A financial institution that creates credit and accepts deposits from the public is known as a bank. A bank’s lending activities are can be carried out directly or indirectly. This is done through capital markets. Banks play an important role in ensuring a country’s financial stability. However, the banking industry is highly regulated to ensure fair trade. In most countries, banks can only have liquid assets that are to a certain portion of their current liabilities. This system of regulation is referred to as fractional reserve banking.
Banks have a minimum capital requirement so as to enable them to remain liquid. This is based on capital standards set by international agreements. The Basel Accords, for example, are recommendations for regulating the banking industry.
Banks undertake a range of activities including investment banking, personal banking, money market trading, commodity trading, insurance, consumer finance, investment banking and trading in equities.
How do Banks Raise Money?
There are a number of ways banks generate revenue. These include offering financial advice, transaction fees, and interests. Charging interest is the most significant method of revenue generation in the banking industry. Interests are charged on the loans given to clients. The bank makes money from the difference between the rate of interest it pays, customers, for deposits and other sources of income, and the rate of interest it charges for loans.
This difference is known as the spread between interest rates on loans and the cost of funds. In practice, the fees a bank charges for its services and financial advice provides banks with a stable source of revenue compared to interests on loans. Other ways banks earn money include:
• Merging with Insurance Companies and Investment Houses
By merging insurance functions, investment and banking banks are able to effectively respond to consumer demands. This increases banks’ profits.
• Use of Risk-based Pricing
Banks have expanded the use of this concept from lending businesses to consumer lending. Banks charge higher interest rates to clients they consider to be a high credit risk. These clients have a high probability of defaulting on loans. This helps banks to offset losses caused by bad loans.
• Increasing Methods of Payment Processing
This is services are available to both business clients and the public. These products include credit cards, debit cards, prepaid cards, and smart cards. These products make it easy for clients to conduct transactions. Banks make money from these products through the fees charged to cardholders and interest charges.
Types of Banks
There are several types of banking institutions. They include but are not limited to:
• Commercial Banks
The term commercial bank is used to refer to a normal bank; it distinguishes it from investment banks. Today, investment banks and commercial banks can merge into one. Therefore, a commercial bank is a branch of a bank that mainly handles loans and deposits from corporations.
• Community Banks
These are depository institutions that are locally owned and operated. They are usually interested in the needs of the local families and businesses they are located. The employees of community banks live within the communities they are located. People who understand the local needs of businesses and families usually decisions on lending.
• Credit Unions
They are also referred to as co-operative banks. These institutions offer their members loans at lower interest rates compared to profit based banks. Membership is usually restricted to the staff of a particular business organization, religious organization, union members, and residents of a particular area.
• Private Banks
The assets of high-net-worth individuals are managed by private banks.
• Offshore Banks
These are banks located in jurisdictions that have minimum regulation and low taxation. Many of these banks are usually private banks.
• Investment banks
These banks guarantee the sale of bond and stock issues, make markets, trade on behalf of their accounts, manage and advise clients on their investments. They also advise businesses on capital market activities.
• Merchant banks
These are banks that traditionally dealt with trade finance. Today, these banks provide capital to their clients in the form of shares: not loans. They mostly invest in new business establishments.