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How Exactly Do Banks Make Money?

Banks have been around for a really long time and are famous for lending people money.

They are also famous for demanding that same money back with interest, of course.

But is that the only way that banks make money?

It’s A Little More Complicated Than You Think

Exactly how banks make their money is slightly more complicated than you may first realise.

Yes, banks do make a profit by charging for services like protecting your money, and by charging people who want to borrow money fees (such as initiation fees and interest on money they have made available).

On the surface, it may appear that banks lend you their money but interestingly the money they have, is often not from piles of gold or cash that they have lying around in big bank vaults. These days, banks are allowed to lend out a lot more money than they actually have on hand.

What often happens is that the bank is lending people money now that the same person promises to pay back in the future.

‘Sounds weird right? But this is kind of how it works’

Sounds weird right? But this is kind of how it works. They give you your own future money based mostly on your promise to repay, and a little bit of that money they have available right now.

And they have all sorts of insurance and other things in place to protect them, if you miss payments (including large armies of collections agents and attorneys to chase you).  But there are some deeper layers as well.

Getting More Money So They Can Give Out Money

To be allowed to give out money, (and charge fees for doing that) banks must by law have a little bit of money on hand.

They are not allowed to give out money if they have too little money. When many people start to miss payments then the bank has to start increasing the amount of money set aside, just in case there is a problem, like a run on the bank.

This is why banks will sometimes bring in investors or borrow money themselves. They need money so they can give money out.

Who Gives Banks Money?

Banks can go to another bank, like the Reserve Bank (often called the central bank) and borrow funds themselves.

They can use these new funds to lend to their consumers.

Once again, the same rules apply and they do not have to have all the money they lend out, only a small portion of that money, as well as the consumers promise to repay (or be sued if they don’t).

Banks can also go to other sources to get in some funds to lend out. They might do this from shareholders or bond holders.

Shareholders buy into a bank, and thereby have a small say in how the bank is run, and in return get a bit of the profit when the bank is doing well.

Investors buy shares, or may invest in various types of bonds that the bank offers.

Making Money

Banks themselves can make investments by trading on the stock market, or investing in new businesses.

They can use funds from clients or shareholders to ‘play the market’ and try make a profit. Then they can share that profit with shareholders.

Banks also collect interest and fees on all their loans. This amounts to billions and billions of rands each month. This is good, because running branches and marketing and paying collections agents and attorneys and developing technology is pricey!

Many new banks have realised that having physical branches everywhere is not necessary, and there is a whole generation of online only banks competing with the established brands.  It is a competitive field.

By using funds that they get access to from investors or the Reserve Bank, combined with fees they get from helping people, banks around the world can make (or indeed lose) a lot of money.