Banking
How Banks Make Money
Business Characteristics
- Interest income
- Customer deposits
- Lending
- Financial services
- Credit risk
- Capital management
Banks earn money by managing funding, lending, investments, and financial services. Their profitability depends on funding costs, credit quality, operating expenses, and risk management.
What Is It?
Understanding the banking business model
A bank accepts deposits, provides loans, processes payments, and offers other financial services. It earns interest from loans and investments while paying interest on certain deposits and other funding.
Banks can also generate fees from cards, payments, account services, wealth management, and investment banking. The importance of each revenue source varies by institution.
A bank's total revenue is not the same as its profit. It must account for funding costs, operating expenses, credit losses, taxes, and other items.
Business Model in One Minute
How money moves through a bank
Gather Funding
A bank obtains funding through customer deposits and other sources. Deposits can be an important funding source, but attracting and retaining them may involve interest costs.
Provide Loans and Services
The bank uses funding and capital to support loans, investments, payments, and other financial services. Lending decisions require assessing borrowers' ability to repay.
Earn Interest and Fees
The bank earns interest from loans and investments and may collect fees from payments, cards, account services, and other financial activities.
Cover Costs and Manage Risk
The bank pays funding and operating costs, accounts for expected credit losses, and maintains sufficient capital and liquidity to support its obligations.
How It Works
The economics behind banking
A bank's earnings depend on how effectively it manages funding, lending, fees, expenses, and risk. Growing its loan book does not automatically mean the bank will become more profitable.
- 1Funding
Attract funding
Obtain customer deposits and other sources of funding to support the bank's activities.
- 2Assets
Make loans and investments
Use funding and capital to support loans and investments while assessing potential returns and risks.
- 3Revenue
Generate income
Earn interest and fees from customers, borrowers, and financial activities.
- 4Expenses
Pay funding costs
Pay interest on deposits and other borrowings, as well as the costs of operating the bank.
- 5Profit
Account for losses
Recognize credit losses and other expenses to determine how much profit remains.
Banks must also maintain enough liquidity to meet withdrawals and other payment obligations. Deposits and loans are not simply interchangeable pools of cash, so banks must carefully manage the timing and risk of their assets and liabilities.
Who Pays?
Who generates revenue for a bank?
Individual Customers
People may pay interest on mortgages, personal loans, and credit card balances. Depending on the product and account, they may also pay account or transaction fees.
Businesses
Companies borrow to fund operations and expansion, maintain accounts, process payments, and use services such as cash management and trade finance.
Cardholders and Merchants
Card-related activities can generate fees for banks and other participants in the payments ecosystem. The amount and recipient of each fee depend on the product and transaction.
Financial Market Participants
Some banks earn revenue by providing investment banking, trading, securities, and other financial services. These activities are more significant at some banks than others.
How They Make Money
The main sources of banking revenue
Net Interest Income
Net interest income equals interest income minus interest expense. A bank earns interest on loans and investments while paying interest on certain deposits and borrowings. This is an important earnings source, but it is not the same as net profit.
Net Interest Margin (NIM)
NIM measures net interest income relative to average earning assets. It helps explain how effectively a bank generates net interest income from interest-earning assets. A higher NIM is not automatically better if it comes with excessive risk or high credit losses.
Noninterest Income
Banks may earn fees from cards, payment processing, account services, wealth management, investment banking, and other activities. The mix varies considerably by institution.
Trading and Other Income
Depending on its business mix, a bank may also report trading-related revenue or gains and losses on financial instruments. These results can fluctuate and may be less predictable than recurring customer fees.
Where the Money Goes
Where a bank's money goes
Interest Expense
Payments on interest-bearing deposits and other funding. Funding costs can rise when market rates increase or customers move money to accounts offering better rates.
Credit Losses
Banks estimate potential losses on loans and certain other exposures. Provision expense reflects changes in estimated credit losses; it is not necessarily cash paid out immediately.
Operating Expenses
Employee compensation, branches, technology, cybersecurity, payment infrastructure, and day-to-day operations.
