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Friday, 22 June 2012

Bullet Report: How do banks make money?

To Make Money, Banks Need Money
Aside from the startup capital and additional cash that the bank must keep on hand, banks must have a source of funds they can use to invest. To meet this need, banks use the funds in customer deposit accounts to invest in loans and other projects in order to generate a bank profit. When a customer deposits money into a savings--or, less common, checking--account, the bank puts that customer's money to work; in exchange for use of the money, the bank may pay a small portion of the returns to the depositing customer in the form of interest. While banks generally keep enough money on hand to pay out customer withdrawals, banks wager that most customers will not withdraw their funds at the same time, as this action (known as a "run on the bank") would create a situation in which the bank would be unable to meet customer demand.

Banks Loan to Consumers
Using both bank money and the funds held in customer deposit accounts, banks initiate loans to consumers in the form of lines of credit, mortgages, credit cards, and unsecured personal loans. The bank's loan officers carefully evaluate the borrower's ability to repay the loan before handing out the funds, and doggedly pursue repayment if the borrower should fail to make timely remittance. As the borrower repays the loan, a considerable portion of the repayment--sometimes as much as 30 percent--is retained by the bank as profit in the form of interest. A small portion of this profit is paid to deposit customers in the form of interest on their savings account.

Banks Make Commercial Loans
In addition to the usually lower amounts of consumer loans, banks also use their own funds and customer deposits for larger commercial investments. Commercial investments may range from financing a housing development or real estate project to capital equipment loans to business lines of credit for use on virtually any need. Although the amounts are usually larger and the terms governing commercial financing may be somewhat different, the basic premise of commercial lending is the same as in consumer loans: the bank lends or invests a given amount, then collects repayment including interest of up to 30 percent annually.

How a Money CD Works

A money CD, or certificate of deposit, is a timed agreement between you and a bank in which you agree to deposit a certain amount of money in the bank for a specified period of time and the bank then guarantees a specific amount of interest on your deposit.

Banks Also Make Other Investments
While the mainstay of bank investments is in commercial and consumer lending, many banks also explore other profitable investment ventures. Some banks, for example, have a foreign exchange (forex) investment branch that buys foreign currencies when the domestic dollar is strong and sells them for a profit when the dollar fluctuates downward. Other investment programs used by banks include hedge funds, insurance, stocks, bonds, and even retirement fund management.

Collected BY: Matteo Bergamini

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