Monday, July 20, 2009

How do banks make profit?

The word bank derived from an ancient Roman concept where money lenders used to set up their stalls in enclosed courtyards called macella. They used long benches called “bancu” on which they carried out transactions.

Banks have evolved as biggest financial institutions over centuries from mere money lenders of small traders. Now banks are better defined as Government Licensed financial Institutions which provide loans and deposits to any common human being.

Here comes a question, when banks provide depositors extra money in the form of interest on their deposits, how do banks earn profits?

Banks have a unique way of operations. They take money from small depositors and lend the money to bigger borrowers. Loans are the source of income for the banks. Now the question is that the banks can only lend as much they borrow, then how does profit figure? Banks provide interest at a lower rate to depositors and charge higher interest from borrowers. Most of the banks also invest in larger business ventures. They provide long term loans to high return industries. Investments are routed into different channels. These channels include stakes and high risk deposits also. The loans that the banks provide for homes and vehicles etc, are considered as virtual assets of the bank. The banks can show these virtual assets as future returns and can take loans from the Government Financial Regulatory body. To explain this better, let’s take a small example. When we take a home loan, we need to mortgage our property with the bank against the amount of loan acquired. This is called a security or collateral against the loan. Similarly, Banks keep their term deposits of customers as security against acquiring loans from Government Regulatory Authority for their business. This is how banks earn profits. Hence, larger the consumer deposit base of a bank, larger is its capacity to provide loans and earn extra.

Linus Orakles
http://www.authorclub.info/

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