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What is the business Model of Banks?

Business model of Banks is different from other businesses.
We are more accustomed with “manufacturing” business models. Which is as below:

  • Spend money to buy resources (Cost).
  • Use resources to produce goods & services.
  • Sell goods & services to earn revenue.
  • Revenue minus cost is profit.

But banks do not work with this model.

In order to attemp analysis of banking stocks, an investor must understand the business model of banks.

So lets look at the banks business model first.

#1. What is the business model of banks?

  • Give loans, earn interest (revenue).
  • Accept deposits, pay interest (cost).
  • Earned interest minus paid interest is profit.

How banks ensure profit?
Interest earned on loans should be more than interest paid on deposits.
This income is called “Interest Income.
Banks also make money from the other sources like:

  • Distribution of mutual funds.
  • Distribution if insurance schemes.
  • Offering wealth management services.
  • Treasury operations (buying/selling debt securities).
  • Etc.

By providing these services, banks charge a nominal fees.
Income earned from other source is called “Other Income”.
To know any bank’s Interest income or other income, one will have to look into their profit and loss accounts.
Just for example, income of few Indian banks in Mar’18 has been shown:

Rs.Crore HDFC SBI Kotak
Interest Income 80,240 (84%) 2,20,500 (83%) 19,750 (83%)
Other Income 15,220 (16%) 44,600 (17%) 4,050 (17%)
Total Income 95,460 2,65,100 23,800

From what we have seen till now, business model of banks look simple.

  • Collect deposit. Pay lower interest.
  • Issue loans. Charge higher interest.

What does it mean?
Consider a hypothetical bank locker. In this bank locker, money comes in when people keep money in banks.
How people keep money in banks?

  • Savings account (3.5% p.a).
  • Fixed Deposits (7.5% p.a).

On this deposits, banks has to pay interest as shown above.
So this all about expense. How money is earned by banks?
By issuing loan to public/business? This is where our hypothetical bank locker becomes useful.
As banks has liquid funds available in locker, it can use it for giving loans.
How much interest is charged by banks on loans?

  • Home loan: 8.5% p.a.
  • Car loan: 9.25% p.a.
  • Personal loan: 12-15% p.a.
  • Credit Card loan: 39.5% p.a.

What is the business Model of Banks - BusinessModel

#1.1 Business Model and Role of RBI

Why a investor must know this about banks?

It is because, a bank which is not following the RBI’s regulatory rules will soon lose its license.

So a potential investor who want buy banking stocks must check these parameters first.
The role of RBI is that of the regulator. Why a regulator is required?
As money is being handled by banks, hence the interest of depositors and borrowers must be ensured.
Suppose, banks took deposits worth Rs.100 crore from public.
But could issue loan of only Rs.80 crore.
How the money will come to pay the necessary interest of the depositors?
Though this is a very simplified example, but in reality RBI acts as the headmaster to all banks.
Banks must follow the rules or its license will be revoked by RBI.
How RBI ensures safe banking practice?
They ask banks to do the following:

#1.1.1 Maintain CRR with RBI

What is CRR?

Minimum reserves that a bank must keep with RBI.

How much reserves banks must ensure? It is in proportion to bank’s deposits.

This is called CRR (Cash Reserves Ratio).

On CRR, RBI pays nothing to bank (no interest).

The purpose of CRR is to ensure some liquidity.

At present, RBI has keep the minimum CRR limit of 4%.

What is the business Model of Banks - CRR1

#1.1.2 Ensure SLR in government bonds?

What is SLR?

Minimum amount that a bank must invest in government bonds.

How much banks must invest? It is also in proportion to bank’s deposits.

(Note: Government bonds are the safest investment vehicle).

This is called CRR (Statutory Liquidity Ratio).

On SLR, banks also earn a return in form of interest.

This way, the banks are forced to invest their funds. These funds remain safe always.

The interest earned (@7.7% approx.) on these investments is an added benefit.

At present, RBI has keep the minimum SLR limit of 19.5%.

What is the business Model of Banks - SLR

#1.1.3 What happens if bank’s runs out of cash?

Here again, RBI comes into play. RBI acts as banker to banks.

RBI gives loan to banks and charge an interest. This interest is called Repo Rate.

But why charge interest?

This question is justified, right? Banks already maintain CRR & SLR (23.5%).

Why they should pay interest to RBI? Logic is right, but CRR & SLR is not accessible by banks.

Banks must maintain CRR+SLR, and on top of this, if banks need money, take loan.

This is why less people opt for Banking Business. It is very capital intensive business.

This is what regulation does to an industry (negative).

But in banking business, such regulations are a must.

So this means, repo rate is another cost to banks.

They pay interest to depositors and also to RBI.

What is the business Model of Banks - RepoRate

#1.1.4 What is Reverse Repo Rate?

Lets try to see Reverse repo rate in a perspective.

As an individual, lets say we have two options for investment.

  1. Fixed Deposits in Banks: which pays 6.5% p.a.
  2. Debt Based Mutual Fund: which pays 7.5% p.a.

We will select which which investment option?

Lets say 35% people went with FD and 65% with Mutual Funds.

Now suppose, banks increases the return on FD. The yield is as follow:

  1. Fixed Deposits in Banks: which pays 6.8% p.a.
  2. Debt Based Mutual Fund: which pays 7.5% p.a

No more people will be attracted to FD.

Lets say, the percentage changed to 38% FD and 62% Mutual Funds.

Why this happened? Because FD became more attractive.

The analogy is there for Banks as well.

Banks have two options, they can invest their money in following ways:

  1. With RBI: and earn reverse repo rate of 6.5% p.a.
  2. Give home loan to public: and earn 8.3% p.a.

What do you think, banks selects which option? Mostly home loan.

This is their business. To earn higher interest.

What is the business Model of Banks - ReverseRepoRate

Final Words…

Allow me to sum up the business model of banks.

The main business of bank is to lend money to people/business/etc who need funds.

They provide this service and charge a fee. This fee, we commonly call interest on loans.

But from where banks source money for lending?

They source money by providing another services? Which are those?

  • Bank accounts.
  • Fixed deposits.
  • Remittance services.
  • Deals in foreign exchange etc.

They provide this service and again charge a fee. This fee, we commonly call interest on deposits.

It is only logical here to ask, how banks make profit?

To ensure profit, banks must charge “interest on loans” higher than they pay “interest on deposits”.

The post What is the business Model of Banks? appeared first on Getmoneyrich.

This post first appeared on Making First Million In Your 20s, 30s Or 40s, please read the originial post: here

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What is the business Model of Banks?


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