How Banks make money is something which comes to mind of many of us when we hear about their reported profits, come across their financial statements and when we watch an analyst on any business news channel talking about profit maneuvers and earning or growth possibilities of banking sector. To answer this question we must take a look on different type of “banks” in the market.
In market we can come across either Pure Retail Banks (For example; Dena Bank, Allahabad Bank, SBBJ etc.), Pure Investment Banks (For example; JP Morgan, Goldman Sachs etc) and a an intermediate category of banks which act as both Retail and Investment Banks (For example; Axis Bank, IDBI, HSBC, ICICI, Citi Bank, Deutsche Bank, Kotak Mahindra Bank Limited etc.).
So, in a nutshell, so far this article has led us to a conclusion that majorly, banking revenue and profit generating activities can be divided into two broad categories:
Retail Banking –
Retail bank consists of activities which are generally coined to fulfill the financial needs and services required by a retail individual service consumer or small sized corporate entities. Major activities carried out by a bank in retail banking sphere of services are as follows:
ü Organizing Loans & Mortgages for Retail Consumers
ü Maintaining Saving Accounts, Currents A/Cs etc
ü Maintaining FDs and other deposits etc
ü Furnishing Loans to Retail Consumers for their various needs
ü Bank charges an interest rate (say X1) from all its clients to whom it lends money accompanied with other charges like service fees, accountant maintenance fees, paperwork charges etc. and pays at an interest rate (say X2)(of course X1>X2), to all its clients who have deposited their money in the bank and hence, Retail Banks earn an interest margin(or Intt. Differential) on all of the above transactions plus pockets a fair amount of service charges. So, in a nutshell, tagline of Retail Banking is- Lend at high rates, Borrow at low rates and eat margin while doing both
Characteristics of Retail Banking: Low Risk, Solid Cash Flow Generating Sector (from bank’s perspective)
Investment Banking –
Investment Banking is one of the Chief Operations in modern banking, if you have heard of any major M&A activity recently, read about an upcoming IPO/FPO, or have seen a report on an upcoming business deal; you must consider that in one way or other, Investment Bank(s) are involved in these. Some of the Major Activities carried on by an Investment Bank are as follows:
ü Proprietary Trading
§ Taking care of Bank’s Money at Hand
§ Using money with bank to make money
§ Taking Investment Decisions
§ Financial & Liquidity Management
ü Market Making
§ Trade at several types of trading market to maintain flow in the market (let’s call it maintaining the demand-supply equilibrium on a micro level by banks for simplicity)
§ For understanding this feature of banking, we must understand that in a trading market, every prospective buyer of stuff needs a prospective seller who can sell him the requisite stuff as and when required and similarly a seller in a market needs a buyer already existing in the market, an investment bank monetizes this situation by acting as a seller or buyer at different times. Technically speaking, an investment bank carries a long or short position depending upon the type and need of the client and charges a “premium” or “margin” or “service charge” for doing the same
ü Merger & Acquisitions
§ Investment Banks render services by the way of providing advice on Mergers
§ Every major prospective acquirer or absorber seeks the advice of Investment Banks to decide about the valuation of target, its growth prospective, market sentiment about the target etc
§ For such M&A advising and assistance bank charges advising fees which is known by various names, such fees can be fixed or may depend on the size of the deal
ü Assisting Corporate Events
§ Assisting various corporate clients for corporate deals and other events including publicity events, brand management, service feedback procurement etc
§ Helping in issuance of Debt
ü New Issues
§ Investment Bank also helps in issuance of New Equity (and even in issuance of further equity). In other words banks contribute in issuance of IPO/FPO
§ Investment Bank also acts as underwriter of shares and charges underwriting commission for the same
ü Structured Products
§ Investment Banks assist in design and sales of various Financial Securities/Instruments or a group/combination of them
Characteristics of Investment Banking: High Risk, High Expected CF but proper financial management and employment of risk minimization tactics is required
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