How Banks Make Money And Why It's Shifting In 2021 | Nucoro (2024)
Nikolai Hack is Head of Strategy & Partnerships at Nucoro where one key aspect of his role is to keep a close eye on the developments within financial services. His recent focus has been to examine the market shift in realising the opportunity for financial institutions in moving savers into investors. In this blog, Nikolai explains the macro factors driving this change.
For the majority of our lives, the answer to the question“how does a bank make money” seemed to be an obvious no brainer. Accordingly, the definition of Commercial Banking on investopedia.com couldn’t be clearer:
Commercial banks make money by providing and earning interest from loans [...]. Customer deposits provide banks with the capital to make these loans.
Traditionally, money earned in the form of interest from loans often accounts for up to 65% of a banks’ revenue model. However, to anyone who has been paying attention to central bank activity and monetary policy across the world, this definition poses a somewhat puzzling picture.
Central bank interest rates have been in a decade long freefall and are now at unprecedented historical lows. While the Bank of England and the Fed are still holding rates just barely north of nil, in the Euro area, Switzerland and Japan, banks are already being charged to deposit money at their central bank.
The consequences for consumers and debtors generally are severe. On the one hand, in the Eurozone most notably, it has become the norm to find 10-year and longer term mortgages for less than 1% interest. Soaring real estate prices and an over-indebtedness of private households are the result. On the other hand, the annual yield even on fixed term deposits rarely goes over that same 1% threshold anymore. With saving being so unattractive, ever more money finds its way into other asset classes like sky high stocks and riskier bonds.
Here, the macro shifts have definitely also left their mark. Not only has it become increasingly harder to generate margins from core products but a global pandemic has now added insult to injury. With a lot of business activity still on hold in many countries, there is significantly less need for FX and corporate banking services. At the same time, the costs for compliance and regulatory affairs continue their trend of an increasingly steeper upwards trajectory. To put it bluntly, the honest answer to the question “how do banks make money” is by now probably: It’s complicated...
While these developments present the industry with very challenging conditions, there are strategies to deal with them. This will be especially relevant as there is no reason to believe that interest rates will go up anytime soon. If anything, in times of expansive government debt financing of central banks, it is more likely that they will go negative even further.
Key strategy banks must adopt to future-proof their bank operating model
For banks, a key aspect of the necessary transformation is to diversify away from the core products that they have traditionally focussed on: deposits and loans (accounting for up to 35% and 65% respectively). This is important for two reasons. Primarily of course to increase the income streams from alternative activities and unlock additional revenue, but more importantly to reduce the weight of a bloated, yet revenue dormant balance sheet. More deposits and loans mean more regulatory capital. In consequence this results in a reduced return on equity if the achievable margins don’t increase at the same rate.
The benefits of launching an investment proposition
Not surprisingly, of all the options of diversification, we believe that launching an investment proposition achieves the most objectives at the same time. By offering investing, through a robo proposition, self-service trading or in the form of advisory services, otherwise idle funds are shifted off the balance sheet into custodial investment and cash accounts. At the same time as the capital base is decreased, the activities related to asset management allow for a range of fee models. From traditional structures of annual charges to subscription-like flat fees, the additionally generated income significantly boosts the cost income ratio and return on equity. Especially important will be the guidance that is necessary to get clients from their existing savings to the new investment offerings, as only 8 out of the top 30 European Banks currently succeed at this. Holistic experiences that break down the barriers between the two can help to increase adoption and open up opportunities for cross and upsells later (think about the next step from investing to pensions or protection). Importantly, consumers are demonstrating the need to be supported by their banks. With more than a third of UK citizens vowing to manage their money more wisely in the future and 40% of millennials stating their interest in robo-advice.
Regardless of the path that a bank choses, zero or negative interest rates are here to stay and have to be accounted for in the retail banking strategy. And if done right, the question “how does my bank make money” might just be a little more straightforward to answer in the future.
We recently ran a webinar 'The rise of the digital retail investor'where our panel of financial experts had an interesting discussion around the opportunity to convert savers into investors. If you'd like to listen, you can access the recording here.
