Worrying about How do Banks Make Money?

With the emergence of technology, many digital banks are trying to disrupt the banking sector. They adopted a lower cost structure with no traditional branches, relying on technology in the digital client onboarding process, and even adopted AI in handling customer services. Besides a lower cost structure, a user-friendly app with advanced user-interface and user-experience is something widely expected in order to compete with the traditional banks. However, besides adopting advanced technologies, the key features offered by the new digital banks is a higher savings and deposit rates to their retail customers.  

Apparently, no customers will say “No” to a higher savings rate, but a lot of them do have concerns over the profitability of these digital banks. It is fair to conclude that the higher the savings rate offered to the client, the higher the cost of funding. A higher cost of funding could imply lower profitability, but it doesn’t necessarily lead to a loss. To understand if a higher savings rate model is sustainable for a digital bank, it is important to understand how banks make money.  

To put it simply, banks make money by earning the difference between the return generated from client deposits and the interest paid to the client. There are thousands of ways for a bank to generate returns such as providing various kinds of loans or investing in various investment assets. As long as the return is above the cost of funding, it will generate a positive net revenue. In fact, banks can even put the money with the central bank to earn risk-free benchmark returns. For example, a UK bank can deposit the GBP with the Bank of England to earn an overnight rate of 5.25%! On the other hand, even if the bank offers an overnight savings rate of 4.25%, there is still a 1% net interest margin. 1% might look too little but with a base of 10 billion dollars, it can translate into 100 million of net interest income. Hence, it is not too difficult for a bank to make a sizable net interest income.  

In reality, banks’ net interest margin normally ranges from 1% to 3%, depending on their portfolio return against the cost of funding. For digital banks, although they have a lower cost structure, their margin might be on the low side due to the higher cost of funding that arose from offering better savings rates to their client. However, as per the above calculation, a 1% margin of a 10 billion deposit base can generate 100 million net revenue for the bank to cover other parts of the expenses.  

With the law of large numbers, the bigger the deposit base, the higher the chance of a bank to be profitable. Therefore, clients should not be too worried about the profitability or sustainability of these new digital banks. They might take time to hit the critical mass. Their profitability should not be a concern once their deposit base crosses a certain level. 

However, you might heard a lot of negative news about some of the banks such as SVB. In the end, the risk appetite of a bank still makes a huge difference in the level of profitability. We are not trying to suggest that all banks are safe, but we would like to emphasize that for digital banks with a simple deposit and investment strategy, we should not be overly worried about how they are going to make money.If the bank is covered by the FSCS, it means your eligible deposits are protected by the Financial Services Compensation Scheme (FSCS) up to a total value of £85,000 per person. If you have concerns about the Sustainability of the banks, probably you can consider enjoying a higher savings rate with GBP85,000.