How Banks Earn Money? | Business Model of Banks
In the world of finance, banks serve as the bedrock of economic stability, offering a haven for our hard-earned money and providing us with interest on our savings. But have you ever stopped to ponder over the intricate workings of these financial institutions? How do banks manage to not only safeguard our funds but also generate profits in the process? In this comprehensive exploration, we will delve into the fascinating world of banking, demystifying the enigmatic business model that powers these financial giants.
Where Does Your Money Go?
Contrary to the portrayal in movies, banks don't simply lock away our deposits in a vault and hold onto the keys. Instead, they put our money to work by extending loans to borrowers. The interest collected on these loans constitutes a significant portion of a bank's revenue. To illustrate this concept, let's consider a simplified scenario.
Imagine you are the sole customer of a bank, and you deposit ₹100 with them. In return, the bank offers you an annual interest rate of 4%. Your ₹100 now resides with the bank, which proceeds to lend this sum to another individual, say, for purchasing a home. This borrower is charged an 8% interest rate by the bank.
As the borrower repays the bank ₹108, you, as the depositor, receive ₹104. In this transaction, the bank earns a profit of ₹4. This simple exchange mirrors the fundamental principle behind a bank's operations – taking in deposits and leveraging them to extend loans at higher interest rates, thereby generating income.
Safeguarding Depositors' Interests
The scenario described above poses a pertinent question: What happens if you urgently need to withdraw your ₹100, but the bank has already loaned it out? Or worse, if the borrower defaults on the loan? These situations present a dilemma for banks and depositors alike.
To mitigate these risks, regulatory authorities like the Reserve Bank of India (RBI) impose specific guidelines. One such regulation is the Cash Reserve Ratio (CRR), requiring banks to keep a portion of their deposits (currently 4%) as cash reserves. This provision ensures that banks maintain a liquidity cushion to meet withdrawal demands.
Additionally, there's the Statutory Liquidity Ratio (SLR), set at 18%. It mandates that a certain percentage of public deposits be invested in designated reserves, such as government bonds, gold, securities, or investments in public sector undertakings (PSUs). These measures collectively safeguard depositors' interests and maintain the stability of the banking system.
The Profitable Interest Rate Differential
One of the primary sources of revenue for banks is the interest rate differential – the contrast between the interest they pay to depositors and the interest they charge on loans. This difference, known as Net Interest Income (NII), is a key determinant of a bank's profitability.
In many countries, including India, the difference between savings account interest rates (generally 0.1% to 0%) and loan interest rates is substantial. To compensate for the low returns on savings, some banks also charge monthly fees for maintaining accounts, a practice common in several Western European nations.
Diversified Income Streams
Apart from the interest rate differential, banks also derive income from various other sources. One significant revenue stream is fees and commissions. Banks charge fees for services like maintaining minimum account balances and various transactions, contributing to their earnings.
Additionally, banks actively invest in a diverse range of assets, including government bonds, gold, and the stock market. The returns from these investments contribute significantly to their income.
Understanding Profitability: SBI vs. HDFC
To comprehend the nuances of banking business models, let's compare two prominent Indian banks: the State Bank of India (SBI) and HDFC Bank. As of December 2021, HDFC Bank boasted a total valuation of ₹8 trillion, while SBI's valuation exceeded ₹4 trillion. While SBI commands a larger market share in terms of deposits and loans, HDFC Bank's valuation far surpasses SBI's, highlighting the dynamics of public sector versus private sector banks.
Examining key financial indicators, HDFC Bank exhibited a Net Interest Margin (NIM) of 4.2% in Q3 of the Financial Year 2021, surpassing SBI's 3.34%. NIM serves as a critical gauge of a bank's profitability, with higher percentages indicating enhanced profit potential.
Managing Non-Performing Assets (NPAs)
Another critical metric in the banking world is the Gross NPA percentage, signifying the proportion of loans that have soured and are unlikely to be repaid. SBI reported a Gross NPA ratio of 4.77%, while HDFC Bank's ratio was notably lower at 1.32%. A higher NPA percentage raises concerns about a bank's financial health and its ability to recover bad loans.
Profitability in Focus
When assessing the profitability of these banks, we observe that SBI reported an annual revenue of -₹700 billion in March 2021. After accounting for interest expenses and other sources of income, the bank achieved a Net Profit of ₹220 billion. In contrast, HDFC Bank boasted a positive Financing Profit, which, after factoring in other income sources and depreciation, resulted in a Net Profit of around ₹310 billion.
While HDFC Bank's financials appear stronger, it's essential to recognize that public sector banks like SBI have distinct social responsibilities and regulatory constraints that affect their operations. Comparing these two banks provides valuable insights into the diversity of business models within the banking industry.
Charting Your Path in Banking
Understanding the intricacies of the banking business model may inspire you to explore this sector further. If you aspire to start your bank, it's feasible. With an initial capital requirement of approximately ₹5 billion and approval from the RBI, you can embark on this entrepreneurial journey. Just remember that banking is not just a financial endeavor; it's a business that plays a pivotal role in the economic landscape.