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how do banks make money

How do banks make money?

6th April, 2018No Comments

The Banking Royal Commission has revealed a series of scandals from the Big 4 Banks, one of which has seen AMP’s chief executive officer Craig Meller resign from his position with immediate effect.

AMP was found to have lied to corporate watchdog ASIC and had been charging customers fees for advice that was never delivered. The Royal Commission found this practice had been going on for close to a decade.

AMP is not the only financial provider to be involved in such a scam. A combined refund of $216 million will be provided to 300,000 customers from AMP and the Big 4 Banks for services that were never delivered.

While AMP is the first bank under the microscope, it is CommBank who is expected to provide the bulk of the compensation bill for 30,000 customers who did not receive a financial check-up that was promised.

The Banking Royal Commission

After years of mounting pressure from consumer groups, politicians and whistleblowers, the Turnbull government established the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry in December 2017.

The Royal Commission will be investigating misconduct within Australia’s financial services entities and determine if criminal or other legal proceedings should be referred to the commonwealth.

So far the Royal Commission has uncovered alleged bribery, forged documents, repeated failure to verify customers’ living expenses before lending them money, and misselling insurance to people who can’t afford it. Charging fees for services that were never delivered are the latest in a string of appalling behaviour from Australia’s Financial entities.

Australian Bank Profits – Under the Microscope

Australian Banks are renowned for producing massive profits. In fact, last year Aussie households and businesses were charged $12.7 billion in bank fees alone! An annual report released by the Reserve Bank Australia suggests that Australia’s 8 million households spend an average of $551 on bank fees each year.

However, the profits made through bank fees and charges pale in comparison to the profits made through credit card interest, loans and other revenue-raising done by banks. Let’s take a closer look at exactly how banks make money.

4 Ways Banks Make Money

Before we can look at the ways banks make money, we have to look at how banks work. A banks’ purpose can be broken down into two functions – deposits and loans.

Deposits are our spending and saving accounts. Loans include mortgages, personal loans, vehicle loans and credit cards. Banks pay interest on deposits, but charge interest for loans.

A simple way to explain how banks make money is that they charge a higher interest rate for their loans than what they pay for interest on deposits.

Loan Interest

Loan Interest is one of the most profitable ways banks make money. The banks lend money to customers, businesses and other banks with the intention of the borrower paying the money back in full. The trick to making their profit is the interest they charge on those repayments.

Loans to Customers

All banks offer a variety of loan products to customers including personal loans, car loans and home loans. Interest rates for these products vary between each loan but the interest they charge customers is higher than the interest they will offer customers on their savings accounts.

Home Loans are often the best interest-earning assets owned by banks. While home loan interest is generally quite low, it is applied to large amounts of money over several years.

Loans to Businesses

Banks also earn interest from lending to businesses. Business Loans are often much larger and can attract higher interest rates. Business Loans can service small-to-medium enterprises, large corporations and agri-businesses.

Loans to other Banks

Banks can also lend money to other banks. A bank needs liquidity in order to operate properly. This means a bank must always have enough money to cover its deposits, and in order to do so, it must borrow money from other banks. Inter-bank lending terms vary and could be an overnight lend or they could have several months to repay the debt, but the interest rates are often far more favourable than those offered to customers and businesses.

Credit Card Interest

An overwhelming amount of bank profits come from charging credit card interest. A bank will assign a customer with an amount of credit they can spend at any time with the expectation the customer will pay back the amount with interest.

The current average credit card interest rate is 20% on purchases. In comparison, the average interest you can earn on an online savings account is less than 2%. This difference gives you an example of the margin of profit and how banks make money.

Product Fees

Most bank products come with a set of fees including administration fees, annual account keeping fees, late fees and overdraw fees. While these products and fees provide revenue for the bank, interest income from credit cards and loans make up the most of the banks’ profits.

Financial Services

Banks can also offer a range of financial services to its customers such as insurance and financial planning. Banks make further profits by charging for these services.