How Does A Bank Make Money?

Banks buy and sell money. But what they’re really buying and selling is time.

You’ve heard how time is money. Well it really is. Remember when you graduated from school and got a job. You worked hard for six years, eating take out, getting drunk with your friends, and mostly having a low cost but rather fun life.

You save a little. You get yourself the new iPhone (personally I prefer OnePlus!)

And then someone breaks into your apartment and steals all your stuff.

They have not just stolen your possessions, they have stolen the many hard hours of your life you spent toiling to buy all of it. Maybe it was junk. But it was your junk.

It was your life.

Banks literally store and lend your life.

how do banks make money

Image source: GotCredit

Money is a way of measuring your time and your work. Then money becomes a way of storing your work. Banks may not be the best place to keep all your money, but it’s the best place to keep the money for paying the bills.

The middleman of your life

This article is solely about retail banking. US Bank rather than Goldman Sachs.

You know better than I do what they pay you for storing your life. If you’re making $11 a year off of them you should consider yourself lucky. This isn’t actually their fault, it has got to do with the economy, central banks, and interest rates. Stuff so dull even bankers can doze off at the thought of it.

They lend your money out. They lend it to regular people for mortgages. They lend it out to business owners to buy shiny new equipment and computers. When they do these things, they’re helping the economy.

As you can already guess, they lend it out to do other stuff too, other things that are not so useful. But that’s a different story.

Time

Let’s drill a little deeper into money and time. Those $11 we mentioned is what they might pay you, for your money, for a year. When they lend out money the agreement is for the borrower to pay it back over a certain time period.

The future is uncertain. Banks sign contracts about uncertainty, transforming your uncertainty into other forms of uncertainty.

I could have used the word certainty at the end there, but that’s the big lie. Whenever someone in finance promises you certainty, its complete bullshit.

No one can guarantee you the future. Not if they’re the bank on your street corner. Not if they’re your employer of ten years. Especially not if they’re Bernie Madoff.

How do banks make money

How do banks make money?

  1. Banks store your life in dollars. They’re not buying your life though, just storing it so they offer you a pittance.
  2. They rent out your life to borrowers for mortgages and loans. Banks agree to a decent payment to them for this, but banks can always get paid more by finding someone a little riskier.
  3. In a year’s time, the bank and the borrower pay out their interest.
  4. However nothing is certain. If the borrower is bust, then whoops, Houston we have a problem. Primarily they try manage this by lending to thousands or millions of people, diversifying their risk.
  5. Banks complete a cycle of different people’s lives and uncertainties, getting a cut along the way.

Downside

Generally the economy rolls over every 5-10 years. Well behaved banks never go bust, but the sloppy ones take too many risks during the good years and it comes back and bites them and you on the ass.

An anecdote goes, when times are bad you want to own the best managed banks. But when times are good you want to own the worst managed ones. They’re the ones making the most money!

Lending and funding circles

The internet is leaving the banks behind. There are now ways you can cut out the middle man and lend directly peer to peer. In other words, from one human being directly to another human being. A word to the wise, you better be lending to the best borrowers though, because people go bust in every recession.

It is impossible not to.

It is extremely unlikely that checking, or current, accounts will stop being with banks. Free checking is paid for by overdraft fees, so banks do not lose money on them. However these accounts primarily make money as a way to sell loans, mortgages and savings products. It would be hard for a new entrant to change the way your basic account works. But that doesn’t mean everything else the banks do can’t be dis-intermediated!

I am expecting gold to be the best performing asset of 2016 – read all about it here.

If you’re more just curious about all things financial, take a look at my thoughts on the stock market.

Yuen Lo

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