loans. These loans can include mortgages for homes, auto loans, personal loans, and business loans for expansion or operations. On these loans, banks charge a significantly higher interest rate than what they pay out to depositors. These loans are considered a bank's assets, as they generate income for the bank.
Understanding the Interest Rate Spread
The "interest rate spread" is the financial difference that drives a bank's main source of income. It is the core profit margin derived from their lending and borrowing activities.
Key components of this spread include:
- Interest Paid to Depositors: This is the cost of funds for the bank, covering the interest on savings, checking accounts, money market accounts, and certificates of deposit. Banks strive to keep these rates competitive enough to attract deposits but low enough to ensure profitability.
- Interest Charged to Borrowers: This represents the revenue generated by the bank from various credit products. The rates charged on loans vary based on factors such as the borrower's creditworthiness, the loan's term, current market interest rates, and the perceived risk of the loan.
The larger the positive difference between the interest earned on loans and the interest paid on deposits, the greater the bank's profit from this core activity.
To illustrate this fundamental concept, consider the simplified example below:
| Source of Funds | Interest Rate Paid by Bank | Use of Funds | Interest Rate Charged by Bank | Profit (Interest Rate Spread) |
|---|---|---|---|---|
| Customer Deposits | 0.5% | Home Mortgages | 4.5% | 4.0% |
| Savings & Checking Accounts | 0.2% | Business Loans | 6.0% | 5.8% |
| Certificates of Deposit | 1.0% | Auto & Personal Loans | 5.5% | 4.5% |
This table demonstrates how banks can earn a substantial profit margin by borrowing at a lower rate and lending at a higher rate.
Why This Model Works
This model is central to the banking industry due to several factors that allow banks to generate significant profits from relatively small spreads:
- Volume: Banks operate with immense volumes of money. Even a modest interest rate spread on millions or billions of dollars in deposits and loans translates into substantial overall profits.
- Risk Management: Banks employ sophisticated risk assessment models to evaluate the creditworthiness of borrowers. By carefully managing who they lend to, they mitigate the risk of loan defaults, ensuring a steady stream of interest payments.
- Diversification: Banks diversify their loan portfolios across various types of borrowers and industries, reducing their exposure to the failure of any single borrower or sector.
While banks may have other revenue streams, such as fees for services (e.g., ATM fees, overdraft fees, wire transfer fees) or income from investment activities, the income derived from the interest rate spread on their lending and borrowing activities forms the backbone and typically the largest portion of their earnings.
