How Does the Commercial Bank Make Money? Business Model Explained

The commercial bank is the financial institution that provides banking facilities to the business and individuals. The banking facilities include:

  • Accepting deposits and making payment for the interest.
  • Offering checking/savings accounts.
  • Disbursing loans to the businesses and other consumers while earning various fees and the interest.

How the commercial banks conduct their operations?

Commercial banks get deposits from the general public, including businesses, by providing checking and savings accounts. These funds are disbursed to the people making applications for the loan. The banks charge the interest on the disbursed loan and earn various types of the fee. These fees include interest charges, penalties for late payments, overdraft fees, and other fees.

The commercial banks can be state-owned and private as well. The state-owned commercial banks are the ones controlled and managed by the Government/state. The purpose of their existence is to regulate the money environment within the economy and the state can use these banks to achieve some of their managing objectives.

On the other hand, private banks are owned and managed by individuals and their primary purpose is to generate profits.

Let’s glance over different types of services provided by commercial banks. These services include but not limited to the followings.

1- Deposit acceptance

Commercial banks accept different types of deposits. These deposits may be different that include current deposits, savings deposits, and time deposits. The commercial bank does not offer interest on the current account balance. However, most banks provide the overdraft facility on the current accounts to some specified limit.

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On a savings account, the bank makes the payment for the interest. This type of deposit accounts encourages people to use the banking system for savings of their money and helps to bring the money from the people in the banking system/economy of the country.

The fixed/time deposits are similar to the savings account. However, the fixed deposit is for some specified time and does carry a higher rate of interest. Therefore, acceptance of deposits is one of the prime functions of the commercial banking system that helps them to smoothly manage the banking operations.

2- Loan disbursement

Another prime function of commercial banks is to disburse the money under different heads of the loans. Commercial banks maintain certain reserves and issue loans to different people to earn interest.

The loans can include mortgage loans, overdraft facilities, home equity loans, small business loans, student loans, home improvement loans, and commercial loans, etc. These loans may be secured or unsecured depending on the agreement between the bank and borrower. If the loan is secured the bank may opt for the securitization. Thus, increasing availability of the financing for approving further disbursements.

It is important to note that the interest set by the bank on the disbursement of the loan is higher than the interest it has to pay on the deposits. This is because the differential is earned by the bank, which is the prime source of income for the whole banking system.

Income of the bank = interest earned on the disbursed loan – Interest paid on the deposits.

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For instance, the bank may charge a 6% interest rate on the loans disbursed to the people/business and pay a 5% rate of interest on the advances. In this scenario, 1% is the profit earned by the bank, which is the core earnings generated for its owners.

The given equation is like gross profit for the other business operations, and other operating expenses have to be accounted for by the banks before getting to the net profit.

3- Letter of credit

The letter of credit is when the bank guarantees payment to sellers if they dispatch goods to the buyer. Letter of credit – LC is mainly used by the parties carrying out the sale and purchase transaction overseas.

4- Overdraft facility

Sometimes, the account holder does not have sufficient funds in their accounts. The bank ensures the availability of the funds on their signed cheques etc. However, the bank applies a specific rate of interest on the overdrawn amounts.

5- ATMs

The ATM has been the backbone of the successful banking system. It has created ease for the customers to access their funds 24/7 without the involvement of humans. Although, limited deposits can be accessed via ATM.

The banks charge their customers for ATM cards with annual charges.

6- Foreign currency exchange

The banks provide services for the exchange of the currency. In other words, the banks provide a facility for the exchange of foreign currency where one can give one currency and receive another currency after applying the current rate of exchange. However, the banks keep their commission by selling in more and buying in less the same currency.

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7- Locker facility

The banks are considered to be a safe place for keeping the valuables and documents etc. Therefore, the banks provide locker facilities for the people to keep their belongings, and they charge a periodic fee in return.

8- Utility services

The banking channel is widely used around the world to collect payments for utility services. Usually, the electric, gas, and water companies arrange with the bank to collect the bills from the masses and deposit the money in their bank account. These days the banks have connected their internet banking apps with the utility companies, and customers can pay their bills without visiting the branch.

The banks charge a certain amount from the electric, water, and gas companies as compensation for providing collection services.

Conclusion

Commercial banks accept deposits and loans. As a result, they earn higher interest in the loans disbursed to the people and pay less interest rate on the advances. The difference in the rate of interest for the payments and receipts is the income/earnings of the banking system. This is the prime mode of income. However, the banks do earn in several other ways, including providing different services to the people in exchange and collection of money.

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