Compliance and Risk Management
Spending on regulatory compliance, fraud prevention, internal controls, legal requirements, and risk oversight.
Capital and Liquidity
Banks must maintain appropriate capital and liquid resources to support their obligations and absorb losses. These are important balance-sheet considerations, not simply ordinary operating expenses.
What Can Drive Growth?
Where Can Opportunities Come From?
What Can Make a Bank Competitive?
Potential advantages depend on how consistently the bank serves customers while managing risk.
Low-Cost, Stable Funding
A strong base of customer deposits may give a bank a funding advantage, although deposit stability and cost can change with market conditions.
Credit Underwriting
The ability to evaluate borrowers and price loans appropriately can help a bank earn returns that compensate for expected and unexpected losses.
Customer Relationships
Trusted relationships with individuals and businesses can support retention and the use of multiple banking services.
Scale and Infrastructure
Technology, payment networks, data, and operational infrastructure can support a large customer base, although maintaining them also costs money.
Risk Management
Disciplined management of credit, interest rates, liquidity, and capital can help a bank remain resilient through changing economic conditions.
How Banks Compete
Competitive Challenges
What Could Go Wrong?
Banking can be profitable, but its balance sheet creates important risks.
Credit Risk
Borrowers may miss payments or default. Losses can rise when households or businesses face financial pressure or when collateral values decline.
Interest Rate Risk
Changes in market interest rates can affect loan income, deposit costs, the value of securities, and the relationship between a bank's assets and liabilities.
Liquidity Risk
A bank may face pressure if customers withdraw deposits or other funding sources become unavailable faster than the bank can obtain cash without significant losses.
Funding Competition
Customers may move deposits to competitors or higher-yielding alternatives. A bank may need to pay more to retain funding, reducing its net interest income.
Economic Downturns
Weak economic conditions can reduce demand for some services and increase defaults, delinquencies, and credit loss provisions.
Regulation and Capital Requirements
Banks operate under extensive rules governing capital, liquidity, consumer protection, and risk management. Changes in requirements can affect costs and business decisions.
Operational and Cybersecurity Risk
Fraud, cyberattacks, system failures, and internal control weaknesses can cause financial losses, service disruption, and damage to customer trust.
Business Mix and Market Exposure
Banks with substantial trading, investment banking, or wealth-management activities may face additional market-related or cyclical risks beyond traditional deposits and lending.
What to Look At
Metrics that help explain a bank's performance. No single metric tells the whole story.
Net Interest IncomeInterest Income Minus Interest Expense
What it measures: interest income minus interest expense. Why it matters: it shows the net income generated from interest-bearing activities. Limitation: it does not include all revenue or expenses, and changes in the size of a bank can affect the total.
NIMNet Interest Margin
What it measures: net interest income relative to average earning assets. Why it matters: it helps explain the economics of lending and funding. Limitation: calculation methods and business mixes may differ, and a higher NIM alone does not establish better risk-adjusted performance.
ROAReturn on Assets
What it measures: net income relative to average assets. Why it matters: it indicates how effectively the bank generates profit from its asset base. Limitation: it can be affected by unusual items, leverage, and differences in business mix.
ROEReturn on Equity
What it measures: net income relative to average shareholders' equity. Why it matters: it shows the return generated on accounting equity. Limitation: leverage and changes in equity can raise or lower ROE, so a higher result does not automatically mean a safer or stronger bank.
Efficiency Ratio
What it measures: operating expenses relative to operating revenue, with the precise calculation depending on the reporting convention. Why it matters: it helps show how much revenue is absorbed by overhead. Limitation: definitions and exclusions may differ, so check how each bank calculates it. Under commonly used conventions, a lower ratio generally indicates greater efficiency.
NPLsNonperforming Loans
What it measures: loans classified as nonperforming under the institution's reporting definitions. Why it matters: it can indicate deterioration in credit quality. Limitation: definitions and thresholds vary, and NPLs alone do not capture every expected or potential credit loss.
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An example from Scope's company database
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