How Banks Earn Money? | Business Model of Banks | Sohail Khan

 

Hello, friends!

All of us save our money in banks. And these banks pay us interest on our savings. They give us more money.So have you wondered how these banks earn money? In today's Artical, let's understand the Business Model of Banks.

Think about it,

what do banks do with your money? It can't be that banks will take your money, keep it in a gigantic locker, lock it and keep the keys safely, and the money would remain in the locker safely. This is the version shown in films. It's not so in reality. Banks use your money to give loans to others. And the interest that they charge on that loan, is their earnings. Let's understand this with a simplified example.

This is a bank.

There's only one customer in this bank. You. You deposit ₹100 with the bank. And this bank pays you interest at 4%. Presently, this is the rate of interest for the Savings Account, 4% per year. Your ₹100 is now with the bank. The bank then gives out this ₹100 to some other person.  The other person has to buy a house, so he took out a loan for it. The bank charges interest at the rate of 8% from the borrower. So the ₹100 of the bank went to the other person. When the other person pays the bank ₹108, the bank will pay you ₹104. And the bank earns a profit of ₹4. Basically, this is the way the system works. But this begs a very important question here, what will happen when the bank has given ₹100 to the borrower, but the due date to repay the loan hasn't arrived yet. But you urgently need to withdraw your ₹100. But the bank doesn't have the ₹100 with it anymore. Because it has been given out as a loan. Or the other person cannot repay the loan for whatever reason.Your money is lost.These situations are truly very problematic for the banks, friends. Obviously, no bank has only one depositor and one borrower. There are many people. Even so, each bank, doesn't keep most of its money with itself. Instead, it gives out the money as loans to people.

That's why the RBI has a rule.

Of all the money deposited by the depositors with a bank, the bank has to keep at least 4% of it with itself as Cash Reserve. This is known as the Cash Reserve Ratio. And the RBI is the boss of all banks in India. So the boss decides what should be the Cash Reserve Ratio. This keeps changing with time. Some time ago, it was around 3.5% presently, it is at 4%. Apart from it, there's the Statutory Liquidity Ratio. This Ratio is at 18% now. This is the ratio that the RBI directs the banks that at least this per cent of the public deposits it has, has to be deposited at a place specified by the RBI as a Reserve. Such as in Government bonds, or gold reserves, or securities, or investing in PSUs.So for Indian banks, today, if you forget about the 22% of the money (18%+4%), the leftover deposits with the banks can be used to give loans to others and earn profits for themselves. From the difference in the interest rates. You'd say that this isn't a huge ratio. That of all the money we've deposited with the banks, the banks are giving out 70-80% of it as loans to others. And  if you want to withdraw all of it at once. If all the depositors of the bank want to withdraw all their money from the bank, what then? The bank will fail then. This is known as the Bank Run. And it is not possible for any bank in the world. Because  no bank holds all the deposits with itself in cash. It doesn't happen realistically, so there's nothing to be afraid of. Unless people panic because of some news and everyone wants to withdraw their money at the same time. But the thing that does happen is that the bank has given out huge loans, and the loans become Bad Loans. And the borrowers cannot repay the money. And the bank is left with no money to pay the depositors. This has happened to several banks in the past. It happened with the PMC Bank, then the situation occurred with the Yes Bank. Although the situation is under control now, And the Government takes steps to keep them under control. That's why, often in such situations, there's a limit on the amount of money, you can withdraw in a month, It happened to the customers of this bank as well. But anyway, if we return to our topic, this is a huge source of income for the banks. The Interest Rate Difference. The interest rate bank pays, and the interest rate the bank charges. But what about the countries where the interest rate the bank charges from the borrowers, is very low. Like countries such as Germany.  There the interest rate on a housing loan is around 1%. In several cases, the interest rates are at 0.4-0.5%. The interest rate charged on the loans by the bank is almost negligible. In such cases, how will the bank earn from the difference in the interest rates?

How will the bank earn money?

 In such cases, friends,  as with the situation in most of the Western European countries the banks reduce the interest rates they pay on Savings Accounts. In most of the countries, the interest rate on the Savings Accounts, is at 0.1% In many cases, it is at 0%. The bank doesn't give you any interest for opening Savings Accounts. And secondly, the banks charge monthly charges from the people for maintaining the bank account. So if you need to use the bank, if you want to keep the money deposited with banks, you'll have to pay the bank monthly, to do this. It isn't so unrealistic. Because it is already happening in most Western European countries. Apart from this, for all the banks in the world,

there are 2 more main sources of income. First, the revenue from fees and commissions. The various types of fees being charged, if you aren't maintaining a minimum account balance, a fee is charged. The fee that is charged for various services of the bank you use. The bank gets some money from there as well.