How do banks make money? Where do banks invest their money? Have you thought ever in your life? We all save our money in banks and banks also give us the interest amount. Do you know how banks earn their profit? Well, we will see the whole process and much more about these processes and the business model of banks in this post.
How do banks make money?
Just think once that what do banks do with your money? You must have seen in many movies that the banks keep the money in a big locker. But the reality is totally different from what you see in movies. Banks use your money for providing loan purposes in the market. The banks get profit from the interest they charge on that loan. So let’s understand with a clear example.
So suppose you have deposited the 100Rs in your bank account. The bank will use that hundred rupees for giving loans to the second person. The bank will charge 8% of interest on that 100Rs. After getting that 8% interest, the bank will give you your 4% and will keep 4% to itself. Here the bank’s profit is 4%. I am sure you must have understood clearly with this example.
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The most important question is what if the bank could not able to recover the interest amount? Or what if someone wants to withdraw all his deposited amount from the bank at the same time? This situation is so problematic for a bank. It’s obvious that banks have multiple depositors and loan takers. Still, most of the banks do not keep the amount, they give it for loan purposes.
RBI (Reserve Bank of India) has made a rule that a bank has to keep 4% cash of the depositor’s amount. This is also known as Cash Reserve Ratio. RBI is the boss of all banks and other banks have to follow its instructions. It changes from time to time, before a few years back it was 3% but now it is 4%. Apart from this, there is also a term that is Statutory Liquidity Ratio. It is running at 18% and this amount is kept at Government bonds, Gold reserves, securities, and PSU.
What is Bank Run?
If all the account holder withdraws their whole amount together then the bank will be failed. This is also known as a Bank run but it is impossible for any bank around the world. Realistically it does not happen unless someone gets panicked by hearing fake news. Sometimes banks are unable to recover the interest amount due to some reason and after that, the bank is unable to pay the interest amount to the account holder. There are some banks that have suffered from this situation like PMC Bank, and Yes Bank. Sometimes government takes some initiative to help such banks.
That’s why banks put some limitations that you can not withdraw more than 50k or 40k. Bank earn their profit from interest in the market. They also invest their amount in the stock market as well. In a country like Germany, if you take a housing loan then they will charge only 1.8% interest which is very little. In so many cases they charge only 0.5 and 0.4% interest rates. Now you must be thinking that in such a case how do banks earn their profit?
The banks give only a 0.1% interest rate for saving account holders. It happens mostly in Western European countries. The second situation is, banks charge some money to account holders just to keep their money in the bank.
Other sources of bank income.
Bank charges some money for services that account holders use. They charge money for having a credit or debit card. However, these are not the main source of income. The banks invest their money in government bonds, the Share market, and Gold as well. So the banks also earn their money by doing all such investments.
Now let’s see some realistic examples on this topic. Let’s take 2 banks the first is HDFC and SBI these are some of the biggest banks in India. According to Dec 2021 figures, the total valuation of HDFC bank was 8.09 lakh crores and SBI had 4.11 lakh crore. The interest received on loans and the interest paid to depositors is called net interest income. If net interest income is divided by total loan then we can find out the Net interest margin. Through this, you can find out how much the bank is profitable.
What is NPA?
There is also a term that is Gross NPA (Non-performing assets). It means whatever amount the bank has given the loan in the market that has become a bad loan is called Gross NPA. SBI has a ratio of 4.77% and HDFC has a ratio of 1.32% of gross NPA. We can consider HDFC has less NPA. HDFC has a good situation however 4% is also not bad.
But if this goes up to 7% then it is a problem for a bank’s performance. In order to open a private bank, you must have a minimum of 500 crores according to some financial experts. I hope you may get some clear ideas that How banks make money? and how this market work.