Fundamentals of Banking

  • Financial intermediation is principally the channeling of funds from depositors to borrowers
  • A bank’s main income is typically its net interest income, although a world of low rates has pushed banks to increase fee income.
  • Net interest income traditionally provided between half and three-quarters of bank profits.

Banking is based on a very simple and straightforward model that has not really changed since the beginning of modern banking. Many customers do not use up the funds that they deposit with the bank. In fact, many customers have both a short-term fund surplus in current and savings accounts and deposits and a long-term fund deficit with mortgages and loans. Banks lend to those who require credit by using the funds deposited in the bank by their account holders: this is financial intermediation. Banks also source funds from bond markets, inter-bank money markets and from capital markets as well. Effectively, a bank is intermediating finance across society. Additionally, the bank offers ancillary services to customers for which it may charge, although some of these services are bundled with customer accounts.

The concept of banking is based on trust. People with surplus funds will not often risk lending money directly to their neighbours, friends, or family. It is instead banks that perform the function of an intermediary to enable the flow of liquidity and credit across the population.

The bank pays its customers for keeping their funds in the bank checking/current, savings and term deposit accounts (deposits/liabilities). Banks typically accept deposits at a charge of between zero to five-point-something percent, and charge five to twenty percent to people who want to borrow the same money (loans/assets). This pure spread of interest rates in retail customer funds are about 5%, that is, a customer gets 2% on savings and pays 7% on loans, or something around these figures. We are now seeing a negative interest regime in countries like Japan and Switzerland, where large customers such as corporates must pay to keep their money in the bank.

In a typical bank, with all things considered, this margin is  between two to three percent because there are significant interbank and corporate deposits and loan balances at slim margins, currency, and other variables. The margin is about 1% for a bank which is mainly in the mortgage business. The minimum loan amount varies in each country and may be anything from $1,000 up to millions of dollars. For example, a savings rate of around 5 percent and a mortgage interest rate of about 6.5 percent results in a difference of just 1.5 percent. Nonetheless, the real margin of effective retail banking funds can be said to be around 3%. Banks are basically intermediaries in society for the smooth movement of funds across domestic and international borders.

Most accounts have small balances, so consumers are not shopping around except where they have greater amounts at their disposal. This task of bank intermediation eliminates all risks from the borrower as well as the lender. People don’t generally get into money lending. It’s not just that many countries have religious or cultural norms around lending and borrowing, but many if not most people would not lend $1,000 to a friend, let alone someone they do not know. With a bank as an intermediary, a lender/depositor/saver can obtain 4% income on their deposits and their money is readily available for use, while a borrower definitely pays – for example – 7% on their mortgage, with dependable terms. In this way, society and the general population at large are served, and everybody is happy.

Net interest income

The main source of income for a bank is net interest income, the spread being the difference between the interest it earns from borrowers and the interest it pays to depositors. That this business model is running for centuries now is evidence of the fact that it works. Between half and three-quarters of a retail bank’s profits are generated from its intermediation position in the form of net interest income. However, banks now offer a whole range of services which are in some way typically anchored to the funds of the customer. These include payment services, insurance, money transfer, overdraft, cheque and wire transfer, wealth management services, and more.

Such is the global working arrangement for a bank. The bank collects a profit from its lenders and depositors and charges fees for the services it provides. If a bank is focused on providing consumers with the products and services they need, when they need, where they need, and how they need them, sustainability and profitability is likely.