How Do Banks Make Profits?

How Do Banks Make Profits?
Traditional Centers of Bank Profits
© Carmelo Montalbano

Mar 27, 2009
Bank earnings are derived from four main operations: Loans and fees from lending operations, trading profits in bonds, trust department activities, investment banking.

.The basis for a bank's importance is its power to lend. The lending function matches institutions with excess liquidity with those in need of capital on a temporary, or intermediate term. The bank acts as the arbitrator of credit, understanding risk in order to lend, showing economic resilience in order to attract lenders.

Spread Lending Creates Opportunity
The basis for bank lending is their ability to collect deposits primarily through checking accounts, savings accounts, and certificates of deposit. In the last few years short term borrowing have been a major source of funding. This is possible in part because the yield curve is positively sloped giving banks a further advantage if they borrow short but extend their lending horizon. This deposit base is then lent out at a higher interest rate for loan origination and trading and portfolio operation. This lending arbitrage is called the 'spread.' The powerful ability to lend fuels the profitability of banking activities because banks can provide immediate loan resources for any banking deal they originate that requires such financing.

It is the spread that funds credit card lending, mortgage lending, corporate lending, lines of credit and foreign credit. It is from the arbitrage opportunity that reserves are taken for bad debt and 'impairments' or the temporary inability of a creditor to meet interest and principle payments.

Banking Fees and Investment Banking Activities
Advising banking clients and aiding them in financing their strategic plans is a natural result of the bank's lending activity. Investment banking includes the ability to earn fee income from municipalities, foreign governments, corporations, and international agencies. Advising clients is a natural opportunity for banks because as part of the lending function banks know the intimate details of a company's balance sheet and plans. Banks serve as consultants in mergers, acquisitions, public debt issuance and restructuring, real estate construction and financing, and leasing and corporate loan origination.

The Trust Function
Separate from other banking activities are trust activities. Trust is the wealth building and preservation business where, for a fee, banks advise high net worth individuals and companies on their retirement plans and savings. In addition to advisement banks may offer trust services where funds are invested by professional advisers into wealth building assets. This function resembles that of mutual funds but it is usually done on an individual, customized basis. Banks also provide custodial services whereby the bank acts as the intermediary between stockholder and bondholder providing payment services for interest, dividend and principal payments.



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