Bussiness models of banks
In this article, we will delve into the world of banking, exploring topics such as bank operations, the concept of a bank run, and the mechanisms by which banks generate revenue.
How Do Banks Generate Income?
Have you ever wondered what happens to your money once you deposit it in a bank? Contrary to the portrayal in movies where money is locked away in a massive vault, the reality is quite different. Banks utilize deposited funds to provide loans to individuals and businesses. The interest accrued on these loans becomes the primary source of their earnings. Let's break this down with a simplified example: Imagine a bank with just one customer—you. You deposit $100 with the bank, and they offer you an interest rate of 4%, the standard rate for a savings account. Now, your $100 is in the bank. However, the bank doesn't keep this money locked away; instead, they lend it to others. Consider another person who needs a loan to buy a house. The bank lends them $100 at an interest rate of 8%. The borrower repays the bank $108, out of which the bank pays you $104. The bank earns a profit of $4 through this transaction. This is essentially how the process operates.
The Role of RBI Rules
But this raises a critical question: What happens when the bank has lent out $100 to borrowers, but the loan repayment date is still in the future? What if you urgently need to withdraw your $100? Unfortunately, the bank doesn't have your $100 anymore; it's been loaned out. Or the borrower might be unable to repay the loan. This scenario poses a challenge for banks. Naturally, no bank has just one depositor and one borrower; there are many clients. However, banks don't retain most of the deposited funds; they channel them into loans. This is where RBI (Reserve Bank of India) rules come into play. The RBI mandates that banks maintain at least 4% of the total deposits as cash reserves. This percentage is known as the Cash Reserve Ratio. Since the RBI supervises all banks in India, it determines the appropriate ratio. This ratio can change over time, currently standing at 4%.
Statutory Liquidity Ratio
Presently set at 18%, this ratio stipulates that banks must deposit a certain percentage of public deposits in specific RBI-designated reserves. These can include government bonds, gold reserves, securities, or investments in public sector undertakings (PSUs). For Indian banks, considering 22% (18% + 4%), the remainder of deposits can be utilized to provide loans, enabling banks to profit from the interest rate differential.
Understanding the Bank Run Phenomenon
Imagine a scenario: Banks utilize 70%-80% of the funds deposited to provide loans. What if all depositors simultaneously decide to withdraw their money from the bank? This situation is known as a 'bank run,' and it would lead to the collapse of the bank. However, such a scenario is unlikely to occur in reality.
Bank Charges and Investments
In some Western European countries, banks charge fees for various services, similar to fees for opening an account. Banks have two primary income sources. First, they earn revenue from fees and commissions. These fees vary, such as charges for maintaining a minimum account balance or using specific bank services. While not a primary source of income, it contributes. Second, banks invest in various assets. This can include government bonds, gold, or the stock market. Income generated from these investments also constitutes a significant revenue stream.
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