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Blog: Inspiration
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by Shamir Karkal

How Do Banks Work?

Line drawing of icons related to banking and finance

How banks work

Banks work by paying its customers to lend them money. When a person deposits money into their bank account, the bank can then lend other people that money. The depositing customer gains a small amount of money in return (interest on savings), and the lending customer pays a larger amount of money to the bank in return (interest on loans). To make money for itself, the bank keeps the difference.

It can be quite difficult to understand banking, since banks are very different from most other businesses. For one thing, they are highly leveraged, with more than $20 in debt for every $1 of equity. Also, It can be hard to understand what banks actually do, since they don’t make any real products. And a lot of people seem to think that banking is “free”, probably because banks keep advertising free checking accounts, free direct deposit, free bill payment, etc.

The 3-6-3 rule

To fully understand how banks in the US make money, you need to understand a little about the history of banking in the US. Traditionally, banks made money by borrowing from depositors at low interest rates, lending that money at higher interest rates to borrowers, and pocketing the difference. Banking used to be heavily regulated, and the joke was that it was a 3-6-3 business; borrow money at 3%, lend it at 6%, and be at the golf course by 3 pm. Most banks also charged a monthly fee to customers for maintaining a basic account, but most daily transactions were free. But, overall, fees were low, constituting only 30% of total revenues.

The impact of deregulation

The wave of de-regulation, beginning in the late 70s, changed this relationship. Main street companies discovered that they could borrow from the bond markets more cheaply than they could from banks, putting the 6 part of the 3-6-3 model under pressure. And lots of new consumer products such as interest bearing checking, credit cards, money market accounts, home equity loans, student loans, etc became available. Banking became a lot more complicated, so bankers couldn’t just head to the golf course at 3 pm; they had to actually work for their money.

Two things ended up happening: banks realized that the bigger they were, the more loans they could make. With deregulation, the big banks grew even bigger by acquiring smaller banks. Banks also realized that the easiest way to make more money was to simply charge consumers more fees. In fact, the best way to make money was to call a product “free” by eliminating any monthly fees, and then charging lots of fees on transactions.

How banks make money

As we explained to Mike, there are three main sources of revenue in retail banking today:

  • Net interest margin: this is the difference, or “net”, between the interest paid to depositors and the interest received from borrowers. At the moment, the Fed’s low interest rate policy means that depositors get almost no money for their savings, and bank margins are huge. Many large banks are making margins over 4% at the moment, which are even higher than the 3% from the good old days of the 3-6-3 rule.
  • Interchange: Everytime you swipe a card at a store, the merchant pays a small percentage of the money to the bank that issued the card, called an interchange fee. For credit cards this is around 1.7%, while for debit cards it is nearer to 1.1%. Given that Americans spend more then they save, it is a huge revenue stream for banks.
  • Fees: These are the fees that your bank charges you, including ATM fees, overdraft fees, late payment fees, penalty fees, etc. The average household in the US ends up paying over $200 annually in overdraft and bounced check fees alone. Along with interchange, these fees add up to more than 50% of revenue for large banks.

Its important to understand that all this revenue is a real cost to the customer. Some of it may be an explicit cost, when its a fee that shows up on your statement. But even the implicit costs of interchange and net interest margin are real; after all, merchants pass the cost of interchange on to consumers in the form of higher prices, and you could be making 3% interest on your money by buying treasury bonds, which are safer than any bank. By leaving it in the bank at a lower interest rate, you are effectively paying the bank to hold your money.

Costs of banking

Of course, there are also a lot of costs associated with banking. Maintaining IT systems, marketing products, running ATM networks, manning call centers, and paying banking CEOs all cost money. However, all of those are dwarfed by the cost of maintaining branches, which can be over 50% of a bank’s costs. That is the main reason why banks such as ING and USAA can offer both good products and good customer service; being online only means that they don’t incur branch costs and can spend their revenue in more customer friendly ways.

The bottom-line

With the most recent banking crisis, a handful of banks now dominate the market. At their scale, basic retail banking is immensely profitable. Unfortunately for consumers, they don’t really have a choice. Yes, customers can move their money to smaller banks. But smaller banks were also hit by the crisis, and typically have not invested in customer service beyond the branch. So while you may be able to find a small local bank to serve you, the cost of banking and experience may not be as convenient as at one of the big banks.

Mike’s original calculation in his article showed about $500 in revenue for a household with $60,000 in income. With a 4% margin and $200 in fees, that could easily climb to $850+. And that ignores any additional products, such as CDs, money market accounts, credit cards and other lending. So Mike’s original question remains valid - as a retail banking consumer do you feel that you are getting $850 worth of service from your bank every year? If not, may we suggest that you sign up with us.