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How Banks Make Money in the Modern World

July 12, 2011
Credit Cards
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This guest post comes from Kyle Psaty of PerkStreet Financial.

How does a bank make money? Most people never think about it. Ask someone who has and the response will likely come in the form of a simple sentence: “Banks make money by taking the money you deposit and lending it to people who need to borrow it.”

Of course this makes business sense because loan interest is usually far greater than the interest the bank pays its patrons for depositing. By holding your money and paying you a little – either in the form of interest, cash back or services like free checking – banks set themselves up to lend your money at a profitable rate. Of course, sometimes people default on loans, which costs banks money, and, let’s be honest, keeping a bank open all day also costs money. But after all the costs are factored out, the bank keeps the difference in interest as profit. Your bank likely makes money from you by lending the money you keep in it. Simple.

In the modern banking landscape, this is only part of the story…

Today, financial institutions make a lot of money by charging bank fees, issuing debit and credit cards and providing other financial services. Most big commercial banks in today’s landscape make around half their operating income by means of services other than lending – through even more complex offerings like insurance policies, investment products and whole other core businesses like investment banking.

Some don’t do any lending at all. Moreover, some “banks” aren’t even banks by definition. Take my company, PerkStreet Financial, which is not a bank, but rather an “un-bank,” meaning we have a banking partner that holds our funds for us, providing our FDIC insurance. We don’t do any consumer lending, but our business has been steadfast for two years.

PerkStreet Financial makes the vast majority of our revenue through something called “interchange fees.” These aren’t fees paid by consumers, but rather, by merchants – when our customers swipe their cards, we earn a little money. Interchanges fees have become a big business in the United States as debit cards have become more popular. How big? Recently, congress passed legislation limiting the amount of money large banks can make from interchange fees and some have predicted this move will cost banks $14 billion in annual revenue. Even in banking, that’s pretty big business.

But PerkStreet prides itself on sharing our interchange revenues with our customers. When they swipe their rewards debit cards, we make money, yes, and so do they – in the form of unlimited cash back to the tune of 1%, 2% or even 5% of the purchase.

For PerkStreet, the business of banking is as simple as an online checking account, tons of free ATMs and a debit card that aligns our interests with the interests of our customers. We give our patrons a great deal for avoiding debt and they use their cards because they love being partners in our business. For many of our competitors, the business of banking is much more complicated.

The truth is, every bank in this country has, over time, become entirely its own beast. All of the banks you can think of still profit from holding people’s money, and in many ways, they all look the same. But choosing the bank that’s right for you should be more than a quick comparison of which one has the closest ATM nowadays. Remember, you vote for your bank to succeed – you literally power your bank’s business – with your dollars.

Vote wisely and our children may find themselves in a much better economic situation than we’re in now. Who knows, maybe they’ll even live in a world where banking is more easily understood.