How do banks make money?
How banks make money: the spread between loan and deposit rates, net interest margin, fee income, costs and credit losses, with a worked example.
Take office →At its heart, a bank makes money by borrowing at one price and lending at a higher one. The gap is the spread, and almost everything else in banking exists to widen it, protect it, or survive the moments when it goes wrong.
1. Net interest income: the spread
A bank takes deposits (money it owes back to customers) and pays some interest on them. It lends that money out as mortgages, business loans and consumer credit, and invests some in bonds. The interest it earns minus the interest it pays is net interest income. Divide it by the bank's interest-earning assets and you get the net interest margin (NIM).
Margins differ a lot by country and era. Banks with cheap, sticky deposits (salary accounts, current accounts that pay almost nothing) earn fat margins; banks funded by rate-sensitive savings or wholesale markets earn thin ones. Low-rate eras squeeze margins too: when the central bank's rate is near zero, deposit rates cannot fall much further, but loan rates keep falling.
Maturity transformation
Banks also earn from the shape of the yield curve. Deposits can be withdrawn at any time, but mortgages last decades. Because long-term rates are usually higher than short-term ones, funding short and lending long adds margin. It also adds risk, as interest-rate risk and bank runs show.
2. Fee and commission income
The second engine is fees: card and payment fees, account fees, loan arrangement fees, asset management, insurance commissions, and (for big banks) investment-banking and trading income. Fees are attractive because they need little capital, which is why large banks work hard to build them. The catch: fee income draws public and regulatory scrutiny, and some of it (trading) is volatile.
3. What comes out: costs and credit losses
From revenue, a bank pays its operating costs: staff, branches, IT, compliance. The cost/income ratio measures how much of every krone of revenue goes to costs; lean banks run below 50–60%, bloated ones above 75%.
Then come credit losses: the borrowers who do not pay back. Losses are small in good years and large in recessions, and under IFRS 9 banks must provision for expected losses before defaults happen. Finally there is tax.
4. A worked example
| Line (per year, DKK million) | Amount |
|---|---|
| Interest income on 10,000 of loans and bonds at 4.5% | 450 |
| Interest paid on 9,000 of deposits and funding at 1.5% | −135 |
| Net interest income (NIM ≈ 3.2%) | 315 |
| Fee and commission income | 85 |
| Total revenue | 400 |
| Operating costs (cost/income 60%) | −240 |
| Credit losses (0.4% of loans) | −40 |
| Tax (22%) | −26 |
| Net profit | 94 |
If this bank has 800 of equity, its return on equity (ROE) is about 12%. Notice how fragile that is: a recession that triples credit losses to 1.2% of loans wipes out most of the profit, and a price war that trims the margin by half a point removes another 45.
5. Why return on equity is the scoreboard
Shareholders compare a bank's ROE with what they could earn elsewhere. A bank that holds lots of capital is safer but earns a lower ROE; a bank that holds little earns more, until a bad year. This tension between safety and returns is the central trade-off of running a bank, and it is exactly the tension the board applies to you in Going Concern.
Frequently asked questions
What is a good net interest margin for a bank?
It depends on the market and the rate environment. Many US banks run net interest margins of roughly 2.5–3.5%, while European banks, with lower rates and more competition, often run 1–2%. A higher margin is only good if credit losses stay under control.
Do banks lend out depositors' money?
In effect, yes: deposits fund the bank's loans and bonds. In practice a new loan also creates a new deposit in the banking system, but either way the bank must keep enough capital and liquid assets to meet withdrawals and absorb losses.
How do banks make money when interest rates are zero?
With difficulty. Deposit rates cannot fall much below zero, so margins compress. Banks respond by cutting costs, growing fee income, charging for accounts and lending more, which is why the 2015–2021 zero-rate era was so hard on European banks.
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