HOW BANKS WORK

Hello, friends! All of us save our money in banks. And these banks pay us interest on our savings. They give us more money. So have you wondered how these banks earn money? 

In this article, we understand the Business Model of Banks. Think about it, what do banks do with your money? It can't be that banks will take your money, keep it in a gigantic locker, lock it and keep the keys safely, and the money would remain in the locker safely. This is the version shown in films. It's not so in reality. Banks use your money to give loans to others. And the interest that they charge on that loan, is their earnings. Let's understand this with a simplified example. This is a bank. There's only one customer in this bank. You. You deposit ₹100 with the bank. And this bank pays you interest at 4%. Presently, this is the rate of interest for the Savings Account, 4% per year. Your ₹100 is now with the bank. The bank then gives out this ₹100 to some other person. The other person has to buy a house, so he took out a loan for it. The bank charges interest at the rate of 8% from the borrower. So the ₹100 of the bank went to the other person. When the other person pays the bank ₹108, the bank will pay you ₹104. And the bank earns a profit of ₹4. Basically, this is the way the system works. But this begs a very important question here, what will happen when the bank has given ₹100 to the borrower, but the due date to repay the loan hasn't arrived yet. But you urgently need to withdraw your ₹100. But the bank doesn't have the ₹100 with it anymore. Because it has been given out as a loan. Or the other person cannot repay the loan for whatever reason. Your money is lost. These situations are truly very problematic for the banks, and friends. Obviously, no bank has only one depositor and one borrower. There are many people. Even so, each bank doesn't keep most of its money with itself. Instead, it gives out the money as loans to people. That's why the RBI has a rule. Of all the money deposited by the depositors with a bank, the bank has to keep at least 4% of it itself as Cash Reserve. This is known as the Cash Reserve Ratio. And the RBI is the boss of all banks in India. So the boss decides what should be the Cash Reserve Ratio. This keeps changing with time. Some time ago, it was around 3.5% presently, it is at 4%. Apart from it, there's the Statutory Liquidity Ratio. This Ratio is at 18% now. This is the ratio that the RBI directs the banks that at least this percent of the public deposits it has, has to be deposited at a place specified by the RBI as a Reserve. Such as in Government bonds, gold reserves, securities, or investing in PSUs. So for Indian banks, today,  if you forget about the 22% of the money (18%+4%), the leftover deposits with the banks can be used to give loans to others and earn profits for themselves. From the difference in the interest rates. You'd say that this isn't a huge ratio. Of all the money we've deposited with the banks, the banks are giving out 70-80% of it as loans to others. And if you want to withdraw all of it at once. If all the depositors of the bank want to withdraw all their money from the bank, what then? The bank will fail then. This is known as the Bank Run. And it is not possible for any bank in the world. Because no bank holds all the deposits with itself in cash. It doesn't happen realistically, so there's nothing to be afraid of. Unless people panic because of some news and everyone wants to withdraw their money at the same time. But the thing that does happen is that the bank has given out huge loans, and the loans become Bad Loans. And the borrowers cannot repay the money. And the bank is left with no money to pay the depositors. This has happened to several banks in the past. It happened with the PMC Bank, then the situation occurred with the Yes Bank. Although the situation is under control now, the Government takes steps to keep them under control. That's why, often in such situations, there's a limit on the amount of money, you can withdraw in a month, It happened to the customers of this bank as well. But anyway, if we return to our topic, this is a huge source of income for the banks. The Interest Rate Difference. The interest rate bank pays, and the interest rate the bank charges. But what about the countries where the interest rate the bank charges from the borrowers, is very low. Like countries such as Germany. There the interest rate on a housing loan is around 1%. In several cases, the interest rates are at 0.4-0.5%. The interest rate charged on the loans by the bank is almost negligible. In such cases, how will the bank earn from the difference in the interest rates? How will the bank earn money? In such cases, friends, as with the situation in most Western European countries the banks reduce the interest rates they pay on Savings Accounts. In most countries, the interest rate on Savings Accounts is at 0.1% In many cases, it is at 0%. The bank doesn't give you any interest in opening Savings Accounts. And secondly, the banks charge monthly charges from the people for maintaining the bank account. So if you need to use the bank, if you want to keep the money deposited with banks, you'll have to pay the bank monthly, to do this. It isn't so unrealistic. Because it is already happening in most Western European countries. Apart from this, for all the banks in the world, there are 2 more main sources of income. First, the revenue from fees and commissions. The various types of fees are being charged, if you aren't maintaining a minimum account balance, a fee is charged. The fee that is charged for various services of the bank you use. The bank gets some money from there as well. Although it isn't a main source of income. And second is the investments made by the bank. The bank invests on its own in multiple assets. It can invest in government bonds, can invest in gold, it can invest in the stock market, And the money that the bank gets from there, is also a major source of income. If we talk about expenses, a major part of the bank expenses is paying the salaries of the employees and managers. It accounts for about 30%-40% of the total expenses. Let's look at some realistic examples of this business model. Let's take 2 banks. 