The most prevalent trend in the financial services industry today is the shift to digital, specifically mobile and online banking (more on each of those in a bit). In today's era of unprecedented convenience and speed, consumers don't want to have to trek to a physical bank branch to handle their transactions.
They earn interest on the securities they hold. They earn fees for customer services, such as checking accounts, financial counseling, loan servicing and the sales of other financial products (e.g., insurance and mutual funds).
Commercial banks make money by providing and earning interest from loans [...]. Customer deposits provide banks with the capital to make these loans. Traditionally, money earned in the form of interest from loans often accounts for up to 65% of a banks' revenue model.
This framework is the digital-first platform, supported by four pillars – omni-channel banking, smart banking, modular banking, and open banking. Each of these four pillars is fundamental to success in the banking industry of the future.
A run on deposits (leaving the bank without the cash to pay customer withdrawals). Too many bad loans/assets that fall sharply in value (eroding the bank's capital reserves). A mismatch between what the bank can earn on its assets (primarily loans) and what it has to pay on its liabilities (primarily deposits).
The fall was led by fears over the SVB collapse and the risks in Japan's regional banking sector, partly because of exposure to US interest rate hikes. The cost to insure against default on Deutsche Bank debt rose substantially on Friday, 24 March, with the 5-year CDS for the bank's debt rising 70%.
Interest income is the primary way that most commercial banks make money. As mentioned earlier, it is completed by taking money from depositors who do not need their money now. In return for depositing their money, depositors are compensated with a certain interest rate and security for their funds.
Banks create money when they lend the rest of the money depositors give them. This money can be used to purchase goods and services and can find its way back into the banking system as a deposit in another bank, which then can lend a fraction of it.
The primary way that banks make money is interest from credit card accounts. When a cardholder fails to repay their entire balance in a given month, interest fees are charged to the account.
Any type of loan comes with interest, and this is how the bank makes its revenue. The amount of interest that the bank gets from their loans will always be greater than the interest that is paid back to you for keeping money in your checking account.
Banks pay depositors less than they receive from borrowers, and that difference accounts for the bulk of banks' income in most countries. Banks can complement traditional deposits as a source of funding by directly borrowing in the money and capital markets.
It doesn't remain locked away in the bank vault – instead, the money you deposit into a savings account is used by the bank to make loans to other people and businesses in your community so that they have the money to pay for big expenses like houses and cars, or even to operate a business.
Standards may differ from lender to lender, but there are four core components — the four C's — that lenders will evaluate in determining whether they will make a loan: capacity, capital, collateral and credit.
Generative AI may be the most disruptive technology the banking industry has seen in 30 years and I believe it will radically change the way banking is delivered; however, I don't believe it will fundamentally change the basics of banking – collecting and safeguarding deposits and lending money.
Moving into 2024, banks are also facing emergent elevated rates and credit issues. Banks are dealing with higher interest rates, increasing deposit costs, and slower lending due to interest rate fears squeezing margins. Interest-rate volatility in the past few years is also increasing focus on asset-liability risks.
Banking modernization is under way through the use of digital platforms and automated solutions. Banks play a part in addressing societal issues, such as social inequality through financial-inclusion programs or the climate crisis through sustainable financing.
1.1 Technological Disruption and Cyber Threats: The rapid evolution of technology brings both opportunities and challenges to the banking sector. While technological advancements enable digital transformation and innovative services, they also expose institutions to increased cyber threats.
While brick and mortar banks are not going away anytime soon, the online banking trend is undeniable. It's clear that financial institutions should be focused on increasing their flexibility and adaptability, and offer a competitive customer experience for consumers with a wide variety of needs.
The banking sector faces headwinds in 2024. First and foremost are macro- and microeconomic challenges. Investing in digital transformation in the banking sector will continue in the year ahead as banks seek to enhance the customer experience and modernize technology platforms.
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Introduction: My name is Madonna Wisozk, I am a attractive, healthy, thoughtful, faithful, open, vivacious, zany person who loves writing and wants to share my knowledge and understanding with you.
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