Society has today become heavily reliant on banking institutions. Banks have over the years shaped the financial industry to what it is today.
How are banks profitable?
A bank’s operations may sometimes go beyond a loan against interest agreement, even though the biggest proportion of retail bank earnings are derived from such operations.
A customer deposit in a loose monetary environment, or when capital reserve requirements are low, has the potential to be lent out to other customers multiple times so long as the reserve requirements set by central banks are met. When reserve requirements are high, banks are often reluctant to lend out substantially.
A reserve requirement typically imposes a minimum amount of customer deposits a bank must keep in a reserve account, with the rest able to be loaned out for the purpose of money creation.
For example, an initial €100 deposit by person A would be deposited in a deposit account, whereby person A is entitled to 100% of his deposited funds. The bank, meanwhile, can loan out the initial €100 deposited numerous times, creating multiple lines of credit, so long as in each instance, the reserve requirement is met.
In the case of the eurozone, including Malta, the reserve requirement is set at 1%.
Therefore, €99 can be lent out to person B with €1 kept in a reserve account, from the initial deposit. Subsequently the same can be done for numerous other borrowers so long as 1% of each credit loan is kept aside.
One may ask the significance of the reserve requirement. A low reserve requirement encourages banks to lend and create more money in the economy. In turn banks benefit off the interest income from these numerous credit lines.
There are obviously risks banks may encounter by keeping such low reserves, but that is then where risk management decisions by bank management as well as accommodative monetary policy measures by the European Central Bank in this case come in.
In the case of a run on banks, sufficient liquidity should be kept aside to respond adequately to deposit withdrawal requests. The lower the reserve requirements, the higher the risks of insufficient liquidity banks face in the case of a sudden economic downturn.
Other than retail banking, investment banking is widely important in the financial industry. Such banks help promote and sustain efficient capital markets, through numerous services ranging from stock underwritings, bond dealings and brokerage services among numerous others. Investment banks generate income primarily through service fees.
Banks have other service lines available, many a time complimenting other business areas simultaneously. Examples range across wealth management, insurance services, custody services.
Banks are not limited in carrying out such services however. Whilse retail banking is often reserved to banking institutions, investment management, capital market and/or brokerage services among others can be operated by stand-alone financial institutions operating with a licence from a jurisdiction’s financial regulating body.
Disclaimer:
This article was issued by Mathieu Ganado, Junior Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt.The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.