First is the largest bank in India, SBI, And the second, is India's largest private bank, HDFC.

According to the figures from December 2021, the total valuation of HDFC is about ₹8 trillion. And the total valuation of SBI is over ₹4 trillion. You can see the market share of the banks in this table, it shows the market share of the top five banks. Of all the deposits into banks in the country, 23.9% of the deposits are to the State Bank of India. And 8.5% with HDFC Bank. And of all the loans given out in the country, 22.5% of the loans are given out by the State Bank of India. And HDFC gives out 9.6%. As of 31st March 2021, SBI has a total of about 460 million customers. And by comparison, HDFC has approximately 60 million customers. So even though the market share of SBI is more, and SBI has more customers than HDFC, HDFC's valuation is nearly twice that of SBI. The reason behind it is that SBI is a government bank. And public sector banks have some social responsibilities. They need to invest in some projects that are beneficial for the country and the citizens, and they often have to follow government directions. But because the private banks are private, it is up to them where they want to invest. This is the reason why the valuation of private banks is so high. As compared to the public sector banks. The profit from the difference in the interest rates that I talked about, the interest charged by the bank less the interest paid by the bank, is known as the Net Interest Income. The difference between the two. And if you divide this by the total loans. The total assets from where the banks have earned money, you'll arrive at the Net Interest Margin. This is the percentage on which basis you can judge, the profitability of a bank. How much profit it earns. So let's see the Net Interest Margin of our examples. Looking at Quarter 3 of the Financial Year 21, For SBI it was 3.34%, And for HDFC, it was 4.2%. You can say that HDFC is a bit more profitable than SBI. Another interesting percentage that is quite important here is the Gross NPA percentage. The percentage of loans given by the bank that have turned into bad loans. That the chances are those loans will never be repaid. For SBI, the ratio is 4.77%. And for HDFC bank, this ratio is at 1.32%. With this, you can say that the situation of HDFC is much better. Although, 4% is not a bad ratio either. If this percentage reaches 7% or 8% or 9%, then it is said to be worrisome. Then it could be said that the bank is at risk if so many loans have become NPAs, that will never be recovered, then it might be problematic for the bank. Now, if we compare the profitability of the two banks, in these tables, you can see, let's look at SBI's table first, the annual revenue of the bank, the interest that is paid, and the bank expenses, to arrive at the Financing Profit of the bank. for SBI, in March 2021, it was at -₹700 billion. Remember that the figures on the chart are ₹10 million. Then the other sources of income are added, Depreciation is subtracted then, And thus the Profit Before Tax is calculated. It is positive for SBI. Around ₹320 billion. Tax is paid on that figure. And then comes the Net Profit at ₹220 billion. We can see the same table for HDFC Bank. The revenue, the interest expenses, and the Financing Profit of HDFC Bank are actually positive, Unlike SBI bank. And the other income sources aren't very high for the HDFC Bank. So the Net Profit for the HDFC Bank is around ₹310 billion. You can see a clear difference in the figures between SBI and HDFC Bank, But I'd say that both of them are in the same range. It doesn't mean that HDFC is a better bank than SBI, SBI as a public sector bank has its own set of benefits. 

I showed the comparison of both banks simply to compare their business model. So, friends, this is how the banking business in India works. If you want to enter into this business, If you want to start a bank, You can do so. Everyone is allowed to do it. Because after all, starting a private bank is a form of business. Since you've understood the business model, you will simply need ₹5 billion. According to some estimates, you need to have at least this much initial capital, if you want to start your own private bank in India. You will need to get permission from RBI for this. Because RBI is the regulator of the banks. Check if you have ₹5 billion lying with you somewhere, you can give it a try too. Thank you very much.