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 article, let’s understand the Business Model of Banks.
Money from Interest Difference:
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 goes 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.
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 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 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 that all the money deposited by the depositors with a bank the bank has to keep at least 4% of it as Cash Reserve this is known as the Cash Reserve Ratio.
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 percent of the public deposits 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. Of all the money we’ve deposited with the banks, the banks are giving out 70-80% of it as loans to others.
What is Bank Run?
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 is taking 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.
Other Sources of Bank’s Income
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 Although it isn’t a main source of income and second is the investments made by the bank The bank invests on its own in multiple assets
It can invest in government bonds, can invest in gold, it can invest in the stock market and the money that the bank gets from there is also a major source of income If we talk about expenses, a major part of the bank’s expenses is paying the salaries of the employees and managers. It accounts for about 30%-40% of the total expenses Let’s look at some realistic examples of this business model.
Let’s take 2 banks. First is the largest bank in India, SBI, and the second, is India’s largest private bank, HDFC. According to the figures from December 2021, the total valuation of HDFC is about ₹8 trillion and the total valuation of SBI is over ₹4 trillion.
You can see the market share of the banks in this table, it shows the market share of the top five banks. Of all the deposits into banks in the country, 23.9% of the deposits are to the State Bank of India. and 8.5% with HDFC Bank.