How Does a Bank Make Money?

Often times I find myself wanting to write articles that are not necessarily directly related to personal investing but I feel help to round out the skill set that every investor should have such as How Does a Bank Make Money.  Having knowledge of how what I call a "normal bank" but what we can also call a "retail bank" (a bank that takes deposits from people like you and I and makes loans to small businesses as well as individuals) helps one better understand how the economy operates.

The idea of a simple retail bank centers on a couple big concepts; many people probably use different names to describe the functions that allow a bank to make money without getting too technical.

1) Credit Knowledge - banks gather together employees that are knowledgeable of the credit quality of the clients they lend to and thus are better able than the average person to price and make a loan based on the loan customers credit quality.  Logically, if a bank made bad loans all the time to businesses and individuals that could not repay them the bank would ultimately go bankrupt.

2) Banks take deposits from individuals, aggregate them and lend those deposits out to customers at different maturities to profit from an upward sloping yield curve (this should be sound confusing right now).

The first concept allows banks to operate in a manner which allows them to be profitable in engaging in the second concept.  Lets now focus on breaking down the second topic.

We all understand the concept of a bank taking deposits, we all have some form of a bank account (checking, savings etc.) and we all put our paychecks into a bank or at least cash them at the bank.  What this does is leave the bank with a significant amount of cash that they can then lend out.

I will now introduce a second concept that will be detailed in a later post, it is something called the yield curve.  There are many other names for this curve and there are many other similar sounding curves but the yield curve for United States Treasury Securities (what 99% of people mean when they reference the "yield curve"), is the most important.  The yield curve is just what it sounds like, a listing of different debt that the United States government has outstanding for different maturities and what the yield rate (or interest rate) on each of those securities is.  Usually the it is upward sloping because longer maturity debt almost always carries a premium (higher interest rate) because the longer the term of a loan, the greater the risk that an investor will fail to collect on it.  Below is am image of what the yield curve may look like at any given time.

For a current yield curve navigate to the "Rates" section of http://www.bloomberg.com

So we see from above that as the maturity of United States' debt increases, so does the yield.  In short, if Japan purchases a 30-year United States Federal Government bond, they demand more yield than if they purchase a 5-year bond because a lot more can happen over the 30-year period (more uncertainty) than over the five year period.  I'll introduce the concept of spread later (not all of us can borrow at the same rate as the U.S. government due to credit quality) but in general longer loans have higher interest rates.

So back to how does a bank make money.  We give them our deposits - because we can pretty much demand our money from the bank at any point in time, they are short term deposits and thus offer very little interest.  Everyone can recall that putting your money in a CD (Certificate of Deposit) for a lock-up period of a year or more will usually result in higher interest than a regular deposit account. Many savings accounts yield less than half a percentage point.

The bank takes all those small deposits, bundles them together and makes a large long-term loan to a business in the area.  Because the loan is long-term it demands a higher rate.  The difference in what the bank pays on deposits and what they lend at is called the "Net Interest Margin" and is a key metric in analyzing a banks profitability.  Below is an example illustrating the importance of a bank's "Net Interest Margin."

Suppose a bank pays interest to consumers on their deposits at an average annual rate of say .35% and lends out those deposits at an annual rate of 3.4% they have a NIM (Net Interest Margin) of 3.05%.  Assume their total loans outstanding are two billion dollars.  A little math ($2,000,000,000 * .0305% = $70,000,000) nets the bank a cool $70,000,000 over the course of a year, and two billion dollars in deposits may sound like a lot but in reality that is a rather small bank.  To put it in perspective J.P. Morgan has over two trillion in assets.

So what have we learned?  First off, a bank makes money by borrowing short-term and lending long-term.  In addition, the steeper the yield curve the better for a bank because that means they can get a wider Net Interest Margin.  Lastly, a bank has to be able to analyze credit because if too many customers default on loans, the bank will go bankrupt.  In the future we will discuss more of the inner-workings of more complex banks.  In short, we have now figured out how a bank makes money!