How Banks Operate

Posted: October 17th, 2013

How Banks Operate

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How Banks Operate

A bank is referred to as a financial intermediary and a financial institution where deposits are made and then channeled to lending, through capital markets or directly. It is the bridge between customers with capital surpluses and those with capital deficits. Since they deal with highly valuable commodities that bring a significant impact in a country’s economy, banks are regulated by the government through policies, laws and other measurements. In most cases, the banks operate by holding a small fraction of the reserves made and then lending out the rest to the respective parties. This kind of system is known as the fractional reserve banking.

Banks operate under the least requirements on capital, which are grounded on the Basel Accords. The Basel Accords are a set of capital standards that are intentionally recognized. Banks also operate by having current accounts that are meant for the customers, paying drawn checks and collecting checks. As constantly stated, banks also lend finances to the customers. They money is refunded with a calculated interest, which differs depending on the principle. They also pay interest to customers. This is mostly paid to the savings account. The interest paid to customers is meant to save attract more customers and encourage more people to make more savings, since it is a benefit to the banking institution.

The banks use diverse means to encourage customers to make deposits or borrow funds. Attractive packages are made for keeping an active current account. Attractive interest rates on money borrowed are also put in place. Some banks also offer services that include buying products on behalf of a customer. This is a type of money lending. Mortgages are the highest ways of lending money to the customers. Since they are long-term, they become one of the ways of generating long-term revenue into the bank. The banks also lend large organizations and the government in some cases. The government is lent money by the bank through the country’s central bank (Hall, 2008).

How Banks Make Profit

            Like any other business, a bank is a profit-making business. Banks collect revenue by charging a fee on the deposits made. Although some accounts such as the savings accounts are not charged, the fee is mostly charged on current accounts. For most banks, there is a fee charged for deposits made except the savings deposits. Banks also make revenue by charging an interest on the money that has been lend out to customers. In other cases, banks also make investments by buying shares in high profit-making companies, bonds, amongst other investments. Revenue is made through these investments. Revenue is also made by charging services offered to customers such as financial advice.

Banks makes profits by attaining the difference between the interest charged on the money that lend out and the interest given to the deposited money (savings). This variance is known as the spread between the interest on loans and the expense on funds (NEBI, 2000). When the bank deducts all the other expenses and then makes the necessary adjustments as normal businesses do, the profits become evident. For any banking institution, the most revenue is collected on the interest charged on the capital/principal amount of the money that has been lent. This is one of the reasons leading the banks to encourage the customers to borrow as much as they can, as long as they are viable for the loan in question. Some banks have reduced the requirements needed to get a loan over the years in order to encourage as much borrowing as possible.

References

Hall, M. (2008). Banks. Chicago, Ill: Heinemann Library.

New England Banking Institute. (2000). Bank operations. Needham Heights, MA: Ginn Press