bank

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Business models

Banks generate revenue in a variety of different ways including interest, transaction fees and financial advice. Traditionally, the most significant method is via charging interest on the capital it lends out to customers. The bank profits from the difference between the level of interest it pays for deposits and other sources of funds, and the level of interest it charges in its lending activities.

This difference is referred to as the spread between the cost of funds and the loan interest rate. Historically, profitability from lending activities has been cyclical and dependent on the needs and strengths of loan customers and the stage of the economic cycle. Fees and financial advice constitute a more stable revenue stream and banks have therefore placed more emphasis on these revenue lines to smooth their financial performance.

In the past 20 years, American banks have taken many measures to ensure that they remain profitable while responding to increasingly changing market conditions.

First, this includes the Gramm–Leach–Bliley Act, which allows banks again to merge with investment and insurance houses. Merging banking, investment, and insurance functions allows traditional banks to respond to increasing consumer demands for "one-stop shopping" by enabling cross-selling of products (which, the banks hope, will also increase profitability).

Second, they have expanded the use of risk-based pricing from business lending to consumer lending, which means charging higher interest rates to those customers that are considered to be a higher credit risk and thus increased chance of default on loans. This helps to offset the losses from bad loans, lowers the price of loans to those who have better credit histories, and offers credit products to high risk customers who would otherwise be denied credit.

Third, they have sought to increase the methods of payment processing available to the general public and business clients. These products include debit cards, prepaid cards, smart cards, and credit cards. They make it easier for consumers to conveniently make transactions and smooth their consumption over time (in some countries with underdeveloped financial systems, it is still common to deal strictly in cash, including carrying suitcases filled with cash to purchase a home).

However, with the convenience of easy credit, there is also an increased risk that consumers will mismanage their financial resources and accumulate excessive debt. Banks make money from card products through interest charges and fees charged to credit and debit card holders, and transaction fees to retailers who accept the bank's cards for payments.

This helps in making a profit and facilitates economic development as a whole.

Recently, as banks have been faced with pressure from fintechs, new and additional business models have been suggested such as freemium, monetization of data, white-labeling of banking and payment applications, or the cross-selling of complementary products.

Early modern

Fractional reserve banking and the issue of banknotes emerged in the 17th and 18th centuries. Merchants started to store their gold with the goldsmiths of London, who possessed private vaults, and who charged a fee for that service. In exchange for each deposit of precious metal, the goldsmiths issued receipts certifying the quantity and purity of the metal they held as a bailee; these receipts could not be assigned, only the original depositor could collect the stored goods.

Gradually the goldsmiths began to lend money out on behalf of the depositor, and promissory notes, which evolved into banknotes, were issued for money deposited as a loan to the goldsmith. By the 19th century, ordinary deposits of money in banks had become a mere loan, or mutuum, and the bank restored an equivalent sum whenever it was demanded

Money, when paid into a bank, ceases altogether to be the money of the principal (see Parker v. Marchant, 1 Phillips 360); it is then the money of the banker, who is bound to return an equivalent, by paying a similar sum to that deposited with him, when he is asked for it.

The goldsmith paid interest on deposits. Since the promissory notes were payable on demand, and the advances (loans) to the goldsmith's customers were repayable over a longer time-period, this was an early form of fractional reserve banking. The promissory notes developed into an assignable instrument which could circulate as a safe and convenient form of money

backed by the goldsmith's promise to pay,

allowing goldsmiths to advance loans with little risk of default. Thus the goldsmiths of London became the forerunners of banking by creating new money based on credit.

The Bank of England originated the permanent issue of banknotes in 1695. The Royal Bank of Scotland established the first overdraft facility in 1728. By the beginning of the 19th century, Lubbock's Bank had established a bankers' clearing house in London to allow multiple banks to clear transactions. The Rothschilds pioneered international finance on a large scale, financing the purchase of shares in the Suez canal for the British government in 1875.

Definition

The definition of a bank varies from country to country. See the relevant country pages for more information.

Under English common law, a banker is defined as a person who carries on the business of banking by conducting current accounts for their customers, paying checks drawn on them as well as collecting them for their customers.

In most common law jurisdictions there is a Bills of Exchange Act that codifies the law in relation to negotiable instruments, including checks, and this Act contains a statutory definition of the term banker: banker includes a body of persons, whether incorporated or not, who carry on the business of banking' (Section 2, Interpretation). Although this definition seems circular, it is actually functional, because it ensures that the legal basis for bank transactions such as checks does not depend on how the bank is structured or regulated.

The business of banking is in many common law countries not defined by statute but by common law, the definition above. In other English common law jurisdictions there are statutory definitions of the business of banking or banking business. When looking at these definitions it is important to keep in mind that they are defining the business of banking for the purposes of the legislation, and not necessarily in general. In particular, most of the definitions are from legislation that has the purpose of regulating and supervising banks rather than regulating the actual business of banking. However, in many cases, the statutory definition closely mirrors the common law one. Examples of statutory definitions:

"banking business" means the business of receiving money on current or deposit account, paying and collecting checks drawn by or paid in by customers, the making of advances to customers, and includes such other business as the Authority may prescribe for the purposes of this Act; (Banking Act (Singapore), Section 2, Interpretation).

"banking business" means the business of either or both of the following:

receiving from the general public money on current, deposit, savings or other similar account repayable on demand or within less than [3 months] ... or with a period of call or notice of less than that period;

paying or collecting checks drawn by or paid in by customers.

Since the advent of EFTPOS (Electronic Funds Transfer at Point Of Sale), direct credit, direct debit and internet banking, the check has lost its primacy in most banking systems as a payment instrument. This has led legal theorists to suggest that the check based definition should be broadened to include financial institutions that conduct current accounts for customers and enable customers to pay and be paid by third parties, even if they do not pay and collect checks .

Economic functions

The economic functions of banks include:

Issue of money, in the form of banknotes and current accounts subject to check or payment at the customer's order. These claims on banks can act as money because they are negotiable or repayable on demand, and hence valued at par. They are effectively transferable by mere delivery, in the case of banknotes, or by drawing a check that the payee may bank or cash.

Netting and settlement of payments – banks act as both collection and paying agents for customers, participating in interbank clearing and settlement systems to collect, present, be presented with, and pay payment instruments. This enables banks to economize on reserves held for settlement of payments since inward and outward payments offset each other. It also enables the offsetting of payment flows between geographical areas, reducing the cost of settlement between them.

Credit quality improvement – banks lend money to ordinary commercial and personal borrowers (ordinary credit quality), but are high quality borrowers. The improvement comes from diversification of the bank's assets and capital which provides a buffer to absorb losses without defaulting on its obligations. However, banknotes and deposits are generally unsecured; if the bank gets into difficulty and pledges assets as security, to raise the funding it needs to continue to operate, this puts the note holders and depositors in an economically subordinated position.

Asset–liability mismatch/Maturity transformation – banks borrow more on demand debt and short term debt, but provide more long-term loans. In other words, they borrow short and lend long. With a stronger credit quality than most other borrowers, banks can do this by aggregating issues (e.g. accepting deposits and issuing banknotes) and redemptions (e.g. withdrawals and redemption of banknotes), maintaining reserves of cash, investing in marketable securities that can be readily converted to cash if needed, and raising replacement funding as needed from various sources (e.g. wholesale cash markets and securities markets).

Money creation/destruction – whenever a bank gives out a loan in a fractional-reserve banking system, a new sum of money is created and conversely, whenever the principal on that loan is repaid money is destroyed.

Regulation

Currently, commercial banks are regulated in most jurisdictions by government entities and require a special bank license to operate.

Usually, the definition of the business of banking for the purposes of regulation is extended to include acceptance of deposits, even if they are not repayable to the customer's order – although money lending, by itself, is generally not included in the definition.

Unlike most other regulated industries, the regulator is typically also a participant in the market, being either publicly or privately governed central bank. Central banks also typically have a monopoly on the business of issuing banknotes. However, in some countries, this is not the case. In the UK, for example, the Prudential Regulation Authority licenses banks, and some commercial banks (such as the Bank of Scotland) issue their own banknotes in addition to those issued by the Bank of England, the UK government's central bank.

Banking law is based on a contractual analysis of the relationship between the bank (defined above) and the customer – defined as any entity for which the bank agrees to conduct an account.

The law implies rights and obligations into this relationship as follows:

The bank account balance is the financial position between the bank and the customer: when the account is in credit, the bank owes the balance to the customer; when the account is overdrawn, the customer owes the balance to the bank.

The bank agrees to pay the customer's checks up to the amount standing to the credit of the customer's account, plus any agreed overdraft limit.

The bank may not pay from the customer's account without a mandate from the customer, e.g. a check drawn by the customer.

The bank agrees to promptly collect the checks deposited to the customer's account as the customer's agent and to credit the proceeds to the customer's account.

And, the bank has a right to combine the customer's accounts since each account is just an aspect of the same credit relationship.

The bank has a lien on checks deposited to the customer's account, to the extent that the customer is indebted to the bank.

The bank must not disclose details of transactions through the customer's account – unless the customer consents, there is a public duty to disclose, the bank's interests require it, or the law demands it.

The bank must not debank a customer without reasonable notice as regulation demands.

These implied contractual terms may be modified by express agreement between the customer and the bank. The statutes and regulations in force within a particular jurisdiction may also modify the above terms or create new rights, obligations, or limitations relevant to the bank-customer relationship.

Some types of financial institutions, such as building societies and credit unions, may be partly or wholly exempt from bank license requirements, and therefore regulated under separate rules.

The requirements for the issue of a bank license vary between jurisdictions but typically include:

Minimum capital

Minimum capital ratio

'Fit and Proper' requirements for the bank's controllers, owners, directors, or senior officers

Approval of the bank's business plan as being sufficiently prudent and plausible.

Bank lobbying can result in regulations beneficial to banks.

Types of banks

Commercial banks: the term used for a normal bank to distinguish it from an investment bank. After the Great Depression, the U.S. Congress required that banks only engage in banking activities, whereas investment banks were limited to capital market activities. Since the two no longer have to be under separate ownership, some use the term "commercial bank" to refer to a bank or a division of a bank that mostly deals with deposits and loans from corporations or large businesses.

Community banks: locally operated financial institutions that empower employees to make local decisions to serve their customers and partners.

Community development banks: regulated banks that provide financial services and credit to under-served markets or populations.

Land development banks: The special banks providing long-term loans are called land development banks (LDB). The history of LDB is quite old. The first LDB was started at Jhang in Punjab in 1920. The main objective of the LDBs is to promote the development of land, agriculture and increase the agricultural production. The LDBs provide long-term finance to members directly through their branches.

Credit unions or co-operative banks: not-for-profit cooperatives owned by the depositors and often offering rates more favorable than for-profit banks. Typically, membership is restricted to employees of a particular company, residents of a defined area, members of a certain union or religious organizations, and their immediate families.

Postal savings banks: savings banks associated with national postal systems.

Private banks: banks that manage the assets of high-net-worth individuals. Historically a minimum of US$1 million was required to open an account, however, over the last years, many private banks have lowered their entry hurdles to US$350,000 for private investors.

Offshore banks: banks located in jurisdictions with low taxation and regulation. Many offshore banks are essentially private banks.

Savings banks: in Europe, savings banks took their roots in the 19th or sometimes even in the 18th century. Their original objective was to provide easily accessible savings products to all strata of the population. In some countries, savings banks were created on public initiative; in others, socially committed individuals created foundations to put in place the necessary infrastructure. Nowadays, European savings banks have kept their focus on retail banking: payments, savings products, credits, and insurances for individuals or small and medium-sized enterprises. Apart from this retail focus, they also differ from commercial banks by their broadly decentralized distribution network, providing local and regional outreach – and by their socially responsible approach to business and society.

Ethical banks: banks that prioritize the transparency of all operations and make only what they consider to be socially responsible investments.

A direct or internet-only bank is a banking operation without any physical bank branches. Transactions are usually accomplished using ATMs and electronic transfers and direct deposits through an online interface.

Informal banks: banking operations that operate entirely outside of traditional formal banking institutions. Common in many rural communities, these financial services rely on trust, personal networks or community groups rather than contracts, collateral or government oversight. While these services such as local moneylenders, peer-to-peer lending circles, and value transfer systems such as Hawala offer fast, accessible, and culturally aligned financing, they carry significant risks such as high interest rates and lack of legal protection.

In the United States

The United States banking industry is one of the most heavily regulated and guarded in the world, with multiple specialized and focused regulators. All banks with FDIC-insured deposits have the Federal Deposit Insurance Corporation (FDIC) as a regulator. However, for soundness examinations (i.e., whether a bank is operating in a sound manner), the Federal Reserve is the primary federal regulator for Fed-member state banks; the Office of the Comptroller of the Currency (OCC) is the primary federal regulator for national banks. State non-member banks are examined by the state agencies as well as the FDIC. National banks have one primary regulator – the OCC.

Each regulatory agency has its own set of rules and regulations to which banks and thrifts must adhere.

The Federal Financial Institutions Examination Council (FFIEC) was established in 1979 as a formal inter-agency body empowered to prescribe uniform principles, standards, and report forms for the federal examination of financial institutions. Although the FFIEC has resulted in a greater degree of regulatory consistency between the agencies, the rules and regulations are constantly changing.

In addition to changing regulations, changes in the industry have led to consolidations within the Federal Reserve, FDIC, OTS, and OCC. Offices have been closed, supervisory regions have been merged, staff levels have been reduced and budgets have been cut. The remaining regulators face an increased burden with an increased workload and more banks per regulator. While banks struggle to keep up with the changes in the regulatory environment, regulators struggle to manage their workload and effectively regulate their banks. The impact of these changes is that banks are receiving less hands-on assessment by the regulators, less time spent with each institution, and the potential for more problems slipping through the cracks, potentially resulting in an overall increase in bank failures across the United States.

The changing economic environment has a significant impact on banks and thrifts as they struggle to effectively manage their interest rate spread in the face of low rates on loans, rate competition for deposits and the general market changes, industry trends and economic fluctuations. It has been a challenge for banks to effectively set their growth strategies with the recent economic market. A rising interest rate environment may seem to help financial institutions, but the effect of the changes on consumers and businesses is not predictable and the challenge remains for banks to grow and effectively manage the spread to generate a return to their shareholders.

The management of the banks' asset portfolios also remains a challenge in today's economic environment. Loans are a bank's primary asset category and when loan quality becomes suspect, the foundation of a bank is shaken to the core. While always an issue for banks, declining asset quality has become a big problem for financial institutions.

There are several reasons for this, one of which is the lax attitude some banks have adopted because of the years of "good times." The potential for this is exacerbated by the reduction in the regulatory oversight of banks and in some cases depth of management. Problems are more likely to go undetected, resulting in a significant impact on the bank when they are discovered. In addition, banks, like any business, struggle to cut costs and have consequently eliminated certain expenses, such as adequate employee training programs.

Banks also face a host of other challenges such as aging ownership groups. Across the country, many banks' management teams and boards of directors are aging. Banks also face ongoing pressure from shareholders, both public and private, to achieve earnings and growth projections. Regulators place added pressure on banks to manage the various categories of risk. Another major challenge is the aging infrastructure, also called legacy IT. Backend systems were built decades ago and are incompatible with new applications. Fixing bugs and creating interfaces costs huge sums, as knowledgeable programmers become scarce.

Globalization

In modern times there have been huge reductions to the barriers of global competition in the banking industry. Increases in telecommunications and other financial technologies, such as Bloomberg, have allowed banks to extend their reach all over the world since they no longer have to be near customers to manage both their finances and their risk. The growth in cross-border activities has also increased the demand for banks that can provide various services across borders to different nationalities. Despite these reductions in barriers and growth in cross-border activities, the banking industry is nowhere near as globalized as some other industries. In the US, for instance, very few banks even worry about the Riegle–Neal Act, which promotes more efficient interstate banking. In the vast majority of nations around the globe, the market share for foreign owned banks is currently less than a tenth of all market shares for banks in a particular nation. One reason the banking industry has not been fully globalized is that it is more convenient to have local banks provide loans to small businesses and individuals. On the other hand, for large corporations, it is not as important in what nation the bank is in since the corporation's financial information is available around the globe.

There have been two significant attempts to overcome the industry's traditional focus on competing at the national level rather than the international level. In the 1980s, Citigroup and HSBC both began to develop large networks of retail bank branches in numerous countries around the world, in order to become global consumer banking brands. But in 2021, Citigroup initiated an exit from retail banking outside of its core U.S. market, while in 2022, HSBC initiated an exit from the U.S. retail market (except for its wealth management business) and then in 2023 put its retail operations in a dozen other countries under review for sale or closure. According to Wells Fargo, both banks were operating on the assumption that globalization would lead to the rise of large numbers of consumers who would regularly travel across borders for both work and play, but that "global consumer customer never materialized".

bank

Article

Notable quotes

Notable quotes

Article

Activities

Standard business

Range of activities

Channels

Business models

Products

History

Medieval

Early modern

Modern

Etymology

Definition

Capital and risk

Banks in the economy

Economic functions

Bank crisis

Size of global banking industry

Mergers and acquisitions

Regulation

Different types of banking

Types of banks

Types of investment banks

Combination banks

Other types of banks

Challenges within the banking industry

In the United States

Competition

Loan activities of banks

Investment for the fossil fuel industry

Types of accounts

Brokered deposits

Custodial accounts

Globalization