When putting money in your bank account, have you ever
wondered ?what is your bank doing with your deposit?? Does it go in a vault
somewhere, and someday, you can pull that exact dollar back out? Not exactly.
When a person deposits money into their bank account, the
bank can then lend other people that money. The depositing customer gains a
small amount of money in return (interest on deposits), and the lending
customer pays a larger amount of money to the bank in return (interest on
loans). To make money for itself, the bank keeps the difference.
It can be quite difficult to understand banking, since banks
are complex and very different from most other businesses. Part of this is
because it can be hard to understand what banks actually do, since they don?t
make any physical products. In fact, a lot of people seem to think that banking
is ?free?, probably because banks keep advertising free checking accounts, free
direct deposit, free budgeting features, etc.
So how do banks actually work, and what does any of that
have to do with you? Here?s what you need to know.
The 3-6-3 rule
To fully understand how banks in the US make money, you need
to understand a little about the history of US banking. Traditionally, banks
made money by borrowing from depositors at low interest rates, lending that
money at higher interest rates to borrowers, and pocketing the difference.
Banking used to be heavily regulated, and the joke was that it was a 3-6-3
business; borrow money at 3%, lend it at 6%, and be at the golf course by 3 pm.
Most banks also charged a monthly fee to customers for
maintaining a basic account. But, overall, service fees were low, constituting
around 10% of total revenues.
The Impact of Deregulation
The wave of deregulation, beginning in the late 70s, changed
this relationship. Main street companies discovered that they could borrow from
the bond markets more cheaply than they could from banks, putting the ?6? part
of the 3-6-3 model under pressure.
And lots of new consumer products such as interest-bearing
checking accounts, credit cards, money market accounts, home equity loans,
student loans, etc. became available. Banking became a lot more complicated, so
bankers couldn?t just head to the golf course at 3 pm anymore.
Two things ended up happening: banks realized that the
bigger they were, the more loans they could make. With deregulation, the big
banks grew even bigger by acquiring smaller banks. Banks also realized that an
easy way to make more money was to simply charge consumers more fees.
How Banks Make Money
There are three main sources of revenue in retail banking
today:
Net interest margin: This is the difference, or ?net?,
between the interest paid to depositors and the interest received from
borrowers. At the moment (April 2020), the Fed?s low interest rate policy means
that although depositors get almost no money for their savings, bank interest
margins are also suffering as banks are unable to lend money out at a higher
rate due to the low interest rate environment. Many large US banks are making
margins around 3%, which, although on par with the 3% from the good old days of
the 3-6-3 rule, constitutes much less revenue for banks as a result of
deregulation and increased competition over the years.
Interchange: Every time you swipe a card at a store, the
merchant pays a small percentage of the money to the bank that issued the card,
called an interchange fee. For credit cards this is around 1.8%, while for
debit cards it is nearer to 0.3%. Given that Americans spend more than they
save, it is a huge revenue stream for banks.
Fees: These are the fees that your bank charges you,
including ATM fees, overdraft fees, late payment fees, penalty fees, etc.
Costs of Banking
There are a lot of costs associated with maintaining a bank.
Maintaining security systems, marketing products, running ATM networks, and
staffing call centers. However, all of those are dwarfed by the cost of
maintaining physical branches, which account for the majority of bank?s costs.
Companies that offer online-only, or branchless banking
(like Simple!), are able to maintain lower operating costs and spend their
revenue in more customer-friendly ways.
The Bottom Line
After the economic banking crisis of 2008-2009, a handful of
banks now dominate the market. At their scale, basic retail banking is
immensely profitable?but are the big banks the best choice for the consumer?
That depends.
When choosing a bank, you want to have a clear understanding
of how the bank makes money and impacts you: Does it charge activation or
monthly maintenance fees? Does it ding you for making too many withdrawals, or
for transferring money from your savings to checking?
At Simple, we believe your money is your money, and you
should be able to access it whenever you want. That?s why, Simple doesn?t
charge hidden fees or allow overdrafts.
We make most of our money in two ways: the interest margin -
the difference between the amount of interest made on loans, and the amount of
interest paid to customers for balances. And, when you swipe your debit card,
the merchant pays a service fee (called interchange) to the issuing bank..
That?s it. We only make money when our customers use and
love their accounts.